Revisiting Price Compression

by: Cullen Roche

Five weeks ago I posted some thoughts on the concept of “price compression” (see here). I said:

Price compression is when market participants price in many years worth of future performance into the current price. They are, in effect, buying today with the expectation that future earnings will justify current prices. When you combine this concept with an understanding of behavioral finance and the understanding that market expectations can become irrational, you can build some understanding behind the concept of market bubbles. As I’ve described before, A bubble is an environment in which the market price of an asset has deviated from the underlying asset’s fundamentals to an extent that renders the current market price unstable relative to the underlying asset’s ability to deliver the expected result.

Along with that explanation I posted a chart of the iShares Biotech Index saying “Who buys stuff like this?” Since then, the index is off 15%. I wasn’t making a market call. In fact, the purpose of this concept is not to make market calls. But to be able to understand certain market dynamics and when the market appears to be getting ahead of itself.

The concept of price compression isn’t intended to help you time bubbles or short the market. It’s a concept that helps us merely identify markets that may be a bit irrationally exuberant or irrationally bearish. In better conceptualizing the markets through an understanding of pricing dynamics, we can be better prepared to manage certain risks that will inevitably arise.