Last week, we discussed that as the market hit new highs and
the index returned to more extended and overbought conditions, a correction was
likely. To wit:
“Analysts have set a very high bar for
the markets to hurdle, given already lofty valuations. With indices already
well-stretched above their historical means, there is much room for
the currently very overbought short-term market, a 3% to 10% correction this
summer remains likely.”
Well, between Friday and Monday, the market did sell-off by 3% to touch the
50-dma. However, at that point, “dip buyers” emerged
to chase the market back to new highs. While this does indeed negate any
short-term bearish action, it is worth noting two things (shown below):
The volume of the rally was extremely
The sell-off was too shallow to reverse
the underlying technical concerns.
The good news is that the lack of real progress over the last couple of weeks
did work off most of the “money-flow sell
signal,” which preceded the selloff. If the market can continue to maintain
its more bullish posture, this should reverse our signals as early as next week.
While the upside remains somewhat limited, given the already substantial advance
this year, it will alleviate downside concerns momentarily. However, with that
said, the extremely low level of volatility this year is reminiscent of 2017. The
reason is that “stability” is fragile.
In other words, stability ultimately leads to instability.
Economist Hyman Minsky argued that during long periods of bullish speculation,
the excesses generated by reckless, speculative activity eventually lead to a
crisis. Of course,
the longer the speculation occurs, the more severe the crisis will be.
The Next Minsky
Minsky argued there
is an inherent instability in financial markets. He postulated that
abnormally long bullish cycles would spur an asymmetric rise in market
speculation. That speculation would eventually result in market instability and
collapse. Thus, a “Minsky Moment” crisis follows a prolonged period of bullish
is also associated with high amounts of debt taken on by both retail and
One way to view “leverage” is through “margin
debt,” and in particular, the level of “free
cash” investors have to deploy. In
periods of “high speculation,” investors
are likely to take on excess leverage (borrow
money) to invest, which leaves them with “negative” cash
debt” provides the fuel to support the bullish speculation, it is also the
accelerant for the reversal when it occurs. Periods of low volatility,
and steadily rising prices, lead to market complacency. As noted, the last
period where we saw similar levels of low volatility was 2017.
Of course, that low-volatility period in 2017 didn’t last long. The “Minsky
Moment” arrived in 2018 and lasted through 2020 as price swings punctuated
the markets. While this current low-volatility regime can certainly last a while
longer, it is likely naive to believe the next “Miskey
Moment” will be any less punishing than the last.
Minsky taught that markets have short memories and they repeatedly delude
themselves into believing “this time is different.” Sadly, judging
by today’s market exuberance, once again Minsky is likely to be proven
All that is missing is the catalyst to
start the ball rolling.
recession would more than likely do to trick.”
That was February
2020, one month before the recession began.
“In ‘Margin of
Safety,’ Seth Klarman tells a story about the market craze in sardine
trading. One day, the sardines disappeared from their traditional
habitat off of the Monterey, California, shores. Due to their scarcity,
commodity traders bid up the price of sardines. Prices soared.
Eventually, along comes a gentleman who
decides to treat himself and opens up a can of sardines and eats them. He
immediately gets ill and tells the seller the sardines are no good. The
seller quickly responds, ‘You
don’t understand. These are not eating sardines; these are trading
sardines!'” – Doug Kass
On Monday, the market sold off over fears of the “Delta
variant.”(Someone ate the sardines.) On
Tuesday, as the market touched the 50-dma, computer algorithms furiously “traded
Such is not an investor’s market. Rather, it is a market fraught with
speculative frenzy as investors fear “missing
out” more than “losing capital.”
In the short term, speculation seems “normal.” However,
as the price advances, the underlying valuations become an inherently more
significant drag on outcomes. Currently, those valuations exceed levels rarely
witnessed in history. (Table courtesy of Tavi
Costa of Crescat Capital)
If you are a long-term investor, it is becoming more critical to understand the
risk you are undertaking. Likewise, if you are a trader, it is essential to
determine what type of trader you are. As Doug concluded:
“In terms of trading, more than ever,
it’s important to remember that there are two kinds of traders:
Those who are humble.
Those who are going to be humbled.
Remember those words because, despite the
appearance of the many talking heads in the business media who regal in the
reversal of Monday’s losses and consecutive winning trades. The
stock market is likely to grow more difficult and narrow in the months
The views expressed by Lance Roberts are not
necessarily those of RetireEarlyLifestyle.com