Fra Oftwominds blog:
There are seven factors to keep in mind that may intensify reversals and risks:
One factor to keep in mind is the dominance of ETFs (exchange-traded funds) and index funds. As money pours into these passive funds, the funds buy whatever stocks are in the ETF or index. Good, bad and indifferent stocks in each ETF or index are purchased without any assessment of their relative value.
When owners sell, the process is reversed: every stock in the ETF or index is automatically sold to fund the redemption. This leads to “the baby being thrown out with the bathwater” as the best performing companies get sold off with the dregs in the ETF or index.
Another factor to keep in mind is the reliance of bubbles on borrowed money (margin debt) and leverage: 2X and 3X leveraged ETFs and a variety of financialization tricks to increase leverage and thus gains. When assets that have been leveraged reverse even modestly, the losses are quickly consequential, and the “solution” is to liquidate every leveraged asset before the position is wiped out. Selling begets selling, and this is the self-reinforcing feedback of crashes.
A third factor to keep in mind is the decline of short interest to all-time lows. Put another way, the number of speculators who have an incentive to buy shares in a decline is near all-time lows, so the only buyers in a real decline will be “buy the dip” players who will soon be wiped out if the decline continues.
A fourth factor to keep in mind is the narrowing of the speculative universe into a few assets. This creates an extreme dependency on the few rocketships to keep soaring lest the entire ETF / index fund world collapse.
A fifth factor to keep in mind is the potential for the Covid virus to spread globally beyond current expectations. Such an expansion could trigger a global slowdown / recession.
A sixth point to keep in mind is that all fiscal and monetary stimulus suffers from diminishing returns. (see chart below)
The chart of money velocity suggests the returns have fallen off a cliff. (see chart below)
A seventh factor is the dominance of algorithm-driven trading (algos, trading bots, etc., which appears to be mostly programmed to be momentum / trend-following. If these programs are withdrawn to avoid high volatility, the liquidity the market depends on to maintain stability may dry up, increasing the odds of the market going bidless, i.e. buyers vanish and prices crash.
When the warning light is flashing red, it’s prudent to have a capital preservation strategy in place.
