On July 1, 2011, Brett Arends wrote in MarketWatch a piece lambasting groupthink and crowd psychology in “Dominique Strauss-Kahn and your money; Commentary: Wisdom of the crowd comes into question yet again.” The article was an intriguing way to relate the rush to judge DSK in mass media in the absence of complete information to the rush of traders and investors to chase the latest hot stock or investing fad. The article reminded me of why technical indicators can be more important and more powerful than trying to interpret the news and guessing at how the stock market will react to that news.
We are drowning in information and are bombarded with just about every possible opinion and spin on the headlines:
“We think we live in a golden age of information. We have the Internet, cable TV and satellite radio, Twitter feeds, Facebook updates and a constant stream of blogs. We have them everywhere, and all the time, on our computers, our phones and our iPads. We like to think this leads to more information and therefore better-informed judgments. But the reverse is often the case…
This onslaught necessitates implementation of coping mechanisms. In technical analysis, we cope with the market’s numerous and sometimes conflicting signals and headlines by simplifying analysis: the stock market consists of prices and volume. When I am acting as a technician, I focus on T2108 (the percentage of stocks trading above their 40-day moving averages), the 50 and 200DMAs, trading volume, and trends. Occasionally, I may check in on other more esoteric signals for confirmation of an assessment. These signals are windows into the market’s current mood. From there, I decide whether the risk/reward trade favors following the crowd or betting against it. Increasingly, Arends finds himself appalled by the judgment of crowds:
“Financial markets are simply the crowd in action. They reflect the weight of money and investment opinion. That is their strength, but that is also their flaw. The more I see mass judgments in the age of infinite media, the more I think it’s a flaw…
…The judgments become self-reinforcing. Contrarian voices are drowned out. The mob is frequently wrong, but never in doubt. Our new information age is one of more volatility, more misjudgments, wild irrational pricing — and huge bubbles that inflate, and then deflate, in a moment.
Yet despite all this, most investors still remain under the influence of an incredibly dangerous idea: The idea that the market is always right, or at least rational.”
These concepts are tricky. In my opinion, it is more accurate to say the market is always right…until it is wrong. Ask anyone who tried shorting the housing bubble for three years before it finally burst or anyone who “knew” tech was in a bubble but lost massive amounts of money betting against it in 1999. Trends can last longer and get stronger than anyone might expect exactly because of the self-reinforcing impact of trends. As the adage goes, the market can remain irrational longer than a trader can remain solvent. Again, the market is always right…until it is wrong. Conversely (perversely?), contrarians are always wrong…until they are right.
Technicians accept the market for what it is: “a crowd in action.” This approach does not require an assumption of rationality. Instead, technical signals help us evaluate the strength of a trend – is the stock or index still above the 50DMA? How about the 200DMA? – and whether the risk of following the crowd remains worth the potential reward – is T2108 oversold or overbought? Technical signals help us evaluate when groupthink has potentially reached an extreme. This is the time to end the current bet and at least start considering making the opposite bet. The technician can only make this switch in attitude, if s/he remains flexible and sticks to rules. Even reading fundamentals requires the same discipline since the viability of a company’s revenues and profits can never be taken for granted. So Arrends is correct when he cautions:
“We should always be willing to change our minds if need be. This is the hardest thing to do. We constantly have to remind ourselves that we could be wrong.”
I extend this thought to reassure us that it is fine to follow the crowd…as long as you are one of the first to change your mind. And, yes, that is so much easier said than done. However, if your trading/investing framework is grounded in rules you can follow consistently, and if the rules stand above emotions and consensus, you should do just fine.
Be careful out there!
Full disclosure: no positions