If the stock market could be navigated based on simple logic and common sense, then smart computer programmers would control the world. They would just program in the logical responses to certain circumstances and wait for the market to react as predicted.
Fortunately for us humans, it isn't that easy. Navigating the stock market is tremendously difficult in large part because it doesn't think or feel like a normal individual. It is wildly emotional and irrational at times, and common sense will often lead to very wrong conclusions. As the economist John Maynard Keynes is credited with saying, "the market can remain irrational longer than you can remain solvent."
Crowd Psychology
To complicate matters, what drives the market isn't the emotions and psychology of a single individual. It is the emotions and psychology of a crowd. Crowd psychology tends to be even more extreme and can seemingly be wildly irrational when compared to the thinking of any one individual.
The biggest mistake many traders make is treating the market like it is a logical and reasonable person. You have to treat it like it is a crazy person or a crowd of very emotional people.
The market isn't random. It always has logic, but that logic may not be readily apparent much of the time. It is like the person that hears voices that make perfect sense to them but drives behavior that others can't understand.
How do traders use this irrationality and emotionality to their benefit? There are two basic views of crowd psychology. The first is that market players, as a crowd, are overly emotional and delusional. The second view is that the crowd possesses special a wisdom and insight that individuals lack.
Two classic books address these two positions. The first is Extraordinary Popular Delusions & the Madness of Crowds by Scottish journalist Charles Mackay which was written in 1841. He discusses economic bubbles, including the Dutch tulip mania of the 17th century, and observes that "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
The second book is 2004's The Wisdom of Crowds by James Surowiecki. He theorizes that crowds make better decisions because they can aggregate a great amount of information they obtain separately. In essence, it is decision-making by a huge research committee that has far more knowledge than any individual, or small group can possess.
Traders who focus on calling market turns tend to embrace the Mackay view of crowds. They see crowds as inevitably producing excesses as emotions build and the fear of being left out takes hold. Without question, bubbles like the Internet hysteria in 1999 to 2000 were created by this sort of behavior - even the action of the past week has elements of this herd mentality.
Running With the Heard
Momentum traders tend to embrace a different view of the crowd of investors. While the crowd may become irrational and downright hysterical at extremes, the vast majority of the time, the great mass of investors is correct. The way to make money isn't to bet against the herd but to run with it, and profit from its insight.
The current market environment illustrates how the crowd has possessed superior insight in the short term. You have done very well if you have stuck with the trend while the pundits have focused on how irrational the bullish thesis has been.
The contrarians who keep arguing that the masses are wrong and that this market will eventually undergo a substantial correction will likely be proven right at some point, but they fail to appreciate that the crowd has been right for over five years.
Market pundits tend to believe that they possess some superior insight that the crowd is too stupid to see due to emotionality and groupthink. They believe the crowd is blind to the obvious, but the truth is that the crowd can stick with their convictions and carry the market much further than an individual thinks is rational.
The market is largely an exercise in group psychology, but what most people tend to forget is that the crowd is much smarter than individuals are most of the time. It is only at extremes when the herd becomes delusional and is likely to lead us astray.
