Editor's note: Greed can't prop up the market forever...

Lately, investor optimism has permeated nearly every asset imaginable... and overconfident speculators seem to think the run higher will never end. They're piling into irrational trades, hoping to squeeze every penny out of the bull market. But Extreme Value editor Dan Ferris says these traders are missing the warning signs – they don't realize that some of the hottest corners of the market are starting to weaken...

In short, Dan says today's environment looks a lot like the end of the dot-com boom in 2000... And even the most experienced investors should start preparing for the coming downturn.

In today's Masters Series, originally from the June 18 Digest, Dan examines several indicators of investor irrationality... explains why bull runs fall apart when "hot" stocks peak... and reveals a common error that can sink your portfolio...

The Market for Garbage Is Peaking (and Why You Should Care)

By Dan Ferris, editor, Extreme Value

Listen to the market today, and it'll tell you (again) not to worry at all...

The action in Wall Street's so-called "fear gauge" – the Chicago Board Options Exchange's Volatility Index ("VIX") – is the most obvious sign that few folks are worrying right now.

As regular Digest readers know, the VIX is made up of 30-day options prices on the benchmark S&P 500 Index... When the S&P 500 falls, the VIX goes up as worried investors hedge their equity risk by buying put options. And when investors aren't worried enough to buy puts, the VIX falls.

You'll recall that the VIX soared to an all-time closing high of 82.69 on March 16, 2020, at the height of the COVID-19 panic. But it has trended downward in waves since then...

As recently as the start of September, the VIX hovered around 16 – close to its level during the ultra-complacent month of February 2020... You know, back in the old days, when nobody wore masks or did business behind plexiglass.

You can see what I mean in the following chart...

While the VIX moved higher briefly this month, it's back down to around 19 right now.

The VIX has dropped to around 10 on a couple of occasions in the past – most recently for much of 2017, just before the S&P 500 pulled back about 10% in early 2018. But as you can see in the next chart, its current level is still below the indicator's historical average...

That isn't the only sign that investors are giddy with optimism nowadays...

The VIX's lows in recent months were also accompanied by record call-option volumes. People buy call options to try to make big, fast gains when they're really bullish.

The folks at SentimenTrader.com reported in June that "Small traders are rushing into call options again... and not hedging." At the time, call-option volumes hit their second-highest level of the past 22 years (exceeded only by the week of February 12 this year).

And of course, the overall greed was evident in other ways, too... Small speculators were buying call options on "meme stocks" and other old favorites – including movie-theater chain AMC Entertainment (AMC) and electric-car maker Tesla (TSLA).

Meanwhile, SentimenTrader's Equity Hedging Index hit its lowest level in 22 years... In other words, investors reflected virtually zero desire to protect against downside risk.

In the simplest terms, small traders have taken charge of the options market in recent months... And they're exhibiting record-high optimism and record-low pessimism.

Go back 22 years, and you quickly realize that means small traders haven't been this influential in the markets since the headiest days of the dot-com bubble.

Hyper-optimism among investors has infected the bond market, too...

That might not be true yet among the higher-quality, so-called "investment grade" bonds (though their yields are quite low)... But it's certainly the case among the lower-quality, so-called "junk" bonds. They're more vulnerable to a steep correction than ever...

Investors are as crazy for junk bonds as they are for call options. Junk-bond issuance hit an all-time high of $286 billion in the first half of 2021. That eclipsed the roughly $210 billion in volume in the first half of 2020. And this year's junk-bond issuance is on pace to beat last year's record of $435 billion.

In the September issue of Stansberry's Credit Opportunities, editor Mike DiBiase noted that only 0.6% of the roughly 1,900 bonds that his team ranked as "Distressed" on their proprietary Stansberry Credit Rating traded for less than $800. We don't need to get caught up in the nuances of bonds today, but just know... that's near the lowest percentage since the bond-focused newsletter launched back in November 2015.

In other words, just like in the options market, junk-bond investors are exhibiting extremely high levels of optimism and extremely low levels of pessimism right now.

It's insane that investors are more interested in these securities at precisely the moment when they're near the least attractive they've ever been... But that's how market cycles work.

Low interest rates are great for companies that want to borrow money by issuing bonds... But they're pretty terrible for investors seeking adequate returns.

It's no wonder analysts at asset-management firm GMO currently forecast negative seven-year average annual returns for every type of U.S. and international bond class.

If you look at all the financial instruments I've mentioned so far, you can see that a clear theme has been at work for months... The market for garbage is peaking.

You'll also notice that we've been down this road before. A Wall Street Journal article in June posed the question...

Is the dot-com bust happening again right under our noses?... There is a remarkable resemblance between the speculative boom-to-bust of late 1999 and the first half of 2000 and what's happened over the past nine months in the fashionable areas of clean energy, electric cars, cannabis stocks, and [special purpose acquisition companies ("SPACs")].

All four of those sectors – clean energy, electric cars, cannabis stocks, and SPACs – skyrocketed starting last fall, peaked in the first couple of months this year, and then pulled back.

So while overall optimism in stocks, options, and bonds is at record levels... some of the frothiest areas of the markets have already started falling apart.

That doesn't mean you can't find good businesses in all of these industries. In fact, several analysts at Stansberry Research and our corporate affiliates have done just that.

Excellent opportunities exist in every corner of the market... But you better learn how to separate the garbage from the diamonds in those sectors before investing.

The reality is, you'll find more duds in these burgeoning industries than you'd like.

Now, I get what you might be thinking at this point... Big deal. Who cares if all the garbage stocks are peaking and already starting to get crushed? That doesn't mean good businesses' stocks will do the same.

That's perfectly logical thinking...

Why should the share prices of, say, Amazon (AMZN), Apple (AAPL), or Alphabet (GOOGL) fall just because some trashy cannabis, clean-energy, electric-vehicle, or SPAC company finally fell apart? Why does it matter to the broader market if a bunch of stimulus-check-addled, unemployed day traders are about to finally get crushed in meme stocks?

You should care because... this is how bull markets end.

That's how it worked from 2000 to 2002, for example, when the dot-com bubble fell apart...

Back in June 2000, the S&P 500 was down just 4% from its March high. It led many investors to mistakenly believe that the bear market was a dot-com-only event... and that it would leave the broader market unscathed.

But that all changed before long... By the fall of 2002, the S&P 500 had been cut in half.

Most people had no idea a huge bear market was already underway back then... the same way that you (and I, to be fair) have no idea if one is already underway today.

These days, the S&P 500 is continuing to make new all-time highs – it just reached another on September 2 – even though the previously mentioned categories of speculative pockets have already started deflating. It's very similar to the end of 2000.

Among other eerie similarities with the era around the dot-com peak, according to the Wall Street Journal...

Trading behavior was similar, too. The end of 1999 was when fear of missing out drove dot-com skeptics – including institutional investors and holdout hedge funds – to buy anyway, while day traders drove extraordinary day-one gains for Internet IPOs.

The last quarter of 2020 marked the moment Tesla was finally taken seriously, after being admitted to the S&P 500; solar and clean energy became must-haves no matter the price for many big institutions under pressure to show their environmental credentials; and SPACs took the place of the IPO madness of 2000 as a way to funnel money to lossmaking startups.

The optimism in options buying, plus the lack of pessimism in hedging and the VIX, suggest that investors are behaving similarly today. They're essentially saying...

Sure, those other areas of the market are down, but that's because they were speculative bubbles. But hey, the S&P 500 is fine. It's making new highs. That proves everything will be fine in the broader market.

Except that's not how it works. When markets get crazy, a funny thing happens...

Market prices rise because investors see an opportunity for improving fundamentals. Then, the unexpected happens... and the higher prices turn right around and alter the fundamentals of the business.

This is the core of billionaire speculator George Soros' theory of reflexivity. And the perfect example of it has been on full display in meme stocks like AMC Entertainment...

AMC was already an embattled, financially struggling business. Then, COVID-19 hit... Governments locked everybody down... And everybody stopped going to the movies.

As you might expect, AMC's revenue dropped roughly 80% in 2020. Big hedge funds thought the business was doomed, so they sold short a huge chunk of the company's outstanding stock. Bankruptcy seemed like a real possibility as recently as the end of 2020.

Then, the meme-stock speculators stepped in and ran AMC's shares from their January 5 close of $1.98 to their June 2 high of $62.55... a staggering 31-bagger in five months.

That enabled management to sell shares at AMC's new exorbitant valuation of roughly 25 times 2020 revenues. Then, the company could pay its debts and make new investments.

Those small speculators saved AMC from near-certain corporate death (or at least acute financial illness). The company's financial fundamentals were radically altered by the price action of its stock.

It's tempting to see this as the triumph of Main Street (all those small-time speculators) over Wall Street (the big hedge funds that were squeezed out of their short positions in AMC and other meme stocks).

That interpretation is fine... I'm all for the little guy winning. But it doesn't just end there. In the financial markets, you must endlessly ask, "Then what?"

Almost nobody is asking that question today.

In this case, the answer to "then what?" is probably something like... Most of the small speculators who got rich in the short squeeze will start to believe they're more smart than lucky. They'll overstay their welcome in the stock and lose it all back (and then some, if they're using leverage).

Soros' theory of reflexivity says investors respond to attractive fundamentals, push up the share price, and then the share-price move actually changes the fundamentals of the business.

Well, the same thing happens on the downside... Don't look for economic or business fundamentals to deteriorate first. Look for the stock price to weaken first.

In fact, this is already sort of playing out with AMC... The stock has been much more volatile since its early June peak. It's trading for about $40 per share today – down 36% in that span.

My guess is, at some point, speculators will get scared of losing so much money in what's already falling...

So then, they'll sell whatever is left – like stocks of decent businesses that haven't been crushed yet. The contagion will spread... No stock, junk bond, or commodity will be safe.

As greedy as speculators are today for call options, they'll be that scared of them when everything starts to fall apart. They'll be trying to raise cash as quickly as they can.

Maybe the Russell 3000 will weaken first. It's always hard to pinpoint the first domino to fall, but in the end, it doesn't really matter...

Sooner or later, I'm betting the fear will spread like wildfire.

Investors who are as bullish and unafraid as most equity, bond, and options traders are today will go to the opposite extreme... They'll be exceptionally bearish and horrified. That's just human nature.

Keep in mind, markets are less like machines than tectonic plates...

In most cases, you don't notice that they move their own way on their own time... and humans' efforts to control those movements are far more likely to make the situation worse.

Then, one day, they show you who is in charge – and it's neither you, the Federal Reserve, nor the U.S. Securities and Exchange Commission ("SEC")...

When I hear people talk about the Fed as though it has some magical ability to keep the markets buoyed forever, I wonder where these folks were during the last financial crisis. The S&P 500 fell 58% from its October 2007 high to its March 2009 low, despite massive intervention by the government and the central bank.

And remember when then-SEC Chairman Christopher Cox banned short-selling of financial stocks on September 19, 2008, just days after Lehman Brothers declared bankruptcy because the Fed wouldn't bail it out? As the Wall Street Journal put it in a 2011 article...

The market rallied for all of one day before plunging back into the abyss.

The federal government, the SEC, and the Fed don't control anything but their own actions. The belief that humans can control the markets is like believing we control the tides or the phases of the moon... It's pure, modern hubris.

Investors err when they optimize their portfolios for high equity valuations and ultra-low interest rates forever, believing that the Fed and the government can keep markets propped up indefinitely... as though these groups have the power to change human nature.

Maybe it's wrong to "fight the Fed," as some analysts often say. But in my mind, it's even worse to believe a central bank is more powerful than nature itself.

I promise you... the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index can fall just as far as those meme stocks and all that other garbage in the markets.

And as I've discussed today, right now smells like the type of moment when that's a legitimate worry for even the most disciplined long-term investors.

We could be at the start of a bear market that lasts six to 24 months and not even know it yet...

In the end, this bear market – again, if we're already seeing the first signs of that as the garbage stocks sell off – could ultimately wipe out half or more of the value of those big indexes... and do a lot more damage to thousands of individual stocks within them.

I know... I know... I keep doing the thing where I show you all these reasons to be bearish. Then, either it doesn't happen in the short run, or at worst, the market actually goes through a fairly steep correction – like it did back in the fall of 2018.

If all we get over the next few months is a 5% or 10% correction, I won't do a victory lap... But I'll likely take a little credit for warning you that I saw elevated risk when others didn't.

And if it sounds like I'm predicting an imminent market correction, I agree that's the easy interpretation of what I'm telling you today. But as you all know, I hate predictions... Nobody gets them consistently right. Nobody has the skill of knowing the future.

The best you can do when it comes to getting a good read on the future is to identify risk and opportunity like we've done today. And from there, you can prepare for what's next.

Otherwise, just have a nice weekend...

If you've taken my advice previously, you're already holding enough cash to reduce portfolio volatility and seize opportunities when equity or other asset prices fall. You're prepared.

Right now, I believe the U.S. stock market is loaded with more risk than usual. Investors should proceed with caution. And don't tell me six months from now that I didn't warn you.

Good investing,

Dan Ferris

Editor's note: Dan believes some of the hottest sectors are already starting to weaken... and a bear market could be right around the corner. But even if you don't agree with him on the timing, it's critical to prepare your portfolio – before a downturn arrives...

On Tuesday, September 28, at 8 p.m. Eastern time, Dan will join Stansberry Research Senior Partners Steve Sjuggerud and Dr. David Eifrig to discuss their unfiltered views on exactly where they think the stock market is headed and what you should be doing with your money today. Plus, they'll give away the name and ticker symbol of what they're calling "the No. 1 most dangerous stock in the world right now."

This event is free to attend... All we ask is that you let us know you're coming. Click here to reserve your spot.