Trader’s Narrative

The following is excerpted from Robert Prechter’s Independent Investor eBook. The 75-page eBook is a compilation of some of the New York Times bestselling author’s writings that challenge conventional financial market assumptions. Visit Elliott Wave International to download the eBook, free.

By Robert Prechter, CMT

…The natural tendency of people to apply physics to finance explains why successful traders are so rare and why they are so immensely rewarded for their skills. There is no such thing as a “born trader” because people are born — or learn very early — to respect the laws of physics. This respect is so strong that they apply these laws even in inappropriate situations. Most people who follow the market closely act as if the market is a physical force aimed at their heads. Buying during rallies and selling during declines is akin to ducking when a rock is hurtling toward you.

Successful traders learn to do something that almost no one else can do. They sell near the emotional extreme of a rally and buy near the emotional extreme of a decline. The mental discipline that a successful trader shows in buying low and selling high is akin to that of a person who sees a rock thrown at his head and refuses to duck. He thinks, I’m betting that the rock will veer away at the last moment, of its own accord. In this endeavor, he must ignore the laws of physics to which his mind naturally defaults. In the physical world, this would be insane behavior; in finance, it makes him rich.

Unfortunately, sometimes the rock does not veer. It hits the trader in the head. All he has to rely upon is percentages. He knows from long study that most of the time, the rock coming at him will veer away, but he also must take the consequences when it doesn’t. The emotional fortitude required to stand in the way of a hurtling stone when you might get hurt is immense, and few people possess it. It is, of course, a great paradox that people who can’t perform this feat get hurt over and over in financial markets and endure a serious stoning, sometimes to death. Many great truths about life are paradoxical, and so is this one.

For more information, download Robert Prechter’s free Independent Investor eBook. The 75-page resource teaches investors to think independently by challenging conventional financial market assumptions.

Robert Prechter, Certified Market Technician, is the founder and CEO of Elliott Wave International author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

The better analogy in my view is to compare individual investor’s behavior with that of an animal in a herd. Through evolution, we have learned that the “safest” place to be is with the pack or the herd and venturing out on your own can get you eaten. But it is only by doing what others aren’t doing that you gain what other’s miss. As long as you simply go along with the crowd, you’ll be “safe” in the sense that you’ll share the same experience as everyone else (and be able to commiserate during tough times) but you’ll never gain anything extraordinary either.

Whatever analogy you use, the lesson is the same. We are barely more than our “lizard brains” and being able to transcend emotions which lock you into a cycle of behaviors is paramount if you want to be able to achieve above and beyond the average.

Here’s the sentiment recap for this past week:

AAII
Although the participants fill out this survey after the market closes on Wednesdays, the AAII this week actually showed an increase in bearish sentiment. Considering that we had an amazingly trending upday with a wide range, you have to wonder just what it will take to sooth the ruffled feathers of retail investors.

AAII bears went from 53% to 56% while bulls came in at only 29%. This sentiment measure is now showing real fear unlike a few months ago. Back then I theorized that the retail investors weren’t scared because they simply didn’t have anything invested.

Now it seems that they are again committed to the market and very worried. Which, in contrarianland is a great sign that we are going to have a continuing rally here.

Fund Flows
According to AMG Data Services, the only week in November with positive fund flow was the second to last with a tiny uptick. The other weeks saw massive mutual fund redemptions.

In fact, the second week of November witnessed a spike of mutual fund sales which was significantly higher than mid-August this year. As scood commented, there is a huge pile of money sitting in money market funds. So it seems that the crowd has been fleeing the domestic equity market and taking refuge in fixed income.

Time to zig when the crowd zags. But what I don’t understand is if the crowd is sitting in money market funds again, why are they scared now about the stock market’s recent turbulence?

Magazine Cover Indicator
The Economist cover for this week is a bit of a conundrum. The dollar has been crashing and burning for some time now. That’s not news.

At first glance it seems to be a classic contrarian bullish cover… but the fact that they’ve used the word “panic” in the heading gives me pause. It is a bit too self-aware for my taste.

I haven’t even read the article so I’m reserving judgement but even so you could argue that the explanation matters less than the visceral effect of the image. A flaming spitfire, about to crash with George Washington calmly facing the inevitable…

What emotions do you think it conveys?