Monday, May 21, 2007

Moron^H^H^H^H^H More on investing

Amazon's stock is up 7% today -- for no reason. I decided to sell my (small) holdings entirely.

I mean, rah rah company and all, but this is just irrational. Our P/E ratio is 107. In plainer English, this is thinking along the lines of: "If the stock price is tied to a company's performance, if I give you $107 today, I can expect this to be worth $108 a year from now."

This is a worthy investment in, say, a charity (where I expect to reap zero financial return). In a for-profit enterprise, however, it's silly. With inflation running a little over 1% per year, this is a net loss. Most banks will pay you a higher interest rate!

Now, there can be other assumptions being made in the valuation. Some of this is a correction for previous assumptions about stagnant profits, which were blown away during our last earnings report. It could also be shorts covering (an activity I'll explain below). Either way, this is not a position I feel a comfortable basis for investment.
What's this about "shorts covering"? No, it's not a way to hide your underwear. A short seller is someone who makes a bet that a stock fall over some time period. An example of how this works is:
  • Alice thinks Amazon's stock will fall over the next three months.
  • Alice borrows 100 shares of Amazon from her broker, Bob, which she immediately sells for $5/share, netting her $500.
  • Three months pass, and Amazon is now at $4/share. Alice buys 100 shares, costing her $400.
  • Alice returns the 100 shares to Bob and keeps the $100.

Ok, sounds reasonable. But what if Amazon's stock actually rises a month after Alice sells her (well, Bob's) shares? She could hang on, hoping that it will fall in the next couple months; on the flip side, she could decide to cover her losses and buy the shares back right now (before they rise further).

Like anything else, stocks are subject to supply and demand. When a lot of people want to buy the stock, this increases demand and the price rises. You can see how short sellers can create a feedback loop here: A positive report about the stock causes the price to rise; shorts cover their losses, causing the price to rise further.

Anyway, if this sounds a bit abstract and sketchy to you, you're not alone. I prefer a firm connection between a company's performance and its stock price.

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