Don’t confuse brains with a bull market. -Humphrey B. Neill
Spending as much time as I do on social media, namely Twitter and StockTwits, I’ve been absolutely astounded by how many traders have begun to “confuse brains with a bull market.” We joke about it on these platforms but there is an amazing amount of hubris out there right now.
One of my favorite investing quotes comes from an interview Paul Tudor Jones gave just after the financial crisis had ended:
This might be my fav PTJ quote: pic.twitter.com/3syQ3Cn4JT
— Jesse Felder (@jessefelder) April 30, 2015
Clearly, many fundamental investors were caught off guard by the crisis. Stocks they thought were cheap in 2007 got far cheaper over the coming couple of years. Being unable to “read the tape,” these investors suffered the full force of the stock market crash.
As a response to this failure, many investors have seemingly tried to adapt by becoming “tape readers.” Most notably I have seen an explosion in the number of traders calling themselves, “trend followers.”
Now I have great respect for trend-following. Some of the greatest investors on the planet are trend followers, employing a very simple yet very effective and intuitive strategy across a wide variety of markets.
That said, the problem with most of these newbie trend followers is they ignore one of the key components of the strategy: diversification. They are involved only in one asset class, the stock market. Though they respect the trend, they don’t appreciate just how exposed they are to liquidity risk right now, something experienced trend followers ameliorate by broadening out into as many uncorrelated asset classes as possible.
Emboldened by 3+ years of very low volatility, these traders have become the exact opposite of what PTJ was referring to. Their inability to understand the fundamentals, relying solely on the trend, puts them at great risk, especially in an environment of problematic liquidity.
As I’ve demonstrated over the past several months, this stock market is one of the most overvalued, overbought and overbullish in history. Julian Robertson, Stan Druckenmiller, Ray Dalio, Mohamed El-Erian and other super-investors have recently warned about this in one way or another.
However, when I have shared the their concerns via social media, I’m regularly met with dismissal or disdain. These trend followers have become so emboldened by the bull market that they now believe their brains to be even bigger than these giants of the industry.
I have been bearish but have avoided using the “c-word” until now because crashes, by their nature, are impossible to predict. But the hubris on display in the market by those who believe themselves immune to these massive risks has me wondering if some sort of liquidity event in the stock market isn’t inevitable.
If everyone is a trend follower and the stock market begins to sell off, how can everyone get out at the same time? And in a market already plagued by severe liquidity challenges? It seems to me that there is a lesson here that should have been learned a long time ago.
— Jesse Felder (@jessefelder) May 9, 2015
The quote above comes from a fantastic piece Mark Yusko recently wrote about his personal experience with Julian Robertson, who recently said it is, ‘not at all ridiculous to expect another 2008-style decline in the stock market.’
To turn the PTJ quote on its head, counting on being able to sell once it’s clear to all that the trend has shifted may be precisely how those in the trend following space get annihilated in the future. Certainly, we have seen this movie before. Doesn’t anyone else remember “portfolio insurance”?