Psychoanalyzing the Market

Author:
Publish date:

Psychology has a huge impact on prices of financial assets, yet the concept is tough to quantify. When looking at the available indicators -- put-call ratios, bull-bear surveys and the like -- it's useful to have a good theory of why psychology is important and how specifically the psychology of investors might translate into a useful predictor of price direction.

Psychology can lend a clue to the ownership profile. In fact, I think, psychology is

only

important when helps determine the ownership profile. By making this distinction, we can build a theory that works for all investors -- contrarian, momentum, quantitative, fundamental and technical.

The ownership profile is the relative size of owners versus nonowners. As you can see from the schematic below, the relative size of these two camps translates readily into the potential number of sellers and buyers.

As incremental information is disseminated in the market, the investment pools of current owners and potential owners leak into each other's area and move trading prices. Unfortunately, the next incremental piece of fundamental news can be very hard to predict.

The ownership profile, on the other hand, can be observed directly. If investors would simply reveal their holdings, we'd all have an edge on the number of potential buyers and sellers. Of course it doesn't work that way, and information on holdings is jealously guarded. As a result, the ownership profile is often best inferred from a reading of investors' current psychology.

When psychology is negative, it often indicates widespread underownership and a surplus of potential buyers. This is the contrarian viewpoint. Positive psychology for the contrarian is a negative indicator, reflecting overownership and a surplus of potential sellers.

Allowing the ownership profile to take precedence over a reading of psychology allows us to extend the theory to momentum investors, where positive psychology is often viewed favorably. If a stock has an underowned ownership profile, as is often the case with new (the N in CANSLIM) investment ideas, positive psychology simply hastens the shift in investors from nonowners to owners.

Ted Murphy (

ted@pdgm.com) operates the

MarketPlayer Web site. Previously he was a partner at Equinox Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.