interesting article on life cylce of a crisis

Welcome to the Market Psych Report A key factor in investing success is the ability to recognize what other investors are thinking (Bruguier et al, 2010).  The MarketPsych Report analyzes the mind of the market using our proprietary  sentiment software.  Our software performs language analysis and quantifies specific sentiments (such as fear and excitement), topics (such as management changes and layoffs), and tones (such as uncertainty and urgency) in investors' online comments, the financial news, and  executive interviews.  This language data powered our outperforming MarketPsy Long-Short Fund LP, and we are launching this newsletter to share our accumulated insights with the investment community.  Readers will find investment recommendations and trading insights to help grow their bottom-line.  Today's edition focuses on optimal trading strategies after unexpected catastrophes like the recent Japanese earthquake.  We hope you enjoy! The Market Psychology of Natural Disasters At 1:40am on March 11, 2011 federal tsunami warning radios bleeped to life along the Pacific coast of the USA. The voice on the radio reported an earthquake off Japan and warned of a tsunami estimated to arrive in Santa Barbara at 8:24am and in Santa Monica at 8:39am. This tsunami was the direct result of the largest earthquake to ever hit Japan, and the fourth largest to strike the earth in recorded history at 9.0 on the Richter scale. Dr. Richard L. Peterson MD +1 (310) 573-8523 info@marketpsych.com   April 6, 2011 Report No. 1

 

That morning TV viewers watched a 30 foot wave washing over coastal villages in Japan.  Entire towns were lifted and crushed by the wall of water. Given that Japan is the third largest economy in the world, you might think that U.S. traders and investors would rush to sell risky shares, buy puts, hedge, or reposition until they could make sense of the damage. Not so.  By the close of trading on Friday March 11, 2011, the Dow Jones Industrial Average was up 60 points for the day. What were investors thinking? This question, and the opportunities it creates for investors, are discussed in today's MarketPsych Report.  An image of our MarketPsych Fear Index, showing the spike in investor fear due to the Japanese radiation scare, is below.

 

Bullish Sentiment and Momentum The Japanese earthquake occurred in the context of recent middle eastern instability.  Even as the governments of Tunisia and Egypt were overthrown by popular revolution in January and February 2011, the S&P 500 continued to move higher (represented as the blue line in the 9-month chart below). Investors' lingering negative sentiment - a hangover from the financial crisis - declined to pre-crisis levels in 2011.  Investors were expressing very little negativity about the economic recovery or the future of stock prices, and, overall negativity expressed in investor conversations (measured in social media) reached a 9-month low in mid-February 2011, as depicted in the chart below. Unfortunately, a monumental amount of energy was about to be released in an earthquake beneath the waves off Japan's northeast coast.

 

Chart of S&P500 (SPY) Blow-off Top

 

Uranium Stock Investors Anxious after Core Meltdown Following the shock of the Japanese earthquake and tsunami, most investors' initial reaction was one of denial.  The bad news was thought to be isolated.  However, over several days fears of radiation release grew, leading to investor panic. Particularly hard-hit in the panic were Uranium stocks such as Cameco (CCJ), a Saskatoon-based Uranium miner and nuclear power generator.  Fears of increased regulation and slowed approval of nuclear power projects frightened CCJ investors.  But as I noted above, investors had a few days to exit Uranium stocks prior the meltdown in their share prices:  see the "Sentiment hits new lows before price tumbles" comment in the CCJ chart below.   Observing the column on the right side of the CCJ chart below, you can see a list of "Language Alerts."  Language Alerts represent a large surge in a particular sentiment or topic in investors' conversations.  in this case, high levels of anxiety were being expressed by CCJ investors in mid-March. This is expected given that the future of the company is now less secure.   "But I'm a contrarian," you may be muttering to yourself, "does such high investor anxiety mean I should buy Uranium stocks while other investors are panicking?"  Short-term perhaps, long-term no.  The reason not to buy in this case is that 1) Investors' fears are grounded in a real shift in fundamentals, and 2) Investors who bought at the top will gradually turn sour as the price does not recover, and their selling will create a cap on CCJ's long-term price recovery. Ironically, in the CCJ chart below, you can also see that both flags B and C (investors discussing a share buyback) on the red line correspond with the price peak.  Wishful thinking for a stock buyback is symptomatic of investors' excess optimism (a contrarian indicator of a top). Preceding the bull run in the below CCJ chart is a series of positive sentiment spikes.  When a series of good news events occurs in succession, investors create a new mental "set-point" of where they think the stock price should be ("going up!"), and positive price momentum often ensues, pushed by optimism-fueled buying.

 

Commentary: The Market Psychology of Unexpected Disasters As can be seen in the CCJ example, It wasn't until Monday March 14, and again on Wednesday March 16, that investors reacted to the risks - such as radiation - that had emerged from the Japanese earthquake and tsunami. "What took them so long to wake up to the risks?" is a fair question to ask. Below I explain the psychological stages which drive investors and financial markets after unexpected events such as natural disasters and terrorist attacks.  The psychological response to such events follows three stages. Stage 1: Underreaction.  In this stage people don't realize the scope of the disaster. They believe the stock rally will go on as is, and they believe the official assessment of the situation - that all are safe.  This is a good time to be skeptical and to sell or short. Psychological Driver: Cognitive Dissonance and Denial. People have trouble processing new information that is out of their comfort zone. They need time to reconcile new facts with their established habits and beliefs, especially if they do not feel an immediate ongoing threat. Stage 2: Reaction. . Investors realize that significant dangers have emerged, and they take action. The Nikkei drops 14% in one day. The S&P 500 sheds its 2011 gains. This occurred in the second and fourth trading days after the earthquake. Fund managers sold the stocks of companies that were likely to be impacted negatively by supply disruptions and bought shares of those likely to benefit. Psychological Driver: Rational Reappraisal and Arousal to Action. We incorporate the new facts, and revalue securities accordingly. Stage 3: Overreaction.  This is where the situation gets interesting. Uncertainty and fear color investors' assessment of the facts.  Due to rapid changes in the nature and immediacy of potential threats, investors indiscriminately unwind their risky positions.  Stress hormones narrow investors' abilty to see long term, and they begin to follow every news announcement with increasing worry.  Stocks sell off, Potassium Iodide (KI) sells out off store shelves in California, and people sell their stocks because prices are dropping and the situation is unclear.  This is when indiscriminate risk selling occurs.  Psychological Driver: Fear, uncertainty, and feeling out of control. Radiation cannot be seen, is widely feared, and may spread beyond Japan. Perhaps most worrisome to investors, during the crisis there was no trusted authority who could explain the facts coherently - the Japanese government appeared to either not understand the situation or to be trying to prevent panic by hiding the true impact of events. All of those factors led to loss of trust and overreaction.  Such overreaction usually occurs about 4-5 days after a crisis and is seen as panic, when all risky assets are sold and safe assets are hoarded (even iodized salt sold out in many parts of China).  Real investment bargains emerge at this time.  it was a good time to buy Japanese construction and insurance stocks. While we've explained the stages of such a crisis, and the opportunities that emerge in each, our thoughts are with the victims in Japan.  We extend our sincere condolences to all whose family, friends, or lives have been affected by this terrible series of events.