The Wave Principle

The relationship between social mood and the stock market

The Theory:

The theory of mood and markets is a hypothesis of human social conduct depicting the causal connection between the social state of mind and social activity. In human complex systems, such as the stock market, herding behavior results in settings of uncertainty reflected in social mood patterns that fit with various fractal designs or wave patterns. These patterns are repetitive, probabilistic, and predictable. These social mindset patterns determine the character of activities, both in financial markets and in other social settings. The scientific name of the system is socionomics.

Shiller:

Shiller’s (1990) study of the stock market crash of 1987 is a genuine case of the disparity between what institutional investors state is the explanation behind an enormous market swing and what they really did as they sold their stock positions by the droves. The study found that the most prominent reason given for selling was that the market was “overvalued.” However, an astonishing 43% of these institutional investors experienced “unusual symptoms of anxiety (difficulty concentrating, sweaty palms… or rapid pulse) regarding the stock market.” Rather than the quiet thinking procedure of selling they revealed, they were really seen as “…people reacting to each other with heightened attention and emotion, trying to fathom what other investors were likely to do, and falling back on intuitive models….” Post hoc defense of the following action finishes this mind-boggling sort of social activity.

Socionomics:

Socionomics finds financial valuations by different homogeneous participants fills in as the setting for non-rational behavior. This follows variances endogenously in a social mood that drives asset value fluctuations.

The socionomic hypothesis sets that social disposition might be an extension among intuition and habit, between emotional inclination and setting clear discernment and action. Socionomics considers intuition to be an extension among science and social sciences that explains human social conduct. Part of this hypothesis reverberates in Pareto‘s little-known sociological premise of buildups and determinations. Pareto’s proposition of a natural human spirit toward “sociability” is identified with the socionomic conceptualization of herding (Pareto called such impulses “residues”). In contrast, his idea of mental “derivations,” the methods by which individuals legitimize their conduct, is identified with the hypothesis in regards to the role of rationalization in financial decision making. The socionomic model of endogenous causality in a system of homogeneous participants varies from the neoclassical theory of finance that assumes system participation is heterogeneous, and causality is exogenous.

Pareto was famous for his work in making and refining parts of equilibrium theory in economics, and for his economic concept of the “Pareto optimum.” One may say that Pareto was the first to do for sociological behavior what Freud did for intimate and emotional behavior: he lay bare its roots in unconscious motivations.

The neoclassical monetary hypothesis takes its model of causality from nineteenth-century physics (Mirowski, 1989). Socionomics addresses the unpredictable truth of money related conduct from the viewpoint of a comprehensive combination of the causal connections among people and aggregates in society (Prechter and Parker, 2004).

According to socionomics, at the point when people don’t have the foggiest idea, they are affected to go about as though others do. To herd, it is thought to expand the general possibility of survival. Herding depends on the respective state of mind of investors and how they feel. Which is the territory of the prerational regions of the cerebrum, which mediates emotions, not rational ones (Prechter, 2001). This reason for the herding impulse can be found in neurophysiology. The territories of the brain mediating rational ideas assume a job in the herding process. They produce reasoning for the investor’s irrational behavior.

Data from socionomic studies (Prechter, 1999a, 2003) finds that markets are not driven by causes outside the market itself, such as financial reports, wars, terrorism, elections, corporate earnings, scandals, Fed actions or the movements of other markets. The hypothesis expresses that the social state of mind goes before and decides social activity, not the other way around. Additionally, market prices are simply an “epiphenomenon” of an unconscious, subjective valuation process. Waxing hopefulness produces rising prices, and waxing cynicism creates falling prices. Prices are merely a gauge of investor psychology, which comes from the social state of mind. Socionomics is consistent with modern systems theory, where a working connection at the individual level and the aggregate level exists. Likewise, it shows no “cause and effect” relationships that are linear; instead, social activities “proceed relentlessly according to form” (Prechter, 1999) at the aggregate level.

Socionomics can clarify why investment fund managers, in total, neglect to beat the market (Olsen, 1996). It isn’t because the market is random; it is because the managers’ herd, much the same way as individual investors. See Sias (2004), Welch (2000), Graham (1999), Trueman (1994), and Scharfstein and Stein (1990) for proof of herding by institutional managers, foundations, financial journalists, brokers, and money managers. There are no critical contrasts in real-life trading between the conventional classes of “smart money” and “dumb money. The hypothesis perceives the requirement where both reasonability is the standard and digestion of man’s dynamic, endogenous causal procedures in social settings of uncertainty, where herding is the rule. Examples of the difference between logical and nonlogical thinking exist with other social models. Freud’s “primary process” (nonlogical) and “secondary process” (logical) or Kahneman’s (2003) “system 1” vs. “system 2” thinking.

The Elliott Wave:

Socionomics proposes that the positive social state of mind is the wellspring of mental imaginativeness and good faith that prompts innovative achievements and bullish monetary markets and the economy. In contrast, a negative social disposition is the wellspring of stagnation and financial downturns. The social framework shapes the crisis; it doesn’t influence its substance, which relies on the ideas of the person and of financial issues when all is said in done. It is the premise that social temperament, which thus instigates social activities (one of which is purchasing and selling stocks), appears as a hierarchical fractal. The shapes can be traced out according to the “Wave Principle” (Elliott, 1938, 1946; Frost and Prechter, 1978/2005).

The Wave Principle
By understanding the Wave Principle, you can anticipate large and small shifts in the psychology driving any investment market and help yourself minimize the emotions that drive your own investment decisions. Here are some supporting papers.

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