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Do the Wrong Thing

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We have come a long way in 100,000 years, but some things never change. That is what instinct is all about. In trading, it is also about herd mentality. . .the fear of straying too far from what others are doing and saying. Despite losing nearly 4000 Dow points and about as many NASDAQ points over the last two and a half years, a majority of analysts are bullish and the herd still follows them. . .financially deadly and intellectually wrong.

We have all heard the call of the contrarian at one time or another. They are the ones who buy when others are selling and sell when others are buying. They are the ones baling out at the top when others are piling in, and buying with both hands when nobody else will get near a former favorite stock. We hear it said that, "The herd is right in the middle and wrong at both ends". We are all born with hard-wired instinctual reactions that cause these ebbs and flows of fear and greed, not to mention euphoria and depression.

But as counter-intuitive as it is, the contrarians are a successful trading bunch with a lot to teach. However, if we are to take instruction from them, it is helpful to understand the herd mentality first. Just how did it develop, and why do we still follow it even though it is not generally good for our portfolio? That is where the hard wiring comes in. It was born of the "fight or flight" response to danger.

100,000 years ago when we were perfecting the wheel, mastering fire, and chasing down dinner with a spear, big cities with massive infrastructure and farmers/grocery stores did not exist.

Being the hunted rather the hunter was a big problem. If people were to survive through the night, they needed protections from the wilds and the elements. Survival depended on a small collection of people - a tribe - to look out for one another. Some would stand guard while others slept. Some stood guard for protection while the hunters hunted. Some stood guard while the "cubs" grew old enough to survive on their own.

Standing guard is the operative phrase and an element of our development that never went away. People learned to always be on guard because it triggered "fight or flight" and insured survival. Let your guard down and you became dinner for lions, tigers, and hyenas, not to mention large snakes with coils. People could not survive without the benefit of the tribe to insure their mutual safety. The first warnings from the guard instinctively triggered the fight or flight response. The "guard", or analysts in this case, are still calling each successively lower market day "a bottom". The tribe ought to stop trusting the guard.

In short, with an occasional loss, most tribe members survived bouts with danger because they were alerted early enough so that the "fight or flight" response was triggered.

It was and still is very normal to focus our attention on that which might become a danger. Witness jungle law then, or even while camping now. When we hear a noise in the woods, our instinct is to drop what we are doing, face in the direction of the noise and decipher what we heard. Is it a threat or not? Is it a falling pinecone or a grizzly bear that wants our ice chest? When the "tribe" collectively turns to face the noise, all senses are then focused on and notice possible danger only from the direction of the noise.

Two things occur here. First, we are focused on that one danger, which by default means that we are mostly oblivious to anything else. We have narrowed our field of focus to make a "fight or flight" decision. Second, the good news is that everyone is now alert to that danger, and by virtue of the attention it receives, it is handled, and no longer the unknown threat. It is now known.

By inference, we can now see that if the tribe has turned to face the danger, the fact that so many are now focused on it removes a big element of the danger. The bad news is that at the moment the tribe is facing the danger, it is most vulnerable to what may be lurking over its collective shoulder at the same moment. Perhaps they failed to notice the boulder rolling downhill toward camp! The noise they heard in the forest turned out to be forest animals running away in their flight response to the boulder!

The same thing happens in trading. For example, everyone is focused on the, "Is this the bottom?" question for months on end. Do not get me wrong, it is a major problem. But it is a danger that has been accounted for and prepared for. The investor tribe has already turned to face that danger. While everyone is fixated on the question, the real danger lies elsewhere - like in the extravagant personal debt loads and threat of worldwide deflation. But where is the guard watching that unfold? Actually, he's there. He's merely being ignored. Who cares about the erupting volcano when this moment's hunting conditions are reported to be so good?

Need a real example? Remember over a year ago when gasoline prices rocketed at the height of California's energy shortage? As soon as alarm bells rang for $3 per gallon gas, the tribe knew and turned to face the danger. Gas prices then fell and oil stockpiles increased ever since. Again, the danger once known is no longer a danger because steps are taken to avoid it. But it has to be perceived as a danger first. Not so when it comes to analysts view of the market. They don't perceive it as a danger.

But probably the greatest example I know of is the Y2K scare. Panic and doomsday were in the air. The devil known and prepared for is no devil at all, and Y2K was a non-event (other than giant parties). If we perceive the danger, it is already handled and no cause for alarm as long as the guards don't have a logic fault.

So how does this relate to our own trading psychology? In reference again to the tribe, when it hears a noise, turns to face it and warn the others, the noise is no longer a danger. The danger is now everywhere else.

The contrarian knows at that time to turn away from the tribe and find the other danger sneaking up from behind. This is always counter-intuitive. Who really believes Bill Gross of PIMCO is predicting unashamedly for the Dow to hit 5000 before the damage is all over? I do, as do a few others in the minority.

It is always the unexpected that moves markets, never the expected. This is why "buy the rumor, sell the news" works so well and why money manger and Forbes columnist, Ken Fisher refers to the market as The Great Humiliator. Its job is to humiliate as many market participants as possible at any given moment.

That is why betting against the herd works so well at turning points in the market. Turning points? None other than an oscillator's representation of a top or a bottom. Things always seem best at the top and worst at the bottom. That is precisely the time to go contrarily in the opposing direction. Things seem really bleak to many right now, but somehow tech stocks are still the darlings. Until tech stocks are treated like lepers (it hasn't happened yet), they will not find a bottom. There are plenty of boring companies out there that are pedestrian but cheap. Nonetheless, they make money and are about to be discovered (again). Think Philip Morris (MO), Dupont (DD), Cemex (CX). Boring, but pretty dang reliable, and they pay well. They will probably pay even better if/when the market heads for lower lows.

In 1999 and 2000, investors were writing Warren Buffet off as a washed up has-been. Today, Warren looks like a genius because he bucked the trend and did not travel with the herd. The danger lay in what the herd refused to acknowledge or did not see. Namely, that valuations were sky high and unsustainable in the long run. Prudent speculators, and there were only a few, recognized it for what it was - a bubble into which to sell. Sure they missed the final 1000 points of gain in the NASDAQ, but they were out in the ensuing 4000-point drop.

It pays to avoid the herd

Now the only remaining question is, if a tree falls in the woods and no investor is around to hear it, is it a danger? If I am the only investor to hear it, it is a danger. If everyone else hears it, it is not. Trust your judgment and work hard to turn your back on the tribe when they scream the loudest.

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