Why Professional Stock Traders are Terrified

Why Professional Stock Traders are Terrified

The history of booms and busts—and opportunity

According to the VIX index—which is known as the “Fear Gauge”—investors are feeling calmer about the stock market than they have in nearly 25 years.

This “Fear Gauge” is at it’s lowest since 1993.

And professional traders are scared out of their mind.

Why would that be?

Allison Schrader, writing for Quartz, interviewed some professional traders on the “good” news of the low VIX index. Here’s what she wrote:

I recently asked a few traders if they believed lower volatility reflected less risk in the markets. They laughed nervously and said, in essence, “a correction is coming and it will be ugly.” They expect a big group, eventually, will get nervous enough and pull out of the market—maybe institutional investors (pension funds, foundations, and the like) or recent retirees. Once this starts, more will follow. Then, one trader says, it will be “carnage.”

The VIX index is supposed to be a measure of expected volatility in the markets. That it is so low is an indication that most investors are expecting calmness. Yet, the world is seemingly never more volatile than it is now.

Uncharted territory

Just about one year ago, I wrote this on the morning after the Brexit vote:

This morning, I woke up to find the citizens of Britain voted, by a count of 52% to 48%, to exit the European Union (EU). England is the most financially and politically important member in the EU and the first country ever to leave the EU.

Welcome to an uncharted future.

The weeks leading up to the vote had most analysts guessing wrong about which way the vote would go. Along with voting to leave the EU, the vote also meant England will be getting a new prime minister, since David Cameron resigned in the wake of the vote.

In my opinion, the only known fact is that this will create an increase in volatility.

Since then, things have gotten more volatile, not less. We have a continual dust ups with North Korea. Russia keeps buzzing Alaska with jet fighters and bombers. And a global cyberattack is taking computer systems ransom across the globe.

Indeed, we are continuing our journey into the uncharted future.

The problem with predictions

In my article on Brexit, I also talked about how difficult it was to predict the future. “Predicting the future is a loser’s game. It’s easy to be wrong and nearly impossible to be completely right…the hard part about predicting the future is actually following through on the actions that agree with your predictions. There is always more neigh sayers than believers.”

I talked about the Biblical story of Noah. He spent years and years of his life building an ark in the middle of the desert, all the while talking about a coming flood. Everyone mocked him…until the flood came. Then they all wanted on the ark, but it was too late.

In my book, Rich Dad’s Prophecy, I predicted that the biggest stock market crash in world history would happen sometime around 2016. Case in point, it is difficult to predict the future. It’s 2017 and the crash hasn’t happened yet. Many people are happy to point fingers and say, “I told you so.” But I believe the correction will still happen—and like Noah I’m preparing.

Is the crash still coming?

The 75 million baby boomers hold about $10 trillion in tax-deferred savings that they are required to withdraw, and they will do so this year and increasingly in the coming years.

In an interview with MarketWatch, I said:

“I’m not concerned about the professional investor who can short the market, go long, use options, calls and puts,” he said. “It’s the person with a 401(k) or IRA, where all their eggs are in this thing called a retirement plan.”

The professional investors on Wall Street are scared. Things are too calm in the markets. They know that a correction is coming. And when it does, the little guys will be wiped out.

Whether there is a correction this year or in the coming years, one thing is true, corrections always come. The good news is there is always opportunity in every boom and bust—if you prepare well.

Booms and busts

One key to preparing is to understand the nature of market booms and busts. This can be done by understanding history and then seeing the patterns of history in play in our world today.

Over the years, I have read several books on the subject of booms and busts. Almost all of them cover the Tulip Mania in Holland, the South Seas Bubble, and, of course, the Great Depression. One of the better books—“Can It Happen Again?”—was written in 1982 by Nobel Laureate Hyman Minsky.

In this book, he described the seven stages of a financial bubble. They are:

Stage 1: A financial shock wave

A crisis begins when a financial disturbance alters the current economic status quo. It could be a war, low interest rates, or new technology, as was the case in the dot-com boom.

Stage 2: Acceleration

Not all financial shocks turn into booms. What’s required is fuel to get the fire going. After 9/11, I believe the fuel in the real estate market was a panic as the stock market crashed and interest rates fell. Billions of dollars flooded into the system from banks and the stock market, and the biggest real estate boom in history took place.

Stage 3: Euphoria

We have all missed booms. A wise investor knows to wait for the next boom, rather than jump in if they’ve missed the current one. But when acceleration turns to euphoria, the greater fools rush in.

By 2003, every fool was getting into real estate. The checkout girl at my local supermarket handed me her newly printed real estate agent business card. The housing market became the hot topic for discussion at parties. “Flipping” became the buzzword at PTA meetings. Homes became ATM machines as credit-card debtors took long-term loans to pay off short-term debt.

Mortgage companies advertised repeatedly, wooing people to borrow more money. Financial planners, tired of explaining to their clients why their retirement plans had lost money, jumped ship to become mortgage brokers. During this euphoric period, amateurs believed they were real estate geniuses. They would tell anyone who would listen about how much money they had made and how smart they were.

Stage 4: Financial distress

Insiders sell to outsiders. The greater fools are now streaming into the trap. The last fools are the ones who stood on the sidelines for years, watching the prices go up, terrified of jumping in. Finally, the euphoria and stories of friends and neighbors making a killing in the market gets to them. The latecomers, skeptics, amateurs, and the timid are finally overcome by greed and rush into the trap, cash in hand.

It’s not long before reality and distress sets in. The greater fools realize that they’re in trouble. Terror sets in, and they begin to sell. They begin to hate the asset they once loved, regardless of whether it’s a stock, bond, mutual fund, real estate, or precious metals.

Stage 5: The market reverses, and the boom turns into a bust

The amateurs begin to realize that prices don’t always go up. They may notice that the professionals have sold and are no longer buying. Buyers turn into sellers, and prices begin to drop, causing banks to tighten up.

Minsky refers to this period as “discredit.” My rich dad said, “This is when God reminds you that you’re not as smart as you thought you were.” The easy money is gone, and losses start to accelerate. In real estate, the greater fool realizes he owes more on his property than it's worth. He's upside down financially.

Stage 6: The panic begins

Amateurs now hate their asset. They start to dump it as prices fall and banks stop lending. The panic accelerates. The boom is now officially a bust. At this time, controls might be installed to slow the fall, as is often the case with the stock market. If the tumble continues, people begin looking for a lender of last resort to save us all. Often, this is the central bank.

The good news is that at this stage, the professional investors wake up from their slumber and get excited again. They’re like a hibernating bear waking after a long sleep and finding a row of garbage cans, filled with expensive food and champagne from the party the night before, positioned right outside their den.

Stage 7: The White Knight rides in

Occasionally, the bust really explodes, and the government must step in—as it did after the 2008 crash, buying shares in companies like GM and bailing out large Wall Street banks that leveraged themselves too far.

Today, you should ask yourself what stage you think we’re in. The stock market is at an all time high. Investors are running to IPOs like Snapchat even though the company is losing money twice as fast as it did prior to its IPO. The VIX index is at its lowest in nearly 25 years.

And professional traders are saying, “a correction is coming and it will be ugly.”

I can’t tell you what will happen exactly, but I can tell you that you better be prepared.

Original publish date: May 17, 2017