How to tell when a sector is about to crash

Following crowds is a bad idea - crowds make bubbles and bubbles always pop. So how do you know when a sector has been taken over by financial fashion victims? There is one simple but surprisingly reliable way.

You've been taught and probably believe there's no such thing as a predictive indicator in the stock market that works every time.

The stock market isn't that easy, right? Oh, yes it is.

In fact, over the last five years, the financial industry has developed a new indicator that works 100% of the time and delivers gains of more than 50% per trade. More importantly, because this new indicator is triggered by investor sentiment and hype, it will surely continue to work for decades to come. Fear and greed are timeless.

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After being in the newsletter business for nearly a decade, I've seen first hand how investors move in huge crowds. I've watched a dozen different manias develop knowing they would end badly.

When all our subscribers are clamouring for a newsletter to make more recommendations about a particular sector, when we see dozens of start-up publishers covering the same popular idea, when it's splattered all over the headlines in local papers... you can be sure of one thing: A crash is around the corner.

Subscribers wanted internet stocks in 2000 (80% crash)... China in 2007 (70% crash)... and oil in 2008 (72% crash). It's just human nature. People tend to go crazy for the same ideas at the same time. In finance, this kind of crowd mentality produces horrific catastrophes for investors.

Remember in 2007 when agriculture was the rage? Food prices were soaring, Mexicans were rioting over the high cost of corn tortillas and there were actually shortages of rice in Thailand which grows most of the world's rice. You couldn't watch CNBC without seeing an analyst talking up farming and fertiliser stocks. These stocks all went straight up for a few months... until they traded at absurd valuations. Most traded for over 40 times earnings. There's not a farm in the world that's worth 40 years of its production.

I saw the trend develop... and then I waited. I knew it was a mania. I knew it would end badly. Fertiliser companies advanced 350% in just 12 months; it was insane. In June 2007, I wrote, "A severe correction will coincide with a slew of agriculture & farming ETF offerings... Wall Street is never shy about releasing investment vehicles hundreds of percent too late."

A few months later, Wall Street firms began to launch new exchange-traded funds (ETFs) to make buying the entire agricultural sector easier for small investors. Nine months after that, the agricultural sector peaked... and then collapsed. The leading agricultural index fund - MOO - is down almost 70% from its peak.

Another fad that collapsed 2008 was metals and mining. Base metals suffered one of their worst crashes in history... just months after the iPath Copper ETF (JJC) launched. The fund administrator simply gave clients what they wanted... which turned out to be a falling lump of red metal. The copper ETF is down 63% since inception.

When you see Wall Street starting a bunch of new ETFs, you know there's going to be a disaster around the corner.

Launching a new ETF isn't a charitable endeavour. A fund manager launches an ETF because it believes the public is willing to plough hundreds of millions of dollars into the fund... which sends the fund manager millions in management fees. A small ETF of $300 million can generate over $3 million in fees. A large, popular ETF can generate over $30 million.

The way to raise money is to build a fund that's filled with the most popular stocks of the day. The same thing is true about selling newsletters. If you want to garner a lot of new subscribers, you have to fill your letters with whatever ideas are popular right now. And you can bet every single time when investment ideas get wildly popular, they also become wildly overpriced.

Investors who chase the hot sectors don't get the big returns they were seeking. Instead, they become grist for the market. Their losses provide income and earnings for real investors. The 'crowd' keeps the market alive, while being eaten alive by Wall Street. This is the natural flow of the markets; it's the market's ecosystem. It will never change.

My friend, the legendary speculator Rick Rule, likes to say, "You're either a contrarian or a victim." New ETF introductions are an easy test to figure out which category you fall in. If you're buying them, you're failing the test.

This article was written by Brian Hunt for the free daily investment newsletter DailyWealth