The Madness Of Crowds
Understanding Market Psychology
How Market Psychology Drives Corrections and Creates Opportunities
Henry Jennings | Marcus Today | 07 August 2024
This article was originally posted on
nabtrade
In the world of investing, market psychology plays a crucial role in shaping market trends and creating opportunities. While much has been written about fundamental analysis—finding growth companies and trying to emulate Warren Buffett—it's essential to recognise the impact of
market psychology on stock prices and investor behavior.
Investors and analysts often pour over annual reports, build complex spreadsheets, and tweak inputs to determine 'fair value.' Price targets are frequently adjusted to align with market psychology, ensuring they don't stray too far from prevailing market sentiments.
Meanwhile, technical analysts focus on
market psychology by analyzing trends, moving averages, and pivot points. Understanding history and patterns is paramount in predicting market movements and investor behavior.
Understanding the 'Great Rotation' and 'Great Correction' in US Markets
Then along comes a week like last week. The US markets went from the
‘Great Rotation’ in July to the ‘Great Correction’ in August. It happened so quickly. In the Australian Market, we fell from record highs to a big sell-off. The stocks that took us up—the banks—came under serious pressure. Every talking head and analyst had been cautious on banks.
CBA had become our largest company on the ASX. It’s the most expensive retail bank in the world by most metrics. Yet where was the huge growth to justify this valuation? It may be a great franchise, but growth? That looks more irrational in hindsight.
Why Crowd Psychology Always Wins Over Fundamental and Technical Analysis
And what is driving this correction?
Psychology. Crowd psychology. You can build the best spreadsheet and have the best indicators, but the
‘madness of crowds’ will win every time.
Human beings feed on fear and greed. Humans program computers and pass on that fear and greed. In tech speak, that’s called
‘momentum trading’. Nearly everyone has been on the tech trade in the US. The so-called
Magnificent Seven. It’s been the most crowded trade for months. The trouble is, when the crowd moves, it’s every man/woman for themselves. Logic goes out the window, stops from active traders are triggered, and cascade downwards. One step away from sheer panic. A charge of the flight brigade, with the same consequences.
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How Smart Investors Can Capitalize on Crowded Trades
Smart investors can sometimes sense when the crowded trade is just too crowded. If everyone is long and bullish, who’s left to buy? In the game of pass the parcel, who’s going to take the stock off your hands at a higher price? Anyone? Bueller?
The good news is that
these crowded trades unwind fast—fast and painfully for some. For others who’ve been more circumspect and haven’t blindly followed the crowd, it can be a huge opportunity.
These times of turmoil can be
portfolio-defining. Not always in a bad way.
The Importance of Discipline and Strategy During Market Volatility
It’s important for investors to stay disciplined, stick to their investment plan, and use volatility to build long-term positions in quality companies.
You have to look at what’s worked in the past when rates were rising or at least on hold. These trades are unwinding. The so-called
‘carry trade’ has been under pressure; this is when borrowing in low-interest-rate environments is used to gear investments in countries with higher rates. Typically, Japan has provided cheap funding options that have allowed hedge funds and aggressive traders to take leveraged bets. That’s unwinding.
It seems a 0.15% rate rise in Japan was enough to send a shudder through the market with significant repercussions. But we should put this into some perspective, 0%-0.1% to around 0.25%. Maybe more to come. This was designed to curb the slide in the Yen against the US dollar. The Japanese market actually rallied post the announcement. For a day!
It’s all about relatives. Japan is putting its rates up, and at the same time, the US is now looking at more cuts in the coming months. Relatives.
While there are opportunities, there’s no point in standing in the way of the cavalry charge when the herd is moving this quickly.
Wait for the moment. Have a shopping list ready of stocks that you feel safe buying and the prices you feel comfortable with. There’s no rush. A rout like this hits confidence, and that takes time to rebuild.
But it’s important to remember,
this too shall pass.
Henry Jennings 
