“Heads I win, tails I win.”
That’s the attitude of many investors today, who believe stocks have only one way to go… higher!
Just this week, BlackRock – the world’s largest asset manager – announced it’s seeing record levels of retail buying of stocks, and the euphoric sentiment is a major warning signal.
All we need is the economic recovery to stall a bit and take longer than expected, and investor euphoria could turn first to alarm, then to dismay…
Of course, if you’ve been in the markets for as long as I have, you’re bound to see this kind of irrational exuberance from time to time.
In fact, the current situation with stocks reminds me of the situation in the New Zealand dollar three decades ago… and an invaluable lesson I learned back then. Let me explain…
1987 All Over Again
It was 1987, and the kiwi (or New Zealand dollar) had been rallying dramatically for 10 months.
I’d never traded the kiwi before, but I knew a lot of bankers in New Zealand. I regularly executed business there in the major currencies, since I figured one day, I might really need that liquidity. (New Zealand filled up the dead trading zone between New York’s close and Australia’s open.)
But then the summer rolled around, and that’s when the kiwi caught my attention. In just two months, it shot up from 56.6 cents to 66 cents – a 16.6% rally. That’s an explosive move in the currency markets. So I started doing some research on the kiwi…
The more I looked into it, the more obvious it seemed: The central bank desperately wanted a lower currency. It needed inflation to cool off so it could lower rates and help exporters by driving down the kiwi.
Meanwhile, the market was very long the currency. The trend followers (mainly hedge funds) were all long. It was unlikely they’d be buying much more, considering how far the currency had come.
To me, this seemed like a classic bubble. The only question was: When should I start selling?
The market was super-bullish, super-long, and not particularly deep in terms of liquidity. The entire money supply of the country wasn’t that big, so I figured I should put on a modest short position at first. Then, once I had a major catalyst to convince me it was time, I would pile in.
Tell-Tale Signs of Any Bubble
I remember well the conversation that got me started. It was with a trader from ANZ Wellington, the biggest bank in New Zealand.
The trader, whose name was Nigel, called me up and said, “Mate, you need to buy the kiwi. There is only one way for this currency to go… up.”
Usually, Nigel was calm and objective, so he had my attention. He explained that the Consumer Price Index (CPI) numbers were coming out and that they would be the catalyst for the currency’s next surge higher.
If the numbers came in worse than expected, Nigel told me, the central bank would have to raise rates even higher… And that would be great for the currency, attracting lots of capital flows.
Ok, I could follow that logic. I then asked the obvious question, “What happens if the numbers come out better than expected?”
Nigel quickly answered, “Oh, the kiwi would sail. Fundamentals would be better, and money would pour into the country.”
This guy was the chief dealer of the biggest trading bank in the country. I figured his view would be the exception because it seemed so ridiculous. But then I started calling all the banks down there…
I spoke with 11 dealing rooms, and every bank had the same view. At that point, I was convinced. The market could go a bit higher… but this was a mania, a bubble ready to pop.
I started selling lightly over the next week, and each time I sold, the price went higher. I was amazed. I kept selling steadily until I had sold a few hundred million kiwi.
Then something happened. The stock market crashed in the U.S., and people started sprinting for cover.
I was sure the kiwi would crater as people scrambled to get out of their risky positions… And holding a currency that needed 15% interest rates to hold up was clearly risky.
So I plowed in. I sold billions of kiwi over the next three days, and the currency collapsed down to 58 cents – a 13.4% drop. All the longs were forced to bail once the currency broke technical support below 64 cents.
The Central Bank was angry with me for destabilizing their currency… Although they also noted they were happy I had driven the currency lower. They just didn’t want me to do it in a couple of days.
Now, you’re probably wondering why I’m telling you this today. And the answer is simple…
Don’t Ignore the Warning Signs
We have a very similar set-up in the stocks now, as well as in a number of currencies. The market is heavily skewed in one direction, and every scrap of marginally positive news has been baked into the price.
Meanwhile, we still have huge unemployment numbers… rising Covid-19 cases around the world… and the Federal Reserve practically begging Congress to pass more emergency stimulus.
This last fact alone is reason for concern. In a normal world, investors would interpret the Fed’s pleas for fiscal stimulus as a sign of weakness and sell risky assets aggressively.
But investors today are interpreting a clear signal of desperation as a reason to buy stocks more and more aggressively.
It makes about as much sense as the bankers in New Zealand assuring me there was only way for their currency to go. But you don’t have to make the same mistake they made…
If you’ve been following my writing, you already know the U.S. is heading towards a long-term cycle of very modest growth, propped up by zero interest rates and massive fiscal spending programs.
A stock market that is trading at, or near, all-time highs makes little sense if it is in any way reflective of the broader economy.
Just yesterday, we learned that the real unemployment level is still 11%, once we adjust for the reduced participation in the job market by the millions who have been squeezed out permanently. That is a terrifying number.
Now, I am not quite ready to go all in and sell the stock market, so I am not recommending you close your long positions. But I am suggesting that you tread carefully… and manage your positions with trailing stop-loss orders.
Given the current fundamental and technical position of the market, my strongest advice is that you should not get married to your stock positions or assume that every dip should be bought.
Editor, Money Trends
P.S. Some have called me the “Most Aggressive Trader in History” for making a $300 million profit in a single trade. And now, after years avoiding the spotlight, I’ve set out to show a small group of traders how to potentially turn every $1,000 into $30,000 over time. If you want to be one of them, read on…