Crowding at the exits

January 7th, 2007

Share |

Recently, we had done anecdotal verbal surveys and observations among the people we know. We notice these curious trends:

  1. More and more people (i.e. retail private investors) are trading the stock markets on the side. Leveraged derivatives, like Contract-For-Difference (CFD) are increasingly being used.
  2. More and more people believe that a big crash will happen one day.

For the first trend, that may explain the increase in volatility among the stock market, which in our opinion often does not exhibit the most rational of all behaviour. We believe one of the reasons is because of the widespread use of technical analysis. One popular idea among technical analysis is the concept of a ?support level,? whereby stock prices are expected to ?rest? on and rebound from. Traders often place their ?stop-losses? on the support level, which is the price level that they will sell their stocks in order to cut their losses. As the stock price rests on some traders? stop-loss levels, it triggered their stop-loss sales of their stocks. Such sales put downward pressure on the stock price, which may result in other stop-loss levels to be breached, which in turn triggered even more stop-loss sales. The outcome is a very steep and rapid fall in stocks prices. This outcome is an example of irrational and volatile market behaviour that is increasing in frequency. With easy availability of (1) leveraged instruments like CFDs, (2) instantaneous communications via the Internet and (3) automation of trading via computers at the hands of the common people (who are not trained to think like true investors), this effect becomes magnified even more.

For the second trend, it may be the consequence of the fact that the common people are beginning to understand and see the absurdities, excesses and greed in the financial systems. Unfortunately, even among those who believe that a crash is inevitable, they still have a substantial portion of the wealth in the stock market, either voluntarily through their side trading, or involuntarily through their superannuation. For some of these side traders, they may believe that it is all right as long as you know ?when? to get out of the stock market.

This is the scary part.

If you sincerely believe that a crash is inevitable, you have to understand these facts:

  1. You cannot know ?when? to get out. Crashes always take the majority by surprise. Otherwise, the majority would have gotten out long ago, which means it cannot be called a crash in the first place.
  2. By the time you know it is time to get out, chances are, everyone else does too.

What is the implication? The first trend, along with these facts implies that when a crash happens, it will be so extremely rapid that vast amount of paper wealth will vanish in seconds as the gigantic herd heads for the crowded exits simultaneously. Your chances of surviving a crash with your wealth intact is pretty much zero. Even scarier, since the vast majority of people have much of their accumulated wealth in the stock market through their superannuation, a crash will affect this vast majority, which is an unprecedented scale in all of human history.

Please bear in mind that we are not predicting a massive crash in the days ahead. We are highlighting the important point that if you sincerely believe that a crash is inevitable, the time to get out is NOW, which is the most rational thing to do. The ideas of (1) an inevitable crash and (2) staying in the stock market while the party is still on, are mutually incompatible. On the other hand, if this is not your belief, then you can pretty much ignore everything this article has to say.

Tags: , , , , ,