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Is it Possible to Predict When a Market will Crash?

Every once in a while a specific blog comment will elicit a full article rather than a simple blog comment response. Recently Andy Brice from Successful Software (founder of Perfect Table Plan) wrote such a comment on my recent blog entry Manias, Panics, and Crashes: A History of Financial Crisis:

“Interesting. I’m expecting the insane UK housing market to level off or crash any time now. But I’ve been saying that for the last 5 years…”

Andy is a very smart person whose blog I regularly read (and sometimes comment on). Whose opinion I respect. In this case I absolutely agree with him. I’ve been saying the same thing for North America for some time now, as is evident even in my first month of blogging over two years ago here on FollowSteph.com.

The interesting part of his comment is that he (myself included) know just how hard it is to accurately predict a full economic shift from mania to bust. It’s easy enough to see when we’re in a mania; the fundamental economic principles no longer govern asset prices. But what’s hard is to predict when the general public will realize this. It’s just like the Tulip Bulb boom of long ago; as long as there’s a bigger “sucker” willing to pay more for the asset (in that case rare tulip bulbs) the prices are going to keep increasing.

Tulipmania

But now comes the reality. Again it’s not possible to exactly predict when a boom or bust will actually happen, it’s easy to predict when we’re in a boom or bust phase. If the economic fundamental no longer justify the prices then we’re in for either a bust (overly priced as is today) or a boom (under priced as often happens when people overcompensate after a depression). The bigger the discrepancy the bigger the boom or bust.

The good news is that although we can’t accurately predict the exact time a bust will happen, we can still accurately predict when it’s a good time to get in and out at a profit. As Benjamin Graham expresses in his book The Intelligent Investor, as long as you’re buying your asset for less than the real value (intrinsic value) and selling it at a higher price than the real value you’re ahead. He doesn’t show you how to maximize your profit, he just helps you identify how much your asset is overpriced or under priced. No one can accurately tell you when an asset has reached its maximum price (over valuation), that’s speculating on you knowing and understanding the publics psyche which no one can do.

To put it in other words, asset (stocks, real estate, etc.) prices will always shift above and below their true economic value (known as intrinsic value). If you buy them for less than their intrinsic value you’re ahead. If you sell them for more than their intrinsic value you’re ahead. The key to investing is not to try to buy assets at their lowest price and then sell them at their highest price, no one can do this. It would be amazing if that were possible, but it’s not.

What does this all lead to? Well over time an asset can only deviate so much above or below its intrinsic (real) value before it has to re-align itself (adjust its price back to a reasonable value). Right now, at least in North America for sure, prices of real estate properties have deviated significantly above their intrinsic value, so much so that they are now correcting themselves and trying to re-adjust to their intrinsic value. And don’t think we’re there yet, they’ve still got a lot of re-adjusting to do. I expect significantly more fallout before it stabilizes. As a very basic general rule of thumb, a real estate investment property should generate you at least a yearly revenue of 10% of the purchase price (including all costs – renovations, closing costs, etc.). Right now we’re not even close to this, many properties are running at negative cash flow values! This isn’t sustainable.

Intrinsic Value Versus Actual Value over time

Knowing this however doesn’t mean you can’t profit from the boom and bust cycles. All it means is that if you buy assets in the under priced area of the above graph and sell in the overpriced areas you should be able to consistently make profits and protect yourself. The “margin of safety” is generally considered to be the discrepancy between the actual price and the intrinsic value – that is how much the asset is under priced. The further off you from the intrinsic value you are, the bigger the profit potential and the closer you are to the max and min’s of the boom and bust cycles. Of course you need to be extremely careful the further away you are from the intrinsic value, especially for overpriced assets, because when the adjustment happens it will be faster and more volatile!

It’s possible to consistently achieve respectable profits, all you need to do is look at the intrinsic value to know when to get in and out. Although sometimes it may take years for an assets actual price to at least come back to it’s intrinsic value, it eventually does. But as Andy’s comment suggests, knowing when a market has peaked is hard to predict. He already knew that the intrinsic value was no longer aligned with the actual price of the asset (in this case real estate), but he still couldn’t know when the adjustment would occur. No one can!



 
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Comments:

  •     Andy Brice
    · October 17th, 2007  · 4:29 am  · Permalink

    Interesting and I take your point that it is extremely dangerous to try and second guess public opinion, especially when mania sets in.

    But it begs the obvious question – how do you work out the intrinsic value of a house? Although much of the UK rise in house prices is driven by speculation, there is also an element of supply and demand. Does supply and demand figure in the intrinsic value? Or is it just the build cost?

    In the case of the .com boom how would one have worked out the intrinsic value of new businesses? These were new markets, new technologies and new business models (however flawed).

  •     Philipp Schumann
    · October 17th, 2007  · 1:36 pm  · Permalink

    This is a matter of ongoing academic debate between different schools of economics… but my take is that price and (economic) value are always subjective, never “intrinsic”.

    As far as I can tell (from remote distance ;), in the UK situation there is another variable coming into play: even if they wanted to, it is a tough challenge for developers or private individuals to go ahead and start building further housing to meet the apparent demand, largely due to a massive “zoning / planning bureaucracy”. There are all kinds of councils having a say in what you can or can’t build (or in “listed” old buildings: repair/restore) and how much of it. Scares away lots of builders (result: demand cannot be met and prices fail to go down) and certainly drives up the costs of developers. Such a setting is indeed a fertile ground for “extreme speculation”. There’s probably more to it, but I’m always amazed how this particular aspect is never mentioned when UK house prices are discussed.

  •     Philipp Schumann
    · October 17th, 2007  · 1:42 pm  · Permalink

    It occurs to me that contrary to the UK, here in Germany most “middle class” people in Germany are *building* homes (even if they have or are going to inherit one from their parents), instead of buying them. There really isn’t much building going on in the UK, other than “a development of 20 new homes” every other year or so, and commercial building. In the UK, most of it seems to be build-to-sell and buy-to-let, whereas over here it’s more “build-to-live-or-let”. If I weren’t so absorbed in producing software, this would be an interesting comparative field study… 😉

  •     Steph
    · October 17th, 2007  · 8:50 pm  · Permalink

    Hi Andy,

    Determining the intrinsic value is the harder part, and unfortunately it’s usually calculated a little differently by different people (depending on what you’re comfortable with). I’ve always personally looked at how Benjamin Graham and Warren Buffett calculated it, which is basically how much money does the asset bring you and how much could you sell it for today if it went bankrupt (ie there is no more business and you had to sell the assets at a firesale).

    The hard part with this is that you can’t take into account potentials. Supply and demand do not really fit in as these are speculative. New markets and new businesses don’t fit in. By don’t fit in I mean you have to assign them zero values. That’s your safety margin.

    So for example, with a business, if you calculate the total of all the assets (inventory sold off at 10%, property sold at fair market value, factories at 10%, etc.), cash on hand, etc. versus the debt, that gives you the asset price. That’s the intrinsic value. Therefore the closer the actual price is to the intrinsic value the better.

    Of course it’s more complicated than that. For example with stocks a lot of companies pump up their brand value as a way of increasing their equity. There’s lots of tricks you can do: Why do Real Estate Investors Not Invest in Stocks the Same Way They do in Real Estate?

    Surprisingly, and often enough, the intrinsic value of some assets will surpass their actual price. I remember buying stocks near the bottom of the dot com bust where the companies had more cash than the sale price of the company (the price of all the stocks combined), and they were consistently profitable!!! It was a great time and I made good money then. The dot com bust wasn’t all bad for everyone 😉 That’s actually what gave me the ability to start and finance my company LandlordMax.

    A really good primer is the Intelligent Investor, especially the revised edition. Both are great, I own and have read both several times. Benjamin is great for determining the underlying value. Warren Buffett took Benjamin’s value calculations and added to them. He added elements into the calculation where a company that could build $2 in revenue from $1 was more interesting than one who could build $2 from $1.50. I’ve studied both of these greats and I’ve learned more than I ever realized possible.

  •     Steph
    · October 17th, 2007  · 9:02 pm  · Permalink

    Hi Philipp,

    I absolutely agree with you that price and (economic) value are always subjective, never “intrinsic”. And it’s that discrepancy that can make or break you. The more you understand how to calculate the intrinsic value of assets, the better off you are. That’s what allowed me to be quite profitable during the dot com bust.

    While I kept hearing everyone losing money, here I was quietly making money. I would even hear people talking about certain stocks saying that they had been so depressed that they should get back in, it could only go up. A stock that was $100 was now down to $1. What a deal! WRONG!!!

    Just because it’s a $1, doesn’t mean it’s worth that. There was one company here that people were going nuts buying when it dropped to $1, just because it had been so depressed and couldn’t go down anymore. Of course they weren’t looking at the fundamentals. It could keep going down, and it did. While the company was selling at $1/share, it was also earning -$4/share. It was losing $4/share. Would you buy an asset for $1 that would be losing $4/year? That’s insane. And people thought it was a bargain!

    On top of this, the company was running out of cash. At that point, if memory serves me right, it had less than 10 cents on the dollar in cash, and loads of debt. And no real assets. The intrinsic value was not $1. It was much lower. The brand name was worth something, but not $1. I predicted it had a lot further to fall, and it did. My prediction wasn’t on the success of the business, but on the price of the stock assuming it was still in business. And if it went bankrupt, than I wouldn’t get much, if anything at all. I believe it had more debt than cash reserves.

    Anyways, to step off my soapbox, you’re absolutely right. The intrinsic value is much easier to calculate and is much less subjective. It’s still subjective but not to the same degree as price, since the businesses potential and speculation fever is often built into the price. The only subjective aspect of the intrinsic value is determining what your safety margin is. For example for me personally goodwill and intangibles (brand name value, etc.) are zero values. Factories and specific real estate assets are worth 10% (I wish GM, Ford, or Chrysler good luck in selling a car factory close to the price they paid, if at all). It’s much more concrete and easier to calculate. And Benjamin Graham and Warren Buffett have really illustrate just how easy it can be to estimate if you can separate yourself from the manic fevers.

  •     Philipp Schumann
    · October 18th, 2007  · 9:38 am  · Permalink

    Now *there’s* a book recommendation that I act upon immediately. Hope the book link above gives you a little payback. Looking forward to reading this.

  •     Steph
    · October 18th, 2007  · 10:07 pm  · Permalink

    Hi Philipp,

    Thanks. It’s a great book. I actually listed it as one of my top 10 investing books of all time.

    It is an amazon link, so I believe the affiliate referral pays out 4%…

    When you’re done reading it, let me know what you think. I’m sure you’ll learn a lot. I still learn something every time I re-read it.

  •     FollowSteph.com - Biggest Stock Market Tip
    · April 30th, 2008  · 10:15 pm  · Permalink

    […] Now this is an easy example, real life is more complex. The total market value is never the same, nor are the amounts of shares available or the price. To compound this, you have to remember that the total market value of a company is rarely equal to the real value of a company. […]

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