Dazed and Confused: Part 1

Editor's note: This is the first installment of a four-part series Jim Cramer is writing on the principles undergirding the current -- and crazy -- market conditions. Please be sure to check out Parts 2 through 4 later this week!

---

The action of the last few months has got me thinking about how all of the rules have changed in this market. It simply isn't the market of old. It doesn't work like the market of old. It doesn't have any precedent.

Sure, the 1994 thesis can play out. The Fed caused the market to derail through tightening, but once the tightening is done -- if you can buy the companies that don't have their earnings wounded by the slowdown -- you will make good money.

But the penalty of missing the rally has never been greater. And the angst that people feel toward this market wasn't lessened a bit by last week's rally. What is causing all of this stress about a market that has basically done nothing all year? Why is this tape so confused and different?

Let's talk about why this market confounds so many people and why it has more people confused than I have ever seen. I think that whether you are in the market through a 401(k), through mutual funds or through individual stocks you have to understand the degree of difficulty that this market is causing everybody. You have to know why you can switch on a dime and be right, but stay consistent and rigorous and lose it all.

First, we have to understand a couple of tenets of this new market. The first is that most of what we know about valuation of stocks has simply lost relevance. That doesn't mean that relevance can't come back; it does mean that betting on it coming back may be fatal to your bank book.

Second, we have to understand that a consistent, bullish philosophy, when applied to the Nasdaq, might have caused you to get wiped out. In other words, this downturn was so severe that if you just stuck with a "Nasdaq 6000" mantra -- the true bull case -- you could have lost it all, especially if you were margined.

Third, the stakes have gotten so high in this game and the pools of money have gotten so big that it is entirely possible for prices to be "rigged" by buying or selling.

Fourth, anything short of a totally flexible policy, one where you can admit that you are wrong, is too rigid for this market. It will lead you astray. Extremism in either direction, bull or bear, is not a virtue.

Let's take these tenets one at a time and see if we can flesh them out to explain the problems and pitfalls of this market.

Valuation

When Cisco (CSCO Quote) was at 50 two weeks ago, going to who knows where on the downside, the fault of the stock was valuation. So said the analysts, the owners, my emailers and the talking heads on TV. They thought the stock had gotten away from valuation parameters that made sense and had to go back to the traditional kind of valuation we are all used to: If Cisco grows at 30%, it can logically sell at twice that growth rate and not that much more, so give it a price-to-earnings ration of 60, and that's where it is headed.

Ten days later, Cisco is at 64. Now, nobody gives a hoot again about valuation. All of that hand-wringing and revaluation mumbo-jumbo was for naught? Maybe. That's what angers so many people about this market. It is the single biggest sore point between those who have been in the market for a long time and those who just got in. Those people who have been picking stocks for years on certain valuation methodologies, simply find those methodologies irrelevant -- until the stocks start going down and then the methodologies become relevant again. But then the stocks stop going down for some other reason and the relevance goes away again.

For a stock professional trying to rationalize investment in this market during a time when his clients understand and know the market better than they ever have, this kind of behavior simply can't be explained. How can you think that Cisco is about to roll over at 50 on valuation purposes and then love it at 64 for momentum purposes? The answer, of course, is that it can't be explained. When I talk with analysts and strategists about stuff like this, they really don't know why it is happening. They don't know how Cisco got valued where it went to, other than to try to explain it as a function of momentum, or inability of holders to sell or "leadership." It is nothing you can get your arms around. It is nothing rigorous or even intellectually honest. It is simply a fact: "Cisco is overvalued, but so what?" (I am picking on Cisco, but I could have used dozens of other stocks to fit this description.)

Some of you demand that it be explained. Some of you say that it is impossible for these overvalued companies to "grow into" their multiples because of the law of large numbers. They can never grow to where they would have to grow to be valued reasonably on earnings. I can't disagree; that seems very logical to me. But remember my goal as a money manager: It is not to dismiss valuations of stocks, it is to figure out how they are being valued and exploit that for profit. Sometimes, this is just Buzz and Batch reasoning: It works, so I will do it until it stops working.

At times I don't think this market gives a hoot about valuation. It is looking at "raising the bar" -- as in, "If management raises the bar at the end of the quarter, the stock goes higher, even if it is overvalued to begin with." Other times the market simply says, "Cisco is a great company with great management and, as long as that is the case, it can go higher."

The pure subjectivity of that claim, the pure hubris of it -- as if management can somehow take a stock out of the realm of valuation parameters -- rankles many of you. It particularly bothers those of you who are used to traditional measures, so much so that you must hate Cisco with a passion by now. I have no salve for you. There is no balm to make that valuation go away. To simply short Cisco because of it is a losing strategy, too, because the stock has gotten progressively valued at a higher level for a couple of years now.

I keep hoping that a more logical valuation matrix will emerge. We tried to use revenue instead of profits, but the market came back to profits with a vengeance in April and pronounced any company that wasn't profitable a short or a company that could go out of business. I kept thinking that rates were headed to some incredibly low level that would justify the prices we are paying for growth, but they didn't.

So, like others, I threw my hands up and joined the party. I couldn't make a good reason up. It is one of those strange things about the business that every pro knows: We don't belong here, but so what? We have to make money. If you can't stomach the lack of rigor, you don't have to own Cisco or any other stock. And if you think the whole thing is a house of cards, you can short Cisco and profit from it when we all come to our senses.

Either way, you could sell 5 million shares of Cisco down a buck, which is all the proof I need to say, "That's where it should be valued."