Irrational Market

It’s irrational to think that irrational market cannot become more irrational. Irrationality cannot be measured and has no limit.

Example 1 – Tesla

This month, Tesla first surpassed Ford’s market value. Shortly after, it surpassed GM’s market value to become America’s most valuable carmaker. Tesla has market value of slighly over 51bn now vs GM’s 51bn vs Ford’s 45bn.

For comparison, GM sold about 10 million cars in 2016 vs Tesla’s roughly 76,000 (130x difference). GM made 9.4 billion profit in 2016 vs Tesla’s 675 million loss. For past 4 years, GM made more than 28bn profit vs Tesla’s 1.9bn loss. Tesla has recorded only two profitable quarters in its history as a public company. Tesla’s valuation is based on exceptional high growth assumption in the future, which will take lots of market share away from the competitors.

Since its IPO in 2010, Tesla’s share price has risen by 15x (yes, 1500%). On the other hand, during the same period, GM and Ford’s share prices were relatively flat. If you plot their share prices on the same chart as Tesla’s, they will just disappear.

Tesla - Share Price - 2017-04-11.PNG

Anyone who bet against Tesla has lost money (so far). Short sellers are estimated to have lost more than 2bn betting against Tesla.

Since many traders are shorting Tesla, which are overpriced when valued based on many valuation methods, should we short it?

The problem with shorting is that you can potentially lose more than 100% of the bet. When the share price continues rising, at some point, you are likely to be forced to cover your short by buying at high price, an action which will push the price even higher. I have seen it happened before my own eyes.

Think about this. If you believe the share price is irrationally high, what makes you think that it can’t get even more irrationally higher? Irrationality has no measure and no limit. You can’t say current price is irrational level 7 and next price is irrational level 8 with the maximum level of 10. If there were such a measure or limit, then everyone would short at level 10. Some people would want to get ahead and short at level 9. Some other people would short at 8 and so on. These actions would have prevented the price from getting irrational in the first place!

Bull arguments on Tesla will argue that Tesla is innovative, it has strong brand and commands premium pricing, has huge potential growth, its electric cars will gain more and more market shares, etc.

Bear arguments will argue that Tesla is still making losses, has limited market place and supply chains, faces aggressive competition, etc.

I don’t know how electric cars market will look like in 10-20 years. But I know that if the market remains small, then Tesla’s electric cars sales will remain small relative to other carmakers’. If the market becomes huge, gaining market share from petrol powered cars, then other carmakers will compete aggressively, coming out with many new electric car models at more affordable prices. Tesla may have early leads and brands for now, but if many carmakers make electric cars, price wars will occur, and mass consumers will have plenty of options to choose from. In either case, Tesla’s chance of commanding and maintaining dominant market share is slim to nearly none.

Tesla’s is not likely to be the “iPhone” in electric car market. In smartphone market, iPhone commands premium pricing and has loyal fans. Afterall, the price difference between iPhone and another phone (Samsung, LG, Huawei, Oppo, Vivo, etc) is just few hundred dollars. People are willing to pay extra to own the premium brand. In cars, it costs a lot more to own premium brand (easily more than one year of saving for most people). It costs even way more to own electric cars compared to normal petrol fueled cars (as of now). Therefore, Tesla’s market is likely to be limited to the well-off people only.

All my thoughts can be wrong. Tesla could indeed be worth so much. It does not matter to me because I don’t own the shares nor short the shares. The point I want to bring is irrationally high price can get even more irrationally higher. If you want to short, you better know your risk.

Example 2 – Amazon

Amazon is worth 437 billion now. Since its IPO in 1997, the share price has risen by 522x! It made 136bn revenue and 2.4bn net profit in 2016, both at record high in its operating history. That makes its current P/E at 184x!

Amazon - Share Price - 2017-04-11.PNG

For comparison, Wal-mart, the world’s largest retailer, made 480-486bn revenue and 13.6-16.4bn net profit over the past 3 years. That means both the revenues and net profits were “relatively” stable over the past 3 years. But, its current market value of 222bn is just nearly half of Amazon’s.

Amazon is another case of technology company with huge growth potential, highly priced by the market, has many short sellers, and whose share price continues to rise years after years. Any short sellers will have be burnt and forced to cover the short, and they would be glad they did.

Bull arguments on Amazon will argue that Amazon’s revenue is growing fast, it is taking shares away from traditional retailers, etc. Bear arguments will argue that Amazon’s profit margin is too tiny and can continue to remain tiny, it has high P/E ratio, etc.

With more than a decade of fast rising share price, no matter how good your bear arguments are, if you short it, you lose money. Even if the Bear turns out to be right several years from now (Amazon’s share price has to drop significantly for the Bear to be right), the Bear are not likely to get any rewards because he/she would have covered the short position by then.

There are many examples where the irrationally high price rises to even more irrational. I just mentioned these two that are the hottest and among the largest market cap.

Long vs Short

Short-sellers can get the reward of making money when share price is crashing and everyone else is losing money. But it comes with the risk of being wrong for a looooong time and at some point being forced to cover or lose more than the initial investment. As the irrational market becomes more irrational (high becomes higher), short sellers will be forced to quit. There is no limit how irrationally high the price can get.

Long only investors can also be wrong for a long time but he can’t lose more than what he invested. If the company continues doing well while the share price is falling, at some point, the attractive dividend yield or accumulating cash holding will attract more buyers to buy the stocks. As the irrational market becomes more irrational (low becomes lower), it will attract more people to eventually buy. There is a limit how irrationally low the price can get, which is zero. The market will not let such a company, with tangible assets and making profits, go to zero value.

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