The fourth quarter has been a historic one for the stock market. As I write this, equity markets are down nearly 20% from their highs in September.
One of the most obnoxious things I’ve seen lately is the thought, “Stocks are on sale! By buying at these prices, you are getting the same asset for 20% less than a few months ago!”
First, this comment implies that at 100% of the price, stocks had a fair price and weren’t overvalued, and second, this also comment implies the future for equities will be favorable.
What bothers me about this comment most is that CATCHING A FALLING KNIFE and BUYING THE DIP are two completely different investing and trading concepts. (If you are unfamiliar with these concepts, I’ll explain shortly)
There are a ton of absurd investing mantras out there, and in this post, I want to talk about uncertainty, psychology and investing in falling markets, central bank monetary policies, and why it might be best to relax on the recent pullback and wait to see where things go in the first quarter of 2019.
Price is what you pay. Value is what you get.
A Personal Story of Chasing Returns
I’m a fan of cryptocurrencies. I’ve talked about this a few times on this blog as an opportunity for asymmetric returns, and also as an alternative to the debt based fiat monetary scheme which is failing for many countries.
Back in the summer of 2017, I made my first purchase of Litecoin, and also bought a little bit of Bitcoin and other coins.
I got in before the madness in December, and had the opportunity to sell and cash out for a large sum.
Unfortunately, I didn’t sell and fell for what I thought was a common investing and trading pitfall.
Here’s a chart of Litecoin indicating where I purchased over the last year:
In January, after the price pulled back significantly, I thought I was getting it “on sale”.
The high was over $400, and the price was down to $240! That’s a 40% sale, right?
WRONG!
What is the fair value of Litecoin? What would I pay for 1 Litecoin, given the option to purchase any other number of securities or assets?
Many of you reading this probably think the price should be $0, so that case, I was chasing returns and letting the psychology of the markets trap me into making dumb purchases.
I thought I was buying the dip, but actually, I was catching a falling knife.
Catching a Falling Knife and Buying the Dip are the same action, but completely different results
Let’s get to some definitions here… what is catching a falling knife and what is buying the dip?
When the price of an asset falls, this might look like a good opportunity to buy.
After buying, maybe the price goes up. Great! You’ve bought the dip and made a good purchase because the price is higher than what you paid.
Maybe the price goes down. That’s not great, you’ve caught a falling knife, and now would have to sell at a loss.
What looks like a similar set-up in the price time series can lead to completely different results and emotions.
I thought I was buying the dip in Litecoin, but I was actually catching a falling knife.
Let’s move on to talking about the stock market, and actually, more generally, the global markets.
Is the Central Bank Liquidity Supernova going Black hole?
Recently, we celebrated (?) the 10 year anniversary of the start of the Global Financial Meltdown which happened in 2008.
After 2008, central banks around the world took extreme measures to keep things afloat.
Central banks’ balance sheets have exploded around the world with purchases of assets, and the money supply has likewise exploded.
This liquidity supernova saved the global economy from collapsing, but 10 years later, has distorted prices, thoughts, and actions of many individuals and institutions.
Talking about the United States central bank, the Federal Reserve (which interestingly enough is not Federal or has any reserves) pumped $4 trillion dollars into the financial markets, an increase of 4 times the existing money supply! Through quantitative easing, the markets have recovered and returned to all time highs.
However, this easy and cheap money cannot go on forever without dire consequences.
In 2015, the Federal Reserve has started to reduce the assets of their balance sheet (quantitative tightening). Currently, roughly $50 billion is being removed from the system each month.
Below is the chart of money supply vs. S&P 500 over time.
This is a personal opinion, but I believe these two time series are intimately related, and if the Federal Reserve continues to remove money from the system, many assets will experience a severe repricing to lower levels.
Fighting the General Trend of Liquidity Might Not Lead to Winning
Central banks all around the world all have massive balance sheets. The Federal Reserve is trying to reduce the size of their balance sheet, but in Europe, China and England, these central banks are still providing liquidity to the commercial banks and companies in those countries.
Looking at the change over time, you can see that globally, money is becoming tighter and actually shrinking over time due to Quantitative Tightening.
Investors and corporations have become addicted to cheap and abundant money over the past 10 years. With interest rates at historic lows (and even negative in some countries), personal and corporate debt loads have gone bananas, and now with money tightening globally, pain is being felt as many people are feeling tapped out.
With money supplies decreasing, it is my opinion this should have a deflationary impact on the general economy.
At the same time, our absurd debt driven economy is made possible with inflation, and if property values fall, stock portfolios fall, and lending starts to slow, there could be a lot of pain felt with bankruptcies and defaults.
I’m not a financial adviser, so please do not take this as a recommendation and please do your own research.
Are stocks on sale? I don’t believe so. I believe stocks are still very overvalued. The charts in 2018 of the S&P 500, Nasdaq and Dow Jones all remind me of the charts of cryptocurrencies in 2017. I wouldn’t be surprised if the S&P 500 touches $2,000 (or even $1,500) before going up again.
What goes up, will come down. Prices cannot go up in a straight line forever.
What scares me is the mainstream media isn’t talking about this, and a lot of people have no idea about what could come in the next few years.
It will be very interesting to watch in 2019. I’m just having a very hard time seeing growth in risky assets when the overall pie is shrinking. Catching a falling knife and buying the dip are two different results from the same action.
Be Careful with Your Money is All I Ask
One thing I will not do on this blog is make predictions or recommendations for what you do with your money.
My goal with this blog is to inspire ORIGINAL thought by providing you with high level thoughts, potential opportunities to go down different rabbit holes, and give frameworks for making decisions which make sense for you and the people around you.
A person who cannot think for themselves is worse off than someone with no skills but can think for themselves.
Group think, confirmation bias, and not challenging traditional thoughts will get you run over in a dynamic world.
Again, I’m not recommending you buy or sell anything. I’m not making a prediction that the market will crash or the market will go up 100’s of points over the next few years.
I want you to be successful in your life, and that involves a monetary component, as money is a tool to do what you want.
The best case scenario is that you, your friends, and your family can all be wealthy! I want this for you and all of the other readers of this blog!
I’m a very positive person, but also am scared of the absurd monetary policies which have been implemented all over the world.
To blindly accept traditional thoughts and not challenge the current environment would be doing a disservice to me, my family, and my principles.
All I ask is to for you to think critically, do your due diligence and research, and understand that there might be bigger factors playing into the markets than we previously thought.
Thank you for reading,
Erik
Related Reading:
- Take Off Your Bull Market Beer Goggles
- All Assets are Worth Considering (and Owning) for Financial Success
- The #1 Financial Mindset for Wealth: Track Your Income and Expenses!
