Yesterday, I shared a story of financial excess from the art world. My goal was to show you what a top feels like…
And another corner of the stock market has been flashing a warning – suggesting that stocks are in an outrageous bubble… one that may have already started to deflate.
Before we move on, just to be clear… I did not just call the top of the bull market.
By now, regular readers know that I don’t do predictions. And I certainly don’t call tops and bottoms.
But in a bubble, assets of all kinds wind up being inflated well beyond their real value.
Eventually, reality catches up with them. Prices plummet back to Earth. True believers tend to hold on to the worst stocks for far too long… And of course, they get badly burned in the end.
The burning may have already begun…
Last year, I wrote about Cathie Wood and her company, ARK Investment Management. Specifically, I pointed to ARK’s exchange-traded funds (“ETFs”) as a sign of the bubble we’re living in today.
ARK is focused solely on innovation… And plenty of the companies in its ETFs are unproven businesses with no profits. They’re long on vision and short on cash.
These ETFs all surged triple-digit percentages off the March 2020 bottom. So in that way, investors were well-paid for what wasn’t there – just like our art-world example from yesterday, on the creators of “invisible art.”
But lately, much of the speculative froth has drained from these ETFs…
As you can see, the ARK ETFs all peaked during the “meme stock” madness in the first two months of last year. Now, they’re almost all down between 30% and 60% from those peaks.
All the ARK ETFs have followed a similar trajectory up and down. That’s a typical bubble-like characteristic… When bubbles crash, all the assets swept up in them tend to correlate, even if they were viewed as non-correlated assets before the crash.
For example, if you thought your shares in the ARK Israel Innovative Technology Fund (IZRL) would perform well even if your shares in the ARK Innovation Fund (ARKK) performed poorly, you’ve experienced a rude wake-up call over the past year.
Of course, it could be just an extended “risk off” moment in the markets, but who knows?
Again, I’m not calling the top in ARK’s funds… I’m just showing what the top of a bubble looks like.
Right now, the story is similar in the major market indexes. With the latest highs in the S&P 500 Index and the Dow Jones Industrial Average happening just three months ago, and the Nasdaq’s and the Russell 2000’s latest highs occurring about four months ago… it’s neither likely nor unlikely that the bull market has peaked.
But again, the point here is not to call the top. The point is to show you ahead of time how the top will look and feel while it’s starting to happen.
The lesson is this… You can’t know that until the top is long in the past.
Everybody else will talk about it long after the top is already in. Even worse, every talking head on TV will smugly act like they knew it all along… even though they never said a word about it until the trend was well-established (like always).
But if you’re not talking about what to expect at the top before it’s in, save it.
The skill you need is not calling tops… That can’t be done.
Since you’re a human and not a cyborg (more on that in a minute), it’s better to talk about what it feels like instead of pretending there’s a perfect suite of metrics that will predict it. There isn’t one.
You’ll know the top isn’t in yet if the Dow, S&P 500, Nasdaq, and Russell 2000 all make new all-time highs again soon… And you won’t know it until that happens.
With the recent pullback, the next bear market may have already begun. But there’s no concrete way to know yet.
One more thing… I’d be doing you a disservice if I didn’t also point out that new highs are more likely than a bear market. Over the long term, markets go up and to the right.
I must also share one caveat… Volatility is not risk – in the stock market or anywhere else.
In fact, a certain amount of volatility is healthy. Over a decade or more, you’ll get plenty of random variations (up and down) from day to day and week to week.
The fewer and smaller those variations, the more prone the market is to a larger correction, as we saw recently. But as long as plenty of small variations are happening, big variations – like market crashes – will be relatively rare.
Now, with that caveat out of the way…
You can’t predict the top – but you can prepare for it.
I often say that the best advice is to prepare for a wide range of potential market outcomes. And you can do that by holding a truly diversified portfolio with four basic components…
- Stocks and bonds
- Plenty of cash
- Gold and silver
- A little bitcoin (or not, depending on your personal preference)
But today, I must confess… That’s not nearly the whole story.
You see, most humans are their own worst enemies in a bear market. If stocks fall 50%, 60%, or more over the next few years (as I believe is likely), too many folks will make the absolute worst decision they could make… They’ll sell at the bottom, exhausted by the pain of watching their net worth fall by half or more.
That doesn’t need to be you. You can handle this emotional battle in one of two ways…
First, you could be a totally passive investor. If you forget about your portfolio for 30 to 40 years, you’ll probably be fine.
But if you’re reading my words right now, that likely isn’t an option…
Odds are that you’re actively managing your own portfolio, buying and selling stocks based on a specific strategy. You either make money or lose money based on decisions that you make every day, every week, and every month.
If that sounds like you, and you’re not an emotionless cyborg, then you absolutely must have a plan to avoid selling in a panic at the bottom. You must plan ahead for when you’ll sell… And it had better be a lot sooner than all those poor folks who panic at the bottom.
Before long, it’ll be too late… It’ll be clear by then that the market top is long in the past.
Good investing,
— Dan Ferris
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Source: Daily Wealth