In Crowd Psychology Part 1, I covered two primary topics:

1. The stock market follows the auction model
2. Crowd psychology influences investors

In Crowd Pyschology Part 2, I discussed:

1. How crowd psychology actually moves individual stock prices
2. Why this matters

Now let’s find out how crowd psychology plays into the market as a whole.

The first concept to realize is that, at any given time, the total amount of money in the entire market is fixed. For example, if we assume that the S&P 500 constitutes the entire stock market, then there are a limited number of S&P shares owned by investors. Therefore, the total value of those shares is fixed at that particular point in time.

Let’s say that I freeze time right now and the total value of the stock market is $X. For the individual investor, three concepts come into play here:

• Every individual investor has a fixed amount of money in his investment portfolio (not just stocks - could be bonds, real estate, etc.).
• Every individual investor has a fixed percentage of his investment portfolio invested in the stock market. Of course, this exact percentage probably varies across different investors depending on their risk profiles.
• Therefore, every individual investor has a fixed absolute dollar amount invested in the stock market.

In order for the stock market to go up in value, at least one of two things must happen (remember that the stock market follows the auction model, so it requires additional demand and money to push prices up):

1. Investors must invest a higher percentage of their investment portfolio in stocks (assuming that their investment portfolio remains constant).
2. Investors must earn more money to put in their investment portfolio.

Let’s analyze the implications of these two statements. Statement 1 indicates that investors must have greater confidence in the stock market and believe that it will offer greater returns than their alternative investments. This shift can happen very quickly. Statement 2 is slightly more complicated and depends on the fundamental state of the economy. This shift happens slowly.

How Crowd Psychology Affects the Stock Market

Hopefully you can see that there must be money available that is NOT in the stock market in order to push prices up. Let’s look at a real example to confirm this argument. In the internet bubble, the NASDAQ went from a low of 1,343 in October 1998 to a high of 5,132 in March 2000. This rapid growth in the market could only have been sustained by statement 1 from above - that is, investors must put a higher percentage of their investment portfolio into the stock market. However, because this growth happened so quickly, most investors in the market had allocated 100% of their investment portfolio in the stock market (and, in fact, many people were borrowing and trading on margin). The majority of this irrational behavior can be attributed to crowd psychology (as seen in Part 1 and Part 2). Once this happened, there was no more additional money available outside the stock market to push prices up. As a result, the only place for the market to go was to come crashing down, which was exactly where it headed. In the next two years, the NASDAQ burst and fell to its low in September 2002 at 1,135.

Lessons Learned

I hope you’ve realized by now that it’s not the best thing in the world when you see the market shoot through the roof without any end in sight. That’s when the media proclaims that there’s no risk in stocks, that the only place for the stock market to go is up. That’s when the naysayers have all but disappeared and even you, who are ordinarily skeptical, have jumped onto the bandwagon.

Here’s a quote regarding the current state of the stock market from the chief market strategist at A.G. Edwards from last week:

“We’re taking a very normal time-out to refresh. One of the best ways to gauge a market is to see how it reacts when you have profit-taking. It shows that the mettle of the market is still quite positive, that there is still money on the sideline that wants in.”

It doesn’t look like the market has reached that state of hysteria that has been seen so often in historical crashes, but always be prepared. Keep in mind that you will have to fight your basic instinct of greed that will take over when all you see is green. If you can keep your mind in the game, however, you’ll be in great shape to capitalize on very cheap stocks after the next crash.