According to Bank of America the dollar is set for its strongest quarterly strengthening since 1992. This is due in large part to the market’s expectation that the Federal Reserve will increase interest rates in June and a current belief that there is no investment alternative or “TINA” to the US market. The result is a higher demand for dollar-denominated investments and an unintended creation of the crowded trade.
Nature of the crowded trade
A crowed trade occurs when the vast preponderance of investors are so convinced in this ‘herd logic’ that they see no need to worry or question their current positions. This complacent trader’s typical response to any misgivings such as “The US stock market is overvalued …is…Yes but you said the same thing last year, and look the market is much higher now.” Complacent investors are slow to change but as in prior crowded trades things generally end badly and for reasons that were unanticipated.
Trying to catch a falling knife
Crowded trades begin to unwind when a large investor suddenly realizes that their positions are way overvalued and fearing that they must act before others, break ranks and sells their investments. The subsequent shock to the stock price begins to challenge the confidence of complacent investors, who only held these stock positions because everyone else did. As more investors wake up to the realization of this misplaced strategy and try to sell at same time, things deteriorate rapidly and stock prices drop sharply.
How could our present “crowded trade” in US stocks fall apart?
It could be as simple as the sudden realization that exports do matter. Even in a consumer-based economy (1) the strong dollar has caused shrinkage in exports that impacted not only multinationals, but also will their US suppliers. The result will soon be weaken job growth or and less consumer spending.
Take home message
As astute investors recognize an increasing risk in US investments, we could soon see a spiraling cycle of falling stock prices that beget more selling and further stock price drops.