HOW TO TRADE A BUBBLE

This is a syndication from Jared's Daily Dirtnap daily market newsletter. WSO readers qualify for a $100 discount...just email [email protected] and mention "WSO Monkey Discount" You can follow Jared on twitter at @dailydirtnap

Q: How do you know when a day trader is losing money on a position?

A: When he starts researching the company.

It is funny because it’s true. But it’s also true that you (the generic you) get to know things really well when you have a position in them, and the larger the position, the better you get to know the company/country or whatever.

So I have a sizable position in MXN, and therefore I pay a lot of attention to what is going on in Mexico. I pay a lot of attention to Carstens. He is an interesting guy. He is a smart guy. So he said something recently that made the hair stand up on the back of my neck; he said that all of this “unconventional monetary policy” (if that’s what you want to call it) and competitive devaluation going on has the potential to create asset bubbles in emerging market countries. I can’t say that I disagree with him, but the reason that hair is standing up on the back of my neck should be obvious. Are emerging market countries (like Mexico) going to take steps to forestall an asset bubble? I hope not. I like asset bubbles.

If that is the case, Mexico is kind of stuck, and there really isn’t much they can do about it, because if they lower interest rates to make the peso less attractive, they are going to fuel a stock market bubble domestically, and if they raise rates to choke off stocks, they are going to make the peso very attractive and attract all kinds of foreign capital, you know, those dastardly carry traders. You can let the leverage generate the alpha. I think Carstens was just complaining about all the idiots in the world. Goodness knows we all like to do that.

Well, Mexico’s stock market looks like it’s about to go parabolic, and this distresses me, because I am not involved. Though I probably have enough exposure as it is, so I should stop whining. But when something turns into a bubble, I want to be there when it happens. Wouldn’t you want to be there when it happens? Everyone says that bubbles are bad things. No they aren’t, not if you know how to trade them!

So here is how to trade a bubble. You pretend that you are dumb. You see, smart people lose money in bubbles because they fight it all the way up and then miss it on the way down, because of all the money they lost on the way up. Dumb people lose money in bubbles because they are long and strong on the way up and then they get rinsed. The only people who make money in bubbles are the smart people who pretend that they are dumb, but then get smart again later. So I pretend I am dumb, I hear something about stocks going up in Mexico, and I’m like, “I’ll buy that,” because if I am smart, I will overthink it, because I am afraid of buying the highs. But dumb people don’t even look at a chart. Or if they do, they are actually motivated by higher prices. It’s going up, I’ll buy it. But smart people have to just pretend that they are dumb, because eventually, there has to be an outtrade. But the outtrade, in a bubble, usually comes long after we think it is time to get out of the trade. If we get out too soon, it is like missing the whole thing!

I am not saying that the MEXBOL is a bubble, but I will say that it is starting to have bubble-like characteristics, and the fundamentals are in place for a bubble in the equity market to appear in the next couple of years. Some of you may be familiar with reflexivity or the idea of a self-reinforcing process. High prices (in the equities, or bonds, or the currency) attract investors, which pushes prices even higher. This is why things trend. Of course, things don’t always trend, but look at MEXBOL and tell me that this isn’t trending. The word is getting out about Mexico (and EM in general, ex-BRIC). The word is getting out that these countries are debt-free, for the most part, competently governed, and a sexy place to invest. But just because the secret is getting out, doesn’t mean it is too late.

Of course, this is all do as I say, not as I do, because, like I said, I have failed to pull the trigger on MEXBOL (EWW) for the better part of a year, waiting for some kind of pullback. So I am the “smart guy” who is going to miss the whole thing unless I just shut off my brain for a while and slam the buy button. Notwithstanding all this, I could be wrong: we might have just put in the highs in Mexico and perhaps we are about to start a protracted bear market. But I seriously, seriously doubt that.

Look at Chile, also. The story is the same throughout most of the emerging world. The really really really smart guys (remember the life cycle of an investment) started writing books in 2002 about how EM was going to be the place to be over the next investment cycle. They were right. Like any bull market, there are ebbs and flows. But if EM is the bull market of the 00’s and 10’s, then it stands to reason that from bull might follow bubble. Mike Bloomberg (I am a detractor, but he is more successful than I am) says that half the game is being in the right place at the right time. Wouldn’t it be nice to be, for once?


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