Woody Dorsey has been writing Market Semiotics from the rural remove of Castleton, Vermont since 1985, for an increasingly addicted, if not-exactly immense, coterie of a very special subset of institutional investors – ones who haven't swallowed the efficient market theory hook, line and sinker.
But Woody, and the iconoclastic brand of behavioral market research he's developed over the years, are about to burst before a larger audience when Texere this spring publishes "Behavioral Trading," his just-finished book. It is as if, like a well-aged Bordeaux, says Woody, he is ready to be consumed in prime time. And why not? If a behavioral psychologist can be awarded the Nobel Prize in Economics, a behavioral trader deserves a hearing. -KMW
Just what is "behavorial trading," or "market semiotics?"
Essentially, semiotics means diagnosis. In a way, it refers to what everybody's trying to do-diagnose the market or figure it out. Originally, the ancient Greeks organized their thoughts on medicine into what they called "semiotics," or a way of looking at their patients' symptoms and categorizing or deconstructing medicine.
Isn't it more often used these days in the analysis of language?
Yes, but I was introduced to the word when I came across the work of Harvard economist Joseph Schumpeter, who is famous for articulating the theory of creative destruction in the tomes he wrote about the business cycle. Schumpeter said, "Look, we're trying to figure out the business cycle, the capital market process. So just like the Greeks did, let's come up with a symptomology. Let's look at trade, capital flows, interest rates." In our case the patient is the capital markets.
Your ideas have evolved into a contrarian approach to the markets that depends very heavily, I gather, on proprietary ways you've developed to measure sentiment?
Well, that is just one aspect of what I've come to call "the tri-unity theory of finance." It's a new dimension within the behavioral finance school. My theory is basically that the market is really a three dimensional entity that is composed of the fundamentals, the technicals and what I call the psychologicals, or the psychological component of the market. And you really need all three. They're basically broad classes of symptoms-that interact. For instance, a year or a year and a half ago, people were saying that the Fed was easing and therefore that the stock market should go up. But that's not what happened. From my perspective, the rate cuts were a fundamental symptom, but not the only thing at work. Sometimes, the fundamentals are very good at explaining the situation. Sometimes they aren't. Sometimes certain technical indicators provide a very good point of view on the market. At other times, they're off-base. But there are also the psychologicals-the mood component of the market. They are the pith of behavioral finance-this acknowledgment that markets have an irrational component. I believe that behavioral finance is in the place that efficient markets theory was about 40 years ago. My book, I hope, will take us to the next step: The conclusion that the markets have a psychological dimension. Of course, Greenspan has spoken about this often, as has Robert Rubin. And there are others, of course, who have been in the market for a long time, who realize that there's a psychological aspect to it.
We've recently had one heck of a demonstration.
Exactly right. That's what's so fascinating about this time-investors have had a firsthand experience, which not all investors throughout history have had, of the tremendous psychological aspect of the market.
That psychology affects markets is just plain common sense. They are auctions, after all. People do the bidding and asking.
Absolutely. Yet there is still this big disconnect. When you visit lots of the rank and file on Wall Street, as I do, you find that they are hesitant to break away from adherence to the efficient markets hypothesis. It's not that if you ask, "Gee, do you believe in the efficient markets hypothesis?' They wouldn't respond, "No, not really." But they are still basically investing under the influence of that thought process. Even though, when you simply look at the facts, it's not a good description.
An enormous institutional infrastructure, for lack of a better word, has been built around the theory that the markets are efficient.
Sure, there are many aspects of the bull market and of the development of the mutual fund industry that can be attributed directly to this idea that it's an efficient market. The idea that the market is going up, so buy and hold. That you can't time the market. So you should buy regularly, buy often.
Hop on an index and enjoy the ride.
But now we're seeing the converse. What I call the return to a professional's market. And, if the business cycle is working, the inference is that we are in for very choppy difficult markets for a while. Another is that the mutual fund industry will suffer. In its place, I think that hedge funds, which are being renamed "alternative investments"-will develop into an industry not exactly unlike the mutual fund industry. Wall Street culture is always a reflection, of course, of what is happening in the markets. We have just had an almost 20-year bull market, which was also the epitome of the efficient markets notion, with the proliferation of mutual funds and the ascendancy of indexing. Now there's something else going on. We're in a different environment. The new burgeoning paradigm is behavioral finance.
What makes you so sure?
There are certain hallmarks, like the fact that [Princeton Psychology Professor] Daniel Kahneman won the Noble Prize in economics. He is a leading behavioral finance guy. It's sort of like when the work of Paul Samuelson was acknowledged early in the previous era. Another was "Wrong-Term Capital." They had the smartest guys in their fund, on their board, advising them. They really felt that they had the answer based on efficient market theories. Yet they lost everybody's money. That was a signal moment.
These supposedly very bright guys insisted on using a theory despite plentiful evidence that what the theory said couldn't happen in fact does occur with staggering regularity in the markets. Big fat tails swat investors in the fanny with startling frequency.
Absolutely. What I wrote is that it is like the invisible hand comes along once in a while to spank the markets. The inference is be on your guard because you know these events are going to happen. When they do, those big fat tails provide the biggest and best opportunities to safely build capital; that's when you take advantage of market opportunities. That's the lesson. What I'm postulating is that this return to behavioral finance has broader implications. The first is that we're all human beings. So investors can be wrong. We make mistakes; we are fallible. We are even prey to systemic cognitive errors.
A very hard lesson-especially for a master of the universe to swallow!
Not only that, it is the opposite of what the efficient market theory says about investors-that we are perfectly rational, perfect utility maximizers. My subtext is that this is about a return to humanism. Efficient market theory is basically saying the high math is all that matters. So behavioral finance is self-empowering in its acknowledgement that there's a humanistic quality to the markets. The markets are made up of people.
Indisputably. And their collective decisions sometimes go to extremes. Not to mention can be as inscrutable or irrational as their makers.
This is exactly true. The other inference is: If we have gone from a mathematically modeled investment universe to one that incorporates fallibility, we are never going to develop a model that will provide perfect answers. So one of my tenets is that I don't have a model or a system. It always shocks people when I tell them that.
No kidding. Then what are you trying to sell?
What I tell clients is that there are provisional answers. In other words, you can know what the market is going to do some of the time. If you also can realize when you know what you know-and what you don't know-you're ahead of the game because there are no absolute answers. Nothing is ever going to predict the stock market all the time. It's patently absurd that people go to school today and are taught that if you find the right variables and you put enough of them into your formula, you're going to figure it out.
So you're offering almost the exact opposite of the neatly wrapped solution most folks want.
True, but I've had a very hot hand in the market lately. That keeps people calling and asking what is going to happen next.
Everybody wants a guru.
Of course what they don't like is that I am willing to say that I have no idea. But it is really the way the world works. You know, because you know people who've been successful professionals in the markets for a long time, that they owe part of their success to being intellectually flexible enough to recognize that they've maybe been wrong about an investment position or stance-and to change it. Instead of sticking stubbornly to some model or rule book-or the notion that they're invincible.
They tend to make a lot of mid-course corrections.
The curious thing is that once you embrace the tenets of behavioral finance, you're also admitting that you're going to be wrong. And you recognize the importance of trying to understand errors. In fact, one of the things that I talk about from time to time is that everyone is too focused on getting the "right" answer and on discovering what I typically call the flavor of the month. My view is that instead, what you want to understand is the error of the month. Because it's only by understanding errors that you can discover opportunities.
Explain-
I'm never going to be smart enough to tell you what GDP is going to be next year. I'm never going to know exactly what IBM's earnings are going to be a quarter from now. But what I do know for sure is that the history of the markets shows that they go to extremes and that people get it wrong. So if you can identify when those mistakes are being made, you can do the opposite-and be right. It's not that you will necessarily know more. It's almost because you know less.
Okay, but how do you translate that into any sort of useful approach to the market?
In the first place, by not usually talking about my philosophy in my reports. By focusing instead, on what the markets are likely to do. I also started a hedge fund, Semiotics Capital Management, about a year ago with a fellow who employs my investment ideas from a relatively short-term point of view-in part, to prove that behavioral finance can be made practical-and we were up 30 percent last year.
You study the market in 3-D, you say, along fundamental, technical and psychological dimensions. Is it safe to assume that when you say technical or fundamental you mean pretty much what everyone else does?
No. What I mean by "fundamentals," is slightly different than what most people mean. To me, the fundamentals are all the things that people think about the market – as opposed to feel about the market. What they are feeling are the psychologicals. Maybe its clearer if I use another term to explain the fundamentals – I also call them transient investment themes.
The curious thing, again if we look at history, is that the most wonderful fundamentals in the world always end up becoming not so wonderful. In other words, they have a life cycle. So, to take a prominent recent example, the investment theme of the Internet being a wonderful technological development and huge market opportunity worked splendidly for three or four years-then it became a terrible idea. Of course, it was a big macro notion, but what creates major market extremes is everyone thinking the same way because there is an extremely cogent idea in the market.
The trick, clearly, is figuring out where you are in the life cycle.
What I've come up with is that each investment theme progresses from not many people knowing about it to basically becoming a slogan. And when it becomes a slogan, that's a symptom-getting back to my semiotics-that you're approaching some kind of an extreme. That's why I wrote an essay in late 1999, for instance, saying that we were approaching what I called e-greed. You had this phenomenal idea abroad in the land that it was very easy for anyone to become rich by borrowing money and buying dot.com stocks. When an investment theme gets translated like that into the vernacular-into a slogan-it's a strong signal that you're approaching an extreme.
Okay, but how do you tell when something shifts from theme to slogan? Much about the Internet theme seemed bonkers several years before it peaked.
That is what is difficult-and where some of my other tools help. Some of the most important are the mood components, what I call the psychologicals. We know from history that at every great stock market extreme, let's say at great price highs, it is always true that people feel very bullish. They're very optimistic. Conversely, at every great price low, people are terrified of stocks. They're very pessimistic. As a principle, this is true, and it always will be true because people make up the markets. What we want to do is find ways to gauge this mood component. And that's why I've set up a daily polling process to gauge both stock market and money market sentiment.
There are lots of sentiment indicators.
But what I've developed, I obviously think, is the best. We basically use about 100 listening posts to tell us, very simply, whether people are bullish or bearish. This isn't data that is all that difficult to gather. What is important is how we interpret these readings. One of my principles is that it's not so much the raw reading on sentiment today that's important, but the history or trend of sentiment. In the same way, from a diagnosis point of view, that if I call my physician to say I'm not feeling well, and tell him that my temperature today is 99, he doesn't know whether I am getting better or worse-unless he also knows that my normal temperature is 96.5, and that's what it was yesterday. Likewise, I have to know the history of my sentiment indicator to put its readings in context. What's quite interesting is looking back at what I call baseline sentiment.
What's that?
We use various moving averages of sentiment to smooth it out, to get a sense of where the baseline is. One of the most informative that we use is about a three-week (15-day) moving average of our sentiment poll. This measure of sentiment has gone to three great pessimistic extremes over the last year and a half. At the October low, the July 24th low, and the September 22nd low in 2001. As the chart shows, while sentiment is currently fairly pessimistic, it's not yet as extreme as it was at those lows. So having that baseline to compare the current mood against is what gives us meaningful indications about the market. We also look for changes in confidence because the market is all about changes in confidence. The most important thing isn't figuring out that people hate the market, because that still doesn't tell you when to step in and buy it.
They might be right.
It's possible. So you want to gauge if you're near some relatively extreme degree of pessimism and further-importantly-whether people can turn around and get bullish. At each one of those three great lows, for instance, our daily sentiment readings, the day of the low and the day before the low, ranged from zero to 4-5 percent bullish. Yet the very next day, our sentiment poll readings ran up into the 90 percent range. These changes in the trend in confidence are very important. Then, just to make it a little more complicated, there are typical ways-patterns-in the way that sentiment unfolds. Generally, what happens is that the market makes a low, and starts to go up, but people are almost afraid to buy it because they're either not sure it has made a bottom, or think they've missed the bottom and are "too late." The psychology is interesting. But then, of course, people start chasing the market. And by the time the market is pretty fully priced, people feel very comfortable getting into-or staying in-the market.
And you track those patterns?
Yes, they are what we look at to distill the technical aspect of the market. This process of people becoming confident about the market has certain predictable characteristics, especially how long it takes, or what you could view as the attention span of the market. I try to distill this down into one simple thing, which is theoretically what technicals should tell you: What is the price action of the market saying. That is why people look at charts. In other words, what we really want to know from the technical point of view is what is the status of the trend. After all, we make money by being on the right side of the trend. So way back 1984-1985, one of the first things that I worked on was what I called "trend duration analysis." I didn't want to look at moving averages or heads and shoulders or any of that stuff. I just wanted to look at how the market behaves. What I think I discovered is that there are classic behaviors of a market that mark where it is in its attention span. But these behaviors, in each different market, have slightly different characteristics. The bond market doesn't behave quite like the stock market. But these behaviors constitute extra symptoms for us to look at.
How about an example?
When the stock market bottomed this past October and began to rally, one could have asked, "How long is it going to rally? By studying the kinds of attention span the market typically exhibits after dropping to very compressed levels, as it had, we could say that it usually doesn't stop in three days-or in seven days.
But could you say anything more positive?
Yes, certain discreet attention spans usually occur. A typical one happens to last about six-seven weeks. Now, that doesn't mean that the market, every time, is going to move in trends that last that long. But that is a typical duration. Which is why it was interesting to me that subsequently the market rallied for six-seven weeks into early December. At which point we started to get some relatively high sentiment readings. Everyone thought, "December's going to be a lay-up."
Santa Claus seemed sure to arrive on a rally. But you told your clients not to believe.
Yep. We'd already seen that the market was exhibiting a fairly classic attention span, and our polls were showing that people were feeling fairly optimistic. Those were signals to us – symptoms – that told us maybe the market wasn't going to keep going up. It was possible, of course, that I might have been wrong. But that's fine. Theoretically, that is where an investor would use risk management-which is another concept that is going to come into the market very importantly because of what's happening in broader financial culture.
You mean people are beginning to realize investing is a risky business?
Yes, it is a risky business. One can be wrong. What you have to do when you're wrong is get out. You have to use stop losses or limit your exposure to a percentage of capital-use some sort of risk management.
Thanks, Woody.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
