Yesterday I published a letter sent to internal clients warning about possible market volatility ahead.
Today I want to provide a little more context around that warning.
First of all, it’s very important to understand that the market doesn’t care what you, I, or any of my colleagues think.
Often, we concoct potential scenarios in our minds and then fervently believe that it will play out…and soon.
Humans do this because we’re very bad at dealing with uncertainty. From an evolutionary perspective, uncertainty was a threat to survival. What’s around that corner? What’s that rustling noise in the bush? What’s out there in the dark?
In the modern world, our survival is rarely threatened by these relics of our evolutionary history. But in the financial markets, it’s exactly the same.
So to deal with this, and to put it crudely, we make sh*t up. We create a narrative about the future to make ourselves feel better and give us the feeling that we’re in control.
To someone sitting in cash, their narrative might be something like: This is a casino. It’s insanely risky, it’s all going to blow up one day.
To someone all in on microcaps: This is a casino, and the central bank/government is pumping money in, forcing you to play. Losers are sitting in cash. Why wouldn’t you get involved, it’s money for jam!
To someone all in on bitcoin: The system is corrupt and rigged. This is the free market’s response to a broken system. It will be the basis of a new monetary system when the old one dies.
I could go on. Whatever it is you’re doing; you have a narrative to support it. That’s how the market works. And asset prices express this collective narrative.
Modern markets, with more and more interference by the state, are less about fundamentals and more about narratives or emotions these days.
The trick is working out what the dominant narrative is and then seeing if it’s true, partly true or completely false.
Today’s dominant narrative, or at least my interpretation of it, is that the stock market is the only place to be because the government and central banks have lost control of the economy and are trying to debase their currencies to inflate our way out again.
In my view, this is correct. If you go back and look through history, you see examples everywhere of soaring stock markets when currency debasement was the policy tool of choice.
But just because it’s correct, doesn’t mean it’s a straight line to profiting from it.
Which brings me back to the warning I published yesterday.
Experienced people in our business all see risks rising to concerning levels. We don’t think there is going to be a big crash. But what we are telling our readers is to be prepared for a decent correction.
It might not come. But every now and then it pays to pull your head out of the common narrative and look around. Look at your portfolio exposures. Are you happy with your holdings? Are you happy to deal with a 10–20% correction (or more with small/microcaps)? Do you have an exit plan if the market turns? Do you have some cash to invest should a correction come along? If it doesn’t eventuate and the stock market keeps marching higher, are you comfortable with your holdings? That is, have you sold too much and now need a correction?
These are all questions smart investors should be thinking about at this point.
The risks in the stock market might be high. But that doesn’t mean a correction is imminent. We could get another 5–10% run before a proper correction gets underway.
And if you look at the largest and most watched index in the world, the S&P 500, it looks pretty benign. That is, it’s still trending higher. Last week’s speed bump didn’t do any technical damage.
The question is, was last week’s sharp sell-off a sign of things to come? The market has bounced back quickly, suggesting the bulls aren’t too concerned about the short squeeze shenanigans. But will it run into more selling as it approaches the old highs?
We’ll soon find out.
In the meantime, here’s a chart to keep an eye on.
It shows the US Dollar Index. For the past few months, ‘everyone’ has been saying that the US dollar is toast. That inflation is coming, and that’s why stocks are melting up.
But as you can see below, the US dollar bottomed in early January. It’s been moving higher ever since. Sure, the trend is still down. So it’s not a big issue just yet. But when assets prices move against ‘conventional wisdom’, you should take notice.
If the US dollar moves up through resistance (former support) just above 92, it will warn of tightening global liquidity. That in turn will probably coincide with falling stock markets.
Remember, nothing is set in stone. You need to understand the risks, the potential scenarios and plan accordingly.
The next few weeks will be interesting indeed!
Editor, The Rum Rebellion
P.S: In a brand new report, market expert Vern Gowdie warns of the dangers waiting in a post-COVID-19 world. Plus, he outlines the steps you should take now to protect your wealth. Learn more.