Are we overly optimistic about the US Market?

Updated: May 28, 2020

Disclaimer: This article is written for educational purposes. It is not professional advice. Please trade responsibly. Do not trade with money that you borrowed.

According to the astrology, 2020, the year of the rat 子 produces plenty of water elements. Water elements govern the wealth and the emotional aspect. It is evidenced by the increase of buyers and sellers in the stock market. Investors' extreme behaviours have left economists puzzled.

In this first quarter, investors are over-optimistic and overconfident in the US stock market. People may overestimate their knowledge, understate the risks, and overestimate their ability to control the situation. A drastic drop in stocks in March [ month of the rabbit which forms a penalty relationship with the year of the rat 卯 = 刑局] followed by the rise in popularity of aggressive growth funds in the US as a sign of such behaviour in April [month of the dragon which forms a water formation with the year of the rat 辰 = 水局].

Because of the overconfidence and over-optimism, long-term growth expectations and long-term return expectations get ratcheted higher and higher. Investors may set themselves up to be disappointed shortly. Because of their blind faith in the new era when the vaccine is invented, firms will do their best to survive and take on new debts in the belief that faster growth will generate the necessary payback with ease. It could lead people to overestimate returns, understate the risk, and be far too sure about their knowledge and ability to control the situation. As Keynes noted, “When disillusion falls upon an over-optimistic and overbought market, it should fall with sudden and catastrophic force.” Factors that could contribute to stock valuations: • Changed expectations of future earnings. • The higher retained earnings of corporates (allowing for faster future growth). • A change in risk premiums. Longer time horizons for investors.” We see new bubbles is in April. Some are declaring the birth of a new bull market. Investors start to extrapolate past high rates of growth into the future, particularly in the medical and technological industries. Groupthink is an essential contributor in such environments. People come under immense pressure to conform to the majority’s view, frequently suppressing their views in the process. Note, myopia also causes herding around a single piece of information.

The build-up in debt during this CoVid19 period poses the most critical danger in the bursting of the bubble. If deflation arrives while the overhang of debt is still massive, then a nightmare is created. If inflation is low at the time the bubble bursts, that act alone can force the economy into deflation. Cash flows will be inadequate to service the debt.

Firms whose cash flows are exceeded by their interest payments will be forced to undertake extreme measures. They will be forced to attempt to create cash flows by capturing market share, effectively buying in volume. The most likely path to capturing market share is to lower prices which only exacerbates the deflationary pressures.

The alternative route to raise cash flow is to seek to sell assets. If whole industries have created massive excess capacity, buyers of such assets will be few and far between. A fire sale results in each decline in asset prices as well. Moreover, any assets that are purchased are likely to be used to produce low-cost output, again undermining the already fragile pricing structure in the real economy, and in the markets.

The only other way out is to default and go bankrupt. Once again, this results in asset fire sales and more asset price depreciation. So, all three paths to debt reduction are deflationary in the extreme.

Bubbles have a probability of bursting each period. Although investors can be sure that eventually the bubble will collapse, they are uncertain as to the timing of that crash. The anticipation of a crash increases in March, prices rose even faster to compensate for the increased risk of the crash.

Rupert Rhea (1932) notes: There are three principles phases of a bear market: 1. the abandonment of the hopes upon which stocks were purchased at inflated prices; 2. the selling due to decreased business and earnings, and 3. the distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets...

Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.

We still observing the market carefully particularly in June [month of the horse which clashes with the year of the rat 午 = 沖局], August [month of the monkey similar to April which forms a water formation with the year of the rat 申 = 水局], and September [month of the rooster which forms a broken relationship with the year of the rat 酉 = 破局]. I would expect more volatility in June. Some bubbles in August. More drastic fall in September which could be worse than March.

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