Investors and traders often hear warnings advising them to beware of “the crowd." Whenever something looks “too good,” it's time to head for the exit or avoid that something altogether. And folks, I’m here to tell you that truer words were never spoken. The latest example: the exciting world of commodities.

It was not too long ago – June 2008 to be exact – that commodities had become the “in” thing. The stock market was tanking and bonds were headed for “Nowheresville." But commodities, now there was an investment category with a future. Whether you wanted to talk about crude oil – and most people did – heating oil, unleaded gas, natural gas, gold, silver, copper, cocoa, corn, soybeans, foreign currencies or live cattle, the conversation went pretty much the same. “Wow, look at that thing go!” 

And one other important thing happened at about that time. The conventional wisdom "crossed the Rubicon” to the point where the consensus coalesced around the idea that higher commodity prices were the new standard. And that should have been the first clue that it was time to invoke the “trees don’t grow to the sky” rule. So whether it is metals in the early 1980’s, the Nikkei Index in the late 1980’s, tech stocks in 1999-2000 or commodities today, no tradable market or security is immune from the realities of the investment cycle. This is not to imply that anyone can state with certainty that commodities have made a major long-term top. There is much discussion now that commodity prices are presently experiencing a pullback in a longer-term bull market. And that might ultimately prove to be true. The primary factors credited with causing the commodity price boom of the last few years – i.e., the explosive growth in the economies of China and India – remain intact. So we will have to wait to see what transpires from here. Regardless, the point here is really to address when to “part company” with the crowd.

In most cases when a market, or industry group or in this case category of markets – i.e., commodities – tops out in price it generally does not happen overnight. Usually there are some warnings for those who are willing to look for such warnings. The problem is that by the time a top is reached most people are focused on the accompanying “bullish news” and are gazing skyward rather than watching their step. Let’s look at a few examples to illustrate this point.

Crude Oil

Chart 1 displays the price action of spot Crude Oil. As you can see in early July, crude made two attempts to test the $150 a barrel price level. The headlines and accompanying stories inevitably mentioned the next target - $200 a barrel. In a nutshell, the great bulk of the investing world was “looking up." However, if instead you look down at the indicators plotted under the price of crude oil in Chart 1, you will note the divergences forming between price and indicators. Once crude topped out it began a relentless decline to much lower prices – down 22% in just 26 trading days.

Chart 1 – Crude Oil
(click here for larger view)

Soybeans

Other examples can be found in the grain markets. Chart 2 displays the chart for spot Soybeans. In late June and early July the news was bounding with stories about “higher food prices” due to “dramatically rising” grain prices. So once again, the average investor or trader was inclined to focus on the “upside." However, a close perusal of Chart 2 finds a market that had hit a previous high, broken through to new high ground and then fallen back below resistance. At the same time, the indicators were beginning to diverge to the downside. After one last intraday pop above resistance in early July, the bottom dropped out and soybeans fell -26% in about 20 trading days.

Chart 2 – Soybeans
(click here for larger view)

iShares Financial (XLF)

On the flip side, consider the action of iShares Financial ETF (XLF). As the so-called mortgage “crisis” unfolded, the mainstream media jumped at the chance to convince as many people as possible that the sky was falling. No surprise, XLF got hammered in the process. Even now, anytime the financial stocks have a bad day, ominous headlines appear warning us that the “crisis is far from over." And perhaps that is in fact true. Still, Chart 3 shows XLF to be well off of its recent lows with the indicators in a decent uptrend.

Chart 3 – XLF
(click here for larger view)

None of this implies that XLF will not retest its July low or even break through to the downside. This is simply another example of how the market tends to reverse while the majority of investors are looking the other way.

Summary

As an investor or trader it is important to keep up on market trends, world events, etc., etc. in order to be able to have some sort of framework for making decisions. Nevertheless, there is a fine line between “just the right amount” of information and “too much” information. Once you cross that line you run the risk of becoming another of the nameless, faceless rabble who swallow and regurgitate headlines whole without stopping to “look under the hood." This is not a good crowd to fall in with.  

You have been warned.

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site