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At the start of year most traders and investors thought it would be an easy ride. After all the stock market has been climbing relentlessly in the last four years on the back of QE or, as I put it, the Fed’s manipulation program. Four years ago the stock market was in a precarious state so the fed and other Central banks came to the rescue. To cut the story short, the Fed embarked on the greatest manipulation program to boost stock prices we have ever seen. What appears to be the solution to revive the economy and the stock market is in my view, a very dangerous game that will back fire. Firstly, the stock market is at risk of another collapse and secondly, if the stock market does collapse, the economy will suffer badly.
What’s the problem?
The people who created this clever financial engineering are not stock market analysts, they may well do the right thing for the economy but they do not understand how the stock market works. What is good for the economy is not necessarily good for the stock market. If it’s not good for the stock market the economy is no way near a recovery. At some point in the near future investors will give up. When the bull market ends (if it has not already ended) we are at risk of a serious crash. Why? Because the uninterrupted rise in the stock market has created an army of over leveraged investors with no skills. What they’ve been doing for the last four years is buying the dips. In a way the Fed has created a false sense of security by changing the natural path the market takes. What is overbought becomes more overbought, what should go down goes up, and corrections are short lived. The ideal ground for taking risk.
The other problem is that many respected fund managers are doing badly because their strategy is not adapted to a manipulated market. Let’s face it how can any strategy work in a manipulated market? Most strategies were developed in normal conditions, well before the financial crisis started. In normal conditions rallies are less powerful and we get many more sideways and corrective moves. In contrast today’s market goes up and up, it is like a one-way bet. As a result many unskilled investors are making money. The stock market has a bad habit of making good money managers look bad or bad money managers look good over a period of time. In a manipulated market statistics are irrelevant, when the manipulations end, the roles will be reversed, the experts will be in charge again and the unskilled investors will lick their wounds.
The result?
When there is easy money in a market people think the process will continue forever so they take more risk by increasing their leverage or margin debt. They also ignore the warnings given by the experts. They become over-confident and arrogant, as if they are expert investors themselves and blind to the real reasons why they are making money. It is not because they are clever investors, but because the Fed is pushing the stock market higher and they are following like sheep in a herd. Look at the chart of the stock market over the last four years, it’s a perfect market to make money. The trend is up and strong, from time to time we see a pull back and these pull backs have always been buying opportunities. People simply buy the dips without asking any question. In the process they borrow more to buy stocks. Look at the numbers:
Note the sharp rise in margin debt since the low in 2009. The level of margin debt is back to the pre-crisis levels.
All that is about to change
The party is nearing an end. The average guy who started to trade stocks or indices in 2009, the professional fund manager who has forgotten how the stock market works, the broker-turned-fund manager in the last few years and don’t forget the taxi driver who tells us what to buy…
When the stock market returns to its natural path, this cohort won’t know what to do, it will no longer be a one-way bet anymore. More importantly they won’t be prepared for what lies ahead. They will be confused and unable to protect their wealth in what will appear to be a chaotic environment. The massive de-leveraging process will get underway, and this could bring the stock market and the economy down.
The tide is already turning judging by the rising number of enquiries I receive. Most of my clients are private investors. When the market goes up continuously as it did in the first half of the year, they don’t need any help. But since May it’s no longer working for them, the FTSE has gone sideways and many investors have lost money. They don’t know what to do so they turn to me for help. I welcome them, given my understanding of the stock market and the way I see the future, I hope to guide them in the right direction.
Thierry Laduguie is Market Strategist at www.bettertrader.co.uk
