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October 2, 2000

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Subject:  The Zoo and the Binary Switch
Author:  GFPE

I visited the zoo yesterday. That always gives me a perspective into human behavior. In animals, you see a switch between normal behavior and hyper-alert fear behavior, the switch being flipped on for rapid response when adrenaline floods the nervous system. Interestingly, the fear response to danger also is binary: fight or flight. Two extreme reactions to danger, where the animal unconsciousnly makes a cost/benefit analysis of facing off with the danger. That's basically what it is, a cost/benefit analysis, even if the analysis takes place at a level of simple processing and takes into account size of the danger, condition of the animal, etc. It's all hard-wired, for the most part.

Humans have the same circuitry. We can cruise along, going about our normal business, then we encounter some strong danger stimulus, and all of a sudden adrenaline rushes into our nerve terminals, our heart rates soar and we react quickly and rapidly by confronting the danger or fleeing from it. Ever almost been in a car crash? Ever been in a fight with someone at school when you were a kid?

The problem is that most of the stimuli that we face in the modern world that may require corrective responses are not as simple as being confronted with a saber-toothed tiger while your out foraging without your club. We are stimulated all the time with information that requires a response, but it is usually not of a life-threatening or extreme kind. But that basic neurophysiology is still there, so our bodies and emotions tend to react on that primitive level as if unpleasant or stressful events were more threatening. Unless you mitigate that basic response by using your mind, which is powerful enough to suppress an extreme reaction, you may act disproportionately to the stress, which may lead to a number of long-term problems like damaged relationships, financial hardship, work difficulties and ulcers and health problems, to name a few that might occur in different situations.

Even those two emotions that are said to rule free market psychology - greed and fear - have their simple animal homologs: greed is more or less an extension of the behavior of hording food in an environment where food is generally scarce, a behavior that allowed your ancestors to survive harder times; while fear is quite simply the same emotion an animal or human feels when confronted with a serious potential threat, an immediate emotional response to a danger that could lead to bodily harm or death.

In our modern world, we've moved these emotions into other realms too, but it's not hard to see how money can elicit these emotions. Fear of losing money is backed up by visions of old and senile on welfare, without any of the goodies you have now or expect to have. For many people, that vision is as bad as that of being physically decimated or dead. Excessive greed toward money, like greed toward a food source in an environment of scarcity, can lead to other types of behavior: obsessive hording, anti-social behavior or criminality and murder. The visions behind greed include the opposite often irrational delusions from fear of losing your money: retire early, living on a private island, owning lots of things, etc.

It's ultimately related to your even more primitive desire to seek pleasure and avoid pain. With money and investment, you project that into the future.

When you view things this way, you see how very disproportionate reactions to bad news can occur in the markets. Clearly, rational evaluation of things would not have led to the response you saw in AAPL. It was already not a richly valued stock, and now it is highly undervalued by any rational measure. This was not a bubble dot-com or optical stock with a P/E in the hundreds that warned that its hyper-growth may be over. This was a stock that was fairly cheap to begin with. At the end of the day, it was absurdly cheap, even for a stock with growth well below that of AAPL. A rational response would have perhaps been some loss of value, dampened by the fact that it was not priced for high growth in the first place. Instead, you saw an extreme loss of value almost instantly, as if it were a stock priced for hyper-growth ("priced for perfection") that suddenly warned that things were far from perfection. AAPL was by no means priced for perfection before, with a valuation that was well below that of the industry average and even below that of the *average* for the entire S&P500, for which the *average* earnings growth is well below AAPL's even now. So a 50% loss of value just based on the fact that AAPL was not valued highly to begin with is simply irrational and almost surreal.

The way to explain it is in terms of basic exagerrated animal reactions that still form the basis of human behavior. I don't need to connect the dots. You can see the relationship and explanatory power of this thinking.

However, one more idea to explain what happened: Myth. AAPL has fallen victim to myth. When a rational market will value a company based on its book value and growth rates, here the market has fixated on a myth of AAPL: the comeback story - from troubled company to not only stabilized company but growth company. The earnings warning shattered for many of the simplistic, myth-minded and momentum-driven market participants. Even though in reality based on valuation, AAPL was never priced for perfection, in the minds of simpletons who had bought on momentum, because of its good gains over the last two years and the image of comeback company, it might as well have been. This is irrational, though, since if a company is not priced for perfection in the first place, it is not valued at these levels to begin with, and therefore a 50% loss for an earnings warning which pushes the P/E down to the low teens (similar to older companies that barely grow at all) is simply irrational. Live by the myth, die by the myth.

Finally, ironies abound: they say AAPL is a niche player with tiny market share, yet they react to it as if it were an overvalued tech *financial* leader bellwether. Compare market caps before between AAPL and other leaders like CSCO to realize the strangeness of this. Another irony: few AAPL investors ever said that they expected to see AAPL to grow into huge market share %-wise. Most real AAPL investors, before the weak momentum investors jumped in, simply expected modest growth. It is the other participants who do not understand AAPL or how a smaller-market stock can still be a steadily growing investment - the ones who only respond to absolute market share dominance (which at that point has many risks to further growth in a different way) - who were most rattled. Yet any more than superficial, myth- and emotion-based evaluation would have lead any reasonable person to see that that is not what AAPL's strength as a stock is based on. So that is irrational too.

Many people look only at absolute strength and power. Hyper-growth is considered the embryo of future absolute strength and power. Yet there are many investments that will return more than acceptable returns that will never be the absolute market leaders or that are in very small, "niche" markets to begin with. In evaluating an investment, it's obviously more important to look at relative health and growth than absolute, in looking at where the company will be at point A compared to point B. And then none of this makes any rational sense unless you look at these properties in relation to the price or value of the stock and company at any time. For an extreme example of a niche product with limited market that has performed as a really great investment, take a look at a chart of MEAD: they make telescopes for amateur astronomers. The stock has done extremely well over a long time frame.

I think most long-term AAPL investors understand this. Unfortunately, many of the superficial momentum-types do not, leading to a skewed short-term behavior that is out of whack with the reality of the underlying fundamentals. When these types dominate, then the price of the stock is purely determined by raw supply/demand without any reference to rational valuation. It's always supply/demand anyway, but usually considerations of valuation and growth determine demand. But when the primitive emotions and switches take over, it's supply/demand set by raw animal behavior and not rational reflection. Usually, this extreme form of behavior is temporary and creates short-term inefficiency, and some kind of reason then emerges. It is the rational who most profit consistently from the markets, and not the emotional.

Unless the markets are permanently cracked, something approximating the more rational will emerge at longer time scales. This is based on the historical record. Keep this in mind, and don't let primitive binary emotional switches or myths to rule your investment decisions.

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