Musings

If you think about things that drive the economy, it pretty much comes down to the way people feel about those things. Generally speaking, the total amount of resources and products available and the the number of people changes gradually over time. However, if a particular product is considered desirable, it suddenly demands a higher price. Conversely, if something that was desirable goes out of favor or is considered too expensive, it suddenly is in an oversupply situation.

This is in fact the primary cause of economic bubbles. If you consider housing, as long as enough people felt that they could get more for their home in a few years than they were paying for it today, the housing market was "hot". It was when prices stagnated for a period of time and started to decrease that all of a sudden people found themselves in homes they couldn't afford. You can talk about sub-prime mortgages and overbuilding as well as excessive speculation but the reason that the market came to a screeching halt was that people no longer believed that housing prices would go up.

It would take more time and data than I currently have to prove this here but I believe there is plenty of proof available. You can consider anything the is "hot" and pretty much know that at some time it will "cool" off. The contraian investors use this concept fairly successfully and if they have the time and resources to wait long enough, they will almost always be right eventually. The only real problem is the timing. Say you feel the stock market is "too hot" right now and want to short it. First, you have to be right about it being "too hot" and second you have to be able to wait out the increases.

By most historical measures, the market is not really overvalued. Of course you may question if those measures are still valid, but generally, the times people start to believe that the rules have changed, they have been wrong. There is no reason to believe that they are right now. Of course they may be, but then again, a few years ago there were some who believed the DOW was going to 30,000.

If you go back to some of the earliest recorded bubbles, you find that the Tulip bubble of the 1600s clearly demonstrates how a commodity price is dictated by people's fancy. Of course knowing what the next hot thing is going to be and when it is going to go cold is the trick.