“If I gave you a bunch of ingredients such as nitrogen, glycerol, sand, and shell, you would probably stick them in the garbage and think nothing of it. They are innocuous ingredients and pose little real danger by themselves. However, you make dynamite using a process to combine and bind them. However, even dynamite is safe as long as it is stored properly. Only when dynamite comes into contact with the appropriate catalyst does it become a problem.
‘Mean reverting events,’ bear markets, and financial crises result from a combined set of ingredients that a catalyst ignites. Like dynamite, the individual ingredients are relatively harmless but dangerous when combined.
Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”
Importantly, this particular formula remains supportive of higher asset prices in the short term. Of course, the more prices rise, the more optimistic investors become. While the combination of ingredients is dangerous, they remain “inert” until exposed to the right catalyst.
That catalyst is always an unexpected, exogenous event that triggers a rush for the exits.“
L. Roberts
Market crashes usually have the same mechanism. People like a thing, so they buy it, so it goes up. More people like it, so they buy more of it, so it goes up more. It goes up steadily enough that people think "ehh I should borrow some money to buy even more of this thing," so they do. Eventually a lot of very leveraged investors own a lot of the thing.
Then something goes wrong with the thing, its price goes down, the leveraged investors get margin calls, and they have to sell the thing to pay back their loans. Their losses are big enough that they have to sell other things, things that were fine, to pay back their loans on the thing that went wrong.
The big leveraged investors who owned a lot of the thing that went wrong also all own the same other things, also with leverage, so there is a generalized crash in the prices of the things that big leveraged investors own.
M. Levine
The Bank of Japan's decision last week to raise interest rates for only the second time in two decades (albeit to only 0.25%) surprised investors and triggered a frantic unwinding of a popular, leveraged "carry trade"...
A carry trade is when an investor borrows money from a country with low rates and a weak currency – such as Japan and the Japanese yen – and then invests that money in assets of another country with a higher rate of return – such as Mexico and the peso.
However, if the weak currency suddenly strengthens, as the yen has done in the past month, surging from 162 to the dollar to 145 today – a stunning move in a market usually measured in pennies – it can trigger huge dislocations.
This carry trade was a classic case of "picking up pennies in front of a steamroller" – a phrase describing investments in which there are small, steady profits... but also the risk of catastrophic losses.
W. Tilson
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We continue to thrive and make money in this volatile market. While the market made a strong rebound yesterday and again early today, I kept saying to my DW Family "Don't trust this rally". And we shorted it for a nice profit again! I think SPX is headed down to retest the Monday's low around 5100 in the days ahead. Be ready for the roll-coasting!
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