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When Bubbles Pop, Only the First Sellers Escape Being Bagholders

When Bubbles Pop, Only the First Sellers Escape Being Bagholders

Hapless bagholders have two options: buy the dip and be destroyed, or hang on hoping for a reversal and be destroyed.

One often overlooked characteristic of the current stock market bubble is the extremely small exit for sellers trying to avoid becoming hapless bagholders. Bubbles always present small exits because once sentiment turns, buyers vanish and so price goes over the waterfall and crashes on the rocks below (accompanied by the screams of all the punters who reckoned they’d exit at the top).

But modern markets have characteristics which have diminished the exit to a tiny hole in the wall. These include:

1. The dominance of index funds. When shares of the index are sold, every constituent stock gets sold. This triggers cascades of selling that overwhelm “buy the dip” buying.

2. Computers do most of the trading, and the algorithms are set to follow trends with extreme ferocity. Once the trend is “sell,” the program selling will self-reinforce the cascade.

3. Central banks have generated a mesmerizing moral-hazard propaganda field that implicitly suggests “we’ll never stocks go down again, ever!” Yet the only way central banks can causally intervene is to buy stocks directly in size, i.e. in the trillions of dollars. (Recall U.S. stocks are around $35 trillion, global stock markets about $85 trillion. Yes, buying futures contracts through proxies works in stable markets, but not so much in panic cascades of selling.)

Beneath the illusory stability, modern markets are extremely illiquid, meaning that when the bubble pops and punters/money managers try to sell, there are no buyers at any price.

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