IN THIS GAME
you have to be at once a skeptic and an optimist. You must firmly believe there's no safe stock, no sure-thing investment and that risk is always present. At the time same, you need the cajones to willingly make big bets you believe will pay off handsomely down the line. From fear to greed to fear to greed again. You're not bipolar. You're just a trader with a love for the markets.
In just a few short months, the valuation of everything from crude oil to Circuit City to the Canadian dollar has changed by hundreds of billions of dollars. The global economy is made up of billions of people. Free markets are constantly working to accommodate their interests. To that end, our positions need to change with the times.
Every trader should develop a style he is comfortable with that works. A big component of mine isn't even focused on what to buy...but what to avoid. As regular readers know, at the top of the list are investments I believe to be favored by "the herd," the slow-moving majority of average investors whose portfolios chronically end up in the red.
I'm often asked about how to identify the herd, and there are some objective standards. For example, herd-owned stocks are always quite active. It's one of the reasons I still don't see the herd as being present in the FX trade. For example, CurrencyShares Australian Dollar Trust is up 11% this year and it barely trades 60,000 shares a day. The PowerShares DB US Dollar Index Bearish fund has only gathered $27 million in assets, even amid one of the most historic moves in the dollar's history. That tells me Joe Six Pack is far from on board the train just yet. For comparison's sake, Energy Select Sector SPDR has $4.8 billion in assets.
Other measures are less objective, such as monitoring message board postings or magazine covers. When the proverbial barber inexperienced novices with a lack of risk capital start recommending XYZ, that's usually a good sign too.
But ultimately the herd is like pornography. You simply know it when you see it. And if you're lucky enough to stick around the markets long enough, you begin to know what to look for.
One mistake is to falsely believe that the herd is in XYZ simply because it has gone up. But as we pointed out back in 2002, markets rise as a result of lack of supply just as they do the presence of demand. XYZ's 20% rise can just as easily be explained by a lack of sellers than presence of "dumb money" as buyers. Beyond the standard fundamental or technical research, surveying the herd requires a behavioral approach: not even analyzing the companies, but the investors who are buying and selling them.
The presence of the herd in a particular stock doesn't necessarily mean it's about to plummet either. Frequently, the popular herd-owned names will continue to rise, often markedly. But this is a game of percentages, and once a trade's ownership shifts from a few to the many, it's an important indicator the odds have tilted against you, even just slightly.
But the popularity of herd stocks is what makes them so appealing. It's rather comforting to buy stocks that are widely owned, actively traded and bullishly endorsed by the big brokerages. CMGI, one of the original "cult" stocks of the 1990s tech run was a herd stock back in the day. Like Cisco, Sun Microsystems and Microsoft, if felt as if you simply had to own it. Everybody did.
Toward the true end of the move, the herd investments start to be touted solely on the basis of their stock performance, not even their underlying fundamentals. "Intel has gone up 1000% in five years", I can remember people saying back in the late '90s. The thought was that if it has risen that much, surely another 10% or so bump was in the cards. There's the flawed thinking: Suddenly you're no longer playing for the major move, just a few more shekels from the big move that has already occurred.
I also look for a wide diversity of ownership as further evidence of the herd in XYZ. Once the dumb money is on board everybody is on board, not just the day traders, suburban housewives or large institutions. In stocks like Apple, which is admittedly quite strong, it's as if everybody seems to have a piece. Investors young and old, big and small, value and growth are all in the trade. It's one dance I'm sitting out.
More recently, the herd has piled headfirst into foreign stocks a dramatic shift since we first started writing about them more than five years ago. An unprecedented amount of new mutual fund dollars now flows into foreign funds and ETFs. A sea change of perception has occurred. Years ago I was laughed at on television for investing in such far-flung locales as Turkey, India or Taiwan. Now brokers and newsletters pitch those investment themes on a daily basis.
The world is constantly changing, and it's the speculator's job to change with it. That involves not only staying ahead of the market, but ahead of the herd as well. Although we're all "dumb money," the recognizable herd is the dumbest of us all. Avoid their favorites and you'll avoid their fate.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.>