There are two popular strategies for investing. The first is value investing, which relies upon the firm foundation theory: http://smallivy.wordpress.com/2010/04/02/firm-foundations-and-castles-in-the-clouds-part-1-firm-foundation/. The second is momentum investing, which relies upon the castle in the cloud theory: http://smallivy.wordpress.com/2010/04/10/firm-foundations-and-castles-in-the-clouds-part-2-castles-in-the-cloud/. Value investors assign a value to a stock based upon current and future earnings and other factors and then buy stocks that are considered inexpensive and then sell when the share price rises to the point that the stock is overvalued. Momentum investors find stocks that are increasing rapidly in price and buy regardless of the relationship between the share price and the underlying value, selling the shares when they feel the price advance is slowing down (the stock is running out of momentum). Value investing is buying low and selling moderately high, while momentum investing is buying high and selling higher. Both strategies are used successfully by investors to make money.
The strategies in this blog tend towards value investing (although because stocks are chosen that have shown a steady increase in price due to a steady increase in earnings, it could also be thought of as long-term momentum investing). There exists a great deal of concern currently about the economy, however, so our attention turns today to the psychology of momentum investing which can explain the recent runup in housing and the economy, as well as the current slump. The same psychology drove the Great Depression, although the vehicle used for speculation then was stocks instead of real estate. In both cases, leverage was a key element.
To understand why momentum investing works, one must understand the Castles in the Clouds theory. This theory holds that individuals will assign value to any asset, be it stocks, bonds, real estate, or commodities, is part based upon recent prices and price movements. For a main street example, gasoline was in the $1.00 to $1.30 per gallon range for most of the country for many years. A few years ago the per gallon price suddenly went to $2.00, hovered there for a while, and then went on to $3.00 and $4.00 per gallon. At $2.00 per gallon individuals complained. At $3.00 people started actually changing their habits, putting off road trips and even moving closer to work and buying smaller cars. This effect was increased even further as the price neared $4 per gallon, where individuals even started talking about boycotts of gas stations and gasoline usage actually began to fall.
Then, the price suddenly dropped, actually falling below $2 per gallon briefly as the combination of less driving and the recession took hold. Since that point, the price has increased again to the $3 range, but there is no longer the same public outcry. The public’s perception of the fair price of gasoline has changed, such that $2.25 per gallon is considered a bargain, and even $3 per gallon, while high, is not unreasonable. Because of recent price movements, a new fair value has been assigned to a gallon of gasoline that has no basis in the underlying worth of the commodity. It is just based upon recent prices.
Likewise, when a stock has increased to a new price level — in particular round numbers — and remains there for a while, people start to assign a value to the stock based upon the new price level. Actually as the price nears the new round number traders will start to sell since the round number is seen as a barrier (called a “ceiling”), and once it crosses the new round number traders will tend to buy if it falls to the level of the round number, which is seen as a supporting price (called a “floor”). Note that recent high prices and low prices can become ceilings and floors, respectively, as well.
Once a stock has increased above an all-time high (or at least a long-term high) there is no longer a ceiling above it, but there is a floor below it, so only upcoming round numbers become price barriers. Momentum investors take advantage of this fact and buy stocks that are reaching new highs since they have support below them but no real barriers above them — the sky is the limit. Because of this — much to the chagrin of short sellers and value investors – stocks tend to stay high much longer than expected, even if they are grossly overpriced by any measure of value. Likewise, stocks that are going down tend to stay down longer than expected since there are now numerous ceilings above them. In this case there is also downward pressure on the stock if any rally occurs since investors who have lost money will sell if the stock reaches the price at which they bought it since they then are “breaking even.” They have assigned the price at which they bought the stock as the fair value for the shares.
Along with price level, the rate at which prices move can have an effect on the perceived value. If a stock has doubled within a few months, and then doubled again, individuals will tend to extrapolate the trend line and expect it to double again in another few months. This starts to become a self-fulfilling prophecy in that the price goes up because the price went up. People are willing to pay more because they expect the trend to keep going, and if they wait too long they will miss their opportunity. It is this effect, along with leverage (borrowed money), that leads to the formation of bubbles and the subsequent bear markets and depressions. Borrowed money is a key to the formation of bubbles, as will be seen in the paragraphs that follow.
Between about 2000 and mid 2007 there was a bubble in real estate. People began to buy houses in the early years of the new century because interest rates were set very low by the Federal Reserve, allowing more people to afford 30-year mortgages. Various Federal programs that encouraged home ownership for individuals who had not traditionally been home owners, as mandated by Congress and implemented by Fannie Mae and Freddie Mac, also had the effect of increasing demand. Because demand began to exceed supply, and because the monthly mortgage payments were less than in the recent past due to the low interest rates, prices began to move higher.
As prices began to move higher, people started to look at houses as not just places to live but as vehicles for speculation. Because the prices moved higher faster than they did in the past people expected them to continue to move higher at the accelerated pace. Also, because housing values rarely fell in the past (because they had traditionally grown at a slow pace), real estate was seen as a safer investment than stocks or other investments, although speculators rarely considered the amount of leverage they were employing when borrowing sums of $300,000 or more and only putting down a few thousand dollars in cash or less. Imagine if individuals had considered that a mere 10% drop in price would leave them owing $30,000 they did not have.
As the prices continued to increase individuals could no longer afford 30 year mortgages or 20% down payments, so new mortgage types were developed to reduce the monthly payment to a level that buyers could afford. There was a sense of urgency to buy houses quickly, regardless of the price, because it was felt that if one didn’t the price would climb beyond one’s reach. There was also a sense of safety despite the risks of the mortgages because one felt that one could always sell at a profit later when the interest rate on the loan and monthly payment increased because the price of the house would continue to increase.
As this continued, individuals started to use their homes as a means to buy goods and services that they could not afford otherwise. They simply ran up their credit cards, refinanced their mortgage, rolling the credit card debt into their new mortgage, and then ran up their credit cards again. This caused the development of a supply of goods and services that far exceeded the amount of actual money that existed in the economy. If one added up the price of all of the “stuff” that was purchased and the amount of true wealth that existed, the value of the stuff was greater than the amount of wealth in existence.
That imbalance was only supportable because people were able to use significant amounts of leverage to pay exorbitant prices for houses. The true amount of wealth that people buying the houses had or could earn in the next several years was far less than the amount owed for them. Once the bills became due and the move up in housing prices stopped, the clouds began to dissipate and the castles fall back to earth. The suppliers of goods began to suffer because there was not enough money in existence to buy all of their services. Companies began to close down and lay people off not because the economy was bad — they failed because the previous demand was fueled by money that did not exist. The previous demand was a leverage-generated illusion.
It should not be expected that the level of the economy will again reach the level of those years until the true supply of money grows to the point that true value can be traded for the goods. An investor should therefore not assign any value to companies based upon where their share prices were before the 2008 period. Instead he should find stocks that are reasonably or cheaply priced based on current and expected future earnings and take advantage fo the general malaise of the stock market to pick up shares.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
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