The Rich Get Richer

Market Update

by Travis Steward | April 14, 2009

What we’re seeing in the global financial markets is just a moment in time. We’ve all heard the news that the financial markets have lost trillions in wealth, that this wealth has been “destroyed.” Well, fortunately, this is not true. As a matter of fact, when speaking of money, it is important to understand that money cannot be destroyed. Yes, it is true many have the appearance of losses at these current prices, but that would only be reality if every investor on earth decided to sell everything today. So these losses are merely paper losses and not actual losses. Money hasn’t been destroyed, it has simply been moved around. And in these moments, the money generally moves from the emotional investor to the disciplined investor.

For most people, the true value of any investment is a very confusing idea. What is a company worth? Most of us don’t know, and we don’t even try. We simply rely on the behaviour and actions of others to determine our perceptions of “value.” This is why we feel companies are valuable when others are buying them, and are not valuable when others are selling them. This concept is a very important concept in investing known as the “greater fool theory.” It probably describes about 95% of investing choices, which we make simply on our emotional assessment of other people’s assessments. It’s a bit of a funny cycle where no one knows what anything is worth. Most people think bull markets become bear markets because the news is particularly bad, but this isn’t the case. Bull markets become bear markets because there is no one left to buy!

A great example is the dot com bubble. For a long time, the news was terrible in regards to these companies. Yet they powered higher. Why? Because the ability of buyers was not yet exhausted. Only when the last person bought (the “greatest fool”) did this extremely lofty market turn to a bear market. The news then follows the market, and reveals our terrible ability to value investments.

However, as the bull markets become bear markets because buying power becomes exhausted, the inverse is true for bear markets. When the ability to sell becomes exhausted, bear markets become bull markets. In every infant bull market, the news is terrible, yet the market will climb higher. It seems strange at first, that is, until you realize there is no one left to sell; to express their negative emotions.

The events that transpired after the T.A.R.P. legislation that was passed in America, which lead to the “crash” as it will be known, was an event that dragged into the market any participant interested in expressing their negative emotions. The amount of motivated sellers during this time was so large, the financial markets literally buckled under the pressure. Since then we’ve seen a muted interest in true selling interest, especially in the Canadian exchanges. One of the finest examples of exhausted selling interest is the TSX Venture Exchange. The Venture Exchange is almost a pure speculative market, with no true “investor” style attractions like dividend yield or earnings outlook, as most companies on this exchange don’t even operate profitably. The Venture Exchange is probably the best guide to determine where we are in the “greater fool” cycle. This particular exchange bottomed in November 2008 and has not seen even close to these lows since. What this implies is that every speculator who could sell did sell, and there was no one left with the ability to take it to lower levels.

cdnx

What we see is that at the very core, investing is a highly emotional endeavour. The best investors in the world, however, completely buck this trend. For instance, Warren Buffett, if his mind could be dissected, would likely reveal no emotional involvement in investing choices. His rational mind prevails, and he has his own proprietary ways to “value” a company. History has shown his ability to value is superior to anyone else, and strangely enough, when he decides to commit large amounts of capital to investments, it is usually very near to where the final seller capitulates and sells their shares. Is this a coincidence? Of course not. His emotional cycle is simply in total opposition to the average human being. This is why he seems to purchase at the right times and sell at the right times. He likely uses other people’s emotions as a guide of what not to do, as opposed to the rest of investors who use the behaviour of others to determine their ideas of “value.”

While the mainstream investor is engulfed in fear and panic, the disciplined, non-emotional investor is now exploiting the opportunity. Interest rates are at historic lows, allowing anyone with access to credit the cheapest carrying costs in years. When money is cheap and with little cost, it is the most attractive time to deploy it. Most can’t, however, as their balance sheets are incredibly impaired from previously poor investment choices at higher rates and lower yields. The few that can gain access to credit have an incredible opportunity to take this cheap money and buy very high yielding income securities. The yield easily covers the cost of the loan, and they simply sit on this investment taking the cash-flow return. Stock markets tend to always rise, and if you are positioned correctly, not only will you make a very nice spread on the yield to the carrying cost of a loan, but you may also experience capital appreciation as the cheap money spurs more disciplined investors into the market. This is all in the context of the absence of emotional sellers, providing the best risk/reward paradigm conceivable within the economic cycle. The next stage is when the emotional buyers re-enter the market, which is always after the first movers, like Warren Buffett, are already fully committed to the market. They then benefit from the emotional frenzy that ensues, and make their discrete exit before the buying runs out.

And this is why the rich get richer.

See you next week!

Contact Information

Travis Steward | Vancouver, BC | Email