Jim Cramer has seen what happens behind the scenes in the stock market, and warned of one huge mistake often made by investors during a sell-off.
“The pundits and commentators say it’s too hard, that ordinary people can’t invest for themselves and shouldn’t even bother trying, but I know from experience … that you can do it as long as you’re willing to put in the time and effort,” the “Mad Money” host said.
Cramer said that one of the worst myths out there is that the market is always rational and makes sense. This is not true.
On any given day, the market can make seemingly random moves for reasons that do not make sense. Sometimes stocks go up when they should have gone down, and sometimes entire sectors move for ridiculous reasons.
“Never assume that just because something happened, it has to make sense because the market is always supposed to make sense. That’s nonsense,” Cramer added.
It is important to be able to look at some of the market’s moves and understand that sometimes, stock moves are just ludicrous. Once investors start cooking up connections that do not exist, they can really get into trouble because they can convince themselves of almost anything, Cramer warned.
The key is to understand the catalysts that make stocks move.
Sometimes, a stock move has nothing to do with the underlying prospects of the company. When that happens, Cramer recommended taking advantage of that irrationality, not buying into it by chasing stocks or panicking out of them.
“Remember, nobody ever made a dime panicking,” Cramer said.
For example, in the case of an inexplicable market-wide pullback, struggling hedge funds may start selling to raise money in order to pay back unhappy clients who are demanding a payout.
Sometimes there is a red-hot deal, like a Facebook or an Alibaba, that is so massive that mutual funds have to sell stocks in order to raise cash to get in on the deal. It may seem crazy, but mutual funds don’t keep cash on hand to make these kinds of investments. That means they often do not have enough cash to participate in these big deals unless they sell stocks they own.
Regular investors might see the selling and start to panic, dumping stocks in turn. Ultimately, this will trigger a sell-off, and the media will try and conjure up reasons to explain why otherwise stable stocks fell.
It can happen to commodities, too. Cramer saw it first hand when oil ran up to $147 a barrel in 2008, even as demand for petroleum was relatively weak — a recipe for oil to go lower.
Only after the rally did Cramer discover that oil prices jumped because a couple of hedge funds had bet against oil and had to buy in their shorts at insanely high prices. Sure enough, after that huge run, oil dived back down to $33 a barrel as hedge funds sold it off to raise cash.
“The worst mistake, the most common mistake you can make these days, is to say that because a particular stock or commodity trades at a given level, it therefore deserves to trade there. Often, that is just fiction now,” Cramer said.
So, when everything in the market or in a particular sector goes down, instead of assuming that the issue pertains to the fundamentals of the underlying company, Cramer suggests asking yourself if it could have been caused by an out-of-control hedge fund or Wall Street money management, then realize that the market’s irrationality can be your opportunity to profit.
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