The great trader Yogi Berra understood all too well how difficult it is to predict the market’s movement. The direction is never clear. If isn’t murky, then your forecast is probably wrong.
Yet there are times near the end of moves where prediction is especially difficult. At these points, logic is often overruled by emotion. Asset prices go up (or down), not because of fundamental reasons, but simply due to herd-following flocking behaviour. These points are especially scary because it seems like the trend will never end, and markets become extremely emotional. Whether it is fear of being long an asset in free fall, or whether it is fear of missing out on a rising market, towards the end of the move, this fear is the main driving force. And the really difficult part of this whole game is no one knows how long this final period will last.
During the 1999 DotCom bubble this “fear of missing out” sent the Nasdaq to truly mind blowing valuations. Many veteran traders tried to short the insanity, but were carried out when the last six months went completely bat-shit-crazy.
On the downside it can be just as stupid. The 2008 credit crisis saw large cap stocks get absolutely decimated.
When it seemed like it had all stabilized and shrewd traders started to dip their toe in the water, we got this final whoosh that was only stopped with aggressive actions by the world’s Central Banks.
There are tons of examples throughout history of the final act of a bull or bear market move defying all semblance of logic.
The US stock market has been steadily rising for the past six years. We are now up 220% from the 2009 low. Most market participants are complacently bullish. Being long has become easy. Making fun of the underinvested bears is all the rage.
There is little doubt in my mind that purchase of equities at these levels will be long term losers. Companies are buying back shares in an orgy of debt fuelled leverage. Central Banks are monetizing their balance sheets against equities in what will become one of the greatest follies in financial history (and there is some stiff competition in that category). These developments have disaster written all over them. My favourite quantitative shop GMO has negative return forecasts for US equities over the next seven years:
I have a high degree of confidence that GMO will prove correct. The only part of the equation that I have yet to figure out is how stupid it gets to the upside before we finally roll over. Don’t forget that in September 1999 the Nasdaq was egregiously expensive. Yet from that level it managed to go up another 150% in the space of six months!
In some ways, this environment is even more susceptible to illogical pricing levels than any market we have ever seen. We have Central Banks pushing short term rates to zero and negative levels. How do you determine a fair price for equities when the main input for discounting the future value of the earnings stream is not available? (Feb 20/15 – The Trouble with Models) According to financial theory, the price of equities should be approaching infinity as the rate goes to zero. But how do you value equities when bonds are negative? The financial markets have entered into a strange twilight zone where not only are Central Banks pushing short term rates to unprecedented levels, but they are even monetizing their balance sheets against equities. Have a look at the Swiss National Bank’s reported holdings in US equities:
There are almost 300 positions! And that’s just one Central Bank that has the decency to trade positions that are reportable.
Although I could envision the US stock market rolling over tomorrow, it wouldn’t take much for me for me to imagine it also doubling from here. We are in the midst of that final part of the move where emotion takes over. When you combine that with the insane Central Bank policies, you have the recipe for almost anything to happen. It will only get more frantic and scary from here. Be careful as the moves will get larger and more violent. The other day Google gapped up 90 handles. That is harbinger of things to come. If you are bullish and we do get a runaway up move, don’t start thinking your shit doesn’t smell. It will be tempting to get caught up in the euphoria, but this will be the time to head for the sidelines.
Most of all – don’t pull a Newton!
Gold entering its final stage of the move as well…
Another market that is experiencing the final part of its move is gold. However this is not fear of missing out of an upside move, but instead the fear of being long an asset that won’t stop going down. We have finally hit the “just get it off the sheets” puke.
Over the past couple of years, there has been a huge amount of damage done to the gold miners.
The sideways action of the past year proved too good to be true, and we have now plummeted to new lows. Emotion is once again high. We have the gold bears rubbing salt directly into the bulls’ wounds. There are bear raids where market players push down prices at illiquid times of the trading day. The bulls are too weak to defend the price, and the selling has begun to feed on itself. This is not the time to get bearish. It is not the time to puke out your position. Yet due to the high volatility and emotional trading, I suspect this is happening in all too many cases.
The markets are much less stable than almost all market participants believe. I don’t know how it is all going to play out, but I suspect we are entering the final innings of this move out of commodities/China/BRICS into US/Europe. I am not predicting the trend will change, only that the volatility of the moves will increase. Trade smaller, get long some gamma, and try to keep your head. The key to successful trading is to be on the other side of these emotional trades. The hard part is knowing how long they are going to last. If you figure it out, please let me know…
Thanks for reading,