Sentiment in the Forex Market: Indicators and Strategies to Profit from Crowd Behavior and Market Extremes

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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

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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.