When you turn on a lightbulb, you may not notice the electrons springing into action, but you do see the end result of electrons showing up at the bulb and creating light. If the electrons went on strike or called in sick, the laws that govern the universe (i.e. physics) would be almost impossible. Markets are not electrons, they don’t always act the way you would expect when levers are pushed and pulled – the market has feelings, electrons don’t. Many participants want markets to act according to a set of immutable laws, but markets are not subservient to a set of exact equations; rather they work through a vague and inexact set of cycles. Physics is exact, markets aren’t, and that is why Richard Feynman, a father of quantum physics once said, “Imagine how much harder physics would be if electrons had feelings”.
Because markets have feelings, and we understand that these feelings create cycles, it may be more profitable for an investor to focus on the cycles as opposed to feelings. Optimism is a feeling, and optimism creates swift and noticeable changes in investor psychology that can lead to irrational risk taking. The part of the cycle that is punctuated by extreme optimism is much easier to see in hindsight, after the ‘burst’ or crash; but at the time there are noticeable warning signs. If your neighbor, who works at the city transportation cabinet is making huge profits trading digital assets or penny stocks, this might be a sign of irrational optimism. If you have family members that want to talk about their new insights into the world of biotech penny stocks, this too might be a warning signal that something is happening in our markets that is not fundamentally supported by reality.
The extreme optimism that typically peaks at some point, has a downside and that is where we will want to focus our attention. Now, the exact timing of these turnings is not consistently ‘knowable’, but we have some idea of the season based on the temperature of the market. You don’t have to know the exact temperature to know it’s hot, and you don’t have to know the exact date of the bust to know things are getting ‘toppy’. And, as a wise man once said, “There is no such thing as bad weather, just bad clothing.” If we take the temperature of our market and we notice things are way too hot, we have to know the actions to take to bring down the risk by clothing ourselves with the right assets.
So let’s talk about the downside of optimistic markets. Unlike physics, markets can be irrational, and changes in the mood can be deleterious to markets prices. Markets melt down because investors melt down, the irrationality that leads to extreme optimism has a downside and that downside is like a Tsunami. Those investors that were blinded by optimism see the losses and freak out, knowing that they are losing money fast and can’t take the losses. This turns into sell-off that tends to bring down fairly priced assets, and eventually turns into irrational pessimism. To the extreme optimists who now have large losses, the whole world of stocks looks like a giant Ponzi-scheme, but eventually the selling subsides and markets constructively move higher.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risks including loss of principal. No strategy assures success or protects against losses.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.