Behavioral Analysis of Markets is a new area of study, proposed by James Gregory Savoldi, closely related to behavioral finance, behavioral economics and socionomics. Unlike traditional models of behavioral analysis which typically integrate insights from psychology with neo-classical economic theory, Behavioral Analysts of markets focus entirely on the psychology of actual market participants and how their present moods control market price movement.
Behavioral Analysts are divided into two groups. One group believes that by studying current market psychology—as displayed in price action—future market psychology becomes predictable, while another group believes in limited predictability with the inevitability of occasional “Black Swan” events. Behavioral Analysts of Markets ignore traditional economic inputs in favor of the more empirical proof of intention through action displayed directly in market price movement. Pattern recognition and fractals play a small role in the behavioral analysts’ toolkit as they use those technical analysis tools only to help predict potential market velocity as opposed to price reversals. In behavioral analysis of markets, a topping and bottoming ‘count’ is tracked (most similar to Elliott Wave Principle) as waves of optimism and pessimism drive price.
Tenets of Behavioral Analysis
Data output created by human reaction to greed and fear thresholds is measurable, and through these measurements future market psychology can be predicted hours, days, weeks, months, years, and even decades before actual trading takes place. Market reversals are an inevitable result of excessively bullish or bearish sentiment (greed or fear) and it’s that “emotion” that causes the majority of traders to enter positions on the same side of a market at roughly the same point in time—which in turn leads to a price reversal.
Behavioral Analysis uses clues created by today’s emotional responses to market behavior in order to predict future market reversals. According to the principles of Behavioral Analysis, events unfolding in today’s financial markets are currently creating a map of the future that will be strictly followed regardless of any attempts through human intervention to change the outcome of price movement. The logic behind this assertion can be attributed to the fact that, regardless of lessons learned by previous generations, human beings seem predisposed to repeat both positive and negative behavior exhibited by past generations. In fact, it is this dynamic that spawned the popular adage “history repeats itself.”
Because of this assumed “law of nature,” market participants’ reactions to future events—although dynamic in emotional extremes—will continue to elicit greed and fear, driven by the intrinsic human desire to pursue pleasure and to avoid pain, and that in turn will result in predictable repeatable reactions in financial markets.
Although these characteristics of “human nature” and their effect on traded markets are generally accepted by market participants, the ability to predict when these emotions will again surface—and the intensity with which they will move markets—is the goal of behavioral analysts.
Boom and Bust Cycles
According to Behavioral Analysts, boom and bust cycles are cyclical and predictable, but not in the sense that the cycles are “fixed” or recurring in their time element as traditional cycle work would suggest. Financial market history teaches proves that it takes much longer for a market to recover from the bursting of a bubble than it does from a simple ‘reaction’ during a more moderate advance in prices. Both booms and normal advances are cyclical in the sense that expansion is followed by contraction, but the extent and duration of the contraction phase should be anticipated to be proportionate to the extent and duration of the preceding advance. In this sense, cycles are generically predictable.
Cycles within Cycles
Within long-term cycles, millions of cycles of smaller degrees (fractals/recursions) are constantly unfolding. Capitulation within capitulation marks ever-smaller data components of markets such that tick data and monthly data exhibit similar capitulation characteristics.
Pain Thresholds and Their Dynamic Nature
A market participant’s ability to withstand pain (losses) will fluctuate on a second by second, minute by minute, hour by hour, day by day, week by week etc. etc., basis and regardless of his best attempts to contain his emotions; he will eventually succumb to the irresistible force to capitulate at each and every individual cycle period threshold. Even using a black-box discipline with fixed stop-loss controls, investment decisions are vulnerable to human emotion on various other macro levels.
According to behavioral analysis, heavy losses come at times when emotional thresholds are super-resilient and therefore able to endure very high levels of pain, and small losses come at times when emotional thresholds are non-resilient and therefore unable to endure almost any level of pain. This explains why the best, most disciplined traders in the world will occasionally let a loser run (instead of immediately cutting his losses). This type of mistake is common and can be attributed to a temporarily elevated pain threshold.
It is because of this tendency toward dynamic thresholds for pain (losses), that behavioral analysts use dynamic measurement components, that is, the ability to discern controlled capitulation from final capitulation. While technical analysts may use fixed plus and minus tick readings (+1000 to +1200 or -1000 to -1200) as a capitulation trigger to enter sell or buy orders, behavioral analysis ignores fixed interpretations of these types of indicators because crashing markets—such as the US stock market in 1987—proved this indicator unreliable. According to behavioral analysis, only a dynamic measure can provide reliable results in predicting future emotional pain thresholds in human beings, because cycles in human resiliency clearly dictate that what may be viewed as highly painful on one day will register only as an annoyance on another day.
The study of behavioral analysis received increased attention after more traditional economic and market forecasting tools witnessed a high-profile failure during the 2008 financial crisis. Economist Robert Shiller—considered a pioneer in behavioral finance—has been credited with forecasting the US housing bubble and its subsequent crash.
Many traditionally trained technical analysts, fundamental analysts and economists are critical of behavioral analysis due to its relatively short track record and vague (some would say secretive) methodology. The same criticism is often leveled at Elliott wave practitioners although that investing methodology has been in use for a much longer period of time.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.