Smart traders profit from the wisdom and delusions of the crowd

Crowds can be wise, but also manic and delusional. An astute trader learns to differentiate between these two extremes.

When there is diversity of opinion, the crowd is a force. The parts think independently, but private judgements combine to join as one powerfully wise collective.

Unfortunately this intellectual juggernaught will not last forever.

At some point diversity gives way to homogeny. Diverse thinkers conform to the will of the group. The smartest person takes the lead, which leads to less variance of opinion and acquisition of knowledge. The group no longer leads, but follows with irrational cognition as crowd psychology takes over the group.

The group is now set up for "popular delusions" and "madness of crowds".

Bubbles form that inevitably pop.

We have seen this play out for centuries. What startsas wise investing turns into a mania. Examples are too numerous to list, but here are a few:

• 1700s Tulip Mania: at one point tulips were more valuable than gold
• 1700s South Sea and Mississippi Company Bubbles: These companies were with more than 80 times all of the gold and silver in France.
• 1927 Florida Housing Bubble: A 2 bedroom condo in 1926 cost as much as a large luxury home in Miami today (4.5 million *without* adjusting for inflation)
• 2002 DotCome Crash: Nasdaq lost 78 percent of it's value in 18 months.
• 2009 Housing Bubble and Credit Crisis: Credit and housing mania leads to 50 percent loss in the market in 18 months.

In all of these instances, what started as smart, logical and prudent investing trends gave way to the insanity of the crowd.

Your job as a trader is to identify when wise crowd logic gives way to delusion.

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The Only Way I Know to Trade Post-Boom Commodity Bust

Today I received an insightful comment about commodity stocks and my recent bounce plays:

This market is nasty. The commodity stocks you point out had a little bounce yesterday but are down again today. The selling seems indiscriminate. I have only been studying the market for about 8 year so I lived through the tech bust. The volatility of this market is amazing compared to the tech bust. These commodities names have been destroyed 20% in less than a week on top of the previous declines. Hard to play this market and you are absolutely correct abtou VERY tight stops.

I agree with the comparison of the commodity boom and the late 90s tech stocks. In fact, in both my Trade Report and in this blog I have made this comparison, with examples. However, that does not mean we should shy away from playing bounces. In fact, if you study the tech bust closely, you will find powerful bounces that killed shorts and made riches for those who knew how to play them.

I will get into it in more detail over the weekend. For now, keep in mind that you have to be careful both long and short with the commodity stocks. Even in a downtrend, you can get killed going short (especially if entered after big down moves). My studies of previous busts (tech in the 90s, television and radio pre-70s, copy machines, etc) show that it's best to only enter during extreme conditions. Go short when the market is overbought on low volume pullbacks to strong resistance levels.

Play bounces when markets are extremely oversold--and I mean extreme. Keep tight stops. You may get stopped out a few times. That's okay. The bounces that do work will more than make up for the small losses taken.

This weekend I'll post some enlightening examples of the old high flying tech stocks, and compare them to the current commodity bubble.