Smart folks know stock market euphoria can’t last forever: Don Pittis

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As U.S. President Donald Trump’s over-the-top comments on North Korea this week have shown, it doesn’t take much to frighten a market that has been soaring for so long.

“They will be met with fire and fury like the world has never seen,” Trump warned, which seemed to imply he is willing to engage in a nuclear duel with another capricious leader on the other side of the world.

Such sabre-rattling rhetoric may appeal to a portion of the president’s base, but on the face of it, starting a nuclear — or even a conventional — war on China’s doorstep would seem bad for the price of stocks.

Cooler heads

Cooler heads in the U.S. government, including Secretary of State Rex Tillerson, downplayed the North Korean threat. And markets have learned from experience that Trump’s statements cannot be taken at face value.

Trump warns North Korea0:32

Nonetheless, shortly after the verbal nuclear sparring match between Trump and North Korea’s supreme leader Kim Jong-un, world stock indexes began to dip.

The market reaction may be about more than geopolitics.

Repeated record highs

Just last week, we in the media ran photos of the guy with the white goatee celebrating with a hat that said “Dow 22,000.”

In March it was the hat with “Dow 21,000.” As recently as January everyone was surprised when it crashed through 20,000.

There seems to be growing feeling things can’t last.

Financial Markets Wall Street

The guy with the white goatee, trader Peter Tuchman, has probably already bought his “Dow 23,000” hat despite U.S. President Donald Trump’s threat. (Richard Drew/Associated Press)

Bearish traders, that is, those who think markets may have reached unjustifiable heights, are watching for a trigger.

“North Korea is being used as a reason to sell Japanese stocks,” one Tokyo trader told the business news service Bloomberg.

But on the 10th anniversary of the last great global economic crisis there is something else in the air.

The big surprise of 2007

“The next crisis will probably come from somewhere where it wasn’t really expected, from causes that haven’t yet been identified,” said former British finance minister Alistair Darling, discussing the beginning of the summer 2007 credit crunch.

Despite what in hindsight seemed like obvious warning signs, Darling was not alone in being surprised when the head of the Royal Bank of Scotland phoned to say the bank, which “was about the same size as the entire U.K. economy,” would run out of cash before the middle of the afternoon.

The anniversary has stimulated a flurry of articles on that crisis, including one in the Financial Times on how to identify the next market meltdown. 

Many other commentators, including FT readers responding to that article, point out that a bubble is only obvious after the fact and that at any moment at least a few investors are betting against the market.

Short sellers, like those lionized in the book and film The Big Short, will only be congratulated for their brilliance in the event that the market happens to collapse before they run out of money to place those bets.

And this is one of the difficulties for anyone trying to anticipate the next market meltdown.

Kicking themselves 

Betting against a rising market too soon can mean a huge loss in forgone returns. It is like someone who sold out of the Toronto housing market in 2008. They have spent nearly a decade trying to figure out a way to kick themselves.

One strategy, the one most commonly advised by those in the business press, is simply to stay invested and plan to ride out any market decline.

If almost everyone did just that, markets would be much more stable and short sellers would never win. But that is not the way real markets work.

Just as markets sometimes go up irrationally, they also go down. 

For the truly nervous or those who can’t afford short-term losses, one answer is to get out of the market altogether and forget it.

That is why retired people are often advised to keep a larger portion of their savings in secure fixed-income securities. Those who didn’t got a rude shock following the 2007 credit crunch when even Canadian bank shares collapsed.

They bounced back, but you had to wait. Inevitably some couldn’t wait long enough. Following the 1929 crash the wait for shares to bounce back was about 20 years.

Of course this doesn’t feel like 1929. It doesn’t feel like 2007. But as Darling said, the beginning of 2007 did not feel like the end. 

New threat

As one market adviser warned this week, the growing moves toward index funds and passive ETFs may represent a new threat to market stability.

“As emotionally motivated, adrenalin-driven ‘investors’ stampede for the exits,” many funds will be forced to sell into a falling market, writes Winnipeg fund adviser Larry Sarbit in the Report on Business.

This is a problem articulated years ago by financial writer Mark Heinzl in his book Stop Buying Mutual Funds, where inexperienced investors buy funds when market euphoria is at a peak and unload when markets start to crash.

Effectively that means the fund managers are forced to buy high and sell low, the exact opposite of a wise investment strategy, and even unit holders who hold tight lose out.

But so long as market euphoria lasts, that seems like a problem for another day. And despite Trump’s warlike rhetoric you just know the guy with the white goatee has already ordered his hat that says, “Dow 23,000.”

Follow Don on Twitter @don_pittis

More analysis by Don Pittis

http://www.cbc.ca/news/business/stock-market-rise-decline-1.4240186?cmp=rss