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Why Investors Should Love Market Crashes, And How To Make Money From A Crash

Markets are there to confuse the majority of investors. Stated differently, because there are lots of losses with the majority of investors, there can be markets with a small minority of winners. Think about it.

As per our vision markets are governed by the 1/99 rule. One may call this the ‘InvestingHaven effect’ which is a specific way to apply the Pareto effect. This is how markets work for investors (not traders):

  • 1% of the news is relevant, 99% is noise and pure waste for investors
  • 1% of stocks is potentially interesting to invest in, 99% is not
  • 1% of the time should investors be trading, 99% of the time only following / watching / analyzing (this implies only a couple of days per year that are worth trading)
  • 1% of the price points on a chart are important, 99% is meaningless

There are many more ways in which the 1/99 rule applies, but you get picture in the meantime.

Market crashes are typically one of those events in which 99% of investors lose money while 1% of investors make big money. So what is the way to play a market crash?

Before looking into this question, it is important to note that crashes may have a very profitable investing strategy that pays off BUT there are some rules associated with it, and certainly some MUST AVOID things. Be careful, this requires ‘parental control’ and exercise; stated differently, ‘do not try this at home’. Sufficient disclaimers? Then let’s continue.

Let’s illustrate the market crash investing strategy with a very recent case: the British Pound. Chart below, annotations are ours.

The Brexit vote in June 2016 was one such once-in-a-decade event for a major currency like the Pound which caused it to crash. Of course, the crash was a process, not an event, and it went one for some 6 months.

What typically happens during such a crash is the following:

  • All media, literally every media, is bearish.
  • Readers get brainwashed. After reading a couple of articles, you are in the bearish mindset.
  • The charts underline and re-iterate how bad the situation is.
  • It is very hard, if not impossible, to see how the market can ever recover from this crash. ‘Stay away’ the only thing that investors remember.

And this is how it plays out in reality (read: supply / demand dynamics which are what markets essentially are):

  • Crash starts.
  • Selling accumulates because of the above-mentioned effect driven by media.
  • Crash continues until all ‘weak hands’ have left.
  • At a certain point, which is often 6 to 12 months, all sellers have disappeared, and a great thing takes place: bottom formation.
  • A bottom is easily recognizable on a chart.
  • Once the bottom is in, a breakout takes place, and smart investors push lots of their capital because they know how the 1/99 rule works.
  • Market rises, former sellers regret they sold and some of them get in again. This simply amplifies the price rise.

Does this resonate?

The Britsh Pound bottom was visible last April: a series of lows, with a higher low in April, after which a higher high followed in May. Beautiful setup, powerful breakout, leading to strongly higher prices 12 months later (today, the Pound trades +20% higher than a year ago, and it is around pre-Brexit-crash levels).

Another interesting case? We spotted a similar formation in several markets in the last years since inception of our research service:

Did we get it wrong? Yes, we did, specifically in gold. As it was crashing at the end of 2016, we expected the crash to continue in 2018 as seen in our Gold Price Forecast For 2018. It is fortunately one of the very few mistakes we have made. What can we learn out of this? One extremely important insight: watch a rounded bottom on the chart after a crash. It was visible on the gold chart, we just did not spot it, which underlines the importance of the 1/99 rule that just 1% of price points are important: by connecting those 1% price points in the right way we could (should) have spotted the rounded bottom formation 18 months ago.

What NOT to do? Please do not invest in every stock that is crashing. Specifically crashing stocks may indicate the company is not sound, doing something wrong, losing money, … So all of the above applies to key markets (commodities, stock indices, sectors, currencies) primarily. There is risk in crashing stocks, so deep research into a company’s situation before applying the above success formula is mandatory! Stated differently, not everything crashing is a good thing, the 1/99 rule applies here as well.

The key take-away? Crashes are great (if you are not invested in the crashing market), investors should follow the crash and watch for the bottom formation. That may be a series of higher lows (Pound, see below), but, in many instances, a rounded bottom formation over the longer term (uranium, gold, …). Entering the market on a breakout is (the first higher higher) will likely result in a very profitable outcome!


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