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This Choice Will Either Ruin You or Save You a FortuneBy Brian Hunt, editor in chief, Stansberry & AssociatesMonday, October 19, 2009 "The market can stay irrational longer than you can stay solvent." – John Maynard Keynes
At some point in his career, every trader will confront the ghost of John Maynard Keynes. The decision he makes then will either ruin him or save him a fortune.
John Maynard Keynes was the most influential economist of the 20th century. His ideas shaped the way the Western world ran its finances after World War II. Keynes was also a brilliant speculator who pulled millions of dollars out of the market.
While I believe some of Keynes' economic ideas were batty (a subject for another time), his quote above (like others we've profiled here and here) is one of the most important things ever said about trading.
It's how Keynes' ghost will forever live in the minds of traders.
You see, Keynes brilliantly cautions traders against shorting a stock or a market that "shouldn't" be rising... and cautions against buying a stock or a market that "shouldn't" be falling.
Great traders are always on the lookout for extremes: extremes in sentiment, extremes in valuation, extremes in momentum. It's by finding extremes and then betting against the crowd that you set yourself up for big gains in a short time.
But watch out for the problem Keynes warns about: The crowd often gets irrational and stays that way for a long time.
For example, a lot of money managers believed the enormous rise in oil prices starting in early 2007 was an irrational move. When crude oil had risen from $50 to $90 a barrel in early 2008, they knew speculators with lots of borrowed money were behind the move. And they knew oil was selling for at least 50% more than its real-world value. So they bet on falling prices.
When oil climbed to $100 a barrel, these money managers knew it was even more irrationally overvalued. Same with $115... and $125... and $135... and you get the idea.
Any trader who stubbornly held on to his short position because he just knew $90 was an "irrational" price suffered the longest summer of his life. He watched that irrational price tick higher and higher like Chinese water torture... and his losses were huge.
Any trader who was short at $90 and hung on was carried out a broken man... He forgot the market can stay irrational longer than any one single person can heavily bet against it and stay solvent.
The market is full of stories like this... Think of the traders who went bankrupt by shorting super expensive Nasdaq stocks in 1999... or the famous blowup of Long Term Capital Management in 1998. Both groups took big positions against markets they felt were behaving irrationally... but those markets just kept on behaving irrationally for a long time.
A corollary to Keynes' quote is the Jim Rogers line, "Markets often rise higher than you think is possible, and fall deeper than we can imagine."
You can put the warning from Keynes and Rogers to real-world use by always minding your stop losses. Go ahead and take a contrarian position at the extremes. But always have an "uncle" point to limit losses in case the crowd keeps pushing prices in a crazy direction.
It's tough to watch a stock you know inside and out move in a direction that isn't rooted in reality. But remember... if a stock can trade for an irrational 50 times earnings, it can trade for an irrational 75 times earnings... or 100 times earnings... or as we saw in the Nasdaq bubble days, 200 times earnings.
It's tough to say uncle on a trade you know has terrific potential. But when you start thinking, "This is an irrational move... I'll just keep betting against it," remember Keynes and Rogers. Know that markets can go farther in either direction than you can imagine... and they can keep going longer than you can stay solvent.
Good trading,
Brian Hunt
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