Are We In a Bubble?
Interest rates are approaching zero. This has caused many investors searching for growth to borrow cheap money and throw it at the markets. With Tesla for example at a P/E multiple of over 1000, it becomes hard to deny that stock market prices might be over inflated.
You know it’s time to take some profits… when your shoeshine boys start giving you stock tips.
Fear Of Missing Out
Unfortunately the excitement of seeing daily price rises becomes addictive. To name an example – some analysts predict stellar prices ahead for Bitcoin. This would mean an exponential increase in price from current levels. Investors fear that if they sell too soon they will miss out on untold wealth in future.
[Also read: How Will a Stock Market Crash Influence Bitcoin]
As prices rise further and the excitement around profits increase, near-crazed investors stuff more money into the market. Then when the crash occurs, these poor souls who are all in with their (borrowed) trading funds now see a massive percentage drop in their total holdings. They are left with the difficult choice of selling at a massive loss to recoup some moneys, or “hodling” (a Bitcoin term for holding on through a crash).
For hodlers, the next year or two while the instrument recovers will be a painful one. All hopes of a tenfold increase is out the window at this point. They would just like to see a recovery of a percentage of their investments.
Buying the Dump
Consider Warren Buffet’s Berkshire Hathaway fund where $104 billion + of their holdings are cash. This approach of “keeping some (gun)powder dry” allows them the luxury of being able to increase their position if the market takes a sudden downturn. For the small investor suffering from FOMO fever, this is one of the hardest decisions to make, since they believe every dollar extracted from the market is a dollar that will grow tenfold over the next couple of weeks.
(This article is not financial advice, merely my approach to investments)
As the price of a stock increase, FOMO-crazed buyers stuff more money into the stock, thereby pushing their average purchase price closer to where the stock is currently (over-) priced. At this point if the worst happens, fear will play a big part of their selling decision, and cool heads will not prevail. I would prefer to not get in halfway along the trend but at a massive discount. I prefer to do most of my buying when there is blood in the streets.
How to Get In – Progressively or All at Once?
After a crash the markets can display several types of recovery.
V-Shaped is where there is a sudden dump and investors start to pile in and prices recover rapidly to previous levels. If the recovery was too swift and investor expectations were too high without taking the underlying problem still persists, the V might turn into a W where prices will fall again.
A U shaped recovery is where prices fall and stay down longer. The nightmare cousin of the U is the L-shaped recovery where prices stay depressed for a year or longer and then only start to recover. This was the case of the crisis in 2007 as the markets only regained the same levels in 2013.
Three ways to cater for the V, W, U or L scenarios above:
The Aggressive Approach: Go 50% in on a 30% drop, the other 50% on a 50% drop.
- This works well for V and W shaped recovery, except if the drawdown on the second half of the W is deeper and more pronounced.
- Disadvantage: If the V only went down to 35% percent, I have committed only 50% of my “dry powder”.
- Disadvantage: This approach is in essence an “averaging down” approach that counts on prices recovering again at some future point and hopefully is not a permanent revaluation of the instrument. In my opinion it would be better to apply this strategy to stock market indexes and not individual stocks.
The Wait and See Approach: Wait for the Golden Cross
For those who do not like the averaging down approach, a wait and see approach could be a better option. A golden cross indicates the recovery of a price after a crash or depression in price. This is when the 50 day moving average crosses above the 200 day MA, indicating the price is not in a downward any longer. In the chart below, a golden cross is seen in 2011 to indicate the markets were ready to rise again.
When to take profits?
Sell into rising prices. The risk will always be that I sell to soon and miss out on the last 50% of the trend, but once I have some cash cleared is there not always other investments that are under priced and overlooked?
This is not a get rich quick strategy but does reward those who are patient enough for the right opportunity. After it has worked well for uncle Warren.
Imagine following this strategy when Brent took a dive.