Obama-nians at the Gate

• The Meltdown of 2007. The summer of 2007 saw the great quant implosion that resulted from a crowded trade. Both the number of quant funds and their assets under management had grown exponentially in the prior years, and they all had similar assumptions underpinning their models.
  
  When the real world intruded with out-of-normal, out-of-model behavior (was it someone getting killed in subprime who had to liquidate all their positions suddenly?), the supercomputers kicked in and unleashed a frenzy of algorithmic trading, with everyone wanting to take the same side of the trade at the exact same time.
  
  
• The Mother of Short Squeezes. In a crowded trade of another sort last November, "the mother of all short squeezes" resulted in Volkswagen's market cap ($370 billion) briefly exceeding Exxon Mobil's ($343 billion). When Porsche announced it had stealthily accumulated 75% of Volkswagen's stock, all the short sellers who'd piled on believing that Volkswagen was overvalued and hardly immune to economic slowdowns got killed.  Another 20% of Volkswagen stock was held by the German State of Lower Saxony, leaving a very large crowd at the exit (12.8% of Volkswagen's stock was sold short, making it at the time, the most shorted stock on the DAX).
  
  
• The Hunt Brothers Take a Bath.  As the Hunt brothers learned when they tried to corner the silver market, things can shift quickly.  One day you control a third of the world's supply and prices have gone from $11 to $48 an ounce; the next day exchange rules on leverage change and a couple of margin calls later, pfffft! you're broke.

What's it all mean?

The irony of course is that while you can make a lot of money as the trade gets crowded, if it gets too crowded, you can lose your shirt.  And gauging whether a trade is too crowded is a bit like knowing when the crowd is about to turn ugly – there's no hard and fast rule. 

That said, here's what we look for in reading the crowd:

• Who's holding the stock? Is the bulk of the stock held by index funds?  Momentum shops?  Deep value vulture shops?  
  
  
• Is the stock heavily shorted? We track the short interest in every stock we own or are interested in buying.  Not just because shorts are nobody's fools and we need to make sure we have any controversy well parsed out, but because we need to know if the short trade is getting crowded.
  
  
• Who's leaning long? A crowded trade on the long side is a little harder to spot, particularly if the fundamentals are also better than expected.  But eventually, marginal buyers are exhausted, the stock is expensive, and the slightest thing can trigger an avalanche of selling. So we like to know where the sell side's head is at, especially with respect to target prices and the catalysts needed to move stock ratings up or down.
  
  
• What are the technical analysis hot buttons? Whether you believe in technical analysis or not, an awful lot of trading gets done on that basis.  It's important to know whether some major technical inflection point has been crossed, as that will cause a crowd to gather at the gate.
  
  
• What are the insiders up to? If the insiders are leaving the party as others are arriving, you want to pay attention.  They're the ones who paid the DJ and will know when the music will stop.

A final word of caution: Sometimes, as fundamentalists, it's too easy to get hung up on the "truth" of owning a purple ticket (the valuation case).  Because while that may give you the right of entry to inaugural nirvana (a higher stock price), the madness of the crowd can trump even the best empirical evidence. 

And when that happens, watching the action unfold from a safe distance is a more than acceptable consolation prize for not risking one's life, financial or otherwise.

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