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For Rational Investors, Stock Market Uncertainty Equals Profits

Stock-Markets / Stock Markets 2011 Aug 02, 2011 - 06:45 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: There's no question that the Washington fiasco, more commonly referred to as the debt-ceiling crisis, has injected a huge amount of uncertainty to financial markets.

That's bad news for the U.S. economy - which Friday's lousy second-quarter gross-domestic-product (GDP) report demonstrates was already suffering from bad fiscal policy, bad monetary policy and a gross excess of new regulations. This deal didn't really solve any long-term problems, won't head off a federal credit-rating downgrade and all in all only adds to the market uncertainty.

But here's the good news. Uncertainty breeds opportunity - especially for savvy, rational investors.

And with the dark clouds of uncertainty that continue to build over the U.S. economy, we can turn this situation to our advantage in a big way.

Let's take a closer look so that I can show you what I mean ...

When Investors Are Certain... But Not Rational
There's an irony about investing that's not lost on savvy, rational investors - even at the retail level: If a market lacks uncertainty, it's awful tough for us to analyze and then invest with confidence.

Just consider the capital markets of the late 1990s. Back then, stocks seemed to be on a steady upward march, posting double-digit gains each year.

The fact that the investing masses believed there was a complete lack of market uncertainty made it very difficult for "rational investors" to invest. Those "rational" players understood that the markets were getting frothy, or speculative - in fact, the warning signs were there as early as the middle of 1996 (six months before U.S. Federal Reserve Chairman Alan Greenspan denounced "irrational exuberance").

The whole tech sector really demonstrated the pervasive belief that stock prices could only go up. After its August 1995 initial public stock offering (IPO), Internet-browser pioneer Netscape Communications Corp. saw its shares double on its first day of trading. And I'm sure we all remember how tech companies in general - and particularly companies with "dot-com" in their title - saw their valuations soar well beyond any rational expectations.

For rational investors, that apparent market "certainty" made it almost impossible to invest with any degree of confidence - short or long.

The market was clearly too high, especially in the tech sector, so buying made no sense. It was impossible-to-gauge euphoric speculation that was driving stock prices - not easy-to-quantify fundamentals. If you bought, you were just hoping that the "Greater Fool Theory" would bail you out with a sale to someone else at a higher price.

Selling the market "short" wasn't the answer, either. Expecting an irrational trend to correct itself is a sucker's bet. And a bullish trend like this one that doesn't correct for five years is an expensive misstep - one that will send stock-market bears straight to the poorhouse.

There was very little un-certainty in the market - the United States was the best economy in the best of all possible worlds and the federal budget was swinging into surplus.

In fact, the only uncertainty to be found was situated far away from U.S. shores. I'm talking, of course, about the Asian economies going into crisis in the summer of 1997 and Russia defaulting in August 1998.

Now there was some market uncertainty that would have let you make some real money.
.After the 1997 "Asian contagion" crash, the Asian stock markets were very underpriced. And after August 1998, the Russian stock market was one of the greatest bargains of all time.

Those two markets were the poster-children for investing uncertainty - trust me, nobody was buying there.

But savvy investors who did their own "due diligence" (research) understood that they had the opportunity to snap up Asian and Russian stocks at truly bargain prices - and then make as much as 10-times their money over the next decade as those economies righted themselves.

Lest you think that I'm writing all this with the benefit of hindsight, allow me to share a story of my own - for in early 1999, as a banker in Croatia, I joined this parade. I bought shares of Croatia's leading food company while it was trading at three-times earnings. I also bought the nation's third-largest bank, which was trading at about one-quarter of its net asset value (NAV) and about 1.5-times earnings.

While the Croatian economy was sound, its stock market was operating in a deep-panic mode. NATO had started bombing neighboring countries, which played merry hell with the tourist business. There were other problems, too.

The bottom line: In early 1999 in Croatia, uncertainty was exceptionally high.

That made it an excellent time to buy.

I sold my stocks when I left Croatia in early 2000. But I'd trebled my money in that short stretch (I would've done even more spectacularly, had I held on.)

Why Uncertainty Abounds in the U.S. Market
Needless to say, the situation we face as investors here in the United States right now is very different from the one that I faced in Croatia in the late 1990s. The U.S. economy is in a deep funk. And fiscal and monetary policies both are way out of balance. The only positive metric of the last few years is corporate profits: Even though the U.S. economy hasn't grown a bit, corporate profits are currently 20% above their 2007 levels.

Uncertainty abounds. The two political parties are far apart on policy - unlike in the late 1990s, when their economic approaches under centrist Democratic President Bill Clinton and the establishment-oriented Senate and House Republicans were pretty close. Thus the November 2012 election is already looming as a watershed that could lead the economy in either of two very different directions.

Monetary policy is also very uncertain. Current Fed Chairman Ben S. Bernanke and some of the central-bank policymakers are attempting to persuade themselves that yet another burst of monetary stimulus is necessary. At the same time, outside observers become increasingly convinced that the lousy state of the U.S. economy shows that the existing stimulus has been ineffective - and quite likely highly damaging.

Fiscal policy is perhaps more of a mixed bag. We all know that the United States is facing gigantic budget deficits as far as the eye can see, with only ineffective efforts being made to restrain them.

The uncertainty is in the reaction of the markets. At what point will the rating agencies downgrade the U.S. credit rating from its current unmerited AAA status? At what point will a second downgrade make really serious inroads into the U.S. Treasury's borrowing capacity?

Most important: At what point will the markets panic, causing a Treasury bond crash that ends the era of sloppy cheap money in the U.S. economy once and for all?

Internationally, it is becoming obvious that all four of the BRIC emerging markets economies are abominably managed. Brazil and India have socialist governments that spend too much money. Russia is run by a coalition of crooks and thugs. And China is an undemocratic kleptocracy whose leaders are terrified that at any moment democracy may break out and sweep them away.

Then there's the European Union, irredeemably split between some of the world's finest economies and a bunch of mooching basket cases. Finally there's Japan, which in some respects stands as an example of what the United States will look like in 2020. In both cases (Japan today or the United States eight years from now), you're talking about a country with a decade of slow growth in its wake, and a debt problem that's ready to go critical at any time.

The Credo of the Rational Investor
If you're a rational investor, the bottom line here is pretty clear: The global economy of today is as uncertain as its late-1990s counterpart was secure. And if you're a rational investor, that's a pretty good thing.

As intelligent investors, we can - and will - take advantage of this, especially if we spot new trends while they are still embryonic and ride them to immense profits. Those who followed me in The Permanent Wealth Investor's "Play-Money Commodities Portfolio" in late 2009 have more than doubled their money and can look forward to further profits ahead.

So as you're plowing through all the commentaries on the debt-ceiling deal, or listening to that crazy cable-TV pundit wringing his hands over the crummy GDP numbers or surging inflation, be a savvy, rational investor and keep it all in perspective.

Remember, following the herd has never been so dangerous; leading it has never been so potentially profitable!

[Bio Note: As Martin Hutchinson told us today, his Permanent Wealth Investor portfolio includes two commodity picks that have generated returns of as much as 100% for his subscribers.

And give the lousy current state of the U.S. economy, there's certainly more to come.

To find out more about Hutchinson's specialized investment service The Permanent Wealth Investor, take a minute to check out this report. You'll consider the time well-spent.]

Source :

Money Morning/The Money Map Report

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