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February 11, 2004

 

 

Holdings

 

 

Feb-04

1

F

2

NBG

3

YHOO

4

NKE

5

BA

6

VRSN

7

JDSU

8

CAT

9

JNJ

10

NSM

11

CA

12

FNF

13

MSFT

14

TKC

15

HMC

16

CRYP

17

X

18

AAPL

19

COP

20

WB

 

 

Performance of Individual Stocks For last 3 months

 

Feb-04

 

FNF

36.27%

COP

20.22%

CAT

10.21%

NKE

18.59%

BA

17.06%

VRSN

14.30%

JDSU

46.09%

YHOO

17.82%

JNJ

11.90%

NSM

-6.45%

CA

16.04%

F

19.66%

MSFT

5.22%

TKC

40.51%

HMC

8.12%

CRYP

13.97%

X

50.67%

AAPL

10.49%

NBG

33.87%

WB

5.51%

 

 

Total Increase (Decrease) since last quarter: 19.50%

Additions:  None

Subtractions: None

Commentary: 

 

My commentary this quarter is on asset bubbles.  Now, it is quite clear that the tech boom in the late 1990s fostered a bubble that would make even a Dutch tulip salesman sigh with how ridiculous it was.  Furthermore, the period immediately following the tech crash was marked by incredible bargains in many tech stocks.  I did foresee that the tech bubble would be followed by a period of value creation, and my purchase of several stocks such as YHOO, NSM, JDSU, CA, VRSN, and even CRYP after the tech bubble peak was well intentioned, although my timing was pretty bad in many cases.  I have been reflecting a lot about asset bubbles recently, and although I feel in the case of tech bubble in the late 1990s I was good at noticing it, I was bad at realizing how low prices would fall afterwards. 

 

So, I want to know how bubbles form, what characterizes them, and how do they normalize (a.k.a. pop or deflate).

 

My general feel is that bubbles form for two reasons.  The first is an imbalance of supply and demand, where there is either excess of demand (perhaps caused by surplus liquidity), or as shortage of supply.  However, I feel that in these cases markets are generally fairly good at reacting to changes in supply or demand, as often times these can be foreseen ahead of time and occur in a cyclical process.

 

The second reason bubbles form is that sometimes there are a range of justifiable projections that can be made about certain factors when there is considerable uncertainty or ignorance surrounding them.  The tech bubble was a good example of this.  No one knew exactly how quickly technology would reshape our society (and I still don’t think we know yet).  Since the bulk of the pricing of tech stocks was determined by projecting future growth and profits, and since such growth was inherently unpredictable, then almost any number could be justified.  My sense is probably that the investment banking community didn’t mind accepting and actively promoting exuberant growth projections for tech companies, since this process was also fueling a lucrative IPO and financing business.  Also, once a bubble like this starts, there is a dangerous positive feedback loop, as short-term results lay the groundwork for fantastic exponential projections out into the future. 

The following are some of the characteristics of asset bubbles:

 

Characteristics of Asset Bubbles

 

Asset bubbles fall into three basic categories.  There are market-wide bubbles, sector-specific bubbles, and individual stock bubbles (overvaluations). 

 

When a market moves into an asset bubble, the following characteristics often hold true1

 

  • Market indexes reach absolute historic highs
  • The average P/E ratio for the market is above its historical average and 10 year average
  • IPOs of low quality companies receive an irrationally favorable reaction in the market
  • The market develops a high speculative component, often financed by margin borrowing and characterized by short holding times for stocks by speculators
  • There is a general enthusiasm about investing and the stock market as a whole.  This can often be seen by changing media attitudes towards the stock market and the proliferation of predictions for solid growth well into the future. 
  • Relative valuations are increasingly used to justify prices that do not stand up to meticulous and honest discounted cash flow valuation models
  • Dividend yields fall

 

When a sector moves into an asset bubble, the following characteristics often hold true:

  • There is a new technology or process that is usually correctly viewed as having the potential to revolutionize human society.
  • Unsustainable growth rates are projected too far into the future by analysts, who arrive at unreasonably high asset valuations
  • Speculative trading beefs up stock prices.
  • New entrants in the sector have easy access to venture capital funding or IPO financing

 

When a stock moves into a bubble phase, the following characteristics often hold true:

  • It trades at multiples above its historic trend

 

As the three headings above show, I am much better at recognizing market-wide bubbles than sector or individual stock bubbles. 

 

I also am bad at spotting the end of bubbles objectively.  I would love to be able to spot the end of a bubble event and the subsequent overcorrection so I can pounce on the market at its low point.  Does anyone else out there have any thoughts on the topic or know of resources I can access to deepen my investigation into this question?  Thanks.

 

1Much of this comes from The Intellignet Investor by Ben Graham, pg. 193.

 

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