Insights & Advice

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Financial froth infects markets

One sure sign that stocks are getting overdone, is the actions of overconfident investors that bid up stocks in a euphoric frenzy, only to dump them at the first sign of trouble. These behavior patterns normally usher in a corrective stage in the stock market, but exactly when that will occur is anyone’s guess.

Investopia’s definition of froth “refers to a market condition where an asset’s price begins to increase beyond its intrinsic value.” Wall Street’s “Reefer Madness” event this week is just such an example. Certain stocks in the Cannabis sector saw their share prices double and then triple in a matter of days. Penny pot stocks with little to no fundamentals skyrocketed higher as well, notching up 50% gains or more each day.

I, for one, was quite happy with those results, at least at first. After all, marijuana stocks were on my 2021 list of sectors investors might want to consider this year. My reasoning had more to do with expectations that Congress would finally legalize the substance. If so, it would allow companies to finally access capital from the banking sector, and possibly trigger a wave of mergers and acquisitions. I never counted on a Reddit Raid by traders.

Evidently some investors, emboldened by their success in pushing up (and then down) some stocks like GameStop and AMC, turned their sights on pot stocks. While traders couldn’t get enough of these shares on Monday and Tuesday, by Wednesday those same stocks saw declines of 50% or more. But those stocks were not the only example of froth. Bitcoin had its own bout with buyers.

Cryptocurrencies were also on my recommendation list for this year. Bitcoin soared this week after Elon Musk announced that his company, Tesla, the electric vehicle manufacturer, had invested up to $1.5 billion in Bitcoin last month. Bitcoin gained 25% this week as a result. Several stocks that were leveraged to cryptocurrencies did far better than that.

Platinum, and platinum stocks (another of my recommendations) hit six-year highs as well this week. Let me go on. Special Purpose Acquisition Companies (SPACs) of all shapes, sizes, and colors are being snapped up faster than they can be created..  never mind that the majority of these investment vehicles in search of an asset have left investor’s holding the bag more times than not if you wait around too long to sell.

It has gotten to the point that traders are now monitoring the feed of Reddit, the internet App, as well as tweets from “Wallstreetbets,” for which is popular with the Robin Hood retail crowd, looking for clues on the next stock or sector that could rise from the ashes.

And yet, if readers were to simply look at the major averages of the stock market, nothing much has happened this week. The S&P 500 Index made minor new highs, as did NADSAQ, but then fell back again. If anything, the indexes have simply consolidated this week.

One would think that a series of successive new highs, combined with a series of frothy escapades would lead to a wildly bullish investor base. Not so. Instead, recent fund flows suggest investors are rather cautious on stocks. Fund flows have favored bonds, rather than stocks since the beginning of the year.

Bullish investment sentiment, as measured by the AAII Index, also fell in January and has still not recovered. Since the beginning of 2021, money market cash has increased by $10 billion and roughly $50 billion has been pulled out of equity funds. One possible reason for the sour sentiment could be the froth I have been referring to.

Media coverage of some of these massive, short-squeezes and the rapid rise and fall of stocks (and even commodities such as silver) may have frightened off the more conservative investor– at least for now.

As readers are aware, I have been advising that taking some profits in investments in which you have out-sized gains makes some sense. I have been taking my own advice this week. I sold some of those stocks that had run up to what I considered nose-bleed levels. I will continue to do so if the opportunity presents itself. I expect we may see one more surge higher (2-3%) before we encounter a more serious pullback, so enjoy the froth while it lasts.

Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.

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