Oct

16

It is very valuable as an investor to review the physical concepts of potential energy and kinetic energy and the magnitude of energy that can be expended when the former is converted to the latter.

First, let’s review the definition of potential energy:

Potential energy is energy that is “captured” in an object, with the potential to be released. There are various different types of potential energy. Many of these - such as gravitational, elastic, or electrical potential energy - arise from the relative positions or configurations of objects. The potential energy may then be defined as the work that must be done against a particular force - in these examples, gravitational, electrical or elastic force - so as to achieve that configuration. Chemical potential energy is slightly different, at least in its macroscopic manifestation: it is the energy that is available for release from chemical reactions (for example, by burning a fuel) or a nuclear reaction.

An example of gravitational potential energy is a wrecking ball hanging in the air. It has a great deal of potential energy stored within. A drawn bow is an example of elastic potential energy and a charged particle can be an example of electrical potential energy.

Kinetic energy is the energy that a body possesses as a result of its motion. It is formally defined as the work needed to accelerate a body from rest to its current velocity. Having gained this energy during its acceleration, the body maintains this kinetic energy unless its speed changes. Negative work of the same magnitude would be required to return the body to a state of rest from that velocity.

Kinetic energy is manifested when potential energy that is stored in an object is released or converted from said object. A wonderful example of this is when an Indianapolis race car is involved in an accident. It is a spectacle to observe when the vehicle seemingly explodes on contact and parts are strewn all over the speedway. The potential energy is in the design and form of the race car. In this case, the energy that is stored in the racing fuel, is converted to kinetic energy by the engine that propels the vehicle. Then the potential energy that is stored within the race car itself is converted to kinetic energy by the accident.

The importance of this understanding in investing should be obvious and instructional.

Potential energy in a stock is energy that is bound in the form of earnings. The most recent glaring example of this is the housing boom that began in 2002. To counter the effects of the 9-11-01 terrorist attack on the world trade center and pentagon, the Federal Reserve began to drop interest rates. This had a profound effect on housing as mortgage rates fell especially in the form of ARMs and they began to flood the marketplace. Furthermore, money became easily available and practically anyone who applied for a loan was approved. Through creative financing, one could finance a home with 0% down payment utilizing a second mortgage to pay for the down payment on the first mortgage.

Thus the great banks and mortgage companies began to fire up their formidable machines to exploit the window of opportunity the “hole in the universe” that developed at this time. Marketing of these mortgage vehicles and untold variations were ubiquitous and they were sold with impunity.

The effect was stunning. The potential energy that was stored in the form of interest rates was converted by work to kinetic energy ultimately manifested in the stocks of homebuilders. This was achieved through homeowners and speculators alike literally throwing money at companies like Toll Brothers, Centex, and others to “please build me” a home. Stocks of these companies exploded in price, for example Toll Brothers went from $10 in late ‘01 to a peak of $55 in mid ‘05.

As with all such events the furor of the homebuilding mania has subsided and Toll Brothers stock has halved its stock price to $30. A “Mister Toads Wild Ride” to be sure.

Where will the next opportunity the next great boom in stocks be? That is of course the key question. Nobody can tell for sure however it is the astute one the prescient investor the observant who notices certain opportunities and seeks to exploit them. We have seen similar phenomenon with the late 90’s boom in tech stocks fueled by Y2K and oil stocks by oils meteoric rise from $30 to $75 per barrel post Katrina. Defense stocks went on a roll after we invaded Iraq and casino stocks went furious with gaming approved in Atlantic City and Gulf states. Trust me. There will be plenty more opportunities, it is just a matter of time.


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