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The Argument
for 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.”
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
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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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
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.
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.”
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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