Economics has the nickname of “the dismal science.” And over the years, many have tried to equate the term science with the physical sciences.
But it’s different. In physics, there are certain laws that have been established that work without fail. For instance, every action produces an equal and opposite reaction. That’s not the case with economics. A change can produce radically unequal results. Or a change may seem to produce no result at all.
That’s because, unlike physics, economics deals with real human beings. They take time to make choices. And while they think they’re acting rationally, they often aren’t. It bleeds over into the investment universe too.
That’s why small changes, like a government policy to hold down interest rates, may seem to have no discernable impact. Yet such a change may lead to riskier behavior by banks in terms of making loans, or by individuals in terms of taking on debt that they couldn’t afford to finance at higher rates.
Because the laws of economics don’t have that same rigidity as the laws of physics, there’s a lot of guesswork. If you noticed the sheer amount of government spending and central bank buying during the financial crisis, you might have looked at prior periods where the same thing happened. Typically, inflation started rising 12-18 months after such big moves. That’s how long it took for the overall economy to react to those changes.
That’s why gold posted strong rallies as the financial crisis ended, and partly why it spiked as high as $1,900 per ounce in 2011. But when inflation didn’t rear its head—and when no new potential crisis emerged—gold prices slumped.
That’s the laws of economics at work. Something can be out of favor or trade quietly for years. But then there’s a sudden flurry of activity that flares up and dies out again. This year, we’ve seen stocks continue their upward moves. Ditto commodities, which are quietly rallying higher. But the biggest move has been in cryptocurrencies, which have surged after years in the proverbial doghouse.
What’s happened there? It’s a somewhat new asset class that’s starting to get more attention. It’s been a few years since the space last saw a speculative rally and decline. While I like the long-term aspects of investing here, the moves have been fast and quick. A pullback will occur at some point, although I suspect those buying today and willing to hold through downturns will turn out well.
The laws of economics are also telling us that stocks, despite trading at high multiples on average, can head higher. The real secret to why is within the broad market itself, not the headlines. In this market, individual stocks are routinely taken to the cleaners on poor earnings or bad news developments. That’s a good sign. It shows there’s some discipline in the system. Investors aren’t just buying everything like they would at the extremely optimistic phase at the end of a bull market.
The flip side of this is the fact that what goes around, comes around. Out of favor names that improve their performance are likely to see sizeable rallies as well. One of my favorite investments this year has been mobile chipmaker Qualcomm (QCOM). Shares dropped in February on a lawsuit with Apple— but shares fell far more than the dollar value of the lawsuit.
There’s been a huge opportunity there throughout the year. And while the company pays a generous dividend and has been fine operationally, it’s taken a buyout offer from Broadcom to get shares close to their pre-lawsuit highs.
That’s the “physics” of investing at work. When something goes out of favor, it becomes undervalued. At some point it will come back in to favor and the market will want to price it at a higher value. How that happens, and how quickly that happens, however, is where there’s uncertainty that you don’t get with physics.
This law seems to apply no matter what the overall market is doing. In other words, there’s always an opportunity to buy undervalued, out-of-favor names and find a market-beating opportunity.
Besides individual names like Qualcomm, I see this opportunity unfolding in the commodity space. Commodities typically have multi-year rallies, and the most recent one started near the beginning of 2016. We’re still in the early quiet phase, where there’s a modest rally off the lows, but none of the bullishness that sends shares substantially higher.
In the energy space, OPEC is pushing to keep production at levels that won’t lead to major price declines. That’s about the best they can do, thanks to the large amount of non-OPEC production around the world. But it may be enough to send energy back to the $70 or $80 space in the next 12-18 months, which, in turn, would lead to a big rally in beaten-down energy names.
I’m a fan of owning or trading options on the big-name company in the space like ExxonMobil (XOM) and ConocoPhillips (COP). While these names aren’t big movers, the option income and dividend payments can go a long way to covering energy costs in the short-term. Over time, however, they’ll likely trend higher.
Finally, there’s the gold space. Yes, inflation still seems benign. But with interest rates rising and the Fed finally starting to make real reductions in its balance sheet (albeit slowly), the conditions for gold to rally are at their best point since the financial crisis broke out.
When gold rallies, gold stocks tend to make far larger percentage moves. The opposite has been true over the past few years. Gold fell less than 50 percent from its highs, but gold stocks lost on average close to 80 percent. Being on the right side of a gold rally—and in gold mining companies rather than the metal—can lead to life-changing returns.
Just remember, this isn’t physics. We’re dealing with the sum of all trader’s hopes, doubts, dreams, and fears. But over time, overvalued parts of the market fall out of favor, and vice versa. Make sure you’re rotating to where the value is.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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