John Maynard Keynes was probably a momentum trader.
The depression-era economist famously said, “Markets can stay irrational longer than you can stay solvent.”
And, if he were alive today, Mr. Keynes would likely be pointing to the multiple irrationalities in today’s market environment and saying, “I told you so.”
Over the past several weeks, the stock market has been dominated by momentum. The strongest stocks keep getting stronger, and the weakest stocks get weaker – almost to the point of absurdity.
It’s kind of like gamblers who follow the hot roller at the casino craps table. They cheer, “Let it ride!” as the roller hits the right number time after time. Soon enough, nobody is paying attention to risk anymore. All the gamblers can think about is how much money they’ll make on the next roll.
Of course, the odds never change. Each roll of the dice carries a 16.7% chance of coming up seven. But, after 10, 11, or even 12 rolls without seeing a seven, most gamblers forget about that possibility.
That’s usually when the roller hits a seven, and the casino takes all the money.
Betting With the Casino
One of my favorite trading strategies is “reversion to the mean.” I’ve discussed it a lot in these pages, especially in relation to Jeff Clark Trader. (It’s one of the ways I helped my Jeff Clark Trader subscribers outperform the market four-to-one, achieve an 82% win-rate, and gain 114%.)
It’s the opposite of momentum trading. It’s similar to betting WITH the casino. We play the odds. We understand that financial markets tend to ebb AND flow. There are rallies, and there are declines. And, nothing moves in one direction forever.
It’s a tough strategy to follow in a market that is fueled by momentum. Stocks that “should” fall keep going higher. Stocks that “should” rally just keep falling.
Eventually, though, the market rolls a seven. The momentum trade craps out. Trends reverse. And, playing the odds pays off again.
Over the past eight weeks or so we’ve seen a remarkable celebration of momentum. Stocks that are overbought are getting even more overbought. Oversold stocks keep getting even more oversold.
We’ve reached the point where the proverbial rubber bands in many sectors and many stocks are stretched farther than at any other point in recent history.
The “snap back” move will be EPIC. It’s not a matter of if it will happen. It is a question of “when?”
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The Snap Back Is Coming
Timing that move is the challenging part.
We do have to risk being early – or else we risk missing out on trades altogether. Remember, as long as the potential reward outweighs the risk, it’s worth it to be early on a trade.
We also have to be willing to repeat trades that have gone against us at first.
After all, the casino doesn’t shut down just because a dice roller is on a hot streak. The casino management understands the odds, and it knows it will eventually get paid.
Best regards and good trading,
Jeff Clark