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It's a Trap!

Written by Briton Ryle
Posted February 6, 2017

Funny things happen when investors fall for the trap. Remember the Brexit vote on June 23, 2016? It was unthinkable that the British would vote to leave the European Union. Economic suicide. Recession, for sure, and a total collapse of the British pound...

But then it happened. The Brits did the unthinkable, and sure enough, stocks plunged — for two whole days.

Then stocks reversed and launched a 10% rally that took us right up to the election...

Oh, that election. Analysts, strategists, and economists alike all predicted with 100% certainty that a Trump win would send the U.S. spiraling into recession. It would be a complete disaster. The media was even better. They stood firm that Trump had no chance. None. Zero. Zip. Couldn't happen, not in a kajillion years. 

Funny that stocks sold off for seven straight days before the vote. The stock market isn't always right, but it sure seemed to have had a sense that Trump was about to make history. Those recession predictions were about to come true...

You probably know the rest of this story. By midnight on November 8, S&P 500 futures were in freefall. Dow Industrials futures indicated a 900-point sell-off when the bell rang on the New York Stock Exchange.

When the bell finally rang to announce the start of trading, the Dow opened in the green and never looked back. 

Bear Trap

Both of these market moves can be referred to as "bear traps." Analysts and strategists were unanimous: stocks would head lower if this or that happened. The bears were licking their chops — finally, the most hated bull market in history would get its comeuppance. On both occasions, traders piled into gold. Brexit saw a huge amount of bond purchases (not so much after the election). Traders bought put options, and they shorted stock. And when the markets turned and exploded higher, they were trapped...

When traders are "short" stock and get caught in a bear trap, they have to buy stock to cover their short when prices are rising. That's because when you sell a stock short, it means you are selling a stock that you don't actually own. A short seller borrows stock, sells it, and hopes to buy the stock later at a lower price and return it to the person from whom it was borrowed.

But when shorts are forced to buy stock when prices are rising, their buying becomes fuel for higher prices. Yep, bear traps can get nasty... 

Why am I bringing all this up now? Because everywhere I look, traders are talking about how this election rally is based on hope and wishful thinking about earnings and economic growth. Everybody is waiting for it to all fall apart. It's just a matter of time, they say. And I will admit, I've been a bit nervous about a 10% correction, too. 

I expect you're familiar with my logic by now. If President Trump were focused on tax reform, infrastructure spending, and some deregulation, then there's a fundamental basis for stock prices to go higher. But that's not what's happening. Trump seems to be focused on immigration and Obamacare. And that's simply not a recipe for a rally. 

But I'm not sure it's a recipe for a big sell-off, either...

Economic growth appears to be accelerating. And fourth-quarter earnings are coming in pretty good. If that changes, if the economy hits a wall and earnings start to look bad, then sure, that correction will definitely happen. But right now, I'm thinking we're about to see another bear trap. 

The last big breakout move to the upside on the Dow Industrial Average started at 19,240, about 800 points lower than it is now. And I can't think of a better way to get the bears in a lather than a quick drop of nearly 1,000 points on the Dow. 

BTFD: Buy the Freakin' Dip

Now, let me be very clear about something: I am NOT telling you that I think a 1,000-point drop in the Dow is starting right here and right now. It's just Monday, and Mondays have been kind of weak lately. And personally, I think that's because investors are getting cold feet on the weekends, when they have too much time to sit and think about things. 

Sometimes, thinking too much is the biggest risk to making money on the stock market. OK, not just sometimes. Thinking too much is a problem pretty much all the time. Especially when that thinking is done to answer the question, "Where's the market headed next?"

That question can be answered easily with a little research. Stocks rally over time because populations are growing and inflation exists. That means more people buying more stuff at higher prices, which in turn means that corporate revenue and profits rise over time. 

All stock market rallies are punctuated by sell-offs. But don't worry about the sell-offs — they should be viewed as opportunity, not risk. Keep a little cash on hand so you can buy good stocks when they sell off. 

How do you find good stocks? Well, there's a bunch in my Wealth Advisory portfolio. But here's another tip, too: use Yahoo! Finance. Get familiar with just two pages. The first is Analysts. I've shared the Analysts page for Bank of America (NYSE: BAC) because I love that stock. Scroll down to where it says "Earnings History." You see how BofA has beaten earnings estimates in each of the last four quarters? Yeah, that's a good sign.

Now, below that section is one titled "EPS Trend." This shows the changes that analysts are making to their earnings estimates. You see how estimates for this quarter, next quarter, the current year, and next year are all rising? Yeah, that's also good. 

Look, I'll be the first to tell you that analysts aren't always right. In fact, they are pretty much never 100% right. But they do tend to get the overall trend right. 

Next, get familiar with the Statistics page, especially the first section, "Valuation Measures." You don't need to know how to calculate a price-to-earnings (P/E) ratio or price-to-earnings growth (PEG) ratio. But if you do a little reading on these, you'll have a sense of what a cheap stock looks like.

There. I hope that helps. And remember, if you have questions, send them to our customer service department (customerservice@angelpub.com), and they will make sure I get them. 

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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