The bears are out in force in recent days trying to figure out what just happened. If you were short entering Monday, the first three days of this week were the equivalent of getting hit with repeated Mike Tyson uppercuts (for those of you who can’t remember the greatest uppercut in boxing history see here). The only thing you can do now is take a breather and try to collect your thoughts and figure out what just happened to you. The burning question is – how could so little news cause such a big rally? There’s a teachable moment in here and an important psychological lesson to be learned from the past few days.
I’ll try to describe it the way I viewed it so as to provide some insights. I entered the week in what I saw as a very low risk/high reward way to play the bullish side. Last week I mentioned I was short US Treasuries for the first time since 2009 (a position I have since covered). In this environment US Treasuries are a bet on the risk trade (understanding the macro is the first crucial element in succeeding – if you don’t understand the asset class correlations in any given environment you might as well go deliver pizzas for a living and stop trading). Yields will rise as equities rise. And Treasuries will be the safe haven if fear settles back in. They’re THE safe haven in a world of the imploding Euro. And what we saw in the days leading up to Thanksgiving was indiscriminate selling in equities and buying in bonds. There wasn’t much news driving the selling (aside from rumors), but we lost 7.5% in 7 sessions. That’s an outlier move. Beyond unusual. No one wanted to go into the weekend holding excessive risk as Europe appeared to be imploding. The end of the world trade had taken control and it was enormously crowded.
So, the question to be asking ourselves here is not whether the market has overreacted to this week’s news, but whether it was spring loaded following an irrational slide last week? My position was that the selling was overdone, but even I was hesitant to take an equity position. I won’t go into details on calculating the risks, but I’ll elaborate on my thinking here. The better trade from my perch was selling US Govt Bonds with the idea that upside was capped in the near-term due to excessive fear. The only way yields would sink further was if Europe actually did implode (something that appeared like a low probability). The upside, however, looked fairly substantial and could be caused by anything other than the end of the Euro. The reason for shying away from equities was simple – if Europe actually did implode you could lose 20% in weeks as we learned in 2008. In other words, we were seeing a disequilibrium in the market where Treasuries had become so crowded that upside was limited, downside was fair, equity downside was substantial and upside was substantial. If you think about the asset mix in this macro sense you can understand why I chose door #4 – the low risk bullish bet. Remember, the market is the summation of bets about future expectations. When those expectations get excessively skewed, the market gets spring loaded and it doesn’t take much to trigger the snap back. And that’s all we’ve seen here. A snap back to early last week’s levels.
So, was the market move excessive? If you’re asking yourself that, you’re thinking about the market all wrong. When you lose a game of chess you don’t think about how you could have avoided the final move resulting in checkmate, but rather, you need to think about how ALL of the preceding moves resulted in checkmate. If you’re on the losing end of a lot of chess matches you’re not thinking far enough ahead. You’re suffering from the recency effect. The last few week’s have been a great lesson from a macro perspective and from a trading perspective. It’s psychological warfare out there. The person asking the right questions and learning from their mistakes has a substantial leg up on the competition. And the guy making excuses about the most recent data point is going to keep losing future chess matches.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.