How You Can Beat an Irrational Market

You knew that once everyone stopped panicking, the market would turn on a dime. And turn it did yesterday, with record point gains for the Dow and S&P 500. That, along with the bank capital infusions announced yesterday, convinced at least some people that the worst is finally behind us.

So as investors turn their minds back from fear to greed, you probably want to know which stocks are best poised to rebound from their losses. The most important factor involved in answering that question comes from one simple statement: If the market's drop was irrational, then stocks that have suffered the most will now likely bounce the highest.

Measuring rationality
Of course, not everyone's convinced that the market's drop really was irrational. Threats of the wholesale destruction of the financial system may have found promising solutions, thanks to coordinated action from governments around the world. But many analysts are still looking for a global slowdown that could limit gains for stocks. Moreover, some sectors -- financials, most notably -- may find themselves transformed permanently, in ways that will make companies less profitable and therefore keep stock prices down.

Nevertheless, from Monday's rebound, it's pretty clear that many of the most beaten-down stocks in recent days were among the top contributors to the Monday's record gains:

Stock

Loss 10/3 - 10/10

Gain 10/13

Reliant Energy (NYSE: RRI  )

(45.1%)

89.6%

Morgan Stanley (NYSE: MS  )

(59.5%)

87%

Mechel OAO (NYSE: MTL  )

(44.9%)

44.9%

Dryships (Nasdaq: DRYS  )

(42.8%)

26%

General Motors (NYSE: GM  )

(45.7%)

33.1%

Petroleo Brasileiro (NYSE: PBR  )

(28.9%)

30.3%

UnitedHealth Group (NYSE: UNH  )

(28%)

34.8%

Source: Yahoo! Finance.

Although these companies represent different industries, different stock sizes, and even different locations around the globe, there's definitely a pattern. A close look at all of yesterday's top-gaining stocks shows a concentration in the financial, energy, and materials sectors. Yet just as the smackdown in stocks has spared nearly no one from losses, you can see gains from the inevitable bounce in nearly every market niche.

The real question, though: Can it last?

One day doesn't make a bull market
Personally, I don't think the market's in the clear yet. Although markets have been happy to buy based solely on the announcements of pending actions to unclog the financial system, the actions themselves will take time to work. And as a reality check, bear in mind that yesterday's record-breaking performance gained back only about half of what the markets lost in just last week -- let alone the huge losses in the past year.

When the market pushes stocks down sharply across the board, you can expect to see indiscriminate gains in a relief rally. If the credit markets stabilize, and global government action produces results, all stocks should benefit for a while.

Get an edge
But while the recovery honeymoon for the markets may last for a few weeks, some companies will emerge with larger competitive advantages than they had before the crisis. Smart investors will realize this and start scoping out the best of the bunch as targets for their buying. Just as individual investors will succeed in buying stocks at bargain-basement prices, cash-rich companies with an eye toward acquiring competitors or strategic partners on the cheap will find some amazing opportunities.

In contrast, companies with large amounts of debt will find themselves without the unlimited flexibility they had when credit was easy. And many financial firms will continue to struggle, especially if the exact terms for future capital infusions prove onerous.

For now, though, the market's trashing of nearly all stocks is an irrational response to the stresses in the financial system. The best strategy for beating that irrational market is to identify superior companies with outstanding prospects, and let falling stock prices bring shares to your portfolio at bargain prices. It's true that you may not get another opportunity like you had last week. But even if you don't, the market's still off one-third from its highs -- and there are plenty of deals left for investors to take advantage of.

More on the market's recent ups and downs:

If you prefer to pick up great companies when their share prices are low, you'll want to read the latest issue of Motley Fool Inside Value. Each month, you get in-depth analysis of great value stocks, along with tips on how to avoid value traps. Best of all, the newsletter itself is a value -- absolutely free with a 30-day trial.

Fool contributor Dan Caplinger uses every trick in the book to try to value stocks -- not always successfully. He doesn't own shares of the companies mentioned in this article. Petroleo Brasileiro is a Income Investor recommendation. The Fool owns shares of UnitedHealth Group, which got the nod from both Stock Advisor pick and Inside Value. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is a great value.


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  • Report this Comment On October 14, 2008, at 1:07 PM, Billdmrdct wrote:

    I have seen a number of technical analysts make comments about the recent market gyrations. Over the past weekend I happened to create a long term(decades) S & P 500 (spx)chart and a large double top formation is very evident. It tells me that this recovery may look like that of the 1930's.

    Billdmrdct

  • Report this Comment On October 14, 2008, at 1:28 PM, AnnuitCœptis wrote:

    Common Misconceptions About The Recent Crisis:

    The Root of the Financial Rout is Systemic:

    which means that the problem comes from the system itself and not from one of its part.

    The sub-prime rout is only one symptom of the problem.

    How do we know?

    Because it is not a few financial institutions that have been plagued it is the whole financial system. So the root has to be global.

    We will find the cause when we observe the chart of long-term rates.

    Chart of the 30 years US Treasury Bonds from 1977 to Present.

    http://www.17-76.net/interest.html#rates

    We can see that for instance the rate of the 30 years US Treasury Bond went from 14.50% in 1981 to 4.30% lately and this in a constant decrease.

    The global acceleration of that phenomenon was termed Greenspan Conundrum:

    "The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums.

    But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

    Chairman Sir Alan "El Maestro" Greenspan

    Federal Reserve Board's semiannual Monetary Policy Report to the Congress

    Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate

    February 16, 2005

    "Considerable debate remains among analysts as to the nature of those market forces. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States."

    Chairman Sir Alan "El Maestro" Greenspan

    Federal Reserve Board's semiannual Monetary Policy Report to the Congress

    Before the Committee on Financial Services, U.S. House of Representatives

    July 20, 2005

    1776 - Annuit Cœptis researches discovered that a normal curve would compensate exactly the owner of an asset for his interest risk. There is Market indifference between short-term and long-term asset. The monetary policy is neutral.

    If the curve is steeper the yield-curve is steep and Market prefers long-term assets. The monetary policy is accommodating.

    If the slope is less steep or even negative the yield-curve is said to be inverted and Market prefers short term assets. The monetary policy is restrictive.

    When the yield curve of market indifference goes through 0% for overnight loans the Market reaches what is known as Keynes' Liquidity Trap. It is according to 1776-Annuit Cœptis research the root of the Great Depression and to a lesser extent the cause of the Japanese Lost Decade [which is now 15 years old].

    When the FED [Chairman Sir Alan "The Maestro" Greenspan] saw the long-term yield going down they tried what they could to avoid the Ominous Keynes' Liquidity Trap.

    They hence shoot up the short-term rates from 1.00% to 5.25% with the hope of pumping up long-term rates.

    .

    However these long-term rates went up a mere 1.00%.

    The yield-curve became inverted so financial institutions not being compensated for the interest rate risk had no interest to finance investments.

    Graph of the Current Yield Curve.

    http://www.17-76.net/interest.html#banks

    They found out that mortgage was a good alternative. But as it was the case for Junk Bonds in the 80's the huge liquidities in the bank needed a commensurate demand which explains why the sub-prime mess started.

    They should have withdrawn from long-term investments instead they started fantasy investing.

    Contrary to Common Belief it is High Short Fed Funds Rather Than Low Fed Funds That Caused the Sub-Prime Disaster.

    But why do long-term yields do go down?

    "New Forces" that were not yet understood were likely behind the unusual environment of low long-term interest rates around the world, he said. "I do think the most relevant likely reason why we are dealing with what we are dealing with are new forces ... in the international market," Greenspan said via satellite from Washington.

    "Their nature and their behaviour is not something we are going to fully understand, if ever; certainly except in retrospect."

    Chairman Sir Alan "El Maestro" Greenspan

    Central Bank Panel Discussion

    To the International Monetary Conference,

    Beijing, People's Republic of China (via satellite)

    June 6, 2005

    Obviously if someone knows that something will be understood in retrospect he does already understand it.

    These new forces are the increase of the income and wealth disparities.

    When the revenue of the poor go down by $1 it takes out $1 out of the demand for good and services. The poor is said to have a high propensity (close to 1) to consume.

    When the revenue of the rich goes up by $1 he saves $1. The rich is said to have a high propensity to save.

    So more and more dollars go to more ad more investments which have lower and lower revenues and profit. Their yield go down.

    Interest Rates are the Cause and Consequence of the Explosion of Income Disparities and the Instability of the System

    "The income gap between the rich and the rest of the US population has become so wide, and is growing so fast, that it might eventually threaten the stability of democratic capitalism itself."

    Chairman Sir Alan "El Maestro" Greenspan

    Conclusion:

    As a consequence any "solution" that wouldn't address the issue of distribution of income and wealth in a extensive way would be doomed on the short-run and any body that would have vested interest in the wealthy have no chance to come up with a solution.

    Any "solution" that would not cancel the notion of credit is doomed on the long-run and any body who have vested interest in the financial institutions have no chance to come up with a long-term solution.

    DIE ZEIT: Can the right monetary and fiscal policy keep the US out of a recession?

    Alan Greenspan:

    "Probably not. Global forces can now override most anything that monetary and fiscal policy can do. Long-term real interest rates have significantly more impact on the core of economic activity than the individual actions of nations. Central banks have increasingly lost their capacity to influence the longer end of the market. Two to three decades, ago central banks were dominant throughout the maturity schedule.

    Thus, the more important question is the direction of long-term real interest rates."

    Chairman Sir Alan "El Maestro" Greenspan

    The Great Irony of Success

    © ZEIT online, 30.1.2008

    The last global bailout of the banks which insure interbank loans will not solve the problem:

    "Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius - and a lot of courage to move in the opposite direction."

    Albert Einstein

    Banks will prefer to loan one another with insurance from governments and will even less be willing to lend to investors and consumers. There will be a massive increase of interbank supply. There will be a total disconnection between the financial market and the demand for investments. Interbank interest rates and treasury yields will go down dramatically.

    Interest will be going down and the fast decreasing amount of new saving vehicles will create the largest and shortest asset price bubble ever a gigantic wave of irrational exuberance [Chairman Sir Alan "El Maestro" Greenspan] or saving glut [Ben Bernanke] a massive capital accumulation [Karl Marx].

    Not only will the price of good assets go up, but the price most risky of them will go up even more: according to the model of 1776-Annuit Cœptis the credit spreads, will go down to zero hours before the crash.

    "Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

    The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the

    financial innovation that has greatly reduced the cost of such transactions.

    Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

    Chairman Sir Alan "El Maestro" Greenspan

    Reflections on Central Banking

    At a symposium sponsored by the Federal Reserve Bank of Kansas City,

    Jackson Hole, Wyoming

    August 26, 2005

    The asset price bubble and the lack of new investment will increase even more the income and wealth gap between the rich and the poor.

    The long-term interest rates will be also necessarly lower as mortgages will not any more be a source of demand for the savings.

    This dramatic fall of long-term interest rates will probably cause the yield-curve to be inverted.

    1776-Annuit Cœptis has proved that it is the cause of the commodities bubble.

    That coupled with the high level of unused liquidities will create a gigantic commodity bubble.

    That bubble will cause an even bigger increase in the income/wealth disparities with probable food crisis.

    The central banks confronted with that "inflation" will increase their short-term rates and increase the inversion of the yield-curve.

    Swamped with liquidities and confronted with an inverted yield-curve banks collectively will most probably do something idiot again.

    Most probably and because the Keynes' Liquidity Trap occurs at a minimum of long-term interest rates at that time the stock market will be at an all time high.

    The fall will be dramatic and ugly with no prior warning.

    Only the shareholders of 1776-Annuit Cœptis are assured of selling at the highest price. Most of others will be left with nothing but debts.

    The solutions offered by governments will not solve the problem neither short-term nor long-term it will in fact accelerate the fall in Keynes Liquidity Trap.

    "At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible.

    But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.

    Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.

    Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. Emperors and armies come and go; but unless they leave new ideas in their wake, they are of passing historic consequence.

    I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval;

    for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest.

    But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

    John Maynard Keynes,

    The General Theory of Employment, Interest, and Money,

    13 December 1935, p. 383.

    Quoted by Chairman Sir Alan "El Maestro" Greenspan

    Adam Smith

    At the Adam Smith Memorial Lecture, Kirkcaldy, Scotland

    February 6, 2005

    Now you know something Chairman Ben S. Bernanke "is not going to fully understand, if ever; certainly except in retrospect.".

    Given the vested interests and inability of those who govern us to offer a credible solution to the serious problem affecting the world, 1776-Annuit Cœptis is forced to assume the responsibilities of these incapable and propose to those who demonstrate the desire a just and efficient solution which without avoiding the economic and financial disaster, will protect its shareholders from all of its ominous consequences.

    The Proposal of 1776-Annuit Cœptis

    Alea Jacta Est

    http://www.17-76.net/

  • Report this Comment On October 14, 2008, at 4:40 PM, websmith1 wrote:

    So the bank bailout has turned into government ownership of healthy banks? Among these banks will be, surprise, surprise, Goldman Sachs, Chase, Morgan, Wells Fargo, and the Bank of America. How is this supposed to help home owners and people who have their retirement finds in failing banks again? What this will do is help the major banks buy the assets of failed institutions for pennies on the dollar.

    At some point, they might want to ask these banks if they're willing to loan money to a population that is already over extended and if they're willing to loan money to businesses that have no place to sell their products or services. They then might want to ask a population that is overextended if they want to borrow more money when their jobs have been shipped offshore, given to illegal aliens, given to H-1B visa holders, and their investments have been wiped out. They can start with the people who are beginning to kill themselves. http://www.cnn.com/2008/US/10/13/economy.violence.ap/index.h...

    While the government is going into emergency sessions to figure out how to fool around with the banks to fix this problem, the source of the resolution is drying up as more people are losing their homes, their jobs, and their lives. The only way that this problem can possibly be fixed is to put money in the hands of the Citizens.

    http://ewebsmith.com/self/StandUp.html

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