Celebrated British scientist Isaac Newton famously lost a fortune in the South Seas Market mania in 1720. His comment sprung to mind earlier this year while I was reading an article on why seemingly intelligent people lose fortunes in markets.
‘I can calculate the motions of heavenly bodies, but not the madness of people’
The explanation given is memorable. Rational and professional market participants struggle to rationalize extreme market movements using tried and tested traditional tools. They find that the value assigned by the market to certain stocks defy rational economic analysis. While they can deal with the odd exception, it is a struggle to understand how the whole market appears to be overvalued according to traditional valuation metrics. This difficulty is compounded when it goes on year after year.
So what can a seemingly intelligent investor do? Like Iaasc Newton did, they seek new models to rationalize higher market valuations. The dotcom boom gave us the infamous eyeballs to price ratio. In this case a company was valued based on the number of people that visited their website. The old reliable metrics involving profitability and debt et al were seen as irrelevant in the new era. New metrics are used when we enter a new era of super high prices. If the old valuation metrics don’t appear to work it may be reasonable, or as least ‘rational’ to look for new ones.
This was Isaac’s mistake. It will not be ours.
Much of the globe is still operating at negative interest rates. This cannot be explained using rational economic analysis. Clever economists tell us that this is just all part of the new normal. It is not. Lending money to a bankrupt entity at negative interest rates is not a rational economic decision. It is an act of charity that may have its own logic, but it is not a rationally sound ‘economic’ investment.
To stick with our Isaac Newton theme we can say that asset valuations can defy profit and loss analysis only temporarily. But like gravity, rational economic analysis will eventually bring assets prices back down to reality.