Learn to Think Irrationally

Ideas that don’t make sense… ‘Vaguely right’ beats ‘precisely wrong’… It’s looking like January 2022 all over again… The market is not a machine… Two irrational strategies that work…

Learn to think irrationally…

As investors, we like to consider ourselves rational people.

We gather data to make a reasoned argument for buying or selling an investment. Many financial analysts even pride themselves on being “data driven.”

Of course, you need to master data analysis to be a great investor. But you also need more than that…

As an investor, you need an edge over others in the market. And data can only get you so far. Big institutions can always hire more geniuses to process data in more ways than you can. As an individual investor, you need to compete in other ways.

In today’s Digest, we’re looking beyond data, logic, and rationality… at ideas and strategies that might seem irrational at first… but can give you an advantage in the market.

It’s time to explore ‘ideas that don’t make sense’…

I stole that phrase from the subtitle of a book called Alchemy: The Surprising Power of Ideas That Don’t Make Sense by advertising legend Rory Sutherland. Sutherland is an interesting guy whose TED talks have more than a million total views on YouTube.

The book contains myriad stories of successes that make no sense – like Red Bull, the energy drink. Early tests showed that consumers hated the taste with a passion. If you’ve ever tasted it, you know it’s disgusting.

But the founder of the company became a billionaire. And the product was successful enough to fund two Formula One racing teams, which cost hundreds of millions of dollars a year.

Sutherland never fully explains Red Bull’s success, since it’s irrational. But he does explain how things like the small size of the can make consumers think Red Bull is more potent than caffeinated soft drinks in 12-ounce cans.

In short, success isn’t always logical, rational, or data-driven.

My journey beyond data began several years ago…

One day, I realized that all the data I was analyzing to make investing decisions was from the past. And the discounted cash-flow models I was using were built on guesses about future data.

Since only the past can be known with precision and the future is unknowable, I adopted Sutherland’s notion that “it’s better to be vaguely right than precisely wrong.”

You see, while I can increase the odds of future investments working, the reality is that some ideas just won’t work. No matter how well I understand the historical data behind my highest-conviction investment ideas, there’s no guarantee that these investments will be successful.

Now, the two times I told Extreme Value subscribers that a stock was “my No. 1 recommendation,” they both did well. The second one is still my No. 1 recommendation. But I don’t take those successes for granted. No matter how much conviction I have, I’ll never know the future.

So what does that mean for investing this year?

It’s looking like January 2022 all over again…

On December 28, former Stansberry Investor Hour podcast guest Brent Johnson of Santiago Capital got me thinking…

He posted on X (formerly known as Twitter) a list of technical indicators at various extremes, along with the fact that the Goldman Sachs Financial Conditions Index was low (indicating that money and credit were flowing more freely). Then he noted that the bulls were making fun of the bears again. Finally, he concluded:

I’m not smart enough to know if [the] market will turn lower now. But I’m smart enough to know this is what happens right before [the] market turns lower.

So far, Johnson’s insight is looking accurate. In fact, the market is looking similar to January 2022, when we had a major market top after the longest bull market in history.

Now, history doesn’t repeat, but it does rhyme. And if today rhymes with January 2022, we’re in for a rough year.

So let’s look at a couple of key data points from the mega-bubble and then the less rational view…

After years of rising, the Nasdaq Composite Index peaked in November 2021. The S&P 500 peaked on January 3, 2022, the first trading day the year. Then both fell… The S&P 500 hit bottom on October 12, 2022, down about 25%. The Nasdaq hit bottom two months later, on December 28, down about 36%.

But bear markets following mega-bubbles frequently feature a blistering rally or two. And we certainly had a massive one in 2023. As you can see in the table below, the S&P 500 and Nasdaq both rocketed off their bear market bottoms.

The numbers are jarring. They’re huge returns for those time periods. But they’re not necessarily unusual. The Dow Jones Industrial Average rallied 48% from November 1929 to April 1930, a period of about six months. And for you statisticians, yes, I realize it’s only a single data point.

However, there have been too few mega-bubbles to provide a meaningful amount of statistical evidence… so we’re already outside the realm of the purely rational.

Another data point a rational, value-oriented investor like me might use to check in on the stock market is its overall valuation, represented by the S&P 500’s cyclically adjusted price-to-earnings (“CAPE”) ratio. When the CAPE ratio gets up to around 20, it means the market is getting expensive. When it’s above 25, you’re in “bubble” land. And when it’s 30 or higher, you’re undeniably in mega-bubble territory.

The CAPE ratio was 44 in December 1999 and 38 in October 2021 – within several weeks of enormous mega-bubble peaks. Today, it’s squarely in mega-bubble territory at 32.

The CAPE ratio in mega-bubble land is a huge warning. Stocks don’t go up forever, and they can trend in a way you’d never have predicted for a lot longer than you’d ever believe possible. Though the CAPE ratio is a non-factor 90% of the time, it’s dangerous to get too complacent when it’s this high.

Now, the CAPE ratio has occasionally spent years in mega-bubble land without a big crash, like it did from 2017 until 2022 (the March 2020 pandemic crash notwithstanding). So while history suggests a CAPE ratio of 32 is concerning, it’s not a given that a market decline is imminent.

However, adding the CAPE ratio to the market’s price action since the 2021 and 2022 top tells me we’re still in a bear market. It might sound irrational. But it feels like history is rhyming.

The economy isn’t a machine…

It’s logical to analyze the economy as a machine. Superinvestor billionaire Ray Dalio has an excellent video called “How the Economic Machine Works,” which is easy to understand and virtually impossible to argue with.

But still… I don’t think the economy (or stock market) is a machine. And in his book, Sutherland agrees:

The technocratic mind models the economy as though it were a machine… But the economy is not a machine – it is a highly complex system. Machines don’t allow for magic, but complex systems do.

A machine is made of physical, mechanical parts. Each part serves a function and interacts with other parts to do a specific type of work. The parts don’t have opinions, favorite TV shows, or complicated relationships with their in-laws. These parts might be complex in structure, but they can’t compete with a human being.

The human brain has been called the most complex thing in the universe, with roughly 1,000 different regions, 86 billion neurons, 85 billion other cells, and more than 100 trillion connections.

Economies and markets are made up of relationships between complex humans, not machines. And humans aren’t logical. As Sutherland says in his book, “The human mind does not run on logic any more than a horse runs on petrol.”

If humans were logical creatures, markets would never hit extremes. A logical human would assume that an asset’s value is the sum of all the cash flows it’ll generate in the future, discounted using a reasonable rate of interest back to the present… and never pay more than that.

But humans do pay more than that… and when they do, like at the 2021 and 2022 top, it seems perfectly rational. During that time, it also seemed irrational to short the market, since all evidence indicated being long was right.

The truth is, we don’t always know what constitutes rational behavior. As Sutherland suggests, what’s rational to one person might not be rational to another.

In a world awash in data, you can use whatever information you want to make a “rational” case. People do it all the time. They make a decision that feels right, then set about finding the logic and data that supports it.

Today, I’m going to advocate doing something irrational…

If we are seeing a similar top to January 2022, plenty of studies will tell you to ride out the market volatility… that your long-term returns will be higher if you do. They’re mostly right… technically speaking.

But those studies won’t tell you that to achieve those long-term returns, you’ll need to ride out gut-wrenching drawdowns. Most folks can’t do that… and they end up selling for catastrophic losses when those logical, rational studies say you should be buying more.

The simple way to avoid this nightmare is to use trailing stops. It seems irrational to sell a perfectly good company with excellent prospects just because it has fallen a certain amount. But when you do, you’re admitting that your facts and reasoning could have been wrong… or that you were right but the market doesn’t care and will push the stock’s price down for longer than you can believe.

And you can use trailing stops and still make good returns. You can see this in the track records of many Stansberry Research publications (which we’ll be reporting on soon in our annual report card).

Another way to handle inevitable market volatility is to diversify. That’s when you have a range of assets that tend to perform differently from one another. Diversifying can help you preserve and grow your wealth over time, because some part of a well-diversified portfolio will always be performing well. But it’s also a bit irrational because you’ll probably always have some part of your portfolio that’s lagging the rest.

For example, I’ve recommended two short funds to The Ferris Report subscribers. The two funds are both down by double-digit percentages since I recommended them last year. But despite the poor performance, I haven’t recommended selling them. And over the past three weeks, they’re among the few stocks generating positive returns. I’ve also recommended other alternative investments that will tend to rise when the S&P 500 is going down or sideways.

Throughout its history, the S&P 500 has risen two-thirds of the time… and it has compounded at double-digit rates for the past several decades. So it seems highly irrational to ever bet against it… And to maintain a losing bet against it must seem even crazier.

But it works. If we get a big, fast drawdown, I’ll recommend selling those funds and reallocating the capital into more attractively priced assets.

If you believe investing is all about logic and rationality, you’d have to conclude that trailing stops and diversification make no sense, since the past few decades have shown that all you need to do is buy every dip in the S&P 500 to compound your capital at high rates.

But again, we’re humans, not machines. And these strategies work in a world we can never entirely understand.

I realize trailing stops and diversifying might seem logical and rational to many Digest readers, but I’m willing to bet many had never heard of them before they discovered Stansberry. And while many folks might have thought those strategies sounded a bit irrational at first, I bet a lot are now true believers.

New 52-week highs (as of 1/18/24): Advanced Micro Devices (AMD), Cencora (COR), Costco Wholesale (COST), Salesforce (CRM), CyberArk Software (CYBR), Alphabet (GOOGL), W.W. Grainger (GWW), Intuitive Surgical (ISRG), Microsoft (MSFT), O’Reilly Automotive (ORLY), Palo Alto Networks (PANW), Parker-Hannifin (PH), ProShares Ultra QQQ (QLD), Sprouts Farmers Market (SFM), VanEck Semiconductor Fund (SMH), Spotify Technology (SPOT), Stryker (SYK), Travelers (TRV), Trane Technologies (TT), Visa (V), Waste Management (WM), and W.R. Berkley (WRB).

Our mailbox is full of your thoughts on Argentine President Javier Milei’s speech at the World Economic Forum and our reporting and take on it in yesterday’s Digest… Do you have a comment or question? As always, e-mail us atfeedback@stansberryresearch.com.

“Corey, thank you for summarizing the speech Argentina’s new leader Milei made to the ‘rich and powerful’ gathered at Davos. It’s encouraging to know there are still world leaders (at least one) who understand government is not the answer to everything. Hoping it didn’t fall on deaf ears… Always enjoy your Digests – keep up the good work!” – Subscriber Tim P.

“Corey, This very well could be the beginning of a (long overdue) global paradigm shift. One which lasts for generations. We drifted so far the new generation has no idea we were once a fairly grounded society. Godspeed. Also a great essay to your credit!” – Subscriber Ed C.

“It is high time that someone tried to stop the socialist monologue that dominates the World Economic Forum. Those who will benefit from the continuation of the [World Economic Forum] program will ignore Milei or at worst try to quiet him. The truth may eventually be evident that the current path leads to the destruction of the world economies, but not until the element of greed is satisfied.” – Subscriber Bruce P.

“Wow, What a breath of fresh air in the mountains of Switzerland! I truly hope the ‘elite globalists’ were paying attention!

“I’m a 76-year-old entrepreneur and love the free market that enables us to deploy capital in ways that we see beneficial to our customers, employees and yes, even owners!

“The federal bureaucracy and U.S. tax system have become so totally distended that it makes me furious – fair share?? – yes, I have no problem with paying my ‘fair share’ and operating within the guardrails of a free market but keep them reasonable, simple and truly fair.” – Subscriber William F.

“They were all listening, just not comprehending. How can the elites possibly be wrong in the path they have chosen?” – Subscriber Erik H.

“For [Milei] to speak truth to the self-delusional elites who participate in that Davos catastrophe was gutsy and probably fell on deaf ears there… but not so around the rest of the globe. He’s right on the money and I hope more like him emerge into the highlights of the earth’s politics – beginning with our USA.” – Subscriber Steve G.

“President Milei is certainly not another Trump – that’s an insult. He is possibly another Reagan.” – Subscriber Al A.

“The difference between the two is: Milei actually cares about Argentina. Trump just pretends to care about America, but really cares only about himself.” – Subscriber M.S.

“Can we ask Milei to send his identical twin to the U.S.? We need to drastically change course.” – Subscriber Molly K.

“A great speech by Milei – let’s hope he lives up to his words. But how is a 50% currency devaluation and adoption of the U.S. dollar going to help his people? I would be a lot more impressed if he adopted Bitcoin instead, like El Salvador has for some time now.” – Subscriber S.I.

“Thank you very much for presenting this and providing the link to read it.” – Stansberry Alliance member Robert S.

“WOW! What a declaration from someone who was being ridiculed in the run-up to his national election. At last there seems to be a person who is prepared to stand up in front of world leaders and the world’s press and tell it how it is.

“Unfortunately, all around the world, many candidates promise fundamental changes during their campaigning but once elected, their promised reforms are either forgotten, or simply watered down. Hopefully this won’t be the case with Mr. Milei.

“Next, will there be another country’s leader that is brave enough to come out with similar rhetoric and back it up with the necessary actions? It certainly won’t be happening anytime soon in the UK!” – Subscriber Chris D.

Corey McLaughlin comment: You bring up a great point, Chris. A speech is one thing, but will the words lead to practical changes in policy in Argentina – or anywhere else a similar-minded candidate might win an election? So far, the answer is yes. In his first month since coming into office in Argentina in mid-December, Milei has consolidated 18 government agencies into nine, fired 5,000 government workers, and introduced a 350-page package of economic reforms. The Argentine central bank remains standing, however – for now perhaps. It will shutter “sooner or later,” Milei said recently in a local radio interview.

(By the way, thank you all for your notes. What we’ve published today is just some of the feedback we received. We’ll share more next week.)

Good investing,

Dan Ferris
Eagle Point, Oregon
January 19, 2024