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The easiest way to spot a market bubble
Have investors learned nothing from the late 90s?
Each time a market bubble bursts, the usual fools on television and in the press cry that capitalism has failed and must be reformed, despite the fact that market bubbles have nothing to do with capitalism and everything to do with human psychology. The psychological atmosphere that enables investors to go berserk over investing prospects, disregarding all rational norms of value, has occurred numerous times.
Supply and demand determine the price of stocks on the stock market. When it appears a company will earn more in the future, stock values tend to climb. Investors may then purchase more of the stock, causing prices to rise even further as a result of greater demand. This can lead to a feedback loop in which investors become swept up in the euphoria and ultimately drive prices well above their inherent value, thereby producing a bubble.
All that is required for a mania to cease and a bubble to collapse is for the masses to realize that the stock price greatly exceeds its intrinsic value. That was the case with every mania. Suddenly, demand decreases. The market falls as prices plummet to absurdly low levels, and the bubbles explode. Today, academics spend a great deal of time and effort attempting to predict what produces a bubble and how to avoid one.
As is typically the case with academics and experts, they tend to overcomplicate matters and frequently make mistakes. Therefore, I want to introduce you to an approach that I personally employ to avoid investing in stocks that are caught up in the euphoria:
The invention of “New Metrics”
First, regardless of whether a business is public or private, there are simple guidelines that apply when determining its worth. They are separated into hard and soft factors. Hard factors include profit, margins, free cash flow, revenue, and so on. In contrast, soft factors include the rest, such as corporate culture, managerial integrity, and economic moat. If investors are obsessed with a stock, yet the company loses money on each transaction (as is common in new, fast-growing industries), they are entering a fantasy world and construct New Metrics to justify their purchase and explain the rising prices:
“If fundamentals don’t explain the rising price, then it must be something else.”
This brings us to ridiculous ideas such as the number of website clicks (in the late 90s) or the number of products sold (Analysts love to mention how many cars Tesla TSLA 0.00%↑ has sold, ignoring that each sale lost them money for a long time). Imagine valuing Hershey HSY 0.00%↑ by how many candy bars they have sold. Or McDonald’s MCD 0.00%↑ by how many BigMacs they have sold. Or a bank by how many clients walked in. Sound ridiculous? Right, but that’s what happens all the time during market euphoria. New Metrics get invented while timeless investing principles become a thing of the past.
No amount of customers, new signups, cars sold, products sold, etc. matters over the long-term if the company is losing money and the revenue doesn’t transform into profits. Fundamentals matter, because they are reflected in every dollar you invest. And you want to buy the best fundamentals for your money.
If the price of a stock rises quickly, investors assume that there must be fundamental reasons for the new, higher price levels. Why else would prices have risen? Although the argument is twisted, it has been essential to the decision-making of many investment experts for some time.
The reality that tens of millions of investors, captivated by the thrill of new technology and encouraged by experts, pump hundreds of billions of dollars into such equities, making their growth a self-fulfilling prophecy, simply escapes them. The fundamental motivating mechanism is momentum: large and quick price increases that created the notion that such increases would continue indefinitely.
You don’t need fancy academic research to predict bubbles because the easiest way to spot such euphoria is to watch out for New Metrics. As valuations enter fantasy land and fundamentals become a thing of the past, you know that sooner or later you’re dealing with the inevitable collapse.
“Every business owner knows that at the end of the day, all that matters is the amount of money in the cash register. Not how many customers walked in.”
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