How to beat the market (Jim Rickards book extract)

Publisher’s note: Cognitive dissonance has been a factor in the markets for years now.

But, as you’ll see in Jim Rickards’ new post-COVID investment manual, it’s even more so post-COVID.

Cognitive dissonance is by far the best way to describe the behaviour of investors right now.

On the one hand, the world is experiencing the worst pandemic since the Spanish flu.

Economic conditions in many countries are the worst since the Great Depression.

In Australia, we have the government using all manner of methods to try and keep things going…and mitigate the impact of closed borders, business closures, job losses and trade disruption.

And yet…and yet…

Prices for houses are at record highs in early 2021.

Any predictions that COVID-19 would sink the Aussie property market have been blown out of the water so far.

Stocks? Well, they’re up. They made back their early pandemic losses…and then some.

COGNITIVE DISSONANCE reigns supreme.

Why? How long can it last? And what does this mean for your strategy for the rest of this year?

Below, in an extract from The New Great Depression: Winners and Losers in a Post-Pandemic World, Jim Rickards examines three important lessons for investing in this weird new world…

***

The first is that you can make money in every kind of market.

The idea that in bear markets you should quickly go to cash and move to the sidelines is untrue. That move will preserve wealth, yet an investor will miss out on profit-making opportunities that exist in bear markets.
Unfortunately, investors are taught that stocks, notes and cash are the only asset classes they can consider (and 401(k) plans are structured exactly that way). Yet there are liquid markets in property, private equity, alternative investments, natural resources, gold, currencies, fine art, royalties, insurance claims, and other asset classes. These asset classes don’t just add range to tired allocations between stocks and bonds; they add true diversification, which is one of the few ways to increase returns without commensurately increasing risk.

The second lesson from cognitive dissonance is that profit opportunities are manifest if you understand that markets are not about being right or wrong; they’re about information.

There’s a myth that markets are efficient venues for price discovery that smoothly process incoming information and adjust continuously to new price levels before investors can catch up and take advantage. That has never been true, and it’s less true today than ever before.

This ‘efficient markets hypothesis’ was an idea dreamed up in the faculty lounge at the University of Chicago in the 1960s that has been propagated to generations of students ever since. It has no empirical support; it just seems elegant in closed-form equations.

Markets are not efficient; they freeze up at the first sign of trouble.

They do not move continuously between price levels; they gap up or down in huge percentage leaps. This can produce windfall profits for longs or wipeout losses for shorts. That’s life; just don’t pretend it’s efficient.

Most important, the efficient-markets hypothesis was used to herd investors into index funds, exchange-traded funds (ETFs) and passive investing based on the idea that ‘you can’t beat the market’ so you might as well just go along for the ride. That works for Wall Street wealth managers, who simply collect fees on account balances and new products. It does not work for investors who take 30% losses (or worse) every 10 years or so and have to start over to rebuild lost wealth.

You can beat the market using good forecasts, market timing, and a perfectly legal form of inside information. That’s what pros do. That’s what robots do. And everyday investors can do it too.

MARKETS ARE RARELY RIGHT

The fact is markets are more likely to be wrong than right in their forecasting. When markets get the forecast wrong, the gap between perception and reality can benefit investors.

The 2007–09 financial crisis came into view in the spring of 2007 when mortgage delinquencies rose sharply. There was liquidity stress in August 2007; two mortgage hedge funds and a money market fund closed their doors around the same time. Then the problem seemed to go away. In September, Treasury secretary Hank Paulson announced the Super SIV (a roll-up special investment vehicle designed to refinance commercial bank off-balance-sheet liabilities; it never happened but sounded good at the time). Stocks hit a new all-time high in October 2007 (that’s six months after the crisis started), partly based on unfounded assurances from Paulson and Ben Bernanke.

In December 2007, a clutch of sovereign wealth funds from Abu Dhabi to Singapore bailed out the commercial banks by buying preferred stock and debt. All was well, or so it seemed.

Yet in March 2008, the investment bank Bear Stearns failed. It was quickly taken over by JPMorgan, and markets breathed a sigh of relief. Then in June, mortgage-finance giants Fannie Mae and Freddie Mac failed.

Congress pushed through a bailout bill and markets again became complacent. Once more, the worst was over! It was obvious we were witnessing sequential failures after the August 2007 warning.

It was equally obvious that the failures were not over. Lehman Brothers had been the weakest link in the Wall Street chain since 1998 and was widely regarded by insiders as the next firm to fail in the new crisis. I explained this threat to John McCain’s presidential campaign’s economic team in August 2008. I was laughed off the call and not invited back.

Markets continued to behave as if nothing were wrong. Finally, on 15 September 2008, Lehman Brothers filed for bankruptcy. That was the point at which the gap between perception (‘the crisis is over’) and reality (‘the crisis is just beginning’) closed abruptly. Most investors got crushed.

The point is that markets did not see it coming, and neither did Fed chair Bernanke, who said in 2007 that the mortgage problems would blow over.

Markets were not efficient discounting mechanisms of future events.

Cognitive dissonance had allowed investors to believe in the best outcomes while the truth was grim. Markets were in la-la land and got a brutal reality check that September. Markets did not see the crash coming in 2008. And they did not see the crash coming in 2020. That’s not what markets do. Understanding what’s coming next is up to you.

HOW TO BEAT THE MARKET

To read what’s next, click here to go straight to the order form and get access to the exclusive Australian edition of The New Great Depression: Winners and Losers in a Post-Pandemic World.

To read more about the book right now, click here.