Mr. Market And Ultra-High Risk For Equities.
Not all that long ago, we discussed the very perilous conditions facing investors in a piece called “Ultra-High Risk For Equities” https://markonomics101.com/2018/08/31/ultra-high-risk-for-equities/. While many stock index chart patterns were in BULLISH mode, especially the “Behemoths” we lovingly nicknamed the “Four Horsemen” https://markonomics101.com/2018/08/23/tipping-point-part-2-the-four-horsemen-of-the-nasdaq-collapse/, the thought of buying at record high valuations with the hope of selling at even higher valuations was like buying while either “high”, or after a few tequila shooters.
If profitability in trading or investing comes from “Buying Low and Selling High”, the odds of success as well as the amount of profit, MUST be less if one buys higher, all other things being equal. Buying into a demonstrably grossly overvalued market requires either the faith, luck, or sheer stupidity of assuming the prevailing extreme conditions will become even more extreme. It’s like experiencing the hottest day in history and betting that tomorrow will be even hotter. Yes, it might happen. And yes, I have a “chance” at playing starting center for the Los Angeles Lakers.
Investing is all about probabilities. Success depends on accurately assessing those odds. Intelligent, high probability trades often lose and low probability trades often succeed. An unfortunate aspect of human nature is the need to take credit for, and not question, any type of success, even if it was nothing more than dumb luck. Are people who win the lottery smarter? The reinforcement of stupidity which results from luck, compounds and leads to erroneous decision making with even more money placed at risk. Anyone ever hear of these “things” called Cryptocurrencies? Somehow that financial revolution was a terrific yarn, but not much else https://markonomics101.com/2018/08/04/inflection-point-part-4-cryptocurrencies-commodities-or-collectibles/. Any day now. Any day now.
Mr. Market operates almost identically to a con man. The traders or investors who actually do Buy Low and Sell High make money. But as the market moves higher, the odds that a trade will succeed diminishes while the profitability of a given trade will also diminish. Higher markets are by definition Riskier, because the probability of Buying High and Selling Low go up. Yet, investors typically perceive the exact opposite. (Anyone ever hear of these things called Cryptocurrencies?) Many of the traders that bought Bitcoin at $20,000 wouldn’t touch it at $1,000. People buy less gasoline at $5 a gallon than at $3 but buy more stock or other assets at $5 than at $3. This makes Mr. Market very happy and leaves investors with substandard returns or losses.
But while they are making money, traders and investors virtually always assume that success is attributable to their superior insight and intellect, rather than luck. When a coin is tossed before a football game to see who kicks off, the team which called it right is the smarter one, correct? Traders fail to even consider the remote possibility that they were lucky, setting up a type of reinforced blind spot to reality. (Anyone ever hear of these things called Cryptocurrencies?)
These late-coming trading geniuses only make money because of the upward momentum of the market. Each new trade is RISKIER than the prior one, yet they typically put MORE at risk rather than less. And, how better to make even more money than by deploying leverage or borrowed funds? Especially when buying at all time overvalued highs: https://markonomics101.com/2018/07/12/inflection-point-part-1-the-long-term-equity-valuation-cycle/. (Anyone ever hear of these “things” called Cryptocurrencies?)
The preposterous valuations make RISK higher, but most investors perceive the opposite. A mathematical, market-based way to demonstrate this is through the “Volatility Index” (or VIX). The VIX itself applies to the Standard & Poor’s 500 but volatility, or the tendency for extreme price movements, can be determined for any asset whose price is subject to some level of variation. The greater the “anticipated” variation, the higher the “implied” or expected volatility. The higher the VIX, the greater the expectation for large movements in either direction for the market as reflected in the Standard & Poor’s 500 Index.
A higher VIX and, therefore, a greater fear of future outsized movements, makes hedging a stock, portfolio or any other asset MORE EXPENSIVE. It is correlated to fear. In the same manner that insurance companies assess greater premiums for protection against the affects of any adverse event, the VIX is the key determinant of the “cost” of “insuring” against a sudden, adverse Market move.
Yet, the VIX tends to fall during rising markets and rise as the S & P falls. The VIX is a poor timing indicator since it can remain low or high for long periods of time. For anyone interested in more detailed information on the VIX, a pretty simple yet thorough explanation can be found here: https://www.investopedia.com/terms/c/chicago-board-options-exchange-cboe-vix-vix-vvix.asp.
What no charts? The probability of that is ZERO. Below is the VIX for the last year. You’ll note that it spiked substantially higher when the market plunged in January, and as the market has rebounded to new highs, it is back to extremely subdued levels.
With the major indexes at new all-time highs, an investor faces a major challenge to make an investment that will pay off.
As the markets become Ultra-High Risk, the perception of that risk decreases. This is precisely WHY they are risky. The market is NOT fully pricing in that risk as the charts for the VIX demonstrates. But, to make money here requires a grossly overvalued market to become an even MORE GROSSLY OVERVALUED Market. The upside is most likely minimal, and the downside is HUGE. This is the very “definition” of Ultra-High Risk and why sometimes it pays to let the lunacy play itself out rather than roll a pair of loaded dice.