Avoiding "Stupid Mode"Brian
Yesterday, I showed you how to sidestep a plummeting market, wait for it to bottom, and pick up big gains on the rebound.
Today, we're going to take that lesson and turn it upside-down. We're going to look at how to make money on the short side by safely calling the top...
Have a look at this chart of Potash Corp. It's one of the great moves of the 2003-2007 stock rally:
Potash is the world's largest fertilizer company. In 2006, grain and farm prices went through the roof... so fertilizer producers went through the roof as well. Potash shares increased 600% in less than two years.
After fertilizer shares ran up hundreds of percent, the investment public caught on. The news was everywhere: Fertilizer prices are skyrocketing!
Wall Street and Main Street went wild. People were so bullish on fertilizer shares, they were willing to pay between 40 and 60 times earnings for these stocks. That's a crazy price to pay for any company... let alone for one that produces boring crop fertilizer. Fertilizer stocks had entered "stupid" mode.
So... you had two big "red flags" here. You had 1) a wildly overpriced stock and 2) rampant bullishness from the investing public.
Time to go short? No way.
Look how sharp that rise is again. Sure, Potash Corp. is super expensive and it "should" suffer a big correction soon, but remember the Jim Rogers quote from Monday:
"Markets often rise higher than you think is possible, and fall lower than you can possibly imagine."
Potash shares were still rising. The stock was a rocket ship with plenty of momentum. It was too risky to trade.
At that point, the right thing to do was just place the stock on your short-side "watch list" and wait for the rocket ship to sputter out and turn cold. Here is what that "flameout" looked like:
As you can see, Potash peaked around $240 in June 2008. It entered a perfectly natural correction at the end of the month... Then the bulls tried to push it skyward again. That rally couldn't push it above $230. It failed the "test." The flame was sputtering.
It was time to bet on the short side and let gravity do the rest. And gravity really worked Potash over. The stock fell 75% from its high. Short sellers made a fortune.
If you never buy assets in freefall and never sell short assets in rocket flight – if you never fight the tape – your trading account will thank you.