“A prudent speculator never argues with the tape. Markets are never wrong, opinions often are.” Jesse Livermore

“The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money everyday, as though they were working for regular wages.”

The Standard & Poor’s 500 Index just had its worst month on August 2015, since May 2012.  The bears are rejoicing, the bulls are uneasy, and the pigs are left slaughtered.

On Monday, August, 24, 2015, The Dow Industrials plunged at the start of the week, briefly tumbling by more than 1,000 points.

At that time, the VIX (CBOE Volatility Index) a popular measure of the implied volatility of S&P 500 index options, also commonly referred to as the fear index or the fear gauge, reached 53.29. Indeed that morning, (and even still today as of 9.1.15  1pm EST with $SPY -2.5%) fear is pervasive over the markets.

Some highlights of the VIX index are:

• 2004 – On March 26, 2004, the first-ever trading in futures on the VIX Index began on the CBOE Futures Exchange (CFE).
• 2006 –VIX options were launched in February 2006.
• 2008 – On October 24, 2008, the VIX reached an intraday high of 89.53.
• Between 1990 and October 2009, the average value of VIX was 19.04
• On August 24, 2015. the VIX reached an intraday high of 53.29

Amidst a current climate of a strong U.S. dollar, developments in Greece,  no definitive guidance regarding FED hikes,  and a rapidly declining Chinese stock market,  the next catalyst to price discovery becomes the devaluation of the Yuan currency.   

Faced with the reality of recording a decline in Chinese exports in 2015, the Chinese authorities begin a frantic move to boost economic growth. Chinese monetary authorities strategically time their decision to suddenly allow market forces to dictate price movement for the Yuan, resulting in an immediate devaluation of the currency.   Adam Smith and his invisible hand would be proud, IF this is truly how the Chinese markets are left to react to price movements in the future.

In a post on ZeroHedge, “Tyler Durden” explains how after the recent devaluation “China has likely sold somewhere on the order of $100 billion in US Treasuries in the past two weeks alone in open FX ops to steady the Yuan.”  That might be a drop in the bucket if you consider the fact that China owns $1.27 trillion in U.S treasuries (June, 2015)

The bigger question that looms is, how will the markets react if this rate of orderly liquidation of U.S Treasuries continues to persist over the next 1-2 years?

“Those who cannot remember the past are condemned to repeat it.” – George Santayana

Imagine the following game: A coin is flipped. If it comes up tails, you don’t win anything thus ending the game. If it comes up heads however, you win $1 and you get to flip again.  If on this second toss it comes up heads again, you double your last payout and you are now awarded $2, and you get to flip again.  If on the third toss, it comes up heads again, your payout becomes $4, and you get to flip again. The probability of each possible outcome decreases as a function of outcome size. The probability of large outcomes is very low, but not zero. The question then becomes, how much would you be willing to pay in order to participate this game?

This scenario known today as the St. Petersburg paradox was first introduced in September 1713 by Nicolas Bernoulli. It was then debated for close to thirty years until when his cousin, Daniel Bernoulli, presented his opinion on risk aversion, risk premium and utility in the paper “Exposition of a New Theory on the Measurement of Risk.”   The following provides graphical illustrations of the outcomes as well as the probabilities of potential payouts:

The answer to this paradox gave way to the introduction of the concepts of utility function, an expected utility hypothesis, and the diminishing marginal utility of money.

In Daniel Bernoulli’s own words:

“The determination of the value of an item must not be based on the price, but rather on the utility it yields…. There is no doubt that a gain of one thousand ducats  is more significant to the pauper than to a rich man though both gain the same amount.” “The man who is emotionally less affected by a gain will support a loss with greater patience. “

Despite this dissonance, the expected utility theory remained our best understanding of how to  choose rationally when we are unsure which outcome will result from our actions.  However,  in 1979, Daniel Kahneman and Amos Tversky published “Prospect Theory: An Analysis of Decision under Risk”; an important paper that used cognitive psychology to explain various divergences of economic decision-making from expected utility theory.

In it, they offer this theory: people don’t always maximize utility, rather people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former – even when they achieve the same economic end result.

For example, in a traditional way of thinking, the amount of utility gained from making a trade with a profit of $500 should be equal to a situation in which you make  two trades; one with a profit $1000 and then another one with a loss of $500. In both situations, the end result is a net gain of $500.

However, despite the fact that you still end up with a $500 gain in either case, most people view a single gain of $500 more favorably than gaining $1000 and then losing $500. Further, most loss aversion studies suggest that losses are twice as powerful, psychologically, as gains.

“We have an irrational tendency to be less willing to gamble with profits than with losses.” – Kahneman & Tversky (1981)

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“All economic movements, by their very nature, are motivated by crowd psychology.” — Financier Bernard Baruch

Originated by the late Paul Macrae Montgomery; The Time Magazine Cover Indicator serves as a contrarian signal, which essentially tells us whether some investment theme has reached a crescendo.  The rationale follows that by the time a company’s success or failure reaches the cover page of a major publication, the company is so well known that it is reflected fully in the current stock price.

The findings of three University of Richmond professors published in their study “Are Cover Stories Effective Contrarian Indicators” prove as much. Their research examined Business Week, Fortune, and Forbes, and found a correlation between the cover of the publication and the performance of a stock.Their findings indicate that positive stories generally indicate that the stock’s price performance has topped out. Negative stories often come right at the time of a turnaround.

The study confirms that it is better to bet against journalists than alongside them. 

Business Week’s August 13, 1979 “The Death of Equities” cover claimed investors – burned by years of bad returns in the 1970s – turned their back on stocks for good. That was just before the market launched into an 18-year rally.

Times’ “Home Sweet Home” cover story in June 2005 called the very top of the housing market. Newsweek’s April 2010 cover declared “America’s Back!” right before the Dow plunged from 11,200 to about 9,500.

However, rather than blame all of our investment woes on journalists, it would be more constructive for us to recognize what Montgomery realized long ago.  “Standard economic theories overlooked the human factor in markets.”

“When we speak of thing’s having value, we are referring to the human desire for that particular thing at that particular time.  Value is thus a quality appertaining not to external materiality, but rather to internal, immaterial mental states.”

Tops and bottoms in any market are a creation of extreme market psychology. “The basic principles of human neurophysiology are so similar, that if we become uncomfortable enough to significantly change our market position, it is virtually certain that a number of other people are doing precisely the same thing at precisely the same time, thereby creating a temporary turning point in bond prices and interest rates.”