Every since markets have existed, many have noted that people tend to go in the same direction at the same time — like schools of fish.

This is the basic thought behind “technical analysis” and “chart reading” in stock and futures markets.

It is also the idea supporting the concept of covariance in Modern Portfolio Theory and what is called “systemic risk”.

It is the mothers’ milk of quants that run hedge funds.

I make this analogy to indicate that covariance isn’t an esoteric mathematical property somehow embedded in stock prices, but rather a manifestation of a common human biological trait that has to do with the behavior of crowds.

When the little boy that was beating the pond with a stick goes home to dinner, the fish that had been jumping hither and yon will calm down and begin to exhibit a different behavior pattern.

Just as large predators, like dolphin, create walls of bubbles to herd schools of fish to be devoured, stock market manipulators understand investor psychology and how to use this knowledge to control investors whose behavior depends on what their neighbors are doing.

A large predator may have left the market, for now

The major force driving investor-fish since 1983 have been corporate stock buybacks that have been used to distract investors while executives divert corporate funds (that should have gone to investors as dividends) into their own pockets by exercising stock options.

See: The stock buyback era is over; Now we can assess the damage.

The market crash of 2008 was a game-changing event (like the little boy going home for dinner, in the above analogy).

Therefore, the old battery of statistics on covariance, betas, and a host of other greek letter measures, should be put aside, and theories reconstructed in terms of new patterns of fish-investor behavior that will emerge in the new market.

Fundamental analysis may again become fashionable

If our investor-fish no longer are driven by the multi-trillion dollar flows of buyback money, as has been the case for a generation, investor behavior may become more difficult to predict.

Successful investors may again become those following the old time fundamental trail blazed in the 1930s by Benjamin Graham.

This means that DYOR may again become the secret of success — rather than trying to build better mathematical models of investor-fish behavior.

However, the information landscape is much different today than in the 1930s. To gain competitive advantage will require more than just financial statement analysis.

The New Fundamental Analyst will know how to use open source investment intelligence.

For further articles on this subject, see:

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research and New technology in open source investment intelligence

See: The DYOR Principle and Respect for Intrinsic Value.

Photo credit: School of fish: flickr by Tom Weilenmann
Photo credit: Wild dolphin play: flickr by Jurvetson.

This entry was posted on Monday, May 11th, 2009 at 2:49 pm and is filed under Capital Flow Analysis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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