Don’t Be a Lemming! (And Other Investing Wisdom)
Human beings are susceptible to blindly following conventional thinking until it takes them right off a cliff. That’s why our in-house experts give great credence to contrary investing, a method that entails bucking the herd mentality.
Contrary investing is the art of going against the crowd and the pressures of conformity. This mindset works in any sort of investment market because human nature is constant everywhere. The sad fact is, most people (and that includes investors) are lemming-like followers, not independent thinkers.
I continually strive for objectivity and right now I’m wary of the froth in the stock market. Don’t get me wrong: You should stay invested and enjoy your gains. But at the same time, beware.
Tulipmania and the madness of crowds…
The first trading day of September started on a positive note. On Tuesday, the Dow Jones Industrial Average gained 0.76%, the S&P 500 climbed 0.75%, and the red-hot NASDAQ jumped 1.39%. The S&P 500 and tech-heavy NASDAQ both closed at record highs. Stock futures Wednesday morning were trading higher.
Since the rally that started in late March, we’re seeing how most people move in groups. Consequently, they tend to buy after prices have already risen and sell after prices have already fallen. By following the advice of this article, you can learn to recognize the extremes of crowd behavior and make investment plays against it.
Charles Mackay, in his 19th century classic economic book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, aptly describes the tendency of investors to behave like lemmings. Consider his account of “Tulipmania”:
“In 1593, no Dutchman had ever seen a tulip. Their beauty and rarity caught the national fancy. In no time, they became ‘the rage’ as aristocrats flaunted the exotic flowers as symbols of power and prestige… Though supplies could be increased only as fast as nature allowed, demand for tulip bulbs accelerated at a fevered pitch.
Soon all tiers of Dutch society were swept up in a tulip-trading craze that peaked in the 1630s, selling ‘futures’ on crops not yet grown or harvested. In the end, crops of bulbs still in the ground were bought and sold so many times that the sales were called the ‘Wind Trade’ (as the speculative prices were being made up out of thin air). After the market crashed in 1637, bankrupting many, the era came to be known as ‘Tulipmania’ or ‘Tulipomania.’ ”
In the above passage by Mackay, substitute “tulip” for “collateralized debt obligations (CDOs),” and you come to the sinking realization that nothing has changed over the last four centuries.
A key factor propelling stocks to record highs in recent months despite an economic recession and negative corporate earnings growth is unprecedented monetary stimulus, courtesy of the Federal Reserve.
According to the Fed’s report to Congress on August 8, the Fed’s balance sheet has ballooned to $7 trillion as it buys everything from U.S. Treasurys to mortgage backed securities. Take a look at the following chart (compiled with Fed data as of August 26):
Remember CDOs? They were the villains of the financial crisis of 2008 and helped trigger the global meltdown. Well, they’re coming back into vogue. The re-emergence of highly risky CDOs doesn’t seem to bother anyone in government, but it should.
The Fed is buying a lot of debt that’s toxic. We face a reckoning, when these imbalances finally catch up with fundamentals. A debt crisis could be the pin that bursts the stock market bubble.
Watch For These Contrarian Indicators
To avoid tumbling off the cliff with the rest of the lemmings, watch out for these key contrarian indicators:
- The mainstream business press is repeating the same talking points about the same trend.
The talking heads on media venues such as CNBC often aren’t financial experts; typically they’re generalists and performers who glibly encapsulate the common consensus. For example, if a neatly coiffed pundit is warning of the imminent dangers of inflation, it probably means that inflation has already reached a peak and these fears are now overblown. Our strategists scrutinize the data and come to their own conclusions.
- A fundamentally strong company is unfairly getting beaten up in the press and by analysts, driving down its stock price to unjustified lows.
If a certain company is getting a lot of bad press for a misstep, sending its stock into free-fall, it could be a great buying opportunity. Take a look at the company’s fundamentals. If the company makes a good product that people will continue to need far into the future and its fundamentals are strong, you should consider making an investment. Bad press tends to be ephemeral. A disciplined contrarian investor is continually on the prowl for “out-of-favor” stocks.
- A fundamentally weak company is riding a wave of positive publicity.
The converse of the above rule also is true. People, with all of their irrationality, are what move markets. A company that’s benefiting from a lot of hyperbolic press coverage might have poor fundamentals and be ripe for a fall.
This dynamic is especially pronounced in the technology sector, whereby Silicon Valley companies announce sexy new gadgets that capture the fancy of consumers and local newscasts. Often lost in the gee-whiz coverage is the company’s unsustainable debt or lousy earnings prospects.
- The mood of investors is persistently gloomy.
If the stock market is bearish and everyone is regarding stocks the way Superman regards Kryptonite, a new bull run may be imminent. When investors are unanimously gloomy, prices can only go up.
- The stock market is on a dizzying upward trajectory, fueled by euphoria.
Which brings us back to the current rally. When everyone and his brother is buying stocks and dishing out hot stock tips, it’s a clear sign that a top is near. Investors tend to buy when they anticipate the market will rise; they sell when they anticipate the market will fall. But if everyone is expecting prices to go up, odds are that everyone who intends to buy already has bought. So, who’s left to bid up prices? The Dutch learned this lesson the hard way.
Let me be clear: I’m not one of those doom-and-gloom perma-bears. I want you to stay invested in stocks. Plenty of profitable opportunities exist in the stock market right now. But you need to remain disciplined, avoid trading on rumors in the press, and stick to the fundamentals. Increase your exposure to defensive plays (e.g., dividend-paying stocks) and consider using stop losses for any added exposure to risk-on assets.
Don’t get swept up by the Fear of Missing Out. You need to think for yourself. Generally speaking, if you consistently buy during times of unreasoning fear, and sell during times of euphoric greed, you’ll do well.
This trader is no lemming…
One analyst who always thinks for himself is my colleague Jim Fink. Jim has figured out a way to cut through the conventional wisdom and beat Wall Street at its own game.
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