Trading Bubbles Created by Government Policy

Last time, we talked about how we can look at the actions of central planners to understand where asset bubbles will be created. In this post, we'll talk about the specific ways this can be traded.

Bubbles Benefit from Active Trading

A concern of many value investors -- meaning those that prefer to invest in companies that will create real economic value -- is that bubbles don't actually create real productivity gains; they are characterized more so by a speculative frenzy. As a trader with a focus on safety and slow and steady wealth growth, I sympathize with and share this concern. But as we discussed in the first article in our series on socialist investing, centrally planned economies do not allocate resources based on market needs, and thus are not conducive to investment strategies based on creating value; instead, centrally planned economies transfer wealth based on political influence. As such, market psychology, not market demands/needs, is a more crucial barometer to watch.

To understand market psychology, I recommend using some simple technical analysis. Specifically, here's what I do:

1. Moving averages. Pull up the asset you believe will receive the bubble on the charting package of your choice. Then draw the 5, 10, 20, and 50 moving averages. When the price is trading above all those moving averages, and when they are bullishly aligned -- meaning when the 5 is above the 10 which is above the 20 which is above the 50 -- the market is bullishly aligned. Ideally, you want to get in right when this alignment happens.

Moving average alignment is at the heart of my trading strategy, and has worked very well for me in trading US dollar devaluation over the past few years. The chart below illustrates this concept in action.

2. Identifying key price levels. If you're trading something that is reaching all time highs, this may not be possible, as there are no historical levels to look for that could signal when the market could make a big move. If the bubble is pushing prices back to where they were before, though, understanding key price levels -- i.e. support and resistance levels -- can help you understand when the market will breakout, and when it will reach a level that might lead to a reversal.

Exiting the Bubble

Remember that bubbles are prone to panic exoduses. Depending how central planners behave, they may or may not look to refuse liquidation, either via restrictions on selling or through cash infusions and direct purchases by the central bank.

Because of this, and because centrally planned economies can be more volatile depending on how aggressive central planners are in directing the economy, I prefer an active trading strategy, as active trading is more conducive to both protecting yourself against volatility and capturing it when it moves in your favor. With that in mind, it is important to understand when market psychology/price action begin to suggest that the bubble may be over. And just as we looked for alignment of moving averages as our cue to follow momentum, we can look for moving average crossover -- i.e. the 5 moving average crossing below the 10 moving average -- as our cue to exit (see the chart above as an example). Alternatively, traders who want more fine tuning than just moving averages may also look for candlestick patterns that suggest indecision in the market place.

In sum, by coupling an understanding of what incentives central planners are creating as well as looking at momentum indicators to determine when the market will respond to these incentives, we can find viable opportunities to grow our wealth in a centrally planned economy.

Comments

[kelm:]

I think you are way ahead of most people on looking out for what the government will do and how their actions will influence the market. These kind of strategies are important. Many people grew up with the Greenspan put ad relied on it because it benefited them. They don;t realize that the more socialist the economy comes via government intervention the more disorderly the market can be.

Keep up the good work.

Feb 20 11:07 AM

[speculari:]

Excellent article! Thanks! IBD's Daily Graphs provides a good basis for utilizing multiple moving averages. One can add or "customize" them as well to enable watching for the type of "crossover" you have identified. I know they have provided me with a number of opportunities over the years - both in saving my tail in finding the right exit point, as well as, the right time to go long in a particular stock. (combined with a few other factors, of course)!

Feb 20 08:22 PM