What to Do When the Market Goes “Nuts”

Guest Post by Jeff Clark

According to the efficient market hypothesis, there’s nothing insane going on in the stock market. Stock prices reflect all of the currently available information and investors’ analysis of that information.

Hogwash.

In the long term, I’ll agree that markets are efficient, investors are rational, and stock prices generally end up where they are logically supposed to.

In the short term, though, the market is nuts.

Fear and Greed

In the short term, stock prices react to emotion, not logic. Fear and greed are more powerful in the short term than a thoughtful analysis of balance sheets and income statements. That’s why crazy things sometimes happen in the stock market.

Back in 2000, for example, any rational person could see the dot-com bubble inflating. Stocks with no earnings, no revenue, and no hope of either were pressing higher nearly every day.

Meanwhile, traditional businesses – with long track records of earnings growth, stable dividends, and long-term business prospects – couldn’t catch a bid.

In 2000, I did not own a single dot-com stock. Instead, my largest holding was Cooper Tire & Rubber (CTB). At the time, CTB was an 87-year-old company. When I started buying the stock in early 2000 at $9 per share, CTB traded at six times earnings and paid a better-than-5% dividend.

In early 2000, CTB promptly dropped to $6 per share.

The stock lost 33% of its value, at a time when the average dot-com stock was racing to the moon.

As you might imagine, the clients at my brokerage firm were frustrated. Their friends and neighbors were bragging about the piles of money they were making in this.com and that.com.

Meanwhile, my clients were stuck in a dusty, old, tire-and-rubber stock that just seemed to fall every… single… day.

All I could do to console my customers was tell them that sometimes, the markets do screwy things. Sometimes, logic takes a vacation. Stocks that shouldn’t go up, do. Stocks that should rally, don’t.

And it is during those times that investors who have the ability to curtail their emotions also have the ability to make outsized gains. But you can only make those gains by going against the emotions of fear and greed… and betting on logic instead.

I lost several clients in early 2000. I refused to buy dot-com stocks. I stuck with buying old, time-tested companies trading at steep discounts to their historic valuations.

By early 2002, most of the dot-com stocks had crashed and burned. The customers who stuck with me were cashing out their Cooper Tire & Rubber trade for a 150% gain.

Here’s my point…

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Decoupled From Logic

There are times in the market where it can be far more profitable to take a slightly longer-term view.

Investors’ short-term emotions have decoupled from longer-term logic. So asset prices have, for lack of a more sophisticated term, gotten out of whack.

It is during these times that it can be HUGELY profitable to take a BIG SWING.

Find a stock that is grossly undervalued by almost every fundamental metric. Find a stock that just can’t seem to get off the mat. Find a stock that nobody likes… a stock that if you mention it at a cocktail party, you end up drinking alone.

Then, buy that stock and hold it for a few months.

You won’t be disappointed.

Best regards and good trading

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