Turning Market Causality On Its Head

What I am about to say may shock some of you that have not read my analysis before.  In fact, this perspective is not likely going to be accepted by the vast majority of those who read it.  But, I want you to at least maintain an open mind to what I am about to say.

From my perspective, the strongest driver to the larger markets is market sentiment.  And, I believe the emotion through which it is driven has the power to override fundamentals.  It provides us with an elegant understanding of why markets “don’t trade based upon the fundamentals” at times, and should be strongly considered within any long-term perspective you take when viewing the overall markets.

During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Greenspan noted that markets are driven by "human psychology" and "waves of optimism and pessimism." Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain of market movements.

Allow me to walk you through an example:

During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive (or, less negative if you will). You see, once you hit a wall, it becomes clear it is time to look in another direction. Some may question how sentiment simply turns on its own at an extreme, and I will explain to you that many studies have been published to explain how it occurs naturally within the limbic system within our brains.

When people begin to turn positive (or less negative) about their future, they are willing to take risks. What is the most immediate way that the public can act on this move towards positive sentiment? The easiest and most immediate way is to buy stocks. For this reason, we see the stock market lead in the move to the opposite direction before the economy and fundamentals have turned. In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.

Let's look at the same change in sentiment and what it takes to have an effect on the fundamentals. When the general public's subconscious sentiment turns away from the extreme negative and towards the positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market at this point in time, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which takes time to secure.

They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow - after more time has passed.

When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals are evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.

Clearly, there is a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change.

This is why I claim that fundamentals can be lagging relative to market sentiment. This lag is a much more plausible reason as to why the stock market is considered to be a “leading indicator,” as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns.  By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time.

In fact, R.N. Elliott once noted:

“At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend.” 

At the end of the day, the goal of this article was to present to you a more elegant and plausible reason as to why the stock market is viewed as a leading indicator, and why we often hear that “the market is not trading based upon fundamentals at this time.”  I think it behooves every investor to be aware of market sentiment just as much as one understands the fundamentals of a particular stock you follow.  As Bernard Baruch once noted:

All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature — a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.”

And, for a final point of consideration, ask yourself what prompted John Maynard Keynes to recognize that:

“Markets can remain irrational longer than you can remain solvent.”

Avi Gilburt is founder of ElliottWaveTrader.net.