Emotional Markets

The Yahoo Finance site redeemed itself a little this weekend with an article reporting on the reaction of the stock market to a big single-day sell-off. 

Long time readers will know that in genuinely tradeable sports (those with relatively frequent scoring such as basketball and cricket) the market frequently overreacts to short term scoring streaks (I wanted to say runs, but with cricket mentioned, that could be confusing). 

Almost six years ago, I wrote:

Now clearly there are times when 1.07 is value, and I would not agree with Ian that 1.07 or any short price should be avoided simply because it is short (as his comment implies), but in the in-running events that I mainly follow, the value is more often on opposing the market than on chasing the price down.

It's actually quite comical at times. A team is say 1.7 and tip-off, and they open up strongly. Two minutes into the game as they open up a lead, and the price drops through 1.6 and panic sets in. Money appears to back at 1.59, but the price drops and the same money comes in again at 1.5. It's clear that someone wants in without regard to the value. A lay at this point is often rewarded.

I have written before, more than once, about how the strategy of laying the NFL team that has just scored a touchdown (in many game situations) pays off time and again. The market wants to get on, the price is driven too low, and the market realises it and the price moves back. Put a lay in before the touchdown a few points below where it will rebound to, and if you watch enough games and price it right, you will get matched almost every time. There's also the occasional bonus of an apparent touchdown being called back due to a penalty being called, and when that happens it's a nice bonus.

But back to the NBA. A team has a run, and the market goes into free-fall, but runs don't go on for ever. One time-out, a score, a stop and another score, and the lead can suddenly be down by six. Depending on the game situation, this can result in an enormous swing in price.

I actually find these swings much easier to trade in basketball than in football, American Football, or baseball, in big part because the swing is so fast. Too much time to think can be a handicap in trading. It takes time before you can oppose the leader and hold your nerve, and it can be hard to do. The thing is though, that it's precisely because it's hard to do, that the opportunity exists in the first place. Most people feel happier to be on a leader, and will buy in at (seemingly) any price.

And as Brian wrote in his 2013 blog review:

Cassini champions trading in play particularly on team sports with markets that have good liquidity but that are far from the most popular. His favourites are Basketball and NFL and he makes no secret of the fact that his strategy largely involves laying low when a market shows signs of greed.

As the Yahoo Finance article makes clear, and as is the case with trading sports, each instance 'comes with unique circumstances', but fear and greed are emotions that most people find difficult to control, and it is this weakness in others that gives those of us able to control our instincts, a persistent edge.

My first personal experience of this was back in 1987 when I was working in the City of London, and after an unexpected long weekend due to The Great Storm of 1987, Monday 19th October saw the FTSE 100 drop 10.84%. I quite clearly remember justifying my decision to myself that night to buy more shares the next day since they "obviously" couldn't go down much more, only to see Tuesday 20th October's FTSE 100 drop another 12.22%. Lesson learned!   

The Yahoo Finance article by Sam Ro in full:

In the history of the stock market, some of the best buying opportunities occurred after sharp sell-offs, with some of the single best days following the single worst days.

Adviser Investments’ Daniel Wiener reviewed the performance of the S&P 500 - via the Vanguard 500 Index Fund — to see how the stock market did in the year following one-day sell-offs of 3.5% or more.

“Looking back over more than three decades and focusing on Vanguard’s 500 Index fund, which has long been the easiest way to ‘buy the market’ there’ve been 53 days when the fund has dropped 3.5% or more in a single trading session,” Wiener observed. “Those days have tended to be great buying opportunities as the average one-year return following a big single-day drop has run 21.1%!”

As with most stock market patterns, the track record isn’t perfect. But it’s impressive.

“Investors have only seen negative returns in 10 of those years, so the likelihood you’d make money one year after a 3.5% or greater drop was better than 81%,” he said.

There are a million things that can be said about why this happens. Of course, each of these 53 instances come with unique circumstances. And there’s also plenty to be said about the frequency in which these swings occur with the advance of algorithmically-driven trading.

One thing to highlight is the presence of psychology and behavioral biases in the stock market. Indeed, when the market gets riled up, traders and investors often push prices too far in either direction creating opportunities for contrarians willing to go against the herd.

“The next test?” Wiener said. “June 24, 2017 which will be the one-year anniversary of the June 24, 2016 one-day wonder when the S&P 500 index dropped 3.6%.”

June 24 was when the UK unexpectedly voted to exit the European Union. The stock market has already recovered those losses and then some.