Applying Principles of Behavioral Finance to Understanding the Ups and Downs of Stock Prices
Quality tools for charting, understanding, and forecasting the financial markets are relatively few in number and often questionable in their reliability. However, there is one firm whose indices I believe help detail the subtle yet powerful behavioral dynamics at work in the marketplace, impacting everything from analysts’ earnings estimates to stock prices to the behaviors associated with buying and selling stocks at various points in a market cycle. The firm MPT, Inc. of Seattle is a leading provider of quantitative investment research, used primarily by institutional money managers and plan sponsors. I have found it to be valuable in managing money for high net worth clients.
MPT, which stands for Market Profile Theorems, uses various models that look at the market from different perspectives. Three of these models, the Insider model, the Earnings model, and the Technical model have special interest to me insofar as they help explain the emotions and behaviors often at play behind the setting of earnings estimates by analysts and the prices at which stocks are eventually bought and sold. These models also offer a fascinating backstage look at the dynamism of stock pricing, based on the interplay between different parties operating in the financial marketplace.
▶ MPT’s Insider model helps wealth advisors and investors to better understand and interpret what insiders from a company may be thinking about their company’s vitality and short- and long-term market prospects. Insiders, such as a company’s CEO, CFO, COO, CTO, and board members, all have a substantive, forward-looking grasp of the company’s future growth prospects, its emerging product markets, potential new sources of revenue, long-term profitability, and current cash flows within the company. MPT’s Insider model works to determine and interpret what these corporate insiders think about their company’s current revenue prospects. Are insiders buying up or selling off their stock? The Insider model identifies (by company):
▶ A second MPT model, the firm’s Earnings model, measures corporate earnings from six key perspectives. For example, the model captures the company’s current year expected earnings, as estimated by Wall Street analysts, and earnings estimates for the subsequent two years (referred to as FY0, FY1, and FY2). MPT also monitors earnings estimate changes, surprises in reported earnings each quarter, and standard unexpected earnings (SUE). Finally, MPT monitors, on a daily basis, actual earnings reports for emerging market, industry, and individual stock trends. These numbers and their trends are used to monitor the earnings health of a company.
▶ Finally, MPT’s Technical model captures the actual change in price in a stock and reflects actions taken by institutional and retail investors to buy or sell the stock.
Each of the three main models I’ve mentioned is given a ranking from 1 to 10, with 10 being the most favorable outlook from the point of view of insider activity, earnings revisions, or stock price. Each of the aforementioned models is part of a larger, seven-factor model that MPT uses to measure and gauge stock performance across over 5,000 companies, 59 industry groups, and 16 economic sectors.
So, why do I have such high respect for MPT’s financial markets modeling tools? Simply, MPT’s multidimension model set is based on behavioral finance and the premise that:
As you can see, there is a hierarchy of information that creates a cascade of behaviors from insiders to Wall Street analysts to portfolio managers. The careful observer, using MPT, can understand the nuances of these patterns and invest accordingly.