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Laurence Lavelle
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I have been investing and trading since 1998 in multiple markets and timescales using both fundamental and technical analysis within cyclical and secular psychological and economic trends. Follow me on Twitter: ‏@LaurenceLavelle Faculty Page: Author Page:... More
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  • Crowd Psychology Makes For Irrational Decisions Or When Not To Buy: A Visual Primer

    In my article Frontier Markets: An Antifragile Suggestion I made the observation that frontier markets contribute to a more diverse and hence robust portfolio as they exhibit far less correlation with world markets: "For example the Mongolian MSE 20 versus the MSCI World Index has a 5 year low correlation of 0.28 compared to a very high 0.91 for the MSCI Emerging Market Index versus the MSCI World Index."

    Also included were related comments on the drawback of electronically connected markets, trend trading, computer trading, and crowd psychology - a powerful mixture that often results in unrealistic and poor investment decisions. The consequences of these poor decisions (buying manias) are multiple negative outcomes. One such negative outcome is the poor allocation of capital which depletes productive companies and countries of much needed capital to develop.

    Instead of grinding through tables of numbers and the never ending debate of which numbers are valid here is my Visual Picture of When Not to Buy (along with some obvious valuation metrics). All examples are US equities and indexes trading on US exchanges with y-axis price in US dollars for equity prices.

    The NASDAQ circa 2000 is full of examples of crowd exuberance gone wild, here is one visual picture Rambus (NASDAQ:RMBS):

    (click to enlarge)

    Hard to believe that so many, including professionals (fund managers, analysts, etc.,) saw high prices as their reasoning for even higher prices. At its current ~$9.40 per share Rambus (RMBS) market cap is ~$1.0B. Buying Rambus (RMBS) at any time during 2000 was not a prudent investment, yet so many did.

    Let us move onto visual exhibit B. This time not a hot-technology must-own forget-the-fundamentals stock, instead the venerable highly-respected Citigroup (NYSE:C), one of Wall-Street's pillars with its history starting with Citibank in 1812:

    The green line on the lower right y-axis is Citigroup's (C) current price ~$49, with a current market cap of ~$150B. I recall my early investing days 1999-2000 refusing to buy Citigroup (C) because I could not figure out why C was so highly valued with a market cap larger than the GDP of most countries. I never did figure it out, instead I looked at a plot like the above and knew buying in 1999-2000 did not provide a margin of safety for any type of long-term investment.

    Buy-low, sell-high seems so easy to say and write yet the madness of crowd psychology is ever present and made worse when investments are based on relative performance and momentum investing. When any investment is bought at a low price there is always a greater margin of safety irrespective of current and future market conditions, company performance, and macro-economic trends.

    But enough of the past, what of our current times?

    • The majority have learnt from recent prior buy-high mistakes, right?
    • The same talking heads and investment professionals who promoted internet stocks in 2000, and banks and real-estate in 2007 are not on TV, right?
    • With margin debt currently over $100B higher than the crazy-keep-buying-momentum margin-peak in 2000, people must be buying low priced bargains on borrowed money because they know what happened buying peaks on margin in 2000 and 2007, right?
    • With such strong gains over the last 4-5 years, along with many high valuations, analysts must be issuing sell recommendations with the majority of money managers and investment professionals agreeing, right?

    Unfortunately the answers to all the above questions are a resounding NO. In addition initial public offerings and secondary offerings are being pushed out the door rapidly, as they were in 2000 and 2007. The very smart and prudent 1% (or less) are selling everything that is not nailed down at yet again high prices.

    Here is our current visual picture by way of the S&P 500 Index:

    Below are a couple of individual-stock visual-primers suggesting what not to buy now when looking for investments.

    Tesla Motors (NASDAQ:TSLA) has a current $21B market cap, no earnings, price/sales 15 (industry average 4), price/book 32 (industry average 7). Living in Los Angeles I see them every day, love the car, but would not buy the stock now.

    LinkedIn (NYSE:LNKD) a useful and clever resource, but if the above visual picture does not raise your caution flags then maybe these numbers will: $27B market cap, price/earnings 633, price/book 22 (industry average 6).

    I'll end this visual primer with Z for Zillow which is a "home and real-estate marketplace" with a current $3B market cap. Nothing ever goes wrong with the real-estate marketplace … .

    In my third article I will make the case for price prudent investments that 99% consider too risky yet they have risk/return ratios far lower than the above examples and with macro-economic trends more favorable than the US. Yet they are starved of capital as the investing majority, yet again, chase trends that rational analysis would conclude is a risky allocation of capital and hence poor investment.

    I have intentionally written this as straight-forward as possible with simple graphics. The rapidly rising price and index charts above can be analyzed and described in several different yet related ways. Basically when stock prices, stock indexes, oil price, gold price, bonds, etc., need 6th order polynomial math functions to curve fit the price of tulips, internet stocks, etc., because an exponential curve fit is not steep enough you know it is a buying frenzy that will end badly. Another way of saying the same thing is when every dip is bought and the buying happens more frequently with shorter periods between milder dips - there is going to be a vertical rise in price that will end badly. These are referred to as log-periodic curve fits (otherwise known as bubbles) that end with a finite-time singularity and have been analyzed by Didier Sornette in detail (who was in the UCLA Geology building next to my building when he wrote, "Why Stock Markets Crash: Critical Events in Complex Financial Systems"). For a non-math description of mass investment delusion my favorite is John Kenneth Galbraith's, "The Great Crash 1929".

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Oct 15 3:06 AM | Link | 18 Comments
  • Frontier Markets: An Antifragile Suggestion

    International markets across asset classes have increasingly become interdependent making what should be balanced portfolios more volatile.

    The internet has facilitated instant communication but intra-market and inter-market correlations result from headline noise, or 'news' depending on one's viewpoint, and the growing appetite for trading trends replacing fundamentals. The former, technical analysis, is a useful tool but it is not a replacement for sound productive investments and long-term balanced portfolios. Technical analysis in the hands of computer trading programs ("algos", "bots") and their high frequency trading cousins can and does lead to huge and nonsensical swings in individual stocks, ETFs, and entire indexes. May 6, 2010 is a well-known example with US equity markets and individual stocks undergoing wild swings: the Dow Jones Industrial Average (DJIA) plummeted 1,000 points within minutes and Proctor Gamble (PG, market cap ~USD200B) dropped 37% instantly - the second part of its name taking on new meaning. Less well known but just as crazy algo trading occurs daily and can be seen in all asset classes (stocks, ETFs, options, gold futures, etc.).

    Correlated intraday trading trends are also seen real-time across international markets that are plugged into this electronic world, and their longer term performance is correlated as economic news and numbers, along with political, fiscal, and monetary policies impact developed (USA, Germany, France, etc.,) and emerging markets (China, India, Brazil, etc.,). For example a portfolio with investments in American, Chinese, and French companies as part of the S&P 500, Hang Seng, and CAC 40 respectively, would be considered by some investors a diverse equity portfolio. The 6 month plot below shows they are very much correlated and such correlation does not make a robust or antifragile portfolio which is the objective of diversified equity investments.

    6 month plot ending October 4, 2013 (click to enlarge)

    Stock markets that are independent and therefore contribute to a truly diversified investment portfolio are frontier markets (Mongolia, Pakistan, Sri Lanka, etc.,). They trade independently of daily international news and their longer term performances are significantly less correlated to developed and emerging stock markets and economies. For example the Mongolian MSE 20 versus the MSCI World Index has a 5 year low correlation of 0.28 compared to a very high 0.91 for the MSCI Emerging Market Index versus the MSCI World Index. Few investors appear to be aware that the traditional emerging markets do not give the performance diversification they expect. Whereas frontier markets, as one part of an investment portfolio, do add true diversification creating more rounded, robust and hence antifragile investments.

    In a related article I will discuss the drawback of crowd psychology, trend investing, and how they negatively impact investments and markets with huge potential.

    Highest positive correlation: 1.0
    Highest negative (inverse) correlation: -1.0
    No correlation (essentially noise): 0.1 to -0.1

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: long-ideas
    Oct 09 6:21 AM | Link | 11 Comments
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