Lessons from the Pros

Animal Spirits: Not So Good for Day Trading, or Investing for that Matter

Recently, my family and I got new puppy. He’s been a great addition to our household (although plenty of work), but the cute little fellow is well worth it. Ever since he became part of our home, he got me thinking about the animal spirits that drive some of our decision-making. By this, I’m referring to the term coined by the famed British economist John Maynard Keynes in which he essentially attributes the irrational, illogical behavior of humans for the constant boom and bust cycles markets and economies seem to repeat.

In some respects, the so-called "animal spirits" are good in that they are what lead us to risk-taking, entrepreneurship, innovation and the like. Left unfettered, however, excessive greed and fear are what lead markets to unsustainable heights, as well as drive prices to ridiculously low levels.

In trading, the impulsive decisions we sometimes make can be attributable to these animal spirits. We’ve all been through this scenario: The neighbor down the street pulls up in her brand new Mercedes S Class. You begin to wonder, how is it that she’s able to afford that car? You know where she works. She does okay, but not great; perhaps she’s won the lottery. Your curiosity finally gets the best of you, so you go over to compliment her on the smart new car. Not surprising, she’s gushing over the car and has to take you for a drive. Along the way (as she shows you all the car’s fancy bells and whistles), you begin fishing for the source of her newfound disposable income. It doesn’t take long before she eagerly tells you about this fabulous new company that she invested in. She goes on about the company’s wonderful products, also adding that most of her friends and family are also invested. "And by the way," she says, "It’s not too late to get in because this company’s prospects are still very promising, and the stock just keeps going up." You’re sold!

So you rush home, oh wait, the market’s closed, you’ll have to wait until the open, tomorrow morning. The anticipation makes for a sleepless night. You’re up very early the next morning, you log on to your online brokerage account (your fingers trembling with excitement), and as soon as the opening bell rings – without any due diligence to speak of, or analysis of any type – you purchase a hefty amount of the shares of this (so you’ve been convinced to think) fabulous company.

Indeed, I don’t need to tell you how this movie ends. Let’s just say most of the time, it doesn’t end well. This is what happens when we let our primal instincts take over, and let’s face it – it’s happened to most of us at some time or another, in different facets of our lives.

If we look at the short-term trading realm, this human trait is also alive and well. Often, the fear of missing out on a move causes traders to chase moves impulsively, only to see the stock or futures contract retracement, quite literally as soon as they enter the position.

In the classroom, specifically, during the trading sessions, I make it a point to walk around asking every student what rationale was used in making his or her trading decision. Thinking logically, before taking a trade, is something I put a lot of emphasis on in my classroom. It doesn’t make any difference whether I’m teaching E-mini Futures class, or the Professional Trader class, short-term, or swing trading; making trades based on reason is the only solution in quelling those "animal spirits."

Let’s shift gears now, and turn our attention to the current market environment. In keeping with our animal spirits theme, one can say that investors are more confident now than at any time in the last 12 months. Whether this optimism is just wishful thinking or based on reality is for the economists to figure out. For traders though, it’s best to rely on our charts. In my last newsletter, I highlighted the ES (E-mini S&P) gap resistance as the likely area where the recent rally would stall. We can see from the chart below that indeed, this level has acted as formidable resistance.

Figure 1

Upon close scrutiny (Hourly chart below), we can deduce that the ES is in roughly a 50-point range (927-877). My best guess, based on some of the factors I outlined in the last missive, continues to tilt the odds in favor of lower prices.

Figure 2

One factor that may lend weight to my thesis of lower stock prices is the continued deterioration in the bond market, which in turn has led to higher yields. From an intraday trader’s perspective, the bond auction results are worth putting on your calendar as the immediate perceptions following the release are becoming market-moving catalysts. The CBOE 10-Year Treasury Yield Index chart below is a clear illustration of the recent steep rise in longer-term interest rates.

Figure 3

Some would argue that this is simply a reallocation of assets – money moving out of bonds into stocks – I however, think there is something more sinister going on here, namely, an increasing reluctance by foreigners to purchase our debt. This, I gather, is due to our staggering budget deficit, which is only increasing by the minute.

Nevertheless, those animal spirits will continue to drive irrational people to buy at lofty levels, and those same individuals to sell at bargain basement prices. And to that I say, thank goodness. Because if it wasn’t for them, who would level-headed traders have to sell to and buy from?

Until next time, I hope everyone has a profitable week.

If you have questions or comments, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez