Like the soap bubbles kids like to blow, stock market bubbles often appear as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.
The South Sea Bubble
During his lifetime, Sir Isaac Newton experienced one of the most famous stock market bubbles in history... the "South Sea Bubble." In the early 1700's, the South Sea Corporation was granted exclusive trading and shipping rights to the entire area we call South America. Obviously, this was a pretty big deal at the time, so the price of South Sea stock started to take off.
Sir Isaac Newton was an early investor in the company, and after initially doubling his money, he wisely sold his shares. However, as the stock continued to go up, he suffered a painful experience… had to watch all of his friends getting disgustingly rich while he was sitting on the sidelines. He eventually bought back in (this time with a whole lot more money), only to suffer enormous losses when the bubble collapsed.
After this financial disaster, Sir Isaac Newton could not bear to hear the phrase "South Sea" mentioned in his presence. Of his loss, Sir Isaac Newton is quoted to have said, "I can calculate the motions of the heavenly bodies, but not the madness of people." By letting the roar of the crowd override his own judgment, the world's greatest scientist acted like a fool. He simply did not have the emotional discipline that successful investing required.
Likewise, those who own shares in Netflix (NASDAQ:NFLX) are making the same stupid mistakes as Sir Isaac Newton. They let other investors' judgments determine their own. They have completely ignored the most important rule in investing, which is to always ask "How much is this stock worth?" Most painfully of all, by losing their self-control just when they need it most, these people prove that the investor's chief problem - and even his worst enemy - is likely to be himself.
The Invisible Earnings Experiment
Every time I speak to Netflix investors, I am reminded of the now famous Invisible Gorilla Experiment. In this experiment, researchers constructed a short film of two teams passing basketballs, one team wearing white shirts, the other wearing black. The viewers of the film are instructed to count the number of passes made by the white team, ignoring the players wearing black. This task was difficult and completely absorbing. Halfway through the video, a woman wearing a gorilla suit appears, crosses the court, thumps her chest and moves on. The gorilla is in view for approximately nine seconds. More than half of people who watch this video do not notice anything unusual. It is the task of counting, and especially instructions to ignore the other team, that causes the blindness.
Netflix's management is using a similar tactic on its investors. Just like the researchers were able to make the gorilla invisible by keeping observers intensely busy counting passes, Netflix's management has made its lack of earnings and ridiculous valuation invisible by telling everyone to focus on subscriber growth. Although this is a very clever trick, and has been very profitable for insiders, it will not work forever. Eventually investors will realize they have been fooled.
In fact, it takes little effort to show just how overvalued Netflix truly is. For instance, even if we ignore the company's temporarily inflated earnings, the stock is still trading at nearly 280 times trailing earnings (based on a market capitalization of $19.7 billion). Even if the company doubled its TTM revenue from $4.1 billion to $8.2 billion, and somehow achieved a net profit margin of 10 percent (above its historic norm), the stock would still be trading at over 20 times earnings based on the current price investors are willing to pay. In other words, even if Netflix is able to achieve this spectacular performance, the stock would still be overvalued.
Sell Before This Bubble Pops
The easiest explanation for stock market bubbles is that people simply get carried away. They hear these wonderful stories of their neighbors getting rich and they want a piece of the action. They figure, somehow, that the price of stocks (1929) or dot-com start-ups (1999) or real estate (2006) can only go up. In the end they are always proven wrong.
Similarly, those who allow themselves to get suckered into buying Netflix will also eventually be proven wrong. Once they finally realize that Netflix is just an overvalued movie streaming company with no competitive advantage, the stock will crash. Do not make the same mistake Sir Isaac Newton made, sell this bubble before it pops!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.