Apr-19 | Watch the crowd carefully… And Zig when they Zag!
Crowds are a funny thing. When a part of one a normally rational intelligent person will become a complete reactionary simpleton, allowing themself to be swept along. Being part of a crowd has cultural and evolutionary appeals. From a cultural perspective being part of the crowd brings up unwitting connotations of being accepted and helps fulfil people’s need to be part of the ‘it’ group.
From an evolutionary perspective being part of a group most of the time means safety, protection familiarity and comfort. For our ancestors it was much safer out in the jungle to be part of a large group than alone. Simple maths and probabilities meant being in a large group meant a lower chance of being eaten by a lion!
So from these cultural and evolutionary perspectives being part of a crowd is a good thing. In financial markets as a trader however, it is perhaps the worst thing a person can do! Being part of the crowd as a trader essentially means you are positioned with the great majority of people. That may feel emotionally comforting but it will be a harsh reality check when you look at your returns.
If you are trading your own funds then by default you must believe you can do a better job at generating returns than the benchmark index. It therefore stands to reason that if you think you can outperform the market you must then do something quite different to the market!
Many traders fail to properly grasp the underlying structure of financial markets. Essentially they are just a collection of big pools that are all connected together via piping. The overall amount of money in the pools only changes through 2 things
1. Central banks raising or lowering rates or QE– adding money / removing money
2. Investors adding or removing money – money moving in / out of the investing world from the consumer world.
Aside from these variables, the pool of money in markets doesn’t change – what changes is the ‘levels’ (capitilsation) in the various pools. When the half wits on the local news program say “$45 Billion was lost on the share market today.” It is misleading, what it means is the market cap of the share market has decreased by $45 Bill as compared to the day before. If you look carefully you will find other markets (bonds, currencies, commodities etc) will have risen by an equal amount.
Unless the money was actually removed from the investing world, either by Central banks trying to raise rates or an investor cashing out of an investment and spending the money as a consumer, the money just circulates. The money is never lost, it just moves.
Market Crashes – one laughs many cry…
Consider, when a share crashes from $100 to $50, the person who bought it yesterday at $100 is crying because their investment has declined by 50% overnight. The person however who sold the share to them the day before is laughing because he has the $100 in his pocket. He could go and buy 2 shares now with his $100 – and there we have the money moving around.
Think of it as water on the planet – some of it is in oceans, lakes, rivers while some is frozen as ice and snow and then some is falling as rain. It is constantly moving, changing appearance but always remaining as H20.
Depending on a number of factors, there is more or less water in one area of another. Farmers complain of drought and lack of water, whilst people in the tropics complain of floods! The water is always there it is just how you are positioned that will determine if you are in flood or drought.
Using this analogy of the planets water it can be helpful to understand why positioning one’s self with the crowd is not a wise thing to do. Consider this, where is the vast majority of the water on the planet currently located? In the Oceans (Bonds), by far and away there is more water in the oceans than in any other form. Just as with financial markets there is more money in bonds and fixed interest than any other asset class.
If global warming does melt the ice caps, how much will the oceans rise? Well even if it is by meters from the perspective of relative gains the effect is tiny. Given the ocean can be kilometres deep, a few extra metres of gain is not that much.
Conversely what would be the effect is water from the oceans began pouring into the lakes and rivers across the world? They would rise very rapidly as they are much smaller by comparison. It would not take much to double the size of the lakes and rivers should the water start moving from in from the oceans.
The same type of thinking can be applied to a movement from bonds into equities. The level of money (water) stored in bonds (ocean) should it start to move into equities (lakes and rivers) would cause a dramatic rise.
And this is the point that the great majority of people miss, it’s not earnings or revenue or whether the equity market is ‘bouncing of a support line’ that really matters. It is the underlying structure.
This is why as an investor one always needs to pay careful attention to where the crowd is positioned. As the crowd moves further and further into one asset class it becomes harder and harder for the asset to rise in value as there is already so much money having flowed into it.
When money starts flowing out of bonds and into equities it will be dramatic and far more sustained than the great majority realise. And not because some company ‘beat earnings estimates by 2 cents’ but because the underlying structure will essentially force it to be that way.
If a trader sticks with the crowd they may feel the temporary comfort of being in the crowd but they will ultimately feel the sting when the warm waters of familiarity drain away and they are left fighting the masses for what little water is left in the now desert!
Look for where the most amount of water is pooled and then position yourself so the next area to flood will provide you with a torrent of water!