Ocean-wide differences - part 2 : Herding behaviour
Introduction
One of the most common pattern we can see in the stock market is the herding behaviour: a pattern where major stock market participants tends to move to the same direction. You must have heard the saying: "Strength in numbers" which is true in some cases, however in investing you cannot apply this principle blindly, we need to know who are the people behind these numbers.
Smart and dumb money
In part-1 we discussed about whose smart and dumb money are. If the big numbers are coming from Retail (pool of capital consisting large amount of people) then it's a disadvantage and you need to reconsider the investment you're looking at.
On the other hand, if the big numbers comes from small amount of investors carrying large capital --> this becomes an advantage. So it really makes a difference to what kind of "large number" we are talking about.
Overcrowded trade
Another concept to explain the herding behaviour is how popular investments increasingly become more and more popular (~ strength in numbers). If this goes on it will become what's known as overcrowded trade --> a situation where everyone, even your cab driver, your moms and pops knows about it and buys the stock.
When everyone is already inside an investment (picture a packed full train car) then it becomes heavier and makes it more difficult to move due to the weight of all the people inside the train car.
On the contrary, an undercrowded train car has lighter weight and is easier to move. Now the question is howcome there's overcrowded and undercrowded train cars? What's making them so different that people choose one over the other?
- Business cycle
Which stage do you think represents the "overcrowded trade"
Luxury train and horse cart
Between those two choices, you should've gotten a picture why one mode of transportation is popular and the other is not. Luxury train here represents solid fundamental, while the horse cart represents empty / hollow fundamental. Of course people would've chosen the luxury train, especially if the ticket prices are similar / not that different.
However is it logical to expect luxury train to have similar ticket price to a horse cart? Next question is it possible to buy luxury train ticket at the price of horse cart? When there's market contagion / massive market crash it is possible, which is why for those heavy in cash weighting thrives in a collapsing markets.
Know where your positions are in the cycle
Timing of cycles is one of, if not the most important factor when buying an asset. I'm sure you've seen one of these images:
Economic cycle
Note: pay attention to the sectors outlined here, they can be a guideline over which ones will outperforms the rest.Market cycle
Note: notice there's timing gap between market cycle and economic cyle. This is why it's said: "The stock market moves first, economy follows later".Inflation and interest rates cyle
Note: powerful chart here, pay attention when the cycles are at inflection points (from up to down and vice versa). Also notice usually there are timing gaps too here between central banks cutting rates and the inflation rates themselves. I use the word "usually" because there are times when the central banks are late to the action (like it did in recent years ~ too little too late!).Stock market cycle
Note: the worst of herding behaviour happens at the peaks and bottoms of the market.
These types of graphs looks simple but they tell you a combined history of market wisdom. These are the equivalent of:
printf("Hello\n");
println!("World!");
Meaning they're the "Introduction to..." or the 101 topic. The first thing you need to read and understand the what and how economy works. Back to the luxury train and horse cart analogy, the answer is yes: there are ways to be able buy luxury train ticket at the price of horse cart --> that is when markets are collapsing.
On the other hand when markets are peaking, in order to make profit it's not unusual we see people buy horse cart ticket at the price of luxury train...absolute madness. Herding behaviour becomes much more prominent at market extremes (peaking and bottoming) and we need to make sure we are not into one of these herds.
These market extreme events happens again and again with the bigger ones happens every 5 years which provides bigger opportunities to either: increase or destroy your wealth. If you know your cycle then you'll know what to do and when.
Contrary to the mass point of view, collapsing markets are the ones we need to be waiting for..you'll be missing opportunities of a lifetime if you end up being "fearful" in a crashing market.