“The market can stay irrational longer than you can stay solvent.”
Throughout this series, we’ve argued that Twitter stock is probably too expensive given the current information we have about the company and its growth prospects. However, this doesn’t mean that the stock will decline in price. The stock could continue to increase, based on hype, which is in fancy terms “irrational exuberance.”
Home prices can only go up, right?
The recent real estate boom and subsequent crash are a prime example of irrational exuberance. Many people bought homes for far more than what the properties were worth on a fundamental basis. Home prices nationwide rapidly appreciated as buyers thought to themselves, “The market can only go up, and I’d better buy before it gets too expensive and I miss out!” The market continued to appreciate past where fundamentals, such as population or household growth, economic conditions, and supply of homes could support prices. Eventually, it became apparent that the fundamentals could not support prices. The real estate market eventually crashed.
Many homebuyers bought on the promise of price appreciation far into the future. Similarly, everyone in the market acknowledges that Twitter will grow, and its earnings will grow, and therefore its valuation will grow. However, let’s say a house is selling for double its real value right now. You have a feeling that that’s not the real value, but you think the house will appreciate over ten years. Are you still going to pay double the true value today? Because Twitter will appreciate at some point far into the future, does it mean you should pay far above the fundamental value?
Using another example, take a theoretical financial instrument that pays $1 every year for ten years. Theoretically, the price should never be above $10. What if the security gets a lot of hype, and all of a sudden, there’s a frenzy to start buying it at $20? It’s not rational, but it’s entirely possible. The point is that it’s very possible for assets’ prices to diverge from their values. The markets reflect people’s psychology, and people don’t always behave rationally.
If the market were completely rational, would it make sense that Twitter stock price could swing from $73.31 per share to $63.75 (December 26 to December 27) per share in one trading session with no incremental news? Could Twitter stock continue to appreciate, even if it may be too expensive given where the company is today? Yes. Does the stock necessarily reflect the value? No. Can you lose money shorting it? Yes.