Saturday, June 07, 2008

First tech stocks, then real estate, now oil

I can now say, based on the chart (left) that Oil is now in a "bubble" - where fundamentals or rational analysis have nothing to do with valuation.
The market is ignoring new significant finds in China and Brazil, declining demand due to economic softening., among other factors. Yes, the US dollar is tanking, but that does represent the run up in price (see right) over the past two years. Fundamentally, with the dollar where it is, my stab is that "fair value" is closer to $70 than $130.

Comapre with the run up of the NASDAQ 100 from 1995 through 2001 (below):

Notice the similarities - starting in 1998, the NASDAQ 100 stopped trading on fundamentals, with speculators (i.e. day traders) making wild profits, IPOs being easy money, and talk of a "new paradigm" of valuation, where analysts justify even wilder P/Es even through cash flows and sales don't support them.
My experience on this was first hand. I was working as a broker for a firm up in Canada, and I have several stories about the irrationality of investor behavior. I had one client - married couple, whom I invested their RRSP (for those of you in the US, think IRA) in a balanced portfolio of stocks - both domestic and international, some growth and some value, bonds, and cash. They had a 12% total return in 1998 and they fired me because their friends where invested in tech and were averaging 35%/year and were furious that I wasn't making them 20%+. I had another client who kept buying Nortel stock, even though I did a comprehensive analysis showing it was way overvalued - when it finally tanked in 2001, the client lost $4 million from the time I pleaded with him to sell.

Now, since I'm on a chart fetish, lets look at US real estate prices using the Case-Shiller Index. This chart from the New York Times shows you the run up through mid 2007. As we know, the index has dropped precipitously since then:
We are all aware of this chart - once again, the same facts. An asset (Oil, Tech stocks) starts showing appreciation, then speculators jump in. Initially there are easy profits and they are disproportionate relative to historic returns. As speculators continue to enter the market, pricing no longer is based on fundamentals (in the case of housing, it has no bearing on median income) driving beyond reason until there are no more marginal buyers and the prices collapse.
There is a historical pattern. It repeats itself because human nature is constant. When there is easy profits, speculators jump in, drive up the price well beyond fundamentals, until a point where there there are no marginal buyers and the price collapses from lack of demand. The question at hand, though, is when will the tipping point occur, and what will the top be. We'll only know in retrospect.

1 comment:

Toronto Realtor said...

Nicely written, interesting graphs. I very much agree with you that we're always going to see a pattern here. It always has been happening and it always will. After this crisis will be over, huge amounts of new business will emerge and we can begin the natural cycle again. Great article,

take care, Elli