Making Sense of Irrational Markets

"The market can stay irrational longer than you can stay solvent." – John Maynard Keynes

On Friday, October 16th, while the stock markets in the US were in a mini-decline, I decided to buy more of two of my favorite "takeover target technolgy stocks": NetApp Inc. (NTAP), and Brocade Communications (BRCD).

Why? Mainly because that day they were "on sale," and because in all my reading and personal investigation I've concluded they would be a good fit with some bigger acquirers like IBM (IBM) or Hewlitt-Packard Company (HPQ).

I also bought a technology company that appears to have a great balance sheet and plenty of cash, EMC (EMC). This in spite of the fact that all three of these stocks have had an impressive run-up this year off their March lows.

Whether it was a rational or irrational decision on my part, you can judge and time will tell, but if I decide to sell them today (the dreaded date of Monday, Oct. 19th), I will make a least a small profit.

You see, I've come to believe that the famous comment by John Maynard Keynes happens to be a reality, whether we can accept it or not.

Brian Hunt, editor in chief of Stansberry Research, recently wrote that, "John Maynard Keynes was the most influential economist of the 20th century. His ideas shaped the way the Western world ran its finances after World War II. Keynes was also a brilliant speculator who pulled millions of dollars out of the market.

"You see, Keynes brilliantly cautions traders against shorting a stock or a market that "shouldn't" be rising... and cautions against buying a stock or a market that "shouldn't" be falling."

From my perspective, the most important reason that the markets appear "irrational" is because it isn't as "fundamentally-driven" as so many naive investors think. Until you fully understand how the stock markets in the US operate, until you understand what a "market-maker" or an "exchange specialist" is, you are nothing short of "confused and distracted".

As Brian brilliantly observed on Oct. 19th: "It's by finding extremes and then betting against the crowd that you set yourself up for big gains in a short time. But watch out for the problem Keynes warns about: The crowd often gets irrational and stays that way for a long time."

Remeber back in 2007 when oil prices moved from $50 to $90 a barrel? There were all kinds of "experts" who said it was way too expensive and due for a big correction. Many traders shorted oil at that point.

With perfect hindsight we all now know what happened and how oil shocked the world by going up as high as $147 a barrel before we hit "The Panic of 2008." Any trader who was short at $90 and hung on during oil's remarkable rally lost a lot of money. He or she forgot the market can stay irrational longer than anyone can aggresively bet against it and stay solvent.

Brian continues:

"The market is full of stories like this. Think of the traders who went bankrupt by shorting super expensive Nasdaq stocks in 1999... or the famous blowup of Long Term Capital Management in 1998. Both groups took big positions against markets they felt were behaving irrationally... but those markets just kept on behaving irrationally for a long time."

"A corollary to Keynes' quote is the Jim Rogers line, "Markets often rise higher than you think is possible, and fall deeper than we can imagine." We learned that first hand over the past 14 months in a way that none of us will ever forget if we were invested in the stock markets during that time period."

That is why we all need investment disciplines, and what is said above proves it. Most of the times we can't even trust our senses or emotions when it comes to the markets and our own investing prowess. The warnings of Professor Keynes and Mr. Rogers (not the one who welcomes us to his neighborhood).

"You can put the warning from Keynes and Rogers to real-world use by [deciding to using trailing stop losses]. Go ahead and take a contrarian position at the extremes. But always have an "uncle" point to limit losses in case the crowd keeps pushing prices in a crazy direction" Brian opined.

"It's tough to say uncle on a trade you know has terrific potential. But when you start thinking, "This is an irrational move... I'll just keep betting against it," remember Keynes and Rogers. Know that markets can go farther in either direction than you can imagine... and they can keep going longer than you can stay solvent."

This is very relevant to what we are living and experiencing right here, right now.

There are some big problems in the financial world right now. There are "cockroaches" still breeding in the walls. But I'll finish this article by quoting someone who is far more financially successful than most people and far more "Wall Street wise" than the vast majority of investors. He even has his own very successful TV program.

Yes, I'm speaking about Jim Cramer, who wrote Monday, speaking about last weeks earnings release from the big Banks like Goldman Sachs (GS), JP MorganChase (JPM) and Citigroup (C):

"You know what? Bank earnings really were terrible. With the exception of Goldman Sachs (not really a bank) and JPMorgan Chase, the numbers were pretty hideous.

Cramer went on to opine: "In some ways, I don't think that these companies even have a handle on how bad things are. The foreclosures are all moving parts, anything bought, underwritten or being serviced from 2005 to 2007 is a total disaster. I think something like 40% of the loans and debt that was let that period on anything (cars, homes, credit cards, etc.) is going to default or is defaulting. The losses are mind-boggling and many bankers were either so irresponsible as to be sickening or were victimized by fraud. Also, the numbers are not peak bad. There will be many others that will be worse. Far worse. It is a disaster. Unmitigated. And for the most part, the stocks are all buys."

Now I ask you, gentle reader, how does Jim Cramer know that, "for the most part, the stocks are all buys" in the midst of this unmitigated financial disaster? You and I need to know what Cramer knows, what we don't and why he makes statements like that. If you've read my previous articles, you already know most of the answers.

I'm not interested in "Mad Money", I'm interested in the "Smart Money." I want to know when they are buying and when they are selling. I want to know what they are buying and what they are selling. In the weeks and months ahead I'm determined to learn more and more about all this.

When I do I'm going to find an effective and useful way to share it with all of you so that you can be as well-informed and as rational as Professor Keynes, Mr.Rogers and President Cramer.

Disclosure: I'm currently long Citigroup, BRCD, NTAP and EMC

Comments

[Mad Hedge F...:]

inf When everything is working, and my portfolio is firing on all 12 cylinders, I pinch myself and ask “Is this real? What can go wrong?” I’m reminded of the slave whose task it was to remind conquering Roman generals “All glory is fleeting.” Virtually all of my recommended core longs in gold, silver, Canadian, New Zealand, and Australian dollars, Brazil, Russia, India, South Korea, Taiwan, Vietnam, and junk bonds are at or near highs for the year. I called the bottom in Natural Gas within 40 cents, and mercifully baled on my one short in US government bonds, the TBT. What we are seeing is a global surge in liquidity as cash emerges from the bomb shelter, squints at the day light, and then rushes to buy the first thing it can find. Everything is going up, regardless of fundamentals. It is the proverbial tide that is lifting all boats. You can make a lot of money in these conditions, but there is no way of knowing if this will last for one week, or another year. But they can go on much longer than you think. In the last two liquidity driven markets I traded, Japan in the eighties and NASDAQ in the nineties, fundamental analysts railed against the tide for years, claiming that stocks were overvalued, each call getting their office moved ever closer to the elevator and men’s bathroom. When someone finally did throw the switch on these markets, it got dark amazingly fast. Tokyo went out at an all time high on the last day of 1989, and then dropped a staggering 45% in January. NASDAQ plunged just as fast from its 2000 top. The one thing we can all be certain about is that the survivors have vastly improved their risk control after our recent crash. Make hay while the sun shines, but keep your finger hovering over that mouse. The level of risk is definitely high than it was in March. When the next real downturn starts, it could resemble a flash fire in a movie theater.

Oct 19 06:10 PM

[untrusting ...:]

Marc,
Your buddy, Richard Wendling, is calling for a serious correction on Oct. 19/09 and at worst by the end of Oct/09. It is early yet, but no evidence of that at this point.

Any comments?

Oct 19 09:59 PM

[Roger Knights:]

The great positive in technical analysis and trend-following is that it takes a different perspective -- a value-free perspective -- on the market. Ideally, one should see the market from both perspective, and shift back and forth between rational (value) and irrational (trend) viewpoints at the spots where the mode of the music changes. It takes feel, I think.

Oct 20 03:12 AM

[David Van K...:]

Marc,

Congratulations. You get it.

Dave

Oct 20 11:32 AM