In the old days, we called it a “pump and dump.”
They were low-priced stocks with lousy fundamentals. They often traded for pennies, if they even traded.
They sat at low prices for months. Then, suddenly, the price jumped. Just as quickly, the price fell.
The pump was easy to find. It was a bullish story.
Maybe about a mining company about to find gold. Or the rumor of a big deal for a tech company.
Stock promoters or scam artists wrote the stories. They bought the stock, then pumped the price with their story. Finally, they dumped the stock.
Pump and dump works because the “greater fool theory” of investing works.
Looking at these stocks, you could say the buyers were fools for believing the story. But the buyers believed they were rational.
They planned to sell at a profit when other investors heard the news. In other words, if they were fools, they expected to sell to greater fools.
This strategy is foolish … but sometimes profitable with the right game plan.
But there are too many fools in the market right now.
And that means things could end badly very soon.
Fools Flocked to Hertz’s Bankruptcy
We saw the greater fool theory in action last week in shares of Hertz Global Holdings Inc. (NYSE: HTZ).
The stock price soared even as the company was in bankruptcy:
Speculative Traders Bought up Shares of HTZ
After bankruptcy, shares will probably be worthless. That’s why the company’s largest investor, Carl Icahn, sold his shares.
Icahn is a takeover specialist. He’s an expert in bankruptcy. Yet, after he sold, the stock soared.
The only explanation is the greater fool theory.
Day traders, many of them using the Robinhood app, were buying the stock. They planned to sell quickly to other day traders.
In other words, buyers of HTZ expected a greater fool to give them a profit.
Every Bubble Is Fueled by Fools
The Economist John Maynard Keynes explained how this kind of market works. He compared it to the card game Old Maid.
In Old Maid, every card except one can be matched. The goal is to discard cards that are matched to their pair.
Eventually, just one player is holding a card — the Old Maid — and they lose the game.
He didn’t call this the “greater fool theory of markets.” But that term came into popular use for some reason.
The reason is probably because it’s an accurate way to describe some markets.
Greater fools fueled internet stocks in 1999.
Everyone knew these stocks were overvalued. So, they invented the price-to-eyeballs ratio to replace the price-to-earnings ratio that was no longer relevant.
The stock market surged before crashing more than 76%.
When that bubble burst, investors sought safety in real estate. They began buying homes, and then flipped homes.
Banks gave mortgages for more than the value of the home because everyone knew home prices always go up. Anyone could profit by selling to a greater fool.
Home prices spiked before plummeting more than 33% by 2009.
The problem with markets trading under the greater fool theory is that we eventually run out of fools.
My colleague Ted Bauman recently summarized the evidence that the stock market succumbed to the greater fool theory. You can watch his presentation here.
Your No. 1 Strategy for a Foolish Market
It’s Ok to trade in a market like this if you understand the game will end.
Short-term trading with options could be the best strategy under the greater fool theory. That way your gains can be large while your risks are limited.
For more on short-term options trading, check out this new presentation about my unique strategy.
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader