From Cabot Wealth Advisory 7/21/08 Sign up for free Cabot Wealth Advisory e-newsletter
Bubbles occur when crowds of people (including investors) behave irrationally. It has spelled trouble throughout time.
The first recorded financial bubble occurred in 1636 when tulip mania hit the Netherlands. Tulips became a luxury item and status symbol because of their vivid mosaic coloring. Demand increased rapidly, pushing prices up to foolish heights. Futures contracts were developed to enable buyers to buy next year's crop. Tulips began trading on exchanges. Speculators—not growers—bought bulbs and tulips expecting to resell them at higher prices. At the top, one tulip bulb could fetch the equivalent of 20 years of wages for a skilled craftsman.
But in 1637, buyers for tulips disappeared. Owners and investors could attract no new buyers at such lofty heights. The ensuing crash in prices sent the Netherlands into a recession. Sound familiar?
At the end of the last decade, investors bid up tech stocks to dizzying heights. Price to earnings ratios were abandoned, because "this time was different." If a company had fast-growing sales, not earnings or cash flow, its stock was soaring in price. New companies were welcomed to stock exchanges and experienced an immediate run-up in their stock price. A tech stock with a good story could fetch more than 100 times sales. The Nasdaq Composite Index skyrocketed from 1,000 to more than 5,000 in less than four years.
But in 2000, buyers for technology stocks disappeared. During the next three years, the Nasdaq plummeted 78%, back to 1,100.
Most recently, we all know what has happened with real estate in the U.S. and in other parts of the world. Crowds of people behaved irrationally. Now we are in a re-adjustment period, attempting to bring supply and demand back in balance. Prices are falling while supply exceeds demand. Eventually, balance will be attained and a new price level will be reached.
The current run-up in commodity prices, such as oil, corn, etc., is ongoing. Are we near the top in prices? I honestly don't know. And I doubt that investors or economists know, because there are too many variables. It's too hard to pick the tops of bubbles. As a conservative investor, however, I know my system will work regardless of the trend in commodities because I can continue to focus on lower risk investment opportunities.
My recommendation is to avoid stock sectors that have been bid up to dizzying heights. For every hyper-inflated stock, there is an undervalued stock with a low price to earnings ratio, strong balance sheet and a solid outlook.
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