Sanity Always Prevails

Neil A Costa

We have had a stock market shakeout. Did it really come out of the mist? Did it creep up on traders like a thief in the night, stealing their profits before they knew what had happened?

NO!

There were warning signs. There were warning signs everywhere. The key was to be able to see them, interpret them and to act on them.

History has taught us some excellent lessons.

The United States stock market in 1929 is an excellent example of crowd euphoria in the stock market. Radio Corporation of America’s (RCA) price rose from $94½ to $505, gaining 435 percent in just 18 months. By 1932, its price had fallen to just $2½. For those who decided to wait for the stock to recover its former glory, it took 67 years for them to get their money back. So much for a ‘buy and hold’ strategy!

RCA was the rule, not the exception. The Dow Jones Industrial Average peaked in 1929 at 381. Three years later it bottomed at 41. The crowd had gone from being like a rampant bull to being like a suicidal bear.

In Australia, in the late 1960s, there was a rush to purchase shares in Australian companies that were mining, or hoping to mine, nickel. The most famous, Poseidon, was trading for just two or three cents in 1966. In a four-month period in 1969/70, Poseidon stocks rose from $1.00 to a peak of $280, in less than four months, after news of a nickel discovery.

Poseidon went into receivership in the mid 1970s. It’s final price – zero.

All bubbles burst.

In a ‘normal’ liquid market, there is a balance between buyers and sellers. Traders have their own thoughts on factors such as:

  • Whether they are intra-day or long-term traders.
  • What is a fair price for the stocks, options or commodities they wish to buy.
  • For how long they would like to hold their position in the market.

When there is an imbalance of buyers and sellers, market prices rise or fall. If the strength of the buyers outweighs that of the sellers, the market will rise. It will keep rising until the buying pressure has been exhausted. If the sellers are the stronger group, the market will fall.

Speculative manias, or bubbles, occur when the vast majority of traders want to buy at once. Crashes occur when the vast majority of traders want to sell at once.

What then were the warning signs that the market was getting dangerous?

As the market became more and more overheated, experienced traders started to see the danger signs. Did you observe the following?

  • The number and size of new floats (initial public offerings)? Few company owners would float their company in a very weak market. As a strong bull market matures, the number of floats, per month, start to rise rapidly.
  • The spectacular success of many floats, and the accompanying reports that people were making ‘easy money’?
  • The television coverage of children making thousands of dollars trading the stock market.
  • The coverage of the new breed of so-called day traders who resigned from their jobs to trade full time.
  • The full-page colour advertisement published asking “Need to know what your shares are worth now? MobileNet… and you can.” (The advertisement featured a mobile phone displaying a stock’s share price.)
  • Air Lines Flight Deck lounges across the country installing large stock quote boards.
  • Talk of ‘old’ versus ‘new’ economy stocks, somehow suggesting that you had to purchase the new economy stocks to be ‘cool’.
  • The playing down of the importance of company earnings in justifying the price of so-called new economy stocks.
  • The fact that the stock market had five bull market years in succession – something that had not occurred since the 1950s.
  • Charts, such as the Nasdaq chart, rising in a parabolic manner to a point where its final trendline was almost vertical.

… and so on.

An Understanding of Crowd Psychology Is Vital

As individuals, we tend to behave in an intelligent, controlled manner – at least most of the time. When we become members of a crowd, however, our behaviour can change quite considerably.

Human beings become members of crowds, and follow the crowd, because:

  • Being a member of a crowd gives them a feeling of security.
  • Following a strong leader allows them to feel reassured.
  • Doing what others do helps to combat a fear of uncertainty.
  • We have felt secure being members of different groups all of our lives, and hence we are conditioned to wanting to become a member of a group.

As members of a crowd, we tend to follow the crowd leader, and to trust the judgement of the crowd leader more than our own judgment. In the case of trading, the crowd leader becomes ‘price’. Members of crowds tend to respond only to very obvious changes (such as a market crash), and not slow, subtle changes, such as a bull market slowly making a topping pattern and turning downwards. They also become more emotional and impulsive – which is not a desirable characteristic of a trader.

An understanding of crowd behaviour will help you to understand how traders become mesmerised by roaring bull markets, and how they fail to see the clear warning signs that the market is becoming dangerously overbought. Such an understanding can make you, and save you, a great deal of money!

An understanding of how individuals behave when they are a member of a crowd is very important for a trader, as there are times when a trader must do the exact opposite to what the crowd is doing. In trading, this understanding comes from studying the theory of contrary opinion.

To be a professional trader, you need to be able to analyse what ‘the crowd’ is doing at any one time, and be prepared to do the opposite should your trading system give you a signal to do so. At the very least, you should exercise the utmost care when you observe extreme crowd behaviour.

Mackay, in his classic book Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841, concluded that entire communities can be deluded in the pursuit of easy wealth.

We find whole communities suddenly fix their minds on one object, and go mad in its pursuit; … millions of people become simultaneously impressed with one delusion…

(Preface, Extraordinary Popular Delusions and the Madness of Crowds.)

The following books are recommended reading:

Galbraith, J.K., The Great Crash of 1929, Penguin Books, Harmondsworth, 1963.

Kindleberger, C., Manias, Panics and Crashes, John Wiley, New York, 1996.

Le Bon, G., The Crowd, Traders Press, Greenville, S.C., 1994 (first published in 1897).

Mackay, C., Extraordinary Delusions and the Madness of Crowds, Random House, New York, 1980 (first published in 1841).

Schultz, H., Panics and Crashes – How You Can Make Money From Them, Arlington House, Westport, 1980.

Common Reasons for Not Selling

People have a whole host of reasons they use to justify not exiting a trade when their trading system has given them a clear signal to exit. The following are some of the more common reasons:

The All Indexes are Still Rising

Always remember that we make our money from individual stocks, not from the market index. Key stocks may turn down quite sharply while the overall market keeps rising. If you own one of these stocks, follow your exit signal promptly. You cannot be sure that the index itself will not follow the stock down! Furthermore, even if the index keeps rising, your stock may increase in value at a slower rate than other, stronger stocks. Surely your money is better in another, much stronger stock, in such conditions?

The Stock is a ‘Blue Chip’

No stock is immune from the effects of a protracted bear market. If you doubt this statement, pick any so-called ‘blue chip’ stock and examine its chart for the year 1987! If the overall market sentiment is bearish, few stocks can swim against the tide indefinitely. If your stock is weak enough to generate a sell signal, then don’t look for excuses, just sell. The money is better off invested in another, stronger stock, if the market conditions permit this.

Failing To Sell Because The Dividend Yield Is High

As a stock falls, its dividend yield will rise, if its earnings remain constant. Reduced earnings are often not revealed until the stock has fallen considerably – and by then you could have already suffered a substantial loss.

Waiting for a Dividend to be Paid

A stock can fall faster than you may expect, particularly if the market has just experienced a blow-off top. Waiting for a dividend to be paid can cost you a large sum of money while you wait for a smaller sum of money.

Waiting For The Taxation Year To End

Some people, wanting to avoid being taxed on high profits in the present financial year, delay selling stocks until early in the next financial year. Again, many have found that by the time they sell, their taxation problem has solved itself – the stock price has fallen to the point where the profit has gone! Some, by that time, end up with a taxation loss. When you think about it, the best rule with respect to taxation is to make the money when the opportunity presents itself and to worry about the taxation on the profits later.

Waiting For The Next Rally

Again, this is just an excuse to delay taking the correct action. A rally may not occur until the stock has fallen a substantial distance, and may not be large at all. This means that if you are smart enough to sell at the top of the rally, which is highly unlikely, your profits could have been decimated by this time. Furthermore, if you could not sell when your stop-loss price was hit, the odds are that you will find some other excuse that will prevent you from acting to preserve what is left of your capital.

Failing To Sell A Stock Because The P.E. Ratio Is Too Low

If a stock is falling, the Price Earnings ratio is largely irrelevant. A company’s P.E. ratio can be low because the company’s profits have fallen. It is likely that the stock price will follow the earnings in a downward direction.

As you can see, traders can find many reasons to justify not selling a stock that gives a sell signal. Courtney Smith, a highly respected United States trader stressed in an interview published in Technical Analysis of Stocks and Commodities magazine (edition unknown) that traders must exercise the most discipline when they exit trades:

… on the stop loss, or the exit side, their self discipline breaks down and possibly only 20% or 30% of people use what’s in their trading plan. That’s where their self discipline breaks down – the exit side, not the entry side.

(Courtney Smith, page 87.)

What is even worse is the number of people who do not have a trading plan. Is it little wonder that they get trapped holding stocks that have lost value at an alarming rate?

The Stop-Loss Order

If you do not use stop-loss orders, it is not a matter of if you will go broke, it is a matter of when you will go broke.

(Wall Street saying.)

Stop-loss orders, placed with a stock broker, allow a trader to exit a trade the best way – that is, automatically. This overcomes any temptation to ‘wait and see how it goes tomorrow’.

The use of a stop-loss order is the hallmark of a professional trader! It is rare for members of the public to use these orders.

Traders who understood crowd psychology, who had a proven method for exiting their trades, and who used a stop-loss order to ensure that their trades were closed when their system signal was given, found themselves in a position where their capital was preserved and they were ready for what could be excellent buying opportunities at some point in the future.