Yale economics professor Robert J. Shiller wrote a stellar column in The New York Times at the beginning of September. It sought to explain whipsaw trading in August via “a Keynesian beauty contest” on Wall Street.
So what’s the reason for the market volatility, Mr. Shiller?
John Maynard Keynes supplied the answer in 1936, in “The General Theory of Employment Interest and Money,” by comparing the stock market to a beauty contest. He described a newspaper contest in which 100 photographs of faces were displayed. Readers were asked to choose the six prettiest. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers.
The best strategy, Keynes noted, isn’t to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest. Better yet, he said, move to the “third degree” and pick the faces you think that others think that still others think are prettiest. Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher.
It’s a fascinating theory — and one that has even more evidence after the antics of August continued this month.
As I wrote a few days ago, it’s not “news” moving this market — because frankly, there’s nothing new here. Europe is up to its eyeballs in debt, unemployment is high, yadda yadda yadda. There clearly is more at work here than fundamentals or chart watching. So maybe it’s other investors that Wall Street is watching these days more than anything else.
The idea of second-degree investing based on what you think others are buying and selling — or even third-degree investing based on picking stocks you think other investors are buying based on what still others are buying — is a bit of a head-scratcher. But it certainly is one way to explain wholesale selloffs and $100 daily declines in the price of gold.
How to Get Rich With Third-Hand Stock Picks
I’ll admit this is highly counterintuitive. Stock picks that are exclusive tend to be the best, right? That’s why insider traders get busted. If buying things late made you rich, then we’d still be in a dot-com bubble.
But you can’t look at it that way. You have to think about the fact that what makes sense to you might not make sense to other investors. Even if you’re “right” and a stock’s earnings and revenue are ugly, if two people want to buy that stock and only you are selling it, the price will go up.
Consider Chipotle (NASDAQ:CMG). The company has a forward PE of 37 compared with other restaurant stocks in the 12 to 15 range. Commodity inflation is weighing on margins, the company missed earnings estimates in the last quarter, consumers are hunkering down again and $7 burritos are still pricier than the $1 McDouble at McDonald’s (NYSE:MCD), a 900-calorie burrito is hardly health food — the list of reasons to be skeptical goes on and on. For months I have been baffled by this stock and expecting a flop.
But Chipotle stock is up 50% so far in 2011 and continues to move higher. Whenever I pan CMG, people invariably sneer and say, “How’d that sell call in January/February/March turn out for you?”
I still think I’m “right” that Chipotle will run out of gas. But it doesn’t matter. Because investors continue to buy the stock. So it goes up regardless of who is “right.”
The “Ugly” Stocks are the True Bargains
This is the crazy market that we must endure. But you can use the events to your advantage.
Aggressive traders who try on this mantle may find success. Heck, maybe you should run out and buy Chipotle despite my misgivings after it has rolled back 7% of its 52-week high just a few days ago — just to learn a thing or two about investor psychology.
The other option — and one that I think is much less risky — is to seek out fundamentally strong stocks that have proven numbers but are very unpopular in the current Wall Street beauty contest. This could include Wal-Mart (NYSE:WMT), which has seen annual sales and revenue growth every fiscal year since 2007. No recession there. Same for Google (NASDAQ:GOOG), which in addition to the same track record of year-over-year growth across the past several years has a cool $40 billion in cash and short-term investments just for a rainy day.
These stocks are not the popular picks at the beauty pageant these days. But maybe you can get into these companies while they are out of favor, wait until Wall Street changes its taste, then find yourself with a belle of the ball.
But don’t take my word for it. Ask your friends’ friend what he’s buying or selling first before making a trade.
Jeff Reeves is the editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks named here. Write him at editor@investorplace.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.
