The Melt Up Theory
An overview of a once in lifetime blow off top cycle in risk on assets.
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The Melt Up Theory
It’s important to note that the melt up theory is first and foremost a theory. By any objective analysis, it’s a non consensus and long shot view. That said, it has asymmetric opportunity if it does play out.
The melt up theory predicts that markets will rise to historic levels in a parabolic fashion not seen before in history. The man behind the theory, David Hunter is calling for 6,000 on the S&P, gold to 2,500 and silver to 50.
The reasoning behind the melt up theory is simple. The FED will see that inflation is under control and that they’ve over tightened their monetary policy leading to a recession and begin to pivot.
As FED Chairman Jerome Powell recently said, they’re no longer doing forward guidance but instead ‘watching economic data to determine future moves.’
When the data comes back negative due to the fastest monetary tightening to date, I believe the FED will have no choice but to ease up. Those who have been following me know I’ve been calling for this since day one.
Second, sentiment has been bearish lately with many market participants on the sidelines in expectations of worse conditions are ahead. Many who wanted out have already exited.
Put simply, the market has already priced in the bad news and the majority of participants are short. People will be caught offsides and sentiment will shift, leading to a euphoric high.
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What Happens After?
Well, it depends who you ask. It should come as no surprise though that if the melt up theory plays out, the only logical response to a once in a lifetime melt up in risk on assets, would be a sharp decline.
David Hunter is calling for ‘a global bust’, which would be the worst decline since the great depression. From peak to trough, he expects an 80% retracement in the equity markets, and a secular top that we won’t retest for decades.
How to Play the Melt Up
Disclaimer: NFA. My opinion only. DYOR.
First, my thoughts. Despite this being a long shot, I believe the melt up theory is currently mispriced. With recent recession headlines, almost nobody is calling for it. In other words, the probability of it happening relative to the reward of it happening isn’t properly priced (hence the impetus for this post). That said, I don’t think most should bet on it, as I’ll explain.
Profiting from the melt up theory requires careful planning, market timing and a high tolerance for risk.
In my opinion, most investors will mistime things, let emotions affect decision making and end up buying and selling at the wrong times. Furthermore, there’s certainly no guarantee that the melt up will play out.
Second, it’s crucial that one’s investment thesis match their time horizon. If one is a short term trader, highly savvy, and comfortable with high risk and market cycles, they may want to dabble.
If one is a buy and hold, set and forget, it would be a mistake to get involved. My strong opinion after trading for years, observing others and speaking with hundreds of investors is, just like most people will lose at poker over the long term, most will lose at trading.
That said, if one were to follow the sequence of events, the play would be to long equities into the melt up. The easiest way to do that is simply buy the SNP and hold.
Options typically give one the most asymmetric returns, although volatility is high so they are currently expensive, and of course they come with the highest risk.
I also like bonds because if we do have a ‘global bust’ after the melt up, bonds will likely be seen as the safe haven and be the one asset that will perform well when the market loses its appetite for risk. In short, it’s an easier play with less requirement for market timing.
During the bust, aside from bonds, I believe cash will perform best as it increases one’s purchasing power and although inflation is the talk of the town this year, in a global bust, the conversation will move to deflation.
What Does The Melt Up Mean for Crypto?
As I’ve written about before, I believe the crypto market is highly correlated with macro. Crypto reflects the markets appetite for risk and therefore it stands to reason that it will follow the equities. During the melt up, crypto should perform well. During the bear, it’s likely to get rekt.
One high risk option is to play the crypto markets the way one would play the equity markets, using the increased volatility to act as leverage. This is particularly risky because it relies on both the assumption that the melt up will play out, and that crypto will be correlated to equities.
For example, if one believes in the melt up theory, instead of longing the SNP to 6,000, they can HODL Bitcoin, and, when we’ve approached peak euphoria, move BTC back into cash through the bust. In other words, crypto historically moves faster in both directions, but is highly correlated with equities, so it essentially acts as a leveraged position.
Is this smart? If it works, one looks like a genius, but I believe this isn’t the play for most investors. Be smart, and most importantly, just like in poker it’s crucial to manage your risk responsibly.
How are you playing the markets?