My nephew sent me a text this morning (March 9th early). “Watching the markets. This is insane.”
My response. “This is why you should never be exposed overnight. The wolves eat you when you’re sleeping.”
Our exchange prompted the idea for this post. I thought I’d write a post which might help my customers understand why these situations occur and explain how it can be possible to anticipate the danger ahead of time. This is a bit long but it does serve a purpose and I know a lot of my Twitter followers and email subscribers would like me to write more frequently than I do so hopefully you will find this informative and maybe a little entertaining.
Attempting to trade in this environment is not a good idea for the majority of people in the world so I’m absolutely not recommending you put your feet in the water. This is more about giving a long-term perspective on the cycles of markets. A bit of wisdom is being passed on from a guy who’s been around the block a few times. It’s aimed at the younger crowd but there are some older people who may learn a few things as well. The hope is that this information will one day save some people a lot of money which would have otherwise been lost.
It’s impossible to convince people this type of thing can happen if they’ve never seen it. I can talk about it all I want but people do not believe it till they see it with their own eyes. This is one of the reasons teaching can be quite difficult at times. There have been occasions when a person who’s been trading for six months or less tells me he should be able to make reads every day and hit a monthly profit target and he has a system for trading overnights with a high win rate and yadda yadda and I tell him that he’s not been around long enough to understand how this business works and holding overnights is a bad idea. I try to explain context and cycles and the fact that profits come in waves during good conditions and he dismisses most of what I say because he’s inexperienced and naive. Then he sees this type of action, be it a month later or three years later, and he finally gets it.
I’ve seen this kind of price action multiple times in my life. It’s a new variation of an old theme. Same same but different. I knew it was possible but I cannot convey my experience to my customers through online osmosis, alas.
We are witnessing history in the making. Fifteen years from now, guys in trading rooms will be talking about how crazy 2020 was and telling tales of the first time the Dow dropped over 2,000 points in a day. “Dow was down 2,000! Crude dropped over 25%! It was insane. The whole world was losing its mind.” There will be a 40 year old guy spinning this tale for 25 year olds who, most likely, will only believe a third of what he says and will have no concept of what the action actually looked like or how it impacted the economies and markets around the world. For awhile now, I’ve been one of the guys spinning tales about the Nasdaq boom and bust between ’98 and ’02, the 2008 crash, the flash crash of 2010 and other highly volatile moments in market history. I remember when Crude was trading for $15 a barrel in the late 90s and over $100 a barrel in ’07/08. I’m the guy who tries to convince people to always be careful because you just never know what may happen and when the situation starts looking dangerous, that’s usually because it is. To all you young whippersnappers out there, us older folk do actually know a thing or two about the world. And you will eventually be the older folk telling those tales fifteen years from now.
When I was in my teens, I was that kid who wanted to be Gordon Gekko. Watching the movie Wall Street set off a chain of events in my life which have led me down a long and winding path which, at this pause in the journey (over three decades later), has me writing a blog post about market crashes. Life is strange. At any rate, if you haven’t seen the movie, it’s worth watching as is Margin Call, The Big Short, Inside Job, 97% Owned and Enron: The Smartest Guys in the Room. If a person doesn’t understand what’s going on behind the scenes and what guys like Gekko do in conjunction with politicians and large corporations, the entire thing seems like an incomprehensible mystery. Nothing could be further from the truth. Listen to the speech Gekko gives Bud towards the end of the movie about pulling the price of a paper clip out of a hat. In the movie Margin Call, listen to the speech Jeremy Iron’s character gives while sitting across the table from Kevin Spacey. The writers of these movies were on point.
These are some common thoughts from the global populace:
“Why do markets go higher? Why do they go lower? Why do we have stock markets? Why do banks get to create money from thin air? Why can’t I do that? Someone told me to put my money into stocks. I made a lot. Then I lost a lot. Then I made a lot. Now I’m currently losing a small fortune. Why did it take years for the Dow to go from 20,000 to 29,000 and then only two weeks for it go from 29,000 to 24,000? I don’t understand any of it but for some reason, it affects the entire world and causes people to jump for joy and/or lose their minds.”
There is nothing mysterious or complicated about any of it. The people in charge would have you believe you can’t understand it because that’s the only way they can maintain the status quo. The monetary system is far more fragile and simplistic than most realize. If everyone really understood how it all worked, the charade would be finished, the curtain would be lifted, the wizard of Oz would be exposed for who he really is and the entire system would be dismantled by a bunch of very angry human beings (some of who are attempting it as I write this but probably to no avail). However, I do not foresee the system changing anytime soon so my goal here is to help keep people from being on the wrong side of these situations.
It’s primarily about the money supply. The end goal of the ‘civilization’ model is to get things done. Feed everyone. Clothe everyone. Keep trade going. Keep businesses going. More buying. More consumption. Keep the kids learning. Keep the young working. Keep new inventions coming. Make the high-tech society even more high-tech. Never-ending expansion. Keeping the money going in a circular motion between cities, states, countries and continents is how things get done. Money is a construct of the human mind. It only has value because we, as a group, agree it has value. We accept it in lieu of a tangible item in order to trade goods and services in a more efficient manner (instead of trading eggs for a shirt, for example). There are pros and cons to this. I don’t want to digress so I’m going to focus on how this affects the markets.
Let’s say a large car manufacturer decides to open a factory in a small town. The new factory can employ 1,000 people. The corporation invests its own money but it will also have a credit line at multiple banks. The credit is money created out of thin air. It’s created in order to get the ball rolling. Again, this is how things get done. That money flows into the area. Roads are built. Electrical grids are built. Raw materials are ordered. Jobs are created. Factory opens. Cars are built. Cars are sold. People show up Monday through Friday. Everyone gets a paycheck. This money has to be spent. Now a bank or two opens in the town. A gas station. Restaurants. Coffee shops. A bigger school is built. More teachers are hired because there are more students. More FedEx drivers are needed to deliver more Amazon products because people have money to buy more stuff. More delivery vans are needed. There is now an economy where there once was none. A town of 1,000 people could turn into a town of 5,000 in a few months. This is all well and good on many levels. The irony is that the problems often occur once things begin going too well and too good in too many places around the country.
When there is excess money in the system, that money is always “invested”. A person can only buy so much food at one time. If a car runs fine for five years and the owner likes it, there’s no reason to buy another one. People buy the things they need and want and if they have money left, they begin asking themselves how their money can make them more money. A plethora of investment options present themselves. The excess money typically starts flowing into stocks and real estate before anything else. The bull run ensues.
As a side note: contrary to what most people think, bailouts are necessary if you want the system to keep working. I’m not talking about giving money to AIG so they can distribute it to their employees in the form of million dollar bonuses. I’m talking about saving that company which employs 1,000 people if the company is going bankrupt. If those people lose their jobs, the entire town goes down with the company. The company is the engine that drives the community. If the employees of that company no longer have money, mortgages do not get paid, car payments do not get paid, health insurance payments do not get paid, coffee is bought at the grocery store instead of a coffee shop, it’s burgers at home instead of steak at a restaurant, and so on and so forth. If the money supply feeding the town dies, the town dies with it. This is why there was pandemonium and government intervention in 2008. Arguments can be made for changing the system but that’s a different subject matter altogether.
This is going somewhere and does have a point so please hang with me…
The money flows into the markets slower than it flows out. That’s one of the main issues. The excess is invested in waves here and there by investment funds which are managing billions (usually in the form of retirement accounts for normal people who have two kids, two jobs and a twenty year plan). These investment funds only go one way. They buy. And they buy everything across the board. There is usually plenty for sale on the way up because everyone is happy to sell for a profit but there are often no bidders in sight on the way down because if you were willing to sell at 28 yesterday and are trying to sell at 26 today, you’ll probably sell at 24 tomorrow and possibly sell at 20 next week. Why would I buy today if there will be better bargains in a week? Hence the reason it can take three years to make 20% but only three days to lose 20%.
About a month ago, I posted a tweet saying this reminded me of the Nasdaq boom in 1998/99. I could obviously not have foreseen the coronavirus development or the oil crash today but that’s not what I was trying to convey in the post. I was trying to convey the fragility of it all. It has become a house of cards. If things had slowed down a bit a few years ago, it is unlikely the fallout we are now seeing (and will probably continue seeing) would be as bad as it is. People with money invested in a sector want the bull runs to last forever but the reality is that less volatility and more stability with small increases and decreases in prices is actually better for an economy. The highs aren’t as high with massive ROI but the lows aren’t as low and people don’t get wiped out in a runaway selloff. Between 1998 and 2001, the Nasdaq went from 2500 to 7000 back to 2500 and then to 1700 in 2002. I saw the stock of companies which had never made a profit trading for over $100 a share. I then saw most of them go to $0. I saw rapid, erratic movement causing big runs and reversals every day. I saw a world of people who thought you couldn’t go wrong betting on nothing but tech (they were wrong). I saw people who had no business being in the markets lose everything they had riding it all the way down. I saw people double down, triple down, quadruple down, curse the universe, then go broke.
I have been seeing the same things during the last few years. Dozens if not hundreds of companies trading at absurd valuations. Erratic swings. A philosophy of “buy and hold forever” or “buy every dip because it’s always going to go back up”. And no one putting money into anything besides stocks and real estate. The row of dominoes was already set. The only thing needed to set off the chain reaction was tapping the first domino in the row. Enter the coronavirus. Definitely not what anyone would have predicted as a catalyst but a catalyst nonetheless.
There can always be an event which is seen as the trigger but if people had already been putting money into other investments with decent yields, there would not be such large numbers of people running for the door at the same time. And that brings me to the Fed. The members of the Fed and banks in other countries have been acting like amateurs. I don’t know if they really have no clue when it comes to how the system actually works (probably the case) or if they have been bowing down to outside pressure but whatever the case, their negligence has contributed to this. Their job (in theory) is to keep the system working and in order to do that, they have to try and keep the markets stable. Other investments with decent yields have not existed the last few years because the Fed has been lowering rates instead of raising them. They’ve been adding money to an economy which already has too much money. It’s like forcing a guy to eat an 8oz filet after he’s already eaten a 32oz Delmonico. Where is he supposed to put it? “Here’s more money. Where do I put it? I guess I put it into stocks because I can get 10% there and only 1% in a CD.” It further inflates something which is already overinflated. The tire does eventually pop if you give it too much air.
The half point basis cut they made last week was lunacy. As a friend said (I’ll paraphrase), they are stopping for a bathroom break and facing into the wind. In their minds, they are trying to help but are doing more damage than good. They are scrambling for an out. It’s not there. They already dropped the ball. Neither lowering nor raising rates is going to do a bit of good now but if they had not panicked and left themselves some room to maneuver, they could at least have acted like lowering rates a few months from now would help again and maybe instilled some confidence in the general public. Going from 1.25 to .50 isn’t going to make any difference. Nowhere to go now except zero or negative and if rates go negative, it will create a storm of uncertainty which is probably only going to fuel the selling fire. It is, I think, all going to be too little too late.
Things go bad. Everyone runs for the door. The buyers are nowhere to be found. Prices head lower. When a huge chunk of the public finally manages to make the hard decision of pulling the plug, taking the loss and going to cash, you can believe they’re not jumping back into the market anytime soon. Without that money pumping prices each month, the steam fades and the sustained run stops. The momentum which keeps the train going disappears. It now starts to slow from 200mph to 100mph and getting back to 200mph becomes nearly impossible. There will be swings both ways. No doubt. That’s always the case in these scenarios. I have little doubt we will see some more 1,000 point runs higher but when they will happen is anyone’s guess and I’m not sure they can stop the bleeding at this point. And that brings me to program trading.
The influx of program trading into the markets over the last fifteen years has created some of the most unstable conditions imaginable. The number of programs involved in HFT has grown to the point where it’s out of control. They are exacerbating the moves. What may have been only be a 200 point decline in the Dow if humans were calling the shots becomes a 500 point decline due to programs running wild. There’s no oversight.
The value of retirement accounts is being determined by algorithms trying to scalp the next tick. Tens of millions of people have their life savings locked up in investment funds and those funds are supposed to be keeping that money safe and growing so those people do not have to work until they die yet the value of those savings is changing every millisecond because computers are trading against computers (can anyone say Skynet?) with no other intention than to make a few pennies on 5000 transactions a day. Think about that for a minute or two. It’s a real problem. And you can believe that every person running for political office the next few years will be talking about it a lot more if this fallout continues. They will first blame the virus and then OPEC and then say we need more regulations and more oversight and they will tell you how those Wall Street scum of the Earth types have stuck it to the decent, average citizen yet again and the hedge funds and day traders and their pesky programs are to blame for all your troubles and woes. And the Russians. Can’t forget about the Russians;) I would agree that programs are part of the problem but they are merely an extension of a much bigger issue. The reality, my fellow traders, is this…
The powers that be could have done a lot more to prevent this but, ultimately, bubbles and crashes are destined to happen within this model. The model itself perpetuates the cycle. Now think about that for a minute or two. The cycle repeats because the model dictates that the cycle repeats. The system as we know it cannot deliver an alternate outcome.
You will never prevent people from having parties and when everyone is having a good time, it’s all fun and games and no one wants to stop the party. But when things start getting too rowdy, there is always a moment when everyone has the chance to leave with minimal damage. Some choose to leave. Some choose to stay. The people who choose to stay despite seeing the warning signs are usually the ones who find themselves waking up in the front yard at 6am, lying on their backs, staring at the sky in a state of disbelief, head throbbing, wondering how it all went so horribly wrong.
Incidentally, that analogy can also be used for day trading and any other form of speculation.
If I had wanted to keep this short, I guess the point would be that you can’t call a top but it’s possible to see the warnings. When you see them, don’t tell yourself you’re not seeing them just because the markets go higher again and you don’t want to miss out on the move. Every loser in Vegas thinks he can do better. Winners walk away from the table when they’re up.
Investment advisors and money managers are fond of telling people they shouldn’t try to time the market. That’s because those advisors and managers need that money to make money for themselves. If a person had gone long on the Nasdaq Index in 2000, he would have been waiting 17 years to break even. Look at a chart of the Dow since its inception. Imagine, if you will, what people who bought in the 1960s and 1970s might say about a “buy and hold” strategy. Especially if they were close to retirement when they bought. In case you don’t look at a chart, a person who was the long the Dow Jones Index in 1964 would have been waiting 30 years to see it hit those prices again. For that matter, talk to people who bought in January 2018 and are still holding long positions. They’re not up. That I can tell ya.
This is the way I explain it to family and friends: there are times when you’re risking $5,000 but have the potential to make $10,000 or more if things go well because the conditions are right for it. There are other times when you’re risking $5,000 and will probably only make $2,000 or less even if you’re right. Do you really want to risk losing $5,000 if, best case, you’re probably only going to make $2,000 or less on that investment in the next year or two?
In January of this year, I asked a friend of mine who’s been holding stocks for awhile to run his numbers. I asked him how much he was up in the last two years. He said 10% (and that is only because he had some of the best of the best stocks like AMZN, BABA and APPL). I then asked how much he lost during the selloff that occurred between October and December of 2018. He said 16%. I told him that was the problem. I warned that if another downturn happened, he could easily lose 20% or more in a few weeks but chances are he wouldn’t make more than 10% in the next two years even if things stayed stable. Looking at it from that perspective, did he now think the risk was justified? I should add that he and his wife are planning on retiring in five years so the element of timing is most definitely a factor in the equation. He understood the point.
So…where does all that leave us? For me, mostly on the sidelines right now. The risk isn’t justified. There are moments when I can see it here and there but it’s not something I can teach to new traders and it’s still quite risky even if a person has experience. I will run another webinar at some point in the next few months but not till things have settled a bit and liquidity has returned. In the meantime, my suggestion is to view this as a teachable moment. We may continue to see much more of this action throughout the year so be ready for it. It’s a good illustration of why trading results can vary so dramatically from year to year. A lot of professionals are just sitting out at the moment. They are not losing money but they are not making money either because there is no trade for them most days. High probability/low risk reads do not exist at the moment. There may be some higher probability reads on occasion but nothing is low risk. I do think there will be some great periods for day trading throughout the year but they will come and go as the liquidity comes and goes.
I hope everyone reading this managed to escape the party with minimal damage.