What Is Reasonably Probable?

In law, much of what is analyzed is based upon what is viewed as reasonably probable.  And, as smart investors and traders, we also base our analysis, investing and trading upon what is reasonably probable.  Moreover, we do the same thing when engaging in Elliott Wave analysis as well.  And, this is to what Paul Tudor Jones was referring when he noted:

"I attribute a lot of my success to Elliot Wave Theory.  It allows one to create incredibly favorable risk reward opportunities"

A reasonably probable expectation for a standard impulsive structure is that a 1-2 initial set up projects to the standard target of the 2.00 extension of that set up.  This is what we have learned historically in equity markets, and we use this guideline as a framework for not just profiting in the market, but also in risk management.  And, if an equity move gets stretched, then we can see a move to the 2.618 extension in not so common scenarios.  

To put this into perspective, the SPX is now approaching a 3.618 extension of the 1-2 off the end of March low, and all within 6 weeks. Would you consider this a reasonably probable scenario upon which you would continue to invest or expect on a going forward basis?   I certainly hope not.

Yet, a number of you are quite upset with yourself for not being heavily invested in this type of outlier scenario.  But, rather than be upset, I view you as prudent investors and traders.  You will live to invest and trade another day because you do not take extreme risk. And, yes, this type of move in the SPX represents extreme risk, no less than when I warned you of the same in January regarding silver and gold.

Remember, investing and trading is not a sprint. It is a marathon.  And, if you attempt to sprint while taking high risk each and every day, that is how one ultimately blows up your account.  So, in my humble view, those that are pushing the envelope here with reckless abandon represent the class of investor and trader referred to by Howard Marks in his perversity of risk perspective.  These will likely be the class of investor that will hold all the way down in a deep bear market, or worse, will continue to buy the dip during an environment that will destroy capital, as that has been what they have been trained to do in a Pavlovian fashion.

To this end, I commend each and every one of you that is able to be measured when markets move to extremes.  And, over the course of the long marathon, you will ultimately be rewarded for prudence in the face of extremism.  But, it also means that you have to learn how to manage your emotions during such periods of madness.

Now, that does not mean one should do the exact opposite extreme and aggressively short with reckless abandon during such an environment. That brings to mind the wise words of Keynes: “The market can remain irrational longer than you can remain solvent.”  

While I will still write my usual market update later today, I wanted to send off this missive for everyone to contemplate as the market continues in this extreme fashion so that you can rise above the emotion, gather your thoughts, and execute your plan in the most “reasonable” manner humanly possible. And, rather than engaging in self-flagellation for not being heavily invested in this type of move, please recognize it for what it is and do not base your forward-going analysis and investing on expectations of these outlier moves.