We’re only two weeks into the new year, and the stock market has already set new record highs…
Bitcoin broke the $40,000 barrier for the first time – after a 400% rally in the past year…
And Tesla rose to such heights that founder Elon Musk is now the richest man in the world.
Now, there is an old saying about the markets… That they can remain irrational far longer than you can stay solvent. And while this is true, it relies on a big assumption…
That markets are rational to begin with.
But as I’ll show you today, this assumption is fundamentally mistaken.
And if you have any money in the markets… or if you’re thinking about buying the next Tesla or Bitcoin dip… this could have huge implications for your portfolio. Let me explain…
The Markets Are Always Irrational
The Oxford Dictionary defines the word rational as something that is “based on or in accordance with reason or logic.”
Sometimes, financial markets can appear to be rational. And those moments – where everything seems to happen as it should – are enough for many investors to believe that market action can be explained rationally and logically.
But the hard truth is that financial markets were never rational. To show you what I mean, let’s look at some real-world examples…
First, say I told you that, somehow, I knew Joe Biden and Kamala Harris would suffer a terrible accident on their way to the inauguration… and they wouldn’t be able to assume the roles of president and vice-president.
How do you think the markets would react?
The rational response, it’s safe to say, would be that the markets would sell-off sharply. Now, let’s take this hypothetical scenario one step further…
If you could go back in time to November 21, 1963, knowing that JFK would be assassinated the very next day, would you buy or sell the stock market?
Again, I think it’s safe to say that most people would want to sell the market if they knew beyond any doubt that the President of the United States was going to be shot the very next day.
But now look at the market action that followed JFK’s assassination…
Instead of selling off sharply, the market rallied for another three years.
Okay, I grant that might be a particularly rare black-swan event. But what about another calamitous period in history?
What if you could go back to August 2005, a few days before Hurricane Katrina devastated the Gulf Coast of the United States?
Knowing that this would result in the most extensive damage ever caused by a tropical cyclone, would you buy or sell the market?
Once more, I think it’s safe to say that most people would decide to sell the market. But let’s look at what actually happened after Katrina hit the Gulf Coast…
The market went nowhere for two months, and then it launched into a two-year rally.
Our final example is much more current…
As I’m sure you know, on January 6, 2021, a group of rioters stormed the U.S. Capitol.
They disrupted a joint session of Congress held to certify Biden’s win in the presidential election. And at least five people died in the riot.
That day will certainly live in infamy. The last time an organized group breached the security of the Capitol was over 200 years ago during the War of 1812, when British troops destroyed the building.
But what did the market do after the Capitol riot last week? Did it sell off in panic as the seat of American democracy was under attack by its own citizens?
No! The market went on to close out a record-setting week of new all-time highs.
The reality is that there is no consistent link between events people think should have an impact on market action… and the market action itself.
Sometimes, market behavior can seem rational and logical. But I would argue that most of the time, the mainstream financial media is stunningly adept at performing some incredible gymnastics to fit market action into some kind of plausible, rational explanation.
(Of course, this always happens after the fact. Such is the benefit of hindsight, I suppose.)
This takes me to where our markets are today – and the reason why understanding the market’s irrationality is crucial…
Don’t Chase a Runaway Train
Today, the markets are trading at historic levels of optimism and euphoria.
This fits very nicely with the Elliott Wave model, which longtime Money Trends readers will be familiar with. Here’s what I mean…
As regular readers know, in Elliott Wave Theory, the waves that propel markets to new highs or lows are called “impulsive waves.”
That term certainly seems appropriate when you look at the trading patterns in stocks like Tesla… And it is certainly fitting for Bitcoin’s recent price action.
Impulsive waves are fueled by market sentiment. Two market “moods” in particular – euphoria and despair – are the engines for bull and bear markets.
When sentiment reaches an extreme on the bullish end of the spectrum, people feel that the good times are here to stay forever.
On the other hand, when sentiment reaches an extreme on the bearish end of the spectrum, people feel that things could not possibly get any worse.
Here’s why that’s important today…
Although it may sound surprising, bear markets don’t end on good news. They end when despair reaches its absolute peak.
Likewise, bull markets don’t end on bad news. They end on extremes of optimism, when it seems like nothing could ever go wrong.
The current bull market is a case in point. We’ve had plenty of bad news since last year’s crash, but investors have shrugged it all off.
By the time the market really sells off on bad news, the peak will already have been in place for some time.
So it was with the crashes of 1987, 2000, 2008, and 2020. And so it will be when this bull market comes to an end.
So what can you do about it today? Here’s my advice…
For those who are already invested in surging stocks like Tesla, or who bought Bitcoin at good prices, now is a good time to start tightening stop-losses.
These markets will crack. It is just a matter of when. A broken bull market can sell off very aggressively… And, in my view, it is always critical to protect a profitable position.
For those who are still on the sidelines, I’d advise you to stay put.
I know it can be frustrating to feel like everybody but you is making money in the markets, but I can’t emphasize this point enough…
Do not chase a runaway train.
There will always be another great opportunity on the horizon. But you won’t be able to take advantage of it if your capital is tied up in a stock that has already run its course.
Editor, Money Trends
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