How To Read Market Sentiment

You're not doing what you think you're doing...

On being a contrarian from Michael Lewis’ Liar’s Poker​:

Everyone wants to be, but no one is, for the sad reason that most investors are scared of looking foolish. Investors do not fear losing money as much as they fear solitude, by which I mean taking risks that others avoid. When they are caught losing money alone, they have no excuse for their mistake, and most investors, like most people, need excuses. They are, strangely enough, happy to stand on the edge of a precipice as long as they are joined by a few thousand others…

Contrarianism is the most abused and empty platitude in trading and investing. Everybody thinks they’re one, but few are. 

And that, by its very nature, has​ ​​to be the case. Because to be a contrarian is to go against the herd, the majority. 

Hedge-fund legend Ray Dalio puts it like this, “You can’t make money agreeing with the consensus view, which is already embedded in the price.” 

Drelles was teaching the young Druck about the wisdom of the market, which is based on the​ idea that the crowd is collectively smarter than any one individual. This collective intelligence was first stumbled upon by the late great statistician, Francis Galton, who in 1906 observed a competition at a local fair where approx. 800 people tried to guess the weight of an ox. To his surprise, the average of all the guesses was 1,197lbs.

The real weight? 1,198lbs. Countless studies have been done since, all show similar results.

Crowd >>> any individual. Scott Page, in his book The Difference, lays out the "diversity prediction theorem" to explain how this works and what variables are needed to make a crowd wise.

The theorem states that: Collective error = average individual error - prediction diversity.

The implications of this are 3-fold: 

• A diverse crowd will always predict more accurately than the average individual. 

• A crowd is often smarter than even the best of its individuals.

• Collective predictive ability is equal parts accuracy & diversity.

The takeaway here is that crowds are smarter than any single person, as long as there's a diversity of opinion. This theorem is based on math and is always true. On Twitter, @mjmauboussin has a great paper on this for those of you who want to explore more (link here).

To take this back to markets. Here's Soros explaining why it's KEY to know when to be a part of the "herd" (i.e. follow the trend), and when to disengage & be a contrarian:

You want to be a trend follower when there's a lot of people saying "This move makes NO sense!" and a contrarian when people are saying "This makes SO MUCH sense!" This is why a bull climbs a wall of worry, and a bear falls down the stairs of hope. Trends are driven by (dis)belief.

But, and this is important. You ONLY want to be a contrarian once the tape STOPS confirming the consensus narrative. Reading the sentiment tea leaves is as much an art as it is a science. And when in doubt, defer to the market.

Blake LeBaron, an economist, modeled how this diverse opinion/wise crowd & consensus/dumb crowd works in markets to create trends and crashes (here's his paper).

He built a computer model and imbued "agents" with decision-making rules such as: make money, try not to lose money, don't underperform the average for long periods etc…

What he found was that "During the run-up to a crash, population diversity falls.” Agents begin to use very similar trading strategies as their common good performance begins to reinforce —> This makes the population brittle.

“Anyone to sell to in a falling market since everyone else is following very similar strategies." This confirms Page's "diversity." theorem and explains the mechanics of why markets trend and revert, or move in sine waves.

Trends that "make no sense" are robust. Trends that become consensus are fragile. Soros thought of this phenomenon as high and low "distortion regimes". High distortion regimes occur when price & sentiment form a reflexive loop, which then creates a budding consensus.

This price/sentiment loop, or what I call the "Narrative Pendulum" becomes obvious once you learn to look for it.

For an example, watch this video I clipped together last year that shows the dramatic shift in the dominant narrative that occurred in just two-weeks time (link here)​.

Price drives sentiment which drives price, ad infinium. There is no "smart money" other than the market itself. 

All of us are part of the "dumb money" crowd. The 2 "Bond Kings" calling the end of the bond bull at the exact bottom in 18' is case in point. This game is hard!

So that's what Drelles meant, and this is also what makes Druckenmiller so good. He learned early on to listen and respect the market, to harness the wisdom of the crowds, and to only step in to fade a trend once a consensus was clear & the tape no longer confirmed it.

Whether one knows it or not, we’re all playing Keynes’s Beauty Contest. Most dither at the first level completely unawares. Hopefully, this thread helps you see the market for what it really is so you can begin playing the game at the second, third levels, and beyond.