Once Risk-On Switches to Risk-Off, the Bottom Is Far Lower Than Anyone Believes Possible, by Charles Hugh Smith

In a bear market, it takes a long time before the “buy the dip” crowd realizes they’re trying to catch a falling dagger. Generally they quit trying after impaling themselves repeatedly. They withdraw to lick their wounds, and end up selling their losing positions pretty close to the bottom. From Charles Hugh Smith at oftwominds.com:

So here we are, witnessing the switch from risk-on to risk-off in real time.

All bubbles share common characteristics: during the euphoric expansion, participants are richly rewarded for buying every dip and for confidently embracing the belief that this time it’s different.

(Exactly how it’s different changes from bubble to bubble, but the core mechanism is identical: for these entirely rational and “mathy” reasons, this time is truly different.)

The common characteristic when bubbles pop is the eventual bottom is far lower than anyone believes possible. This confidence in the bubble’s permanence permeates the entire financial system and encourages a faith that buying every dip will continue to be the road to easy wealth.

When euphoric risk-on switches polarity to risk-off, buying every dip becomes the road to ruin as the eventual bottom is incomprehensibly lower than the first stairstep down.

Here’s a composite of what happened during the dot-com bubble burst. An Internet company that hit $90 per share has slipped to $60, and investment banks are recommending it at $60 based on “the Internet has endless growth ahead” and the loss of a third of its valuation makes it a relative bargain. The I>buy the dip crowd has already lost money buying every stairstep down, but a 30% decline must ne the bottom, right?

Perhaps a 30% decline is the bottom in a risk-on market, but in a risk-off market, the eventual bottom isn’t $60, it’s $6 per share. In the optimistic, euphoric “this is permanent” risk-on phase, a $15 drop from $90 to $75 is a screaming buy. A decline to $60 is literally incomprehensible.

The decline to $40 is a shock to the system because the rebound to $90 was the near-universal expectation. Those who could have sold at $85, $75, $65, $55 and $45 but did not are now so shell-shocked they cannot grasp that selling at $40 is the fantastic opportunity of a lifetime compared to selling at $9 or the eventual bottom at $6.

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