Dancing fever is gripping the Dow

Dance at Molenbeek by Pieter Brueghel the Younger, Wikimedia
Dance at Molenbeek by Pieter Brueghel the Younger

Have you noticed how extremely volatile the Dow has been recently? I’m sure you have. Up-moves of several hundred points in a day have been followed the very next day by a decline of similar proportions – to be followed again by another sharp rally of hundreds of points. This has made trading it a very tough proposition.

I am getting giddy just watching it. The traders pushing the markets around must have contracted St Vitus’ Dance!

I was fascinated by this phenomenon as a child and its story is absolutely fascinating, and a very early documented example of herding, a subject dear to my heart.

This peculiar dancing craze started in the 7th century and died out a thousand years later, when it stopped abruptly.

In one instance in Germany in 1518, a woman began dancing manically in the street and within four days she had been joined by 33 others. Within a month there were 400, many of whom suffered heart attacks and died.

Under this mania, people seemed to be in a state of unconsciousness and unable to control themselves.

This weird behaviour reminds me of how the herd operates near the end of a huge bull market.

The herd starts off small with a plausible proposition, then slowly gathers momentum with the ‘bullish’ news spreading. More people are attracted as they sense something is happening that they should be part of. The fear of missing out is a very powerful motivating factor.

When the craze reaches a natural climax, something clicks, and most people see the mania for what it was – a temporary madness. Now their rational mind takes over and they suddenly stop dancing.

But this is the thing: the mania and its climax is a natural phenomenon and is not engineered by outside events. It is an internally-generated effect that obeys no rational law. That internal effect is what ends market manias (and very abruptly).

Crucially, the dancers do not acknowledge the harm they are doing to themselves while in the mania and ignore the physical symptoms they must be suffering.

Likewise, traders/investors who get caught up in a stock buying mania ignore the obvious signs of distress around them.

One of these obvious signs is the growing mountain of debt in the world. Central banks, through their quantitative easing (QE) and zero interest rate policies (ZIRP), have made borrowing as cheap as it has ever been in the entire history of the planet. As a result, even a hint of interest rates coming off the floor will send shock waves through stock markets.

So far, the debt mountain has been invisible to investors – but for how much longer? When will the Titanic meet its debtberg?

Three reasons for this market madness

Why do I believe stock markets are in manias? Here are a few pieces of evidence in the US markets:

• The cash-to-assets ratio of US mutual funds has been below the historic low of 4% since 2009 (the recent major low). This unprecedented ‘cash is trash’ belief cannot be taken much further. Investors are all in.

• US residents use money market funds to park short-term cash. These are major funds and recently, the percentage of funds held in them compared with S&P capitalisation has reached an all-time low in a flight from cash into equities.

• The percentage of assets held in cash by private investors with Rydex – a major firm that offers a diverse range of funds – recently reached a record low of 2.5%.

‘Cash is trash’ is an overwhelmingly widespread belief. And as that great trader Joe Granville always maintained: “When something is obvious to everybody, it is obviously wrong”.

Naturally, there are logical reasons why these extremes exist with the record-low (even negative) returns available from holding cash.

A quote from yesterday – after the release of more weak China manufacturing data – perfectly depicts this mania for shares: “The soft number implies continued underlying weakness in the manufacturing sector despite stimulative policies rolled out since last November,” said Dariusz Kowalczyk, senior economist at Credit Agricole SA in Hong Kong. “Markets will now expect more easing, including on the monetary front.”

Asian stocks climbed to a seven-year high as investors weighed weak China manufacturing data against prospects for more monetary easing.

So, the stock exchange really is a casino, not an honest marketplace where capital from private savings can be raised for genuine productive purposes – its original function.

Today, punters are betting that the prospect of more available money coming their way at virtually no cost will induce others to buy and keep the bubble inflated. The economy is in trouble, but who cares?

The ‘Flash Crash’ trader was not the only one

Of course, casino or not, my tramline trading methods are still working in this netherworld.

But one rather more dubious method has been recently exposed, that of the London trader, working from his bedroom in his parents’ home, who ‘caused’ the 2010 ‘Flash Crash’. He supposedly accomplished this by entering spoof orders, bids or offers that are quickly withdrawn before execution in order to drive the market one way.

Who knows how much this kind of high-frequency manipulation is affecting the markets. But market manipulation is nothing new. The market has always been subject to shady dealings (read Reminiscences of a Stock Operator by Edwin Lefevre – AKA Jesse Livermore – written in the 1920s); the ‘Hound of Hounslow’ is far from the only person to manipulate the markets. He’s just one example of the madness of equities today.

How far will this stock mania – and its converse, an utter hatred for cash – persist? One straw in the wind is that we’ll see a sharp rise in long-term interest rates this week as crude oil recovers.

But with the speculative Nasdaq having diverged from the more sober Dow, will the Dow play catch-up, or is the Nasdaq about to reverse? And when will traders stop dancing?