For those of you who are members you will know this familiar reference I am about to make. For those of you who are not, this may (or may not) change your perspective on how you see the markets. 

Let's imagine for a moment that every stock in the stock market is a dance club. There are some clubs that are really popular filled with celebrities and with lines out the door, some clubs that are staples where you know you should go to if things are dry that evening, and some clubs that used to be popular but now foster a repulsive response similar to the one you get when you think of getting chlamydia. 

Let's focus our attention on the "hot club" -- this place is bustling, filled with models, celebs, people with more money than God, and the wanna be's. Now it's safe to say that this club survives on the backs of the people with the real money, the "Fuck you" money. The athletes, the Wall Street tycoons, the Saudi Royalty etc. Sure your $200.62 bartab pays their bills too, but they don't rely on you. They don't need you. You are replaceable. You are the fodder. I understand that sounds bawdy but it is the truth. The sooner you understand your place on this totem pole, the sooner you can advance up it. Sure sometimes you can strike gold and sit at the high roller table but most times you are just along for the ride. 


  What the fuck does any of this have to do with the markets? 


If you apply this analogy to the stock market you can classify each stock you watch as falling into one of these categories. For the remainder of this post we'll focus primarily on the "Hot Clubs" (hot stocks).

Using this example and visual from above, the hot stocks that trade on the NYSE are the hot clubs. Your high beta stocks, the NFLX, AMZN, CELG, REGN, TSLA, FB, BLUE, MBLY etc of the world. The hotter the club, the longer the line and the more people are willing to pay to get in. 

Once they're in they have a double edged sword of expectations. They are using their high entry fee as a means to justify how "Epic" it is in there (How great a company's potential is) and they're simultaneously pounding their fist on the table expecting their astronomical expectations to be met given the prices they're paying (high expectations/earnings expectations). 

An interesting thing happens with the life of any club. The longer the club is open the more people that end up walking through its doors. The big fish come and go early and the little fish slowly drip in (much) later as it becomes more easily accessible. At some point, this establishment slowly starts losing its luster but the average joe doesn't see that yet. They are just now getting their fill while the big guys have been having outlandish nights there for months. The club starts holding events to up the interest and keep the appeal. They hold the line at the door to peak interest etc etc. 

This is the part where you hopefully start to see that human psychology is human psychology. It doesn't matter if you are talking about the stock market, a club, a football team, or a f'ng cronut. The higher the perception of value behind something the more you're willing to pay for it. The more you're willing to pay, the higher the expectation. That's marketing/branding 101. And nothing is more powerful than the scarcity effect. So with the example above, the hot stocks give off the perception that they are going to continue to grow exponentially. As their share price continues to go higher and higher and shares become more and more scarce people want to get in more and more willing to slap the bid at almost any price. They begin to justify their unwarranted expectations.

As the club gets more and more packed, the other ones like it/near it start to fill up as well. The next "hot" club opens up by the same owners. People line the streets, pay any price at the door, and facebook and instagram about it. It's Gatsby all over again. 

I want you to envision the scene of a packed club picture how crowded it is and how difficult it is to move in there. Now I want you to imagine something terrible -- a small fire. First there is the scent of smoke and some people will exit because they don't like the scent. Shortly thereafter some people start to see actual small flames and start to head for the exit. As it gets bigger more and more people become aware until the DJ's music is abruptly stopped and everyone starts running for the exits at the same time. 

Though that scene is a horrible one to envision, it paints a visual for you. Now hypothetically speaking, let's say there was no large fire and that it was a small kitchen fire. The fire department shows up, people find it out it wasn't a big deal and it was a one time thing. A few days later it is business as usual, like the fire never even happened. 

Now I want you to imagine that it is a few weeks later and this time another similar situation happens. Same thing, kitchen fire, no big deal, gets put out right away and people return. A few days later, the same thing happens, only this time it's serious. By now, the people who have been through the two previous fires will think "Oh, no big deal. I will take my time here." The DJ music won't cut off right away. The bartenders won't stop serving drinks as quickly. This time however, the fire is for real. It grows and spreads quickly and by the time people realize it's the real deal they panic and head for the exits. In this last scenario, the exits are not enough. People will literally try to get out by any means necessary. Some will survive and some will not. 

This scenario I just painted is similar to when a trend line is broken briefly but reclaimed in high BETA stocks. The first time it happens some people will panic, some will stay put, and some will reduce their size. The next couple of times it happens people will grow more accustomed to a bounce until one of those days, it doesn't bounce and panic ensues. Once that day comes, people look for the exits. When they can't get to the exits, they break the walls and the windows to get out. That is why it is fundamentally important to respect your stops. You can always re-assess once outside the burning building. 

 

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