Chart illustrating the distribution and liquidation of the stock market
There’s no way to dodge it now. Severe and widespread negative effects have reached a critical level. There is no cure except a major reset of investor beliefs, logics and expectations.
It is important to note that this reset does not correspond to “typical” overly optimistic booms driven by fashion and easy money. Rather, it is a return to traditional capital market operations, biased by the Federal Reserve since 2008 – 15 years! Never has there been such a long period and huge anti-capital market actions.
Note: “had been biased” is the appropriate description, as the bond and money markets have now resumed their role in setting interest rates. This is a key step because using market supply and demand-driven capital pricing is at the heart of robust and prosperous capitalism.
The Fed’s two main actions were near-0% interest rates, which produced dramatic inequality, and trillions of dollars of money creation that led to high inflation – reflecting what all history has shown. Perhaps worst of all is the harm done to investors and others by 15 years of inappropriate Fed actions and misleading, even false, explanations.
So here are the new training courses. They will be painful and, at first, seem wrong. In fact, the media is already trying to explain some of the current negative aspects and even add a positive connotation to it by assuming that there will be a return to the previous conditions imposed by the Fed. It will not happen. When trends reverse, they disappear because successful investing always refocuses from the old, worn-out trend to the new, future-oriented trend.
Why does there have to be a crash?
The recent sell-off lasting more than two months was insufficient. The long list of negatives and the strong investor mentality require a major shake-up to make things happen. And this means that a frightening fall is necessary to produce the necessary shock.
As for the negatives and the current liquidation, I have discussed them in these previous articles:
How low could the stock market go?
There’s no way to know now. There are too many unknowns about how investors (individual and institutional) structure their portfolios. We know that options, margin accounts and other uses of leverage are popular. These investors will be hit the hardest, as it doesn’t take a 100% price drop to wipe them out.
Additionally, the hedge fund industry has enormous investment power. The ability and willingness of these funds to take large positions, both long and short, increases risk. Remember the saying: “It is easier to scare an investor than to reassure them.” In other words, a short sale caused by short sales can have a significant effect on investors’ desire to sell and exit.
Add to that the Achilles heel of the stock market: a rapid fall in stock prices. Without specialists ready to help calm a stock’s progress, “circuit breakers” (temporary trading halts) are activated when a price movement reaches a percentage, down or up. But then, the exchanges resume, and the same actors (long and short) can resume their actions. GameStop
GME
GameStop 1-day trading – Orange circles are circuit breaker breaks
Bottom line: Investor emotions are about to take over
When understanding is compromised, reasonable thinking disappears and emotions come into play.
It is therefore to be expected that investors (and the media) will soon move into a no man’s land where perplexity reigns. Then, as the stock market continues to fall, we realize that – for whatever reason – something is wrong and things could get worse. Finally comes the skid, when many investors decide to pull out, either because they can’t take it anymore or because they expect something terrible to happen – a climactic fall in the stock market and /or an economic depression.
The best way to protect yourself against such mistakes is to have sufficient cash reserves. This cushion not only softens the blow to performance, but it creates positive buying interest when sales heat up.