Why Stock Market Highs Beget More New Highs

Whatever else is going on in the business world -- sluggish economy, Washington budget battles, Cyprus bank runs -- the stock market doesn't seem to care. Why is this?
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Whatever else is going on in the business world -- sluggish economy, Washington budget battles, Cyprus bank runs -- the stock market doesn't seem to care. Why is this?

First, markets are a bit like psychics -- they 'talk' about what is going to happen in the future. Prices historically have portended the situation 6 to 12 months from now. If you can remember back to before the financial crisis exploded, you'll recall that the market dropped precipitously in August 2007. It then rose to the old highs we are talking about now in October '07 but that turned out to be a minor detour on the trail to the double-black diamond descent that ensued in 2008.

Second, when markets are making new highs everyone who is 'in' is already making money. They are happy and disinclined to sell. Their pleasure translates into total fewer sellers and the need for any new buyers to have to offer more to get the happy guys to part with their wares. Sounds like an auction -- doesn't it?

Third, if you are not in the market, you tend to start to wish you were. You become another buyer in line to meet up with the dwindling sellers and up the price goes.

Last, and admittedly this one is a little complicated but there are people who play the market from what is called the "short" side. They are betting on it going down. They sell stock that they borrow. So when the price goes up and they have to return what they borrowed, to get it back, they too have to buy. In other words, they get in that same longer line facing the ever-dwindling row of sellers.

As short-selling takes a little bit of wrapping one's head around the idea, let's look at it from another angle. Imagine you wanted to take your love of old cars and trade in vintage Mercedes instead of stocks. Say your neighbor wanted the 1968 280SL -- you might agree to sell it to him for $42,000 knowing you knew of one for sale in another state at $38,000. If it all worked out, you do the work of going to pick it up and you take home four grand before expenses. However, say the one you knew of for 38K was swept out from under you while you were on your way there. You would still have to find one below 42K to make any money. You already took your neighbor's money and promised her the car. You would in fact be "short" a car. If you couldn't find another well-priced one, if the market in Mercedes was making new highs, you would be in the proverbial pickle. How long or how high would the price have to go before you just paid up to stop losing money?

This is alas the exact dilemma of the short seller in a market making new highs -- which leaves us with even more buyers who not only need sellers but need them in a panicked way and just might pay anything to stop their financial pain.

The temptation when a market is making new highs is to think it is too expensive and you missed it. The problem becomes that over time as the markets makes new highs, the dynamics above continue to play out until the very last person who ever thought they might buy a stock does. That is the last point at which you want to be buying.

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