Trading News Psychology

By: Adam Hamilton | Fri, Nov 26, 2010
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Overnight Tuesday, selling pressure slammed futures on the ominous news of North Korea shelling a South Korean island. What ought to have been a relatively-quiet market day heading into Thanksgiving was suddenly filled with anxiety. How would the South Koreans retaliate? Was a new war erupting?

Nothing moves the stock markets, and individual stocks, faster than unexpected news. By definition, it erupts out of the blue with zero warning. And in our exceedingly interconnected and lightning-fast Information Age, prices all over the world are affected within minutes of breaking news. The vast, vast majority of speculators have no choice but to react after much of the moves have already been made.

While often vexing, sharp news-driven moves can offer good opportunities for speculators. Although each news-driven event is different and unique, there are definitely tradable parallels underlying most of them. As I've watched breaking news unfold over the decades, moving the markets and stocks I owned at the time, a definite psychology of news has become apparent. Traders who understand it can capitalize on news-driven moves.

News moves markets simply because it affects sentiment, or how traders happen to feel. When they feel good they are more likely to buy stocks, and when they feel bad they are more likely to sell. News amplifies or dampens prevailing greed or fear, leading to more trades being made. And higher volume, especially when news has galvanized many traders into sharing a similar worldview, sometimes leads to big moves.

The collective emotions of all traders that drive most short-term market action are greed and fear. And they are not symmetrical in their impact. Greed builds gradually, as one at a time traders slowly get excited about rising markets. But fear flares instantly, as a herd traders all get scared simultaneously. Thus fear-driven plunges, big selling events, are virtually always much faster and sharper than greed-driven rallies.

Newsflow plays right into this natural greed-fear asymmetry. Unfortunately we live in a world where bad news is far more likely to be reported than good news. This certainly isn't because good things don't happen, but because bad news drives sales for the news business. Bad news scares people, leading them to spend more time seeking news. This drives up news organizations' ratings, which increases their advertising sales. So naturally, seeking to maximize their revenues, they dwell on the bad.

Human psychology is very predictable, which is probably the biggest reason why successful speculation is even possible in the first place. And news businesses understand us better than we understand ourselves. They naturally play up the fear side of stories, trying to spark our herd-oriented behavior when scared. While good news may gradually attract a trickle of viewers over time, bad news attracts a flood rapidly.

In most cases, news events don't lend themselves to simple video explanations. They are complex, so video is either not sufficient to describe them, good footage doesn't exist, or it is too gory to show on the air. So news organizations all call in experts to help us unwashed masses better understand and interpret what is going on. And this expert testimony is riddled with conflicts of interest that inevitably exacerbate the natural fear and anxiety we feel.

News is a very competitive business, especially in this hyper-connected Information Age. We all have endless options for getting our news, from the internet, to television, to radio, to newspapers and magazines. And all these outlets are competing for a very finite pool of advertising dollars. Their ratings, and hence their sales potential, only improve when they can win viewers away from their competitors.

So when news organizations seek experts to help us understand breaking news, they tend to gravitate towards the most extreme and flamboyant. They find the guys spinning the absolute worst-case scenarios, the scariest-possible outcome for any crisis. The worse we viewers think an event will play out, the more time we will spend seeking information on it. You know it's true, we all do it all the time!

Knowing that news organizations are looking for the scariest, most-pessimistic experts, the experts themselves play into this expectation. These experts are either businessmen or academics, and every single one lusts for free publicity. The more widely-known they become, the more business they can drum up or the more grants and respect they can earn. So when they get a call from a news producer, they know darned well they better not downplay the crisis du jour if they want any precious airtime.

These incentive traps dominate the whole news process, which leads to any event inevitably initially being considered in worst-case-scenario terms. It happens every single time, even in relatively trivial events like severe storms. And this is the key to trading news psychology, realizing that the endless worst-case scenarios spun around emerging news never come to pass. The reality is never anywhere near as bad as the initial fears, which are manipulated by ratings-hungry news businesses.

The examples are legion, I could write a book about just the ones in recent years. An older one that really caught my attention relative to trading was the Kuwaiti oil fires lit by the Iraqis in early 1991. Before being driven out by Washington's invasion, Iraqi soldiers engaged in a literal scorched-earth retreat by igniting about 700 of Kuwait's oil wells. At peak, these were consuming an estimated 6m barrels of oil a day. At the time, this was the equivalent of over 9% of the entire world's daily oil consumption! It was scary.

Experts came to the media in droves, each trying to outdo one another's alarmism to maximize their moment in the limelight. They claimed it would take at least 5 years to put out most of the fires, and that some burned so hot and dangerous they would simply have to flare for decades until their feeding oilfields were depleted. Carl Sagan, the famous scientist, predicted a new "nuclear winter". He said oil smoke in the upper atmosphere would reflect so much sunlight that we faced massive agricultural failures and famines globally. He likened it to the super-volcano Tambora's eruption in 1815!

What came out of all this initial pessimism and alarmism? A whole lot of egg on experts' faces! The elite hellfighters who put out oilwell fires were able to extinguish every single well the Iraqis set ablaze in just 9 months! This was obviously just a tiny fraction of the time the experts had predicted. And though wellheads were destroyed, Kuwaiti oil production rebounded far faster than any of the experts had anticipated.

How about the 9/11 terrorist attacks? At the time, experts predicted an endless wave of new terrorist attacks on US soil. As usual, the most-extreme experts who could spin the scariest scenarios commanded the most airtime. They wanted to maximize their media exposure to expand their business or academic notoriety. Yet more domestic terrorist attacks didn't happen, the terrible strikes of 9/11 were a one-off event as all crises are.

If these events have faded from memory, consider last summer's BP oil spill. Holy cow! For months it was all we heard about on any media outlet, the furor was deafening. An endless parade of experts was marched in front of the cameras, making outrageously-pessimistic claims. The blowout could never be capped, it would turn the entire Gulf of Mexico into a sea of toxic sludge, the beaches would turn black with crude, the sun would overheat the oil-stained waters and spawn super-hurricanes, etc.

Yet even at the time, the reality of that spill was nothing like the perceptions the media fostered to generate anxiety and hence ratings. News crews would literally search the coastlines for weeks before they found a single oil-soaked bird to exploit. The truth is the amount of oil leaked into the Gulf of Mexico, despite seeming large, was utterly trivial compared to the vast volume of water in that huge basin. A similar-sized oil spill occurred off the coast of Mexico in 1979, yet it didn't taint the Gulf for decades to come.

In the markets, pure financial events are treated the same way by the financial media. It lives and dies on ratings as well, so it too often seeks the most extreme experts to promulgate the most pessimistic scenarios in its quest to drive ratings. Remember the euro panic last spring? Experts claimed the debt crisis in Europe was so bad that the euro would continue plunging through parity with the dollar. Of course it never even came close, as the euro-to-zero trade was totally emotional and irrational.

How about that Hindenburg Omen scare in August? That was hilarious. An unreliable obscure indicator with an ominous name became mainstream news. Traders were scared and they wanted their fears justified rather than starting to think rationally. Upon a little investigation, it turned out the Hindenburg Omen was a total joke. It had successfully forecast 25 of the last 2 crashes and panics over the past 25 years! Even the Wall Street Journal reported "significant" market declines only occurred 25% of the times after this indicator triggered. Yet somehow it was big news.

With worst-case scenarios always assumed up front, or at least early in any news event, the initial selling is always overdone. Prudent speculators can really capitalize on this, as we have done often at Zeal. When everyone is scared and expecting the worst, stock prices are knocked down to unsustainably-low levels. Once you understand news-psychology-driven fear peaks early, you can really capitalize on it.

Recent examples abound, which we traded for big profits. In June and July when the news organizations were suggesting American oil production might never recover, we were aggressively buying cheap oil stocks. The result? Our subscribers bought a bunch of oil stocks then that now have unrealized gains running as high as 70%! We also aggressively bought oversold commodities stocks around that Hindenburg Omen scare, and have enjoyed massive gains since.

Interestingly this news psychology applies the same way to individual-stock news. When an event first hits, news organizations look for experts who believe the direst scenarios. These experts invariably influence traders' opinions in those initial days of confusion when everyone is trying to evaluate the event. So stocks experiencing bad news usually see their prices driven down the farthest soon after the news breaks. But time always restores reason and sanity, so their prices soon start normalizing.

This leads to another critical point on news psychology, the half-life of any attention-grabbing crisis is unbelievably short. The things everyone was nervously fretting over last spring and summer have been totally forgotten. In a few weeks today's crises du jour, like the Korean skirmish and the Ireland debt fears, will also be forgotten. Unfortunately we have an incredibly-short attention span, which is a key reason why news organizations have such an easy time manipulating our fear and anxiety for ratings.

So trading news psychology is pretty easy. Early on in any news-driven selloff, realize that the experts' predictions (which are going to be worst-case since the media chooses which experts to interview) will never pan out as feared. All the anxiety generated leads to emotional selling, which is always overdone. So speculators looking to capitalize on news psychology should buy early when much uncertainty remains, hence prices are the lowest. As the collective understanding improves of the true magnitude of a situation, stock prices soon normalize and big gains are won.

A corollary exists on the sell side. If you happen to own a stock crushed by unexpected news, it is usually foolish to sell it during the emotional initial trading. All that does is guarantee you get close to the worst-possible exit price. If news hammers one of your positions, hold on to it for a few weeks before selling. Even though you probably won't regain the pre-crisis price, you will usually get a much-higher exit after that initial media-driven fear spike abates and traders start viewing the situation more rationally.

At Zeal we've studied market psychology extensively, because collective greed and fear are the biggest drivers of short-term price action. We always help our subscribers understand where sentiment is on the greed-fear continuum, and how they can best trade it by fighting the herd's emotional extremes. This contrarian approach has helped produce some amazing gains for our subscribers. Over the past decade, all 222 stock trades we've closed in our flagship Zeal Intelligence newsletter averaged annualized realized gains of +43.2%! Subscribe today, start capitalizing on the herd's irrational fear!

The bottom line is news-driven psychology is very predictable. In order to improve ratings and thus advertising revenues, the media seeks out the experts with the scariest views on an unfolding event. The experts play into this, as they desperately want the media exposure to advance their own careers. The result is an alarmist and pessimistic initial take, sparking excessive fear. Traders react with kneejerk selling, pushing prices much lower than the reality of the situation warrants.

But as time passes, it always becomes clear that the crisis is nowhere near as dire as the early experts suggested. People are far more resilient than the media gives us credit for, we accept our misfortune with stoicism and then immediately get to work fixing problems and rebuilding. As the initial irrational fears fade, prices gradually start rallying back towards pre-news levels. We can capitalize on this behavior.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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