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Sentiment Analysis: How Investor Perception Drives Market Prices

InvestorEducation / Learning to Invest Apr 12, 2008 - 11:51 AM GMT

By: Money_and_Markets

InvestorEducation

Best Financial Markets Analysis ArticleJack Crooks writes: Topsy-turvy markets like these can easily make your head spin. I mean, we're currently dealing with overdone trends, implosive fundamentals, government regulation and an increasingly globalized world economy.

And as if simply understanding those complex dynamics wasn't enough, we still have the difficult task of trying to make money.


Often times, when there's so much going on it makes sense to step back to a more basic approach — one grounded in human nature. This may actually be your best bet in making money in the long-run.

In this issue of Money and Markets , I want to focus on one key point that, if properly understood, may well increase your trading profits during the next eight months, and beyond. I'll also tell you about two popular trading systems.

Let's start with this simple premise ...

Prices are Driven by the Ever-Changing
Perceptions of Buyers and Sellers

Conflicting ideas between traders exist at all times, everywhere. That's why it is said that markets are grounded in human nature. And remember, it takes disagreement over value and price in order for a market to exist in the first place.

The following illustration is a perfect example of this tug-of-war playing out in the currency markets.

The U.S. dollar was suffering on Thursday morning ... again ... and breaking down below critical support levels.

But the price action was merely a head-fake, to suck in short sellers, before a sharp dollar rally that would knock them upside the head and force them to cover their shorts.

We've been presented with many similar situations in the past few years. And every time it seemed as though the dollar succumbed to market pressure and quickly pressed even lower.

But sure enough, the buck staged a mighty reversal this time.

Of course, it goes without saying now that some traders have been handed their losses, the dollar's next leg lower is probably soon to come!

Rational? Of course not! But the turbulent price action in the dollar does sum up exactly the point I am attempting to get at ...

Markets NEVER Behave Rationally

After so many years in the markets I've developed a few pet-peeves. At the top of that list is when I hear someone say "The markets are acting irrationally."

Well of course they are. Markets never behave rationally — never. How can markets be rational when humans create markets and humans are irrational? Market prices are based on an expected future based on assumptions that are always flawed because the future cannot be forecasted. The best that can be said is that there are "degrees" of rationality in the market.

Some people seem to think that prices are event driven. In other words, economic releases and news events are always what cause prices to move the way they do. In actuality, the people who believe this are wrong.

For instance, if IBM were to report better-than-expected earnings, its share price will go up, right?

Not necessarily. Its share price may go up, but it also may go down!

The price action depends on how the players trading shares of IBM feel about the current earnings report, future earnings forecasts, current market environment, their personal financial situations and so on and so forth.

Traders and investors' reactions to events and fundamentals drive prices. Real people move real money based on the difference between expectations and reality.

Without differing perceptions we could never have a dynamic market. And for that reason, strategies have been developed in hopes of harnessing these perceptions. One of them ...

The Dow Theory:
Three Phases of Price Movements

Charles Henry Dow developed a series of principles for understanding and analyzing market behavior which later became known as Dow Theory.
Charles Henry Dow developed a series of principles for understanding and analyzing market behavior which later became known as Dow Theory.

The Dow Theory, as credited to Charles Dow, was created after a gathering and analysis of numerous editorials written by him, and further explained and improved upon by William Hamilton, and finally culminating in a book titled, The Dow Theory , written by Robert Rhea.

The Theory is made up of six major tenets. In an effort to explain the make-up of major trends within markets, one of these tenets outlined three phases of price movements within a primary trend. (The phases, as described below, refer to a primary uptrend.)

Phase #1 — Rebound and Accumulation

After a primary downtrend expires, enter the smart money. Beaten-down prices slowly recover and buying interest grows. The primary uptrend builds from this turning point.

Phase #2 — Public Participation

Fundamentals begin to brighten and investors begin to feel that prices need to go higher. The public gets in on the action and powers the uptrend. This accounts for the largest and most rapid change in price.

Phase #3 — Speculation

This is the last hurrah for the primary trend. At this point, the only thing driving prices higher are those investors giving too much credit to lackluster fundamentals. The speculators are left buying even when conditions aren't necessarily improving.

The three phases make up basic stepping stones that help in understanding how investor sentiment drives prices. Charles Dow noticed that markets tend to move in an orderly fashion, repeating the same patterns over and over again.

But Dow wasn't the only market follower who attempted to dissect the role of sentiment on markets. Ralph Nelson Elliot sought to develop a systematic approach to analyze investor attitude.

Elliot and His Wave Theory

The process Elliot developed would eventually be known as Elliot Wave. And while a perfect understanding of Elliot Wave is complicated, there are a few simple ideas that can guide you in analyzing market sentiment.

First , there are impulse and corrective waves that make up a trend. Impulse waves steer the trend, i.e. they move in the same direction as the primary trend. Corrective waves are a response to impulse waves and retrace pieces of the trend, i.e. they move against the primary trend.

Second , these impulse and corrective waves typically join together to produce a 5-wave pattern. Now, I'm not going to force-feed you the monotonous information required to understand wave construction and formation, but I do want to visually share with you the most basic 5-wave pattern.

Basic 5-wave pattern

In this basic pattern you can also find the three phases described in Dow Theory as I mentioned earlier. I've overlaid them on the same basic 5-wave pattern in the following graphic:

Dow Theory

Needless to say, there's something to this. But again, I want to drive home the point that however complicated all this technical analysis might appear, it's all based on human nature. In fact ...

In the Endgame, Understanding Investor Attitudes Is Critical

I firmly believe that keeping a pulse on investor attitude is hugely important. Perhaps more important than knowing how much profit Google reeled in for the fourth quarter, or exactly the rate at which the Japanese economy grew in 2007.

So how does all this apply to the turbulent price action we witnessed in the U.S. dollar this past week? Well, I tend to believe we're very near a critical turning point.

Let me leave you with this weekly chart of the U.S. Dollar Index. This chart captures the most recent major down leg of the dollar bear market that began all the way back in 2002. Is 'Wave 5' close to wrapping up? It sure looks like it to me!

Best wishes,

Jack

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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