Congress May Increase The Moral Hazard Building In The Stock Market

By: Avi_Gilburt

A few weeks ago, I wrote about the moral hazard being created by the Pavlovian buy-the-dip perspective in the market. As I expect the market to top out in the next few years and enter into a prolonged bear market, the nature of the market rallies over the last 10 years have thoroughly trained investors that all you have to do is buy-the-dip, as the market always comes back.

In fact, this past week, I saw these two comments in my articles, which only reinforces my perspective:

“I love a good press on an author from a paid subscriber but I’ve been making money hand over fist by trading and pouncing on pullbacks on a few stocks I closely watch. You have to have the time and you have to know the stocks well. Making much more money this way than I ever was buying/holding/speculating.”

“As some Yolo financial wiz kids postulate on TikTok: buy stocks that are rising and sell when they trend down: a great way to make a living and be one’s own boss so they can focus on things they love.”

Even “Roaring Kitty” reinforced this perspective during his testimony this past week on Capitol Hill. To be honest, there are more “Roaring Kitty” wannabes out there than you can imagine. In fact, many of you reading this article are likely some form of a “Roaring Kitty.”

I have now been operating my service Elliottwavetrader for over nine years. In that time, I have trained literally thousands of investors/traders about the market, as we are now approaching 7000 members, with almost 1000 of them being professional money managers. And, I still see many “investors” who treat the market like it is a sprint, as they want to make a lot of money overnight.

Folks, you should be viewing making money in the market like a marathon rather than as a sprint. Consider that 90% of traders fail to make money when trading the stock market. This statistic breaks down further to suggest that, over time, 80% lose money, 10% break even, and 10% make money consistently.

The main reason that most fail in the market is that they do not understand the nature of the market or how they should personally approach the market. In my opening letter to new members of my services, I outline the secret to success, and here is a portion of that letter:

Now, if you are like most people, you stumble upon a chart/[stock] you “like,” and decide to do your first trade on your first day on the site. Forget that you really do not understand what is going on, but you just want in on the action, and to be a part of “the winning team.” And, nothing could be worse for you to do on your first day.

Well, I take that back. There is one thing worse – and that would be if you did your first trade and you made money. Often, winning on your first trade or two makes you feel invincible, but you are now on your way to becoming reckless. And, I have yet to meet a single trader who, upon starting out this way, hasn’t given back all of his or her profits from those first trades and then some.

Starting in this manner is not the recipe for a successful long-term career in this industry. In fact, there have been many studies of traders done throughout the years. The great majority of traders surveyed had a risk of ruin so high as to make eventual bankruptcy virtually inevitable. The traders with the shortest time frames (day traders) lost the most money and had the highest risk of ruin.

The question traders must ask themselves is if they have what it takes to be a trader, or to simply resign themselves to being an investor. And, in truth, there is nothing wrong with either one. BOTH SHOULD make money. The issue is learning who you are, your strengths and weaknesses, and which role suits you best. Until you understand yourself, you may be trying to fit your square peg into a round hole, and that is a sure fire way to lose money.

And, yes, it takes time to learn who you are as a trader. So, a main suggestion I always make is to paper trade until you learn which role suits you best. And, even then, when you have money on the line, be open to the fact that you may be wrong if you came to the decision while paper trading that you are a trader. When money is on the line, emotion often takes over. So, if you find yourself unable to control your emotions while trading, then trading is not for you. Learn it early enough so you aren’t forced to learn it by blowing up your account.

A long time ago, when I was first starting out, and not doing so well, someone in the business gave me some good advice: TRADE THE CHART, NOT THE MONEY. But, when someone has put a lot of money down on a single trade, the emotional attachment to that trade makes it very hard to trade the chart, since your primary concern is the money.

So, I have modified his advice somewhat: Trade the chart using appropriate risk management, so that you are not as worried about the money on any single trade. It is for this very reason we suggest that one does not use more than 3% of their trading capital for any single stock trade, and much less if it is an options trade. By sizing your positions appropriately, it makes it much easier to be less emotional about a trade, and to make the right decisions no matter if the decision is to stop out on a pattern that has broken support, or to take profits at a target.

Since I know you are new, and I do not want to inundate you with advice which is hard to remember on a daily basis, I am going to try to keep my advice to two things. The second piece of advice is that before you enter any trade, know your entry level, your stop out level and your target . . . and adhere to this trading plan no matter what happens.

There is an old adage that when you fail to plan, you plan to fail. So, before you enter any trade, you MUST have a trading plan. And, most importantly, you MUST adhere to that plan, and not fall into the “hope” that grips most new traders.

The inexperienced traders will sit in a position until it turns in their favor, if it ever does. Develop a plan BEFORE you enter into a trade, and stick to it. This is setting you up for what traders view as “cutting your losses short and letting your profits run.” Remember, it is not letting your losses run until they finally turn in your favor. The money can be better utilized in another opportunity to make money rather than lying dormant or continually losing.

HOPE AND BEING OVERLY AGGRESSIVE BLOW UP MORE TRADING ACCOUNTS THAN ANYTHING ELSE.

In summary, my point in writing this letter to new traders is to have them focus on two main things. First, you need to take the time to attempt to learn what type of trader you are and the environment in which you now find yourself. You MUST be brutally honest in this self-assessment, or you will blow up your account. Second, you must adhere to strict risk management so that no one trade, or even 10 trades, can jeopardize your account. And, within this risk management process, you must size your trades appropriately and have a clearly defined plan to which you MUST adhere.

I am quite confident that if you follow these two rules at all times, you will likely be successful in making money in the investment world, no matter what HONEST conclusion you come to about yourself.

Unfortunately, many of those that were trading with the Reddit crowd have recently learned these lessons the hard way. But, I assure you that they are not alone. In fact, I am sure this is striking a chord in many of you reading this article. Moreover, it will continue to happen as the market continues to rally over the coming years. The level of mass greed will continue to rise along with the market in the coming years, which will only attract more “Reddit-type” traders looking to make their million overnight. Add this to the Pavlovian trained “buy-the-dip” crowd, and the moral hazard of which I have been warning will likely ripen and peak in a few years.

But, based upon the questioning I heard during the hearing this past week on Capitol Hill, I fear that Congress may exacerbate this already extreme moral hazard which is developing.

Based upon the questioning by some of the members of Congress, there seem to be two paths they are considering. First, they seem to be considering a transaction tax on buying and selling of financial products. While this clearly is not a reasonable path in my humble opinion, I do not believe it will increase the moral hazard currently inherent in the market.

However, the second path that we can glean based upon the questions being asked is some form of additional controls and curtailment of short trading. This, in my humble opinion, will significantly increase the moral hazard inherent in our financial markets.

While I certainly do not believe that any entity should be able to short 140% of a stock, we have to recognize that short sellers provide liquidity to the market. This provides for orderly and efficient price discovery within the market. If we curtail short selling, we create a vacuum in price below the market. This means that when the market does turn down, it would exacerbate any selloff, which can make the March 2020 sell-off look like child’s play.

So, while one may view curtailment of short selling as being a “reasonable” cure to the issues that have recently come to light because of the GameStop (NYSE:GME) debacle, such a “cure” would be quite short sighted and cause more harm than good.

Doctors take the Hippocratic oath, within which they promise to, first and foremost, “do no harm,” and, that they “will abstain from all intentional wrong-doing and harm.” I suggest that Congress take heed of these words, and recognize the harm of the intended “cure” they may be considering at this time.

And, if you are wondering about my current perspective in the market, we have not yet developed that break out set up I highlighted in my last article. So, I suggest you retain a bit more patience, as the market can still pullback over the coming weeks before we develop that break out set up to 4300+. But, 4300SPX is my next major target for the SPX on the upside in 2021 after the next bout of weakness completes over the coming weeks.

Avi Gilburt is a widely followed Elliott Wave analyst and founder of ElliottWaveTrader.net, a live trading room featuring his analysis on the S&P 500, precious metals, oil & USD, plus a team of analysts covering a range of other markets. He recently founded FATRADER.com, a live forum featuring some of the top fundamental analysts online today to showcase research and elevate discussion for traders & investors interested in fundamental rather than technical analysis.

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