Stock Trading: The Majority is Always Wrong

Experienced traders know the Wall Street maxims: "Don't argue with the market" and "The market is always right." "The majority is always wrong" is less known and harder to absorb, but it does not make it any less accurate - it just needs clarification.

If the market is always right, how can the majority always be wrong? Shouldn't the market action be the result of the majority opinion? The relationship between the number of market participants and the majority stock ownership is not linear: it's a pyramid. There are plenty of statistics to show how widespread stock ownership in the US is, but in the end the largest stock holdings are in the hands of the few. When "the market is right," it's the big money, not the masses, that moves the stocks, and that is why it is so dangerous to argue with it.

"The majority is always wrong" requires another qualification: the majority is always wrong at precisely the wrong times, or at critical turning points. To appreciate this, one needs to look at how opinions are formed and acted upon in the market.

No trend lasts forever. At some point it must reverse. Few can ever accurately predict when, but it always does. While a trend is firmly in place, the predictions run a full gamut, from "the sky is the limit" through "this time it's different" to "there is no reason this should be happening" and "this is going to end badly." Even in the last scenario, the post-apocalypse projections vary.

But someone within that full gamut must be right because at some point a trend ends and a new one starts. Even if the predictor was right on the course, he may still be off on the timing, and in any event he is in a tiny minority until his predictions begin to come true. When that happens, more and more people begin to agree with him. People change their opinions gradually, one at a time. As this happens, the new trend gains strength. This produces more converts until seemingly everyone is on the same side of things. But a market requires two sides to each transaction. If everyone is on the same side, there is simply nobody to take the other side. That's when the trend stops working.

There is no shortage of examples. The Internet boom lasted for several years, although there were skeptics all along, but the bubble burst in 2000 when the frenzy reached a boiling point. In 2007, oil was going to $200 or even $400 a barrel and we were running out of it. What happened? Oil reversed at $175 and has since lost half its value. If we are running out of oil, why bother to plug the Gulf of Mexico hole - it will run out pretty soon. In 2009, we were going into the greater than the Great Depression. Did we?

I can't wait to see what the next collective craze will be so that I know what will not happen.