Author's Note: I attempted to publish this last week, and unfortunately it would have been a nice heads-up on the serious run that RIMM has had since then. However, Seeking Alpha editors are looking for primarily fundamental analysis, and this article is focused on actual investor psychology and a bit of my methodology, which is a primary technical study with fundamentals used as a complimentary tool (i.e. how far disconnected is psychology with fundamental reality).
As such, I've decided to post this up as an instablog, because I would like the community to become familiar with where I, as a trader and writer, am coming from. Part 2 and 3 will have more of a fundamental focus, as I am dealing with current situations in those instances, not historical ones, whose fundamental measures are more readily available and paint a clear picture.
Thanks for reading.
A Great Story, And When (Or If) You Should Play It - Part 1
Living in the era of concentrated financial bubbles has given modern day investors a chance to see the cycle of human expectations play out several times within the last generation. Instead of financial and asset class bubbles being something our grandfathers talked about, we have had at least one major financial or asset bubble per decade. Many of us have studied the charts and time-lines and social, economic, and monetary backdrops to these astounding events, and there are some interesting conclusions to be drawn.
There has been some brilliant, well researched, and objective works written on human manias, and I won't attempt to rehash those works here. What I will attempt to do is to point out some of the commonalities from a speculative investment point, and how we, as investors, can maximize potential gains and find asset categories or single investments that have the absolute worst baked into them post-bubble, while retaining their integrity as investment assets.
Leaving aside the obvious exacerbating contributor of an infinitely replicable monetary unit and its propensity for pushing hot money into something in a self-feeding loop, there are forces a lot more base than our current Buzz Lightyear monetary system at work when a bubble plays out. I am referring to raw human psychology, and how someone can get sucked into what we recognize later as a "maniacal" herd of human beings doing what we later see are pretty zany things with their money, but they can do it while seeming to retain all of their rational faculties at the time. i.e. why normal then is very different than normal now.
Many have seen this basic bubble-model chart. It sums up the herding mechanisms succinctly, and can be overlaid on top of almost any actual chart of a financial mania that occurred. The more segregated the asset class against all existing capital, the more likely it is that it will exhibit the "perfect chart".
Here's the general model:
We can see the basic components - base-building, then expanding early-adoption, then finally seeing widespread adoption and a mad blow off around the time the "new normal" is declared and everyone believes it.
Bubbles are about conviction. They boil down to the belief that a) an existing trend will continue in the future, and b) someone will be willing to pay more in the future for what you are buying today. They also demonstrate that human beings tend to do things in groups, as our core desire for safety drives us to.
We feel it all the time. If we walk into a restaurant for the first time, many of us might take pause if there are no patrons in it - the absence of our peers cause us to question whether we are making a good decision to eat there. But if the booths and tables are at least moderately full, we take an instinctive comfort in that we have made a safe decisions that is being verified by our peers. We react even more instinctively to intangible assets, more abstract concepts like tiny fractional ownership of a business that we aren't directly involved in and have, in reality, limited information about. Long-term value investors rely on inductive reasoning as opposed to deductive - that the existing observable evidence allows us to draw reasonable conclusions. It is what we treat as evidence that causes us to herd, since our psychological mechanisms tend to react positively to re-enforcing actions by our peers - in other words, the fact that other people are buying a stock and driving up the price gives us a little emotional and instinctive nudge to do the same, and when the selling is on, the same occurs. Because our inductive reasoning methods are crippled by intangibility, the fact we can't make rational observations that are the same all the time (i.e. I notice that every day the sun rises from the east, therefore I think that tomorrow, the sun will rise from the east) lead us to "follow our gut" more than in any other area of life.
If an investor can overcome this and look at investments as objectively as possible, they will be primed for successful decisions, including a proper reference to time. The tiny minority of investors who understood panics and value and the time-tested purposes of investing purchased blue-chips for a song near the bottom of the great depression. They took tens of thousands of dollars at the time and turned them passively into tens or hundreds of millions of dollars and millions per year in passive income for their grandchildren. Meanwhile, even the major financial institutions of the time had fully bought into the "new normal" bull market, to the point where they thought that a group of them could stave off market decline - this just goes to show that everyone is and can be subject to these mechanisms.
My underlying thesis, why a truly contrarian investment approach that focuses on the information we can get about intangible assets and holds it up against a backdrop of human psychology (why technical indicators are extremely important), is that human investment behavior towards intangible assets that seems rational at the time, is almost polar opposite to human behavior toward tangible assets.
Case and point: What would you do if you walked onto a used car lot and the salesman came out to you, proclaiming "Hey, you should check out that 2007 Civic over there. The price has rallied 30% in the last month. It's a great time to buy it". You would probably look at him like he had two heads. If a shoe-salesman told you that a new line of shoes had rallied in price by 40% since being introduced into the market last year, would you be more inclined to buy them?
And yet, our stock-broker will call us and tell us that AAPL has rallied 10% the last month, therefore it's a great time to buy, and we treat this as though it's a completely rational way to approach investing. We might still feel a little nag of doubt at the prospect of risking money, but the argument is convincing enough for many investors.
I am not going to claim that no herding occurs within the physical investing world, however much of that type of herding can be attributed to a backdrop of herding in an intangible asset that drives the physical good or service. Real estate is a great example, because it was driven by the herding towards the intangible - the belief in the extrapolation of the trend, a feeling of security and assurance about the future (else debt levels would not have skyrocketed), the fact that other people were demonstrating huge success in real estate (touting unrealized gains), and that - because of the credit-for-all-forever mentality of the fiat monetary system - there seemed to be an unquenchable thirst for MBAs and other instruments that kept the originating credit facilities churning out new digits. Essentially, we have seen so many bubbles over the past 50 years, because they are microcosms - bubbles within bubbles that get blown up because the media by which rampant speculation can occur is so readily available.
Since bubbles have been a wider field of study post-2008 meltdown, I won't dwell specifically on the modern bubbles - 1970's commodities, 1980 silver, 1980's Nikkei, 1990's internet, 2000s real estate, 2008 commodities, and 1980's - 20?? government bonds. Instead, I will focus on the internal aspects of a bubble, whether long-term or not, and how we as investors can take a rational approach to investing and apply a constant understanding of human psychology in order to maximize opportunity.
Question 1 - what is a Great Story? Is it an "investment"?
How do we measure a bubble, how do we determine what is just a "great story" versus a true long-term opportunity that gets carried away and taken to extreme levels of resource misallocation?
The first thing that someone needs to ask is whether this story can actually become a usable and profitable reality, and therefore profitable - is this "story" a) possible, using verifiable evidence from independent sources, b) an extrapolation of an existing trend, exhibiting the participation characteristics of a bubble, and c) going to produce something on an entrepreneurial level that will generate an actual income/cash-flow and give value to you, as a shareholder.
An Investment is something that generates a yield. Preferably a direct cash-flow yield straight to the investor (profit sharing or a dividend), however an internal yield (i.e. a company that does not pay a dividend but builds net equity for shareholders over time through profitable operations, thus increasing net cash-per-share value) is also acceptable. Buying something regardless of internal metrics, valuations, application, etc., with the expectation of someone paying a higher price at a later time is not an Investment, it is a Speculation (which is what all bubbles evolve into).
Let's look at the most systemic bubble to recently pop - Real Estate. Using the idea that an Investment must be a positive cash-flow entity, the idea of just buying a house and calling it an "investment" is ludicrous. Under normal market conditions, it is widely understood that a house is a depreciating asset that requires inputs from its owner in order to simply maintain its physical state and not deteriorate into worthlessness. i.e. a house is actually a negative cash flow asset, unless it is able to generate an income that at least covers its depreciation and service. Purchasing a house to rent out to tenants, covering the mortgage payments, bills and upkeep, is considered an investment. Purchasing a house with the hope that someone will pay a higher price for it later, while you are actually bearing the carrying costs, is a Speculation.
Somewhere along the line, what is a speculation becomes regarded as an investment by the participating public. Most people wouldn't refer to themselves as speculators, but investors, and when an asset class enjoys widespread speculation by "investors", you can pretty much bet you are looking at some scale of a bubble.
This is where a sub-set of the bubble psychology can be applied as an investor. The Innovation Cycle/Hype Cycle
As investors, if we seek out deep-value assets, likely to generate positive cash-flow through the productive use of whatever has attracted these expectations, and we can see the expectations play out in the price and demand signals, we can hop onto the "slope of enlightenment" and take significant yields during the actual productivity phase.
Case and Point: The Internet
The idea was beautiful, and has become even more beautiful. That information could be shared instantaneously and simultaneously between any computer connected to a massive "web" of like machines using standardized protocols. A new platform for humans to engage, a means of freeing up billions of dollars of human capital devoted to tasks that could now be automated or instantly replicated. A means of opening up new markets, entirely new channels of doing business. The potential was enormous.
And so the speculative internet bubble was born. It morphed into a massive asset bubble in what amounted to mostly "stories", now-infamous IPOs of companies, some of whom hardly had business plans, let alone means of generating real revenue within 3-5 years. The game plan was to generate traffic first and figure out a way to make revenue later. Looking back, we wonder how it was possible for so many people to invest hard-earned money into what were so many pipe-dreams.
I encourage you to read this report on the valuations of IPOs during the dot com boom. It measures just how manic things really got. A few highlights:
- Median Age at Issue from 1996-1998 was a fairly regular 14-17 years, but, by the time the 1999-2000 period rolled around, it had dropped to a staggeringly low 4-6 years (this includes non-internet IPOs - the age for internet stocks specifically was far less) - Median revenues, including those of non-internet IPOs, fell from $22.9 million for the average IPO in 1996, down to $10.6 Million in 1999
- Median book equity (before a cash infusion via the IPO) actually fell to negative by year 2000, meaning investors were actually paying cash value for something worth less than 0, excluding their own cash.
- The number of issuing firms losing money was 44% in 1996. By 2000, it had risen to 80%
- Even while the number of negative-cash-flow IPOs increased to 4 out of every 5 companies, the average first-day gain of an internet IPO jumped up to 89% in the year 2000
- The average P/E for an IPO, of the 20% that were profitable, was 79.0 in 1999, and 80.3 in 2000
Clearly something was wrong. All of the traditional, time-tested methods of valuing businesses and their operations were tossed out the window. The "new normal", "new economy" was embraced by all. Equity ownership levels were at the highest level ever in US History.
And here is the NASDAQ bubble chart:
Now, the context of bubbles and bursts must be established in order to build a strong case for the contrarian investment approach - namely, that we are seeing an exacerbation of the visible signs of bubbles within price signals by the sheer volume of money running from place to place. The means of speculation - a surplus of money due to central bank activity, and where that surplus of money ends up - itself enables a continuation of bubble-blowing and bubble-bursting.
The current monetary situation is not going to change until a true debt liquidation can occur, since all artificial booms must follow by a subsequent bust to wipe out the capital that has been misallocated towards an artificially long time-preference. When interest rates are suppressed alongside an artificially expanding monetary base, capitalists are receiving price signals - arbitrary, not real - that consumers are foregoing current consumption in favor of consumption in the future. Interest rates tell entrepreneurs just how much saving is going on (how large is the time preference), versus how much current consumption is occurring. This tells entrepreneurs to invest in longer term projects, since debt service rates are far lower (think borrowing $1,000,000.00 at 8% interest versus 4% over 10 years). Under normal conditions, it would also innately signal to entrepreneurs that consumers would actually have the savings in the future to spend on whatever product or service this capital investment creates. The importance of interest rates to economic health cannot be overlooked - they are the price signal upon which all other price signals are built. It is to the great detriment of the world that interest rates are arbitrarily determined and not based on actual metrics and real human actions.
Until such a liquidation occurs, businesses attempting to make accurate forecasts on consumer behavior and real savings/consumption rates are going to be in trouble. The underlying fundamentals of the existing economy are worse-than-shaky. Case in point: Last quarter, 88% of the earnings growth in the S&P500 came from just 10 companies. This type of hyper-concentrated growth can only come in an economy that is highly centralized, because its medium of exchange and store of value is highly centralized, and the price for that medium is highly centralized - especially given that, of the four companies contributing 50% of earnings growth, three of them are financial firms on tap for the limitless flow of cheap money from the Federal Reserve. This is very telling.
So here we find ourselves, seeing bubbles within bubbles within bubbles that continually burst and leave a wake of damaged speculators. As contrarian investors, we can seek out opportunities within this mess, but we must pick and choose carefully, attempting to use the same sort of reason that we would use in our physical lives, understanding what would constitute an investment and a speculation (which both have their place)
Going back to the NASDAQ bubble and the mass wave of what we can now see as irrationality, how do we sift out the chaff, which is all too common during speculative bubbles, and the real goodness. How do we know when that goodness is realistically priced, or - hopefully - far under-priced because of uncertainty. Within every speculative bubble, there is a nugget of gold. As contrarian investors, patience is key, because it is only through the burning process that the impurities are removed and the true value is revealed. While everyone is licking their burns, is when a contrarian investor is seeking opportunity.
Let's apply the idea of utility to the broad medium in which the overall Nasdaq bubble took place - The internet.
By 1997, it was very easy to determine that the internet itself was a growing and usable idea.
Home PC Ownership (the only consumer means to access the internet at the time) was continuously increasing, while the price of computers kept coming down (indicating wider market participation by producers). Internet usage was exploding alongside the NASDAQ bubble, but continued to climb even as the prices of the "new economy" crashed off. As a good stress test against a "fad", we saw the increase of real participation within the tangible world, where human beings are capable of making more rational decisions with better information, even while the intangible investment side was imploding through 2003. The contrast ended up being a further 50% increase in internet subscribers during the collapse of the bubble, and a stunning drop of almost 70% in hardware costs on consumer side, meaning physical access to the internet was cheaper than ever.
So, we have an exploding new frontier of communication and commerce against a collapse of the assets which were meant to use it to generate profit. This is a fantastic place to start looking for opportunities as a contrarian. This is where the names that made it through the other side while exhibiting actual, tangible measures of growth and breadth begin to look very cheap. EBAY, Apple, Intel, etc. By waiting for the chaff to burn away, we can pick through the good assets that remain and build a strong and safe position that will generate superior returns over time.
This is the price/demand curve for products and services within the real world. It boils down to this: Lower price generally equals higher demand for a given product.
I posit that the price demand curve for intangible, financial assets is the exact opposite of any product or service. That, while lower prices induce higher demand within the tangible world, higher prices actually induce higher demand within the realm of individual financial assets.
Let's take a look at some examples to see if the evidence verifies the thesis:
The correlation between increasing price and increasing volume is extremely high.
Another high correlation between asset prices and total volume in a stock that experienced a tremendous run-up and blow off
A current expectations-bubble being blown up in 3d Printing (something I will cover in-depth in a later PRO article). Again we see that high correlation between price and volume - not just Dollar Volume, but actual volume of shares traded per day, meaning multiples higher numbers of dollars seeking to purchase this asset.
There are, of course, always outliers. Internal volume divergences are actually a very handy tool that can point out a trend reversal ahead of time, or signal a "paradigm shift" towards a specific asset. Coupled with diverging internals, this is one of the key indicators I use to determine whether a trend is about to change. Pairing internal technical analysis with an outside a good business model not only tells you where you can find a good asset, but when that asset is cheap and pessimism is far overdrawn.
A recent example is my call for a trend change on RIMM
In "A Great Story, And When (Or If) You Should Play It Part 2", I will discuss a few asset classes that investors should avoid, because they are "great stories" far more than they are - or will be in any realistic time-frame - great cash-flow-generating investments, and should thus be avoided. In Part 3, I will cover a few assets that are ripe for a trend change, and are beginning to enter their productive phases of generating real growth. Part 2 and 3 will be published on Seeking Alpha PRO.
If you have any questions or feedback, or are looking for coverage or thoughts on any particular assets or individual companies, please don't hesitate to fire me a message off through Seeking Alpha's interface.
Disclosure: I am long RIMM.