Cramer on Index Funds, Crowded Trades, and Why Being Right for the Wrong Reason Can Hurt Investors

Cramer opened the program by describing its purpose. He said his job is not just to entertain but to educate and teach viewers, and that his goal is to make them money. He said he wanted to level the playing field for all investors and promised to help them find the market opportunities that exist.

Cramer said that the most useless thing an investor can do is worry about what everyone else is worrying about. He added that the flip side is also true: there is no point in getting excited about something that everybody else is eagerly anticipating.

His reasoning is that when most investors agree something will happen, the stock market has already priced it in. He contrasted this with the real economy, which moves slowly. Borrowing money, building equipment, manufacturing goods, shipping them to retail outlets and waiting for customers all take time, while stocks move close to the speed of thought.

He said that once a preponderance of hedge fund and mutual fund managers decide the economy is slowing, speeding up or flatlining, stocks start trading as if that is already the case. Because building that consensus takes time, such moves rarely happen instantly, but once large institutional managers are on the same page, Cramer said investors can be fairly confident the view is baked into the averages.

Cramer explained the efficient markets hypothesis, under which stocks immediately adjust to reflect new information. He said index fund purists cite this theory to argue that stock pickers cannot gain any edge, because anything an investor knows about a company should already be reflected in its share price. In that view, stock picking is basically the same as gambling.

Cramer described the extreme version of the theory: if everything you could know is already priced in, the only thing that can move a stock is a new piece of information that nobody knows about. He invoked former defense secretary Donald Rumsfeld's phrase about unknown unknowns and joked that betting on such events is like playing roulette, though more fun. He noted that index fund advocates adore the theory because it tells them individual investors cannot consistently beat the averages, leaving a low-cost index fund that mirrors the S&P 500 as the only way to gain equity exposure.

Cramer said he has no quarrel with index funds and considers them the best way for the vast majority of people to invest in the market, a position he said he has held since 2000. He said that even investors with the time and inclination to pick individual stocks should still direct a large portion of their savings, if not the plurality, into a cheap S&P 500 index fund. He described this as the safest way to gain equity exposure and a good fit for retirement accounts, where contributions can be made gradually with each paycheck.

Cramer rejected the idea that the efficient markets hypothesis proves stocks are always perfectly valued. He said that he consistently beat the averages at his old hedge fund in nearly every year, giving clients a 24% compound annual return after all fees over 14 years versus 8% for the S&P. He argued that markets are not perfectly efficient and are often irrational, ignoring information and misvaluing it, which he said is a major reason individuals can make money picking stocks.

Cramer compared the efficient markets hypothesis to communism, saying it makes sense in theory but does not necessarily work in real life.

Cramer said that although markets are not empirically efficient in every case, the efficient markets hypothesis remains a useful idea. He described it as a rough guideline rather than an ironclad law, one that can point investors in the right direction. He said markets try to be efficient and aspire to efficiency.

He explained that the speed at which news is absorbed varies. When a company reports a fantastic quarter, the stock spikes immediately because that kind of data gets baked in very quickly. By contrast, when the Federal Reserve changes policy, the news takes longer to be reflected in the averages. Cramer cited the Fed's signal in late 2023 that it was probably done raising interest rates, saying that baking such news in can take months. He also noted that even when the Fed abruptly changed course at the end of 2018, it took weeks for the change to work through the averages.

Cramer said stocks that benefit from lower rates can rise instantly, but it can take days, weeks or months for the average to fully reflect a new normal because portfolio managers need time to reposition large blocks of stock. No hedge fund or mutual fund can buy or sell them all at once, though a new equilibrium is eventually reached.

He offered a shorthand version of the idea: when there is a widely held consensus about something, positive or negative, investors should assume the stock market is already discounting it. Examples he gave included a euphoric view of the job market and widespread worry about a temporary Fed-mandated slowdown, both of which he said are probably baked into prices. When investors fear a bad earnings season, he said stocks may not be slammed by disappointing numbers because the disappointment is already anticipated.

Cramer said that when investors pile into a crowded trade, they are playing with fire. If everyone is on the same page about a stock or sector, he said, the easy money has usually already been made. Profiting from something obvious is still possible, but latecomers face lower returns and higher risk. He added that nobody forces investors to follow the herd, and they do not need to gauge sentiment to spot tops and bottoms.

He described other approaches that take different amounts of work: trying to time market swings by buying near bottoms and selling near tops, trading around a core position by lightening up after overextension and buying back after a selloff, or holding cash and waiting for a broad market selloff to buy favorite stocks at a discount. He said he enjoyed this kind of work at his old hedge fund and that it can be a terrific way to make money if an investor has the time, inclination and resources.

For people with full-time jobs, Cramer said this approach is impractical. He said regular workers do not have time to stare at the tape all day, and that actively trading is not a good use of free time or worth the agitation. He said his show is designed so viewers can take a less intense approach that lets them go to work and have a personal life.

A caller said his girlfriend, in her early 60s and retired, holds 600,000 dollars in stocks and ETFs managed for a 1% annual fee. He said the manager has lagged the S&P 500 and has largely avoided the Magnificent Seven and growth stocks. Cramer said that if he were managing the money, he would put two-thirds in an S&P index fund. He said that if a manager cannot beat the index, the investor should go for it and join it.

For the remaining third, Cramer suggested a portfolio of about six to ten stocks, with two or three of them overweighted. He said such picks could come from the CBC Investing Club portfolio, which holds more than 30 names. He said that investors who want to pursue individual stocks part-time can also put most of their mad money, meaning cash outside retirement savings, into a low-cost index fund or ETF that mirrors the S&P 500.

Cramer said that investors who manage their portfolios well, do their homework and stay disciplined can beat the S&P 500 with a diversified group of individual stocks, but he noted that not everyone has the time, temperament or willingness to take on more risk. He said suitability is the key, and that investors should keep the index fund option in their back pocket.

Cramer said that when markets fall, investors may be tempted to panic and sell everything. Such a move might avoid a substantial decline, but sooner or later the investor will need to get back in. He said the whole point of sidestepping a decline is to sell high and buy favorite stocks back at a lower level, but getting that timing right is very hard. He said that if an investor dumps everything, there is no guarantee the stocks can be bought back before something changes and the market comes roaring back.

He cited the market bottom in October 2023, which came when long-term interest rates peaked and began heading lower. He said almost nobody saw that coming.

As a practical approach, Cramer suggested continuing to do homework so investors know what they own. When stocks surge, he recommended selling part of the position, raising cash after a move of 20% or more. When stocks fall, he suggested putting that cash to work buying more shares at lower prices. He said investors do not need to nail every short-term top and bottom and that they need only be good enough rather than perfect.

Cramer said that many stock price moves have no connection to the company's fundamentals. He said that at a given moment there are simply more buyers and sellers, which may be unrelated to the actual business. He pointed to a stock called Stride from long ago as an example and referred listeners to his book Confessions of a Street Addict for a fuller account.

He listed other non-fundamental reasons a stock might surge or fall, including market mistakes that are later corrected, investors misreading a good quarter as a bad one during earnings season, and money managers selling one group simply to raise cash to buy another that is hotter.

To identify action that carries real significance, Cramer said he looks for the unusual. A blowout quarter sending a stock higher or an analyst cutting estimates and sending it lower is ordinary business, he said. More interesting, in his experience, is a stock that refuses to go lower on bad news, which often means it is putting in a bottom and may be ready to rocket higher. He also said that when a company reports a fantastic quarter and strong guidance but the stock is slammed, that is also the kind of signal he looks for.

A caller named Howie said he has been watching the show daily and that his stocks have gained anywhere from 60% to 200%. He asked when to start trimming, how much to trim and when he could get back into stocks he still believes in. Cramer said discipline must always trump conviction.

His method is to start trimming when a position is up 20%, trimming between 5% and 10% of the holding, and repeat the process at each additional 20% gain. He said this discipline is necessary to be in a position to buy shares back, and that otherwise investors can let winners run once they have taken cash out.

Cramer returned to his warning that when everybody expects the same outcome, it will often not play out as expected because it is already priced in. He said investors should be especially wary of the IPO cycle. A pattern repeats: a wave of new deals initially rise sharply, while flooding the market with new stock supply that eventually drags prices down. He said the stock market is like any other market, driven by supply and demand, so too much supply pushes prices lower.

He said that when IPOs make people fortunes, exuberance develops, and when deals attract less interest, that exuberance turns to hostility and the whole market tends to get slammed. He cited the pattern in 2020 and 2021, when many people invested government stimulus checks in the hottest stocks. He said there were roughly 400 traditional IPOs and another 200 SPAC mergers in 2021 alone. He described SPACs as originally blank-check companies that would make acquisitions, and said that in 2020 many startups used them to go public while evading the strict regulations the SEC places on IPOs.

Cramer cited Zoom Video as an early example of a deal that caught fire. It went public in 2019 and soared in 2020 once the pandemic made its platform essential. He said that many electric vehicle and charging station IPOs and SPAC mergers followed in 2020 and at first seemed unstoppable. He also compared the pattern to the dot-com era, saying hundreds of low-quality companies that went public in 2000 ultimately went bankrupt.

Cramer said roughly 600 companies came public in 2021 alone, which created far too many newly minted stocks. By the second half of that year, he said, many of these deals were blowing up because the market could not absorb them. He said the moment the Fed began talking tough about raising interest rates in November 2021, the entire structure collapsed, and new issues were eviscerated through most of 2022. He noted that many stocks fell more than 90% from peak to trough, and that some of the companies turned out to involve fraud, with one founder and CEO sentenced to prison.

Cramer said he warned in late 2021 that flooding the market with new supply is a surefire way to wound a bull market. He also said that when portfolio managers want to put large sums into new IPOs, they often must sell existing holdings to raise the money, and in a large IPO cycle that means heavy selling. He said 2021 differed somewhat because of the Fed's zero interest rate policy and government stimulus checks, but in a normal cycle new money tends to crowd out the old.

He added that most new money entering the market goes into index funds, which cannot take part in IPOs because the new stocks are not yet in the indices.

Cramer said investors must be careful about doing the right thing for the wrong reasons, which he said happens more often than people expect. He gave the example of an investor who buys a well-run company with strong fundamentals and a good dividend. If the stock rises, the investor may conclude it is rallying for all the reasons that were originally appealing. Cramer said that is not always true, and that when investors do not understand why a stock is moving, they are likely to be confused when it reverses and to make poor decisions.

He used Procter & Gamble as an example of a consumer packaged goods company, noting logical reasons to like it, such as management, the dividend, and falling plastic and fuel costs that could raise gross margins. But he said logic is rarely what drives the stock market day to day. If an investor buys the stock for those reasons and it rises, the investor may tell themselves they were right, when the rise might come from something else. Cramer said investors should ask whether they were right or just in the right place at the right time, because it is better to be lucky than good, but investors still need to know which one applies.

Cramer also noted confirmation bias, the tendency to believe you were right all along when new evidence appears to confirm your thesis. He said investors should approach that feeling with skepticism.

Cramer used residential solar stocks as a concrete example. They soared in 2020 and 2021 and kept running into 2022, even while most growth stocks were getting pulverized. An investor might have thought they were winning because people embraced renewable energy and the government subsidized it heavily. But in 2023, Cramer said, residential solar stocks were obliterated. He said that had nothing to do with the popularity of renewable energy or the generous federal subsidies.

Instead, he said, people cannot easily afford residential solar systems without borrowing money, so the industry was built on financing rather than on solar alone. Once investors realized that long-term interest rates would stay elevated for some time, the residential solar stocks were crushed. Cramer said it was no coincidence that Enphase had surged in 2020 and 2021, when people could borrow for next to nothing.

He concluded that it is helpful to understand why a stock is going up or down. When you have a win, he said, do not lazily assume you simply got it right, and consider what it means if you were only in the right place at the right time.

A viewer asked how to identify the best companies within an industry. Cramer said he looks at who has the highest gross margins, because high margins mean a company has the biggest moat and can make the most money from each sale. He said investors do not look at gross margin enough. A guest agreed that revenue growth rate is another good measure.

The guest suggested reading the conference calls of the company, its peers and its customers to see who partners with whom. He said this offers a good indication of which company is best of breed, which has the best products and which is doing the best by its customers. The two also noted that analysts' questions on conference calls can reveal whether they are impressed or see something suboptimal.

A viewer asked about the difference between an S&P 500 index fund and a total stock market index fund. The guest explained that the S&P 500 is mostly large caps, while a total stock market fund also includes mid-cap and small-cap stocks. Over the long run, he said, there should not be much difference in returns between the two.

Cramer said that John Bogle, the father of the index fund, personally advised him to put his 401(k) in the total stock market fund at Vanguard, because over the long term the investor would be diversified away from the S&P and would own some promising young growth stocks. Cramer said he did so partly out of homage to Bogle, although he said a long period of outperformance by the total market fund was not guaranteed to continue.