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CHAPTER 1
The Argument
for a
Sentiment-Based
Approach
A
t its core, sentiment is a general thought, feeling, or sense. In free
markets, sentiment refers to the feelings and emotions of market
participants. All of the participants’ feelings toward a specific mar-
ket result in a dominant psychology that is either optimistic or pessimistic.
Every change in price results from a change in the balance between opti-
mism and pessimism. Price itself is a result of where collective psychology
lies in the never-ending oscillation between optimism and pessimism. As
oscillation suggests, the psychological state of a market experiences peaks
(optimistic extreme) and troughs (pessimistic extreme). These sentiment
extremes are what affect market tops and bottoms.
In the 1932 edition of Charles Mackay’s classic Extraordinary Popu-
lar Delusions and the Madness of Crowds, Bernard Baruch wrote in the
foreword that “all economic movements, by their very nature, are moti-
vated by crowd psychology.” Baruch went on to write in the same fore-
word that “without due recognition of crowd-thinking (which often seems
crowd-madness) our theories of economics leave much to be desired.”
1
It seems that so many, if not most, of the members of the financial com-
munity seem to forget these basic truths. Analysts, traders, and financial
media members attribute reasons to price movements with an uncanny
ease.
For example, “The government reported a larger than expected in-
crease in the number of jobs created, which supported the U.S. dollar.” For-
get that the same report one month earlier indicated that fewer jobs were
created than expected ...and the dollar rallied anyway. On that day, the
1
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2 SENTIMENT IN THE FOREX MARKET
headline probably read something like this: Dollar Rallies Despite Down-
beat Jobs Report. These examples are hypothetical, but if you follow the
currency market, you have undoubtedly witnessed similar inconsistencies
in financial reporting. How can the movement of a currency be attributed
to an outside event such as the release of an economic indicator one
month when the same currency and same economic indicator show ab-
solutely no relationship in other months? If a relationship exists only some
of the time, then by definition there is no consistent relationship. Yet, the
majority of market participants base trading decisions on economic indi-
cators anyway. Why? Even though the approach is suspect, it is conven-
tional and popular and humans like to be with the crowd, even if they
are wrong. It is much easier to be wrong in a crowd than be wrong by
yourself.
Baruch also wrote in the foreword of Extraordinary Popular Delu-
sions and the Madness of Crowds that:
Entomologists may be able to answer the question about the midges
and to say what force creates such unitary movement by thousands
of individuals, but I have never seen the answer. The migration of
some types of birds; the incredible mass performance of the whole
species of ocean eels; the prehistoric tribal human eruptions from
Central Asia; the Crusades; the mediaeval dance crazes; or, getting
closer to economics, the Mississippi and South Sea Bubbles; the Tulip
Craze; and (are we too close to add?) the Florida boom and the
1929 market-madness in America and its sequences in 1930 and
1931—all these are phenomena of mass action under impulsions and
controls which no science has explored. They have power unexpect-
edly to affect any static condition or so-called normal trend. For that
reason, they have place in the considerations of thoughtful students
of world economic conditions.
2
The last example that Baruch cited, the 1929 stock market crash, may
be on the verge of repeating as I write this book in late 2007. The herding
instinct is a fact of human nature and manifests itself in all our speculative
activities; whether real estate, stock markets, or currency valuations. Mar-
kets move in trends but reverse at extreme levels of bullishness (tops) and
bearishness (bottoms) as English economist Arthur C. Pigou explained:
“An error of optimism tends to create a certain measure of psychological
interdependence until it leads to a crisis. Then the error of optimism dies
and gives birth to an error of pessimism.”
3
This is the rule in all financial markets, where man’s impulse to herd
creates extreme and unsustainable levels that ultimately lead to a reversal.
Markets always overshoot and do not seek equilibrium as the Efficient Mar-
ket Hypothesis (EMH) would have you believe.

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