The Market Can Stay Irrational Longer Than You Can Stay Solvent

The title of this post relates to just about any environment that involves investing, markets, speculation and the like. It is a quote I was introduced to early in my day trading days and one that has served me well.

"The Market Can Stay Irrational Longer Than You Can Stay Solvent" - John Maynard Keynes

image source

I decided to write this post as several people of late had told me they never heard it before and liked the message it sent investors.

So let's talk about it a bit....

What I have learned from using this quote is that most often people are one to two years early when deciding something is in a "bubble" or "makes no sense"

I have fallen victim to this in my past. Seeing all the reasons a market is prime for a meltdown only to watch it melt higher for another year.

It's completely irrational and it doesn't matter because it is a freight train of momentum that takes a long time to turn or needs to run into a black swan event to be suddenly dis-railed.

Logic Will Ruin You

That is herein the issue. Many of us are logical creatures, thus we look at all the facts and evidence of something and deduct a conclusion. Then the market goes against it and you throw your hands up that it makes no sense.

Let the actual events dictate your pace

Here's the thing - I have thought for a year now that the U.S. stock market is due for a nasty correction. I also know that just because something is due to happen (and that's assuming my hypothesis is correct) it does not mean it actually will happen in a near-term time frame.

Reading the Tea Leaves

There is a saying to read the tea leaves, but what I have learned is that after you read the tea leaves and see the writing on the wall, you need to wait for some of those leaves to start falling before it's time to take action.

image source

Example

The latest market crash in 2008 is a simple example of irrationality lasting longer than an investor can stay solvent.

Many traders/investors started shorting the US market in early 2007 after a combination of factors came to light.

The real estate market had been red hot and the cracks started to show in late 2006 when an October report of building permits showed a 28 percent year over year decline.

Then in 2007 sub-prime mortgages began to default and that only snowballed to the point the FED started buying the debt in August 2007 as they realized the banks could not handle it on their own.

But the party continued...

The US stock market continued to go higher despite the wheels falling off the housing market and GDP growth shrinking.

On October 7th 2007 the Dow Jones Industrial average hit what would become it's pre-crash high, 14,164. At the time it was up 13% on the year, following a 16% return in 2006 despite all the warning signs.

Irrational Kicking Solvents Butt

Think about this - Investors and traders that started shorting the market in early 2007 when the signs of trouble were clear we're likely down more than 10% on their positions at this point.

How many of you can hold a position for more than six months that is going against you?

How many of us have the capital to take even larger paper losses?