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Todd N Kenyon

Bubbles and Vacuums - neither persist

November 21, 2008

We’ve all become painfully familiar with inflating bubbles that subsequently burst. Tech, housing, etc etc. But what of anti-bubbles, or bubbles of negativity? They are just mirror images of euphoria-driven bubbles.

Bubbles are characterized by parabolic or steeply climbing price trajectories. Plotted on a log scale, they look like steady, steep upward slopes - until they don’t. Then they look like steep downward slopes as mean revision kicks in. Typically, they overshoot to the downside before returning to mean long term trends. It’s a simple rule of nature - what goes up must come down, trees don’t grow to the sky, houses built of cards surely must collapse, and financial assets priced way above intrinsic value eventually devalue.

An interesting characteristic of financial bubbles is the similarity of their plots. Look at the following figure, and see if you can “name that bubble!”

Answers: Oil prices 2007-present, NASDAQ tech bubble 1997-2002, Nikkei (Japanese stock index) 1986-1993, and the stock price of Crocs from 2006-present.

The assets in question have little in common other than they are traded on public markets, and therefore subject to peaks driven solely by temporary euphoria.

Now how about these bubbles? All but one are unresolved:

Answers: OK I lied - these plots are inverted. They are anti-bubbles, vacuums, whatever. The first plot is the S&P 500 in the mid 70s. The unresolved “anti-bubbles” are the XLF (Financial Sector SPDR), the 13-wk T-Bill, and the S&P 500, all showing “highs” (which means lows) as of today.

Here is what they actually look like:

The order is reversed of course. Can anyone look at these unresolved craters and believe that they represent real, efficient pricing of the underlying assets? They positively scream rebound to me.

The takeaway? Bubbles clearly don’t last, neither do vacuums - there is a bottom to every valley and then there is another side that leads upward. The selling in the S&P 500 has lost all touch with reality. Intrinsic value doesn’t matter, much like in times of euphoria. At some point, this must reverse, perhaps violently.

About the author:

Todd N Kenyon
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.6/5 (17 votes)


Amit Chokshi
Amit Chokshi - 9 years ago    Report SPAM
Yup, same people talking about the S&P losing touch with reality have been saying that since Dow dropped from 14k to 12k and about every thousand point drop. A lot of those charts screamed rebound at higher levels and people would have lost their shirts chasing a rebound. The main problem is most people just don't know how to value a stock nor have they really considered the impact of what LEVERAGE means in every facet of investing. I'm not talking even about company-level leverage but consider for a moment that the average hedge fund uses 3-4x leverage.That's why even though hedge funds account for a small amount of total capital, they control a ton because for every $1 in capital a hedge fund has, it can be using $3-$4 in gross long exposure and since most hedge funds are net long, many of the "normal" prices people were used to were the result of amplified buying power.

Outside of that, people are just kicking around the same ideas. AXP at $40 is a buy, at $30 it's a buy, etc. GE is a buy, whatever. Nobody does forward looking analysis that disregards analyst estimates or actually does anything to say, well if loss reserves tick up, card usage drops, etc how does that impact the valuation? It's one thing if AXP was improving but getting cheaper but the worst is yet to come.

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