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Crowd Psychology Makes For Irrational Decisions Or When Not To Buy: A Visual Primer

|Includes:C, LNKD, Rambus, Inc. (RMBS), TSLA, Z

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)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.

Footnote:
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.

Stocks: RMBS, C, TSLA, LNKD, Z