Why the “Pain Trade” Is Higher

Here's how a Wall Street adage has meaning today

There is a saying on Wall Street that the markets try to deliver the maximum amount of punishment for the most investors possible.

They call this phenomenon the “pain trade”.

In essence, the pain trade is when investors become so overly bullish about a specific theme or outcome that they overload one side of the boat. As the boat tips and leans further to one side, the majority of participants become complacent as their thesis bears fruit. This leads to a heightened level of pain or fear as the equilibrium shifts and the boat tips back to flat or in the opposite direction. The shifts usually happen in a very short period of time and with little warning, which makes them difficult to predict and re-position ahead of time.

In bull markets, the pain trade is typically lower. In bear markets, the pain trade is typically higher.

Right now, I believe that the trade that will cause the maximum amount of pain for the most investors is for stocks to march higher.

Let me explain what I mean by that…

In January I was having a conversation with a friend of mine that is a really sharp trader. He asked me the question that is usually on most people’s mind at the start of the year – where do you think the market will end 2016?

At the time, we were about 10% off the highs and sentiment was in the dumps. Just about everyone in the main stream media, social media, etc. had declared this to be a pernicious bear market. So my response caught him off guard when I said that I would not be surprised if the market finishes the year positive.

I can visualize the look on your face right now as you read that. The first thought going through your mind is probably “are you $$$ng kidding me? There is no way that can happen.”

Follow-on thoughts likely take the shape of:

  • “sell the rallies”
  • “the game has changed”
  • “this time it’s different”
  • “this guy doesn’t know anything”

It’s not different this time. It’s different EVERY time.

Let me be clear by saying that I’m not in any kind of perma-bull camp. In fact, my current asset allocation for my clients is very much on the conservative side. I fully realize the macro forces at work in the global markets and that right now the odds seem slim that there will be a bright light at the end of the tunnel. That’s the way that psychological cycles in the market work. It always seems like the end is never far and the conditions are sub-optimal.

Yet at the end of the day, the market is littered with the carcasses of bears who fail to engage with a sensible investment approach. They love to be in cash or short on the way down, but they never seem to get back in the market near the bottom.

Most investors I speak with are asking me about when the next crash is going to occur, not where they can make 20% during the next rally. In addition, we have seen a tremendous flight to defensive instruments like treasuries, gold, cash, and low volatility stocks. When was the last time you found everyone already in the bunker this close to the top?

All of these observations are anecdotal and far from scientific.

However, they have been honed by years of market cycles and continued evidence that points to undisciplined investors making the wrong moves at the wrong times.

I fully admit that conditions can always worsen. We could start to see a deterioration in employment data, a pullback in consumer activity, treasury yields drop to new lows, gold float to new highs, or even the specter of a full blown recession. Maybe a half decade of quantitative easing has created a distorted view of market fundamentals that will lead to a new wave of deflation. However, in my opinion, there are appropriate ways to hunker down during these periods without becoming overtly catastrophic about the future of the market.

If the market does defy the odds and rally higher from here it would likely create a wave of short covering, asset allocation shifts, performance chasing, and overall fear of missing out. This anxiety is the pain trade and should not be discounted in your investment decisions.

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