The stock market has become very volatile and irrational over the last year. I contribute some of this volatility to the uncertain economic climate. However, in my opinion a big cause of the huge price swings in the market is the tremendous growth of hedge funds and their need to generate short term returns.

Hedge funds make most of their money by being able to generate positive returns (they take a big percentage of the gains they make: 20 percent or more). The investors who accept these large fees expect hedge funds to deliver gains regardless of what the market is doing. Consequently, this puts a lot of pressure on hedge funds to outperform the market.

When the economy is expanding and the stock market is going up every day it is a lot easier to make money in the stock market. A rising tide lifts all boats so to speak. When the economy is heading for a recession and the stock market is going down it becomes much harder to generate positive returns. This is a big reason for the volatility in the stock market and other asset classes such as commodities. Hedge funds and other short term investors are chasing after quick gains in a very tough market.

This has led to a lot of irrational behavior in the market. For instance, stocks that haven’t blown away expectations have been sold off in spite of strong quarters. Stocks that have reported flat growth have seen severe and undeserved drops in their share price. It seems investors would rather bail at a loss and chase another gain than to be patient and hold for a few quarters.

Another example of the irrational behavior in the market is the huge short term upswings that certain stocks and commodities have seen in the last year. It seems that there are quite a few greater fools in the market today. A greater fool is an investor who buys a stock that has already had a huge jump and hopes that a greater fool will buy the stock at a higher price than him or her. This is also known by the phrase “hope a dope”.

For instance, take a look at the one year price chart of LOCM. It shows a ridiculous news related jump in July of 2007. It’s amazing the stock price was able to go up so much before crashing. I saw similar jumps in quite a few other stocks in the past year.

Another example of sheer speculation and greater fools can be seen in the commodities market. Oil has been trading mostly on speculation for the last couple of years. If you read an article on oil you will hardly ever see a mention of supply and demand. Oil is currently trading close to an all time simply because speculators continue to bid it up.

Some other examples of speculators (most likely hedge funds) chasing quick money in the commodities markets are the extreme rise in platinum and wheat. Since the stock market is stagnant these speculators are willing to bet on anything that’s hot. I’m surprised more hedge funds aren’t going broke due to all the stupid trading that is taking place.

The irrational behavior in the market is providing both long and short opportunities for investors who are rational and patient. If you have a long time horizon I think now is a good time to pick up small caps and tech stocks that have been sold off indiscriminately. You can also profit from shorting stocks that have extreme short term runups.

I would avoid trying to trade based on news or short term price movements. If you do you will most likely just chase after gains and lose a lot of money.