Contrarian Investing: Slaughtering the Herd
The situation is common and usually happens every couple of years. An asset class (stocks or real estate) rises in value: first doubles, then triples, then quadruples. And although we have seen the devastation of these asset bubbles after they explode, many of us still make the same mistakes. Recent events, such as the US Real Estate Bubble (2007), Uranium Bubble (2007), Oil Bubble (2007), or the Dot Com Bubble (2000), will do very little to remind the general population of financial bubbles. However, you can go back to the 1920’s Stock Market Bubble (1929), or even as far back as the Tulip Bubble (1637), these are not a new phenomenon.
With history on our side, we can see that since money was created, people often overvalue many asset classes; often with severe financial consequences. This ultimately leads me to believe that most people are financially limited and as a result, stand to make the same mistakes over and over again. Parents do not educate their children and hence, stand to repeat the exact same mistakes as the parents made. However, this also means that some, a small percentage, stand to make a lot of money from the herd which got slaughtered.
Let’s start off by showing a chart of the stock bubble of the 1920’s and the 2000 dot com bubble:
As you can see from the two charts above, the similarities between the two events are unmistakable even though over 70 years separates them. This is because in both circumstances, the assets were traded with emotion rather than value in mind. One difference between the two charts is that the Dow recovered fairly quickly from it’s collapse while the Nasdaq has yet to recover and very well, many never recover. We should also note that regardless of the asset class, the shape of an asset bubble is very similar. And once the price goes exponential and turns the curve from horizontal to vertical, a crash is imminent.
Now just as everyone and their dog were taking out loans and buying stocks in the late 1920’s to buy stocks so did people in the late 1990’s. In both scenarios, people with little investing experience were buying at the peak of the mania, and with borrowed money. A contrarian investor however, would probably look at the escalation of the asset and consider that it is too risky to invest.
Unless the financial fundamentals can support the asset escalation, it is best to stand aside and let the greater fools duke it out. The contrarian would put that stock on the back burner and watch what it does. Then, when the proverbial “shit hits the fan”, he can think about purchasing the asset.