3 Ways to Spot Inflection Points

We all follow trends.  They are a sign of the times, a reflection of the zeitgeist and have the benefit of being relatively easy to spot and extrapolate off of.

However, what’s really interesting are the inflection points, when trends switch directions.  That’s when fortunes are made and lost.  Here’s three ways to spot them.

Everybody Agrees

At any given time on any given subject, various people will have different opinions.  So we should view excessive uniformity of as a reason for pause.

Markets function by buyers meeting sellers, both of whom must believe they are getting a fair deal for a transaction to happen.  When everybody seems to agree on where things are going, the pricing mechanism fails to do it’s job properly.  George Soros calls this the principle of reflexivity.

Everybody throwing their money in the same direction is bound to cause problems. It means that people have stopped looking at the facts and began to put more emphasis on other’s perception of the facts.  In a boom, skeptics become quiet and in a downturn optimists are timid.

Whenever the trend becomes decoupled from the fact pattern, a reversal is coming.

Extrapolating Trends leads to Absurd Conclusions

The value of any investment is based on a stream of future earnings.  If it’s a loan, that return is fixed unless there’s a default, but if it’s an equity investment then you essentially get a share of those future earnings.  Furthermore, when you invest equity, you expect some extra in return for the risk.

The point is that no matter what the trend of asset prices, there needs to be a realistic expectation that they reflect a future payback.  If not, then there will eventually be a correction.  To see what I mean, take a look at this article about the Facebook valuations that are being bandied about.

We can see the same phenomenon in emerging advertising markets.  Much like asset prices are dependent on future earnings, advertising is dependent on an overall economy which can support about 1% of total GDP for advertising (and slightly more in the US).  Nevertheless, in fast moving developing markets, growth forecasts are rarely tamed down when that level is approached.

Trends, if they are valid, should make sense in the future as well as in the present.  If they do not, that’s a good sign that the trend is unsustainable.

Vast Change in Costs

Perhaps the best sign that a change is coming is when prices for inputs change significantly.  Having been through a few boom-bust cycles in emerging markets, I know that when salaries levels start going haywire, the end of the boom is near.

It becomes tough to hire staff, people change jobs frequently and criteria get adjusted downward.  Companies are willing to invest more to get less.  The result is predictably poor.

Chris Anderson, in his book Free, gives the other side: when prices fall to zero or nearly zero, abundance is created where there was once scarcity.  The result is a sea change in the way business is done.

This is most apparent in media, where we rarely ever paid for content, but rather for distribution (and even that has been heavily subsidized).  When corporations and individuals have access to the same “free” infrastructure, lines blur and we begin to see completely new forms of communicating (as well as Rupert Murdoch throwing tantrums on Op-Ed pages).

Why Inflection Points are More Valuable Than Trends

Trends are nice, mostly because they are easy to follow.  The problem is that everybody else is following them as well, and that makes it difficult to make money or gain a competitive advantage off of them.  Any change is already priced in.

Inflection points, however, are outstanding opportunities if you can see them coming.  You can buy when things are cheap and sell when they are overvalued.  The key is to look ahead a bit and see that what everybody agrees will happen no longer fits any fact pattern.  That’s a clear signal that the market’s getting it wrong.

It’s the curves in the road that make life interesting.

– Greg