"A lot of people would rather understand the market than make money"
- Ed Seykota
It is not hard to understand the way the market is supposed to work. In theory, the investment process is quite logical. Find stocks that are good values or set up well technically and then hold them as the market discovers their true value. News like the Covid crisis or economic issues may cause some volatility along the way but ultimately the market is logical and functions as a discounting mechanism that will eventually reward astute stock selection.
That is the theory. The reality is that the stock market is wildly irrational at times. Valuations become meaningless, trends climb to the sky and it seems like the dumbest investors are rewarded for their lack of rigorous analysis.
These periods of irrational action are the nature of markets. They occur regularly and they will always eventually come to an ugly end. They almost always last longer than seems reasonable. It is the herd mentality at work and a stampede of hungry bulls doesn't usually end too abruptly.
Many market players shake their heads at this sort of action and say things like 'it will end badly'. Of course, it will. Recently social media has been full of comments about the irrationality of the big moves in IPOs like DoorDash (DASH) and Airbnb (ABNB) . The movement in the SPAC names has been compared to the internet bubble in 1999-2000. The screens are full of stocks moving 10% or more in a day and it makes many people so nervous that they never profit from it.
The easy thing to do is to predict that the action won't last and that there will be a substantial pullback and a rotation out of the craziest stock. It is an absolutely certainty that this action won't last but it is very likely to last longer than most people think. That is the nature of bubbles. As bubbles build the fear of missing out becomes stronger and the pain of trying to fight the trend with shorts becomes more painful. It becomes a vicious cycle of positive reinforcement that keeps things running to irrational levels
Here is what you need to know to navigate an irrational market
- A Ponzi Scheme mentality is in play. Ponzi schemes work as long as the participants are confident that someone else will come along and pay an even higher price than they just paid. Eventually, those buyers fail to show up and the scheme collapses. In the stock market, the traders that are trading super momentum stocks have this belief that a new supply of buyers will continue to show up and pay even more. They use a variety of arguments to justify valuations but mostly they just count on momentum. When there is a high level of liquidity in the market like there has been in 2020, that money keeps coming into stocks because there just aren't any alternatives that are providing sufficient returns.
- It will last longer than you think is reasonable. One of the reasons that irrational action can last so long and go so far is that there is a huge crowd of people that are betting against it. They think that the market is going to suddenly appreciate all the compelling reasons for a collapse, but the more skepticism there is the easier it is for stocks to keep running higher.
- All runaway markets have key themes or sectors. Most of the irrational action in the market is in a relatively small group of stocks. Traders gravitate toward the fastest moving groups and they stick with them until they start losing money. The internet bubble is the classic example but at other times it has been groups like the FATMAAN stocks, or high beta technology that are favored. Currently, it is IPOs and SPACs that are favored. There is some sympathy action in other stocks but it is the theme plays that become very crowded that work best.
- The primary focus is on stock picking rather than the indices. While the indices may make some very strong moves during these periods, it is individual stocks that offer the most opportunity. Stocks that double in a few days are not rare and that is where the most aggressive money will flow.
- Be ready to lose money. The key to trading during these irrational periods is to build up a cushion of profits and then to be ready to give some back when the turn comes. You will not know in advance when this action will end. When it does end you will take some hits unless you have been sitting on the sidelines doing nothing. I contend that the opportunity lost of trying to time a top is generally much higher than the risk of loss that you will suffer when there is a turn.
- Trends don't die easily. Strong irrational market action creates a huge supply of people that have missed out. They are determined to not miss the next run and they will be ready to aggressively buy the first few pullbacks and corrections. It is only after they have been burned several times that they give up on the dip-buying approach.
- Irrational action works to the downside also. Markets go down much differently than the go up but the opportunities in irrational selloffs can be even greater especially if you focus on counter-trend trading.
- Don't obsess over market timing. Stay focused on individual stocks and let them determine how much exposure you have. When your individual stocks start to falter then sell them and only make new buys if you find the right setups. Your stocks will do your market timing for you. You don't need to study macroeconomics or Elliot Wave Theory. Sell stocks that are breaking down and if you can't find new buys then you will be ready for a bear market.
Irrational market action offers some of the greatest profits but many people squander their chances by proclaiming that the market is irrational. The market will always be irrational. The best way to deal with it is to embrace reality.