Contrarian Investment Strategies Page 3
Assisting him in his efforts to calm the markets was his highly respected secretary of the Treasury, previously the head of one of the most formidable investment firms on Wall Street and a legend in his own time. Many other powerful market figures also threw their financial heft and hard-won reputations behind the secretary and the president.
The Treasury secretary worked with the leaders of some of the largest banks and with leading investment bankers in the country in an attempt to head off what was beginning to look like a financial disaster. A gigantic bailout plan was put together by the banks for immediate execution. The news sent stock prices soaring. Battered investors hoped this action would save the market and the financial industry, but the rally fizzled within a week and prices began to nose-dive. If the banks and the big-money pools couldn’t find a fix, who could? Many professionals now saw the possibility, even the likelihood, of complete financial disintegration.
Surely this happened just prior to the infamous 2008 crash, right? But wait, this description also fits the tumultuous events before the October 1929 crash. Amazingly, the president could be either President George W. Bush or Herbert Hoover, and the Treasury secretary could be Henry “Hank” Paulson or Hoover’s secretary, Andrew Mellon. (Mellon, who served through three administrations, was formerly the head of the Mellon Bank and the leading financier and industrialist of his day, with an income behind only those of John D. Rockefeller and Henry Ford.)
How badly did these crashes affect us? The 1929 crash and the ensuing Great Depression sent shock waves through the U.S. economy and global economies that radically changed Americans’ tolerance of the Wall Street they knew. Within several years after 1929, major legislation was passed to stop many of the egregious abuses that had been identified. Still, none of the reforms restored confidence in the financial system for decades. As the nation approached World War II and Selective Service was reintroduced in 1940, stockbrokers were designated the ninety-ninth out of one hundred least important categories to be exempt from the draft. Unemployment was near or over 20 percent for most of the 1930s, while the value of the companies making up the Dow Jones Industrial Average dropped from $150 billion in market value in 1929 to $17 billion in 1932, down 89 percent.
The crash of 2007–2008 was as devastating in many ways, taking financial stocks down 83 percent in a little more than twenty-one months—slightly more than half the time it took stocks to reach their lows of 1932. The free fall in the value of assets so frightened lenders that they refused to lend to banks that needed to borrow, and credit, the indispensable financial lubricant that had driven the wheels of commerce for centuries, froze. Jean-Claude Trichet, the president of the European Central Bank, remarked that it was the worst drop in credit since the Industrial Revolution. The industrial world was on the brink of a credit seizure it had not experienced since the Dark Ages.
“Why Bother with Bubbles and Panics?”
That’s what Fred Hills, an outstanding former editor at Simon & Schuster, asked me in 1997, when I submitted my last manuscript to him. “Even my twelve-year-old daughter knows about bubbles and panics,” he continued. Fred was dead-on. I’m sure that virtually every reader knows about manias and crashes. You’ve probably read about investors in Holland in the 1630s scrambling frantically to buy tulips and paying the equivalent of $75,000 for a Semper Augustus, a rare bulb, during Tulip Mania. Maybe you know the story of the printer in the 1720 English South Sea Bubble. Envious of the promoters all around him who were coining money by starting companies “to bring up hellfire for heating” or “to squeeze oil out of radishes,” he hatched his own scheme: “A company for carrying out an undertaking of great advantage, but nobody to know what it is.”1 When he opened his door for business at 9 A.M. the next day, long lines of people were waiting patiently to subscribe. The printer took every pound offered and wisely took a boat to the Continent that evening, never to be heard from again.*2
Perhaps you’ve even heard of the Mississippi Bubble in France in 1720. The Mississippi Company promoter John Law was an expert at painting the canvas of concept. As one of his numerous spectacles to hype the stock, he marched many dozens of Indians through the streets of Paris bedecked in gold, diamonds, rubies, and sapphires, all supposedly coming from the almost unlimited mines of gold and precious stones in the mountains of Louisiana. The stock appreciated four thousand times before it collapsed in 1720.
When our forebears left for the New World with the hopes of escaping tyranny and persecution and finding a better life, Mr. Bubble took the perilous voyage with them and flourished as much as anyone on the journey. Bubbles and market meltdowns have occurred regularly since the nation’s founding; the panics of 1785, 1792, 1819, 1837, 1857, 1873, 1893, and 1907 and the crashes of 1929, 1967, 1987, 2000, and, of course, 2008. Depending on the technical definition, more could be added.
These stories are all too familiar, it’s true, but we will not be looking at bubbles through the eyes of an economic historian or simply retelling tales of the almost unbelievable levels of folly and self-delusion investors can reach. The purpose here is very different; a discussion of bubbles is essential to the investment methods we will examine in the book.
Contagion and crashes are, in fact, the starting point for our understanding of psychological behavior in the markets. After all, if everyone knows about financial bubbles, how can they keep on happening? Shouldn’t economists have figured out by now how to watch for the equivalent of the engine warning light coming on?
We all know that it’s very hard to pinpoint exactly when dangerous financial overheating will blow up the financial structure. We realize that stocks can become enormously overvalued, but still, most people don’t fold their cards and walk away with their mounting piles of chips. We just can’t seem to get the timing right. This situation has not been helped by the prevailing wisdom touted by economists.
Economists following the efficient-market hypothesis (EMH) state that bubbles are impossible to predict. Market bubbles are something like stealth bombers, they say; you can’t pick them up on radar, and you won’t know what’s hitting you until your investments are getting shellacked. No less an authority than Alan Greenspan, the former chairman of the Federal Reserve and the “prophet” of prosperity, concurs with this economic thinking: “It was very difficult to definitively identify a bubble until after the fact—that is, when its bursting confirmed its existence.”2 There is widespread agreement by economic scholars with his statement. But even worse, the popular theory states that bubbles are rational. In short, absurd pricing is always justified by the actions of totally rational, nonemotional investors, who keep prices exactly where they should be. As we’ll see, this is an easy out. But it certainly protects the Fed’s and academics’ reputations. To accept it means that we are not capable of ever valuing anything accurately. So bye-bye to all theories of valuation, whether you are buying a home, purchasing stocks, or building a new plant. Any price is good—until it isn’t. We will go into this rather tortuous logic in some detail later on, but it’s obvious that investors often do not, in fact, keep prices where they should be.
Our purpose in this book is to change this thinking or at least to help change your thinking, and your investing decisions, by revealing its folly. In this chapter we’ll take a quick ramble through history to show you a dozen of the main causes of bubbles and convince you that it is vital to come to a better understanding of how to spot them and avoid their carnage. Most of us looking back at earlier manias think that we could never make the same silly mistakes. I know I did when I first came to Wall Street in the late 1960s. In researching my earliest work, I logged a lot of hours at the New York Public Library and pulled out virtually every book I could find on bubbles and panics; I then read the daily financial section of both The New York Times and The Wall Street Journal for several years preceding the 1929 crash to get a real feel of these events. At first it looked so easy to make a killing by going against the obvious madness of these silly invest
ors in the era of speakeasies, flagpole sitters, and “jazz babies” with short skirts and boyish figures. Didn’t they know markets couldn’t go up endlessly? Taking advantage of such folly would be a cinch.
It wasn’t. It bears repeating that within a year of starting my career on the Street, I got caught up in the exact same foolishness, in the 1966–1969 Go-Go Bubble. That is a personal reason why I know that it is only through thoroughly understanding what causes manias, along with the continual overvaluations of popular stocks, that you can protect and possibly enhance your capital.
Some Common Characteristics of Manias
As we noted earlier, one of the most remarkable characteristics of speculative manias is their similarity from period to period, even if hundreds of years apart. Take the excessive use of credit as the first of many destructive characteristics most bubbles have in common.
Let’s flash back again briefly to the 1929 and 2007–2008 crashes. Enormous leverage was employed in both periods, as it was in many bubbles in the past. In 1929, investors could buy stocks on 10 percent margin. Many investors back then bought investment trusts, which themselves employed large amounts of borrowing, in effect substantially increasing the 10 percent margin the buyer normally put down. By early 1929, the Federal Reserve was very concerned with speculation and raised the interest rates on margin loans to an astounding 20 percent. That put a damper on buying on margin for only an instant. After all, 20 percent a year is only 1.67 percent a month, and stocks’ performance in the recent past had conditioned most investors to expect gains of 10 percent, 20 percent, or even more in months. Markets could only go higher, and quickly.
During the housing bubble that led to the 2007–2008 crash bankers margined themselves up to twenty-five to thirty times their capital, while investment bankers such as Bear Stearns, Lehman Brothers, Goldman Sachs, and Morgan Stanley were leveraged even more, up to thirty to forty times their capital, much of it in highly illiquid mortgage instruments. They believed that real estate markets could only move higher. With so much leverage, it took only a very small drop in the value of subprime mortgages for the bubble to burst.
Another similarity of manias is that virtually all of them have been bred in solid economic conditions, when investors’ confidence was high. Each mania had sound beginnings and was built on a simple but intriguing concept but was then characterized by the almost complete abandonment of prudent principles that had been followed for decades, if not generations.
People believed each bubble offered opportunities far more enticing than they had ever seen before. In the classic South Sea and Mississippi bubbles, the lure was the endless flows of gold and jewels from the New World that would enrich speculators beyond their wildest dreams. In the technology bubbles of the 1960s, ’70s, and ’80s, it was the inexhaustible profits to be derived from the sales of innumerable numbers of semiconductors, computers, and other state-of-the-art technological products. Speculators mesmerized by the prospect of huge gains have quickly abandoned all valuation standards in bubble after bubble.
The seemingly inexorable rise in stock prices prior to the 1929 crash was called the “New Era.” Earnings growth, it was said, would be so great that investors could toss all old-fashioned value standards aside, because things were really very different this time. In the Roaring Twenties, many major breakthroughs had occurred, from the invention of radio to the exciting promise of commercial aviation, and new and very profitable auto and industrial manufacturing techniques that could turn out almost unlimited amounts of goods and services. Those would continue to be scooped up by national and international markets, creating a remarkable new level of profitability on company stocks. During the 1996–2000 dot-com bubble, investors justified the enormously high stock prices by asserting that the dot coms had ushered in a “New Economy.” Stock prices no longer had to be justified by the valuation standards that had been followed for generations. A new wave of much higher technological profitability now called for much higher valuations.
In every bubble, the experts have also been caught up in the speculation, not only condoning the rising prices but predicting much higher ones in the future. After all, in each case people thought they had good reason to believe that the opportunity this time was really far better than any other they had ever seen.
Another kind of flawed thinking common to all manias is the “Greater Fool Theory.” In each mania some independent and skeptical thinkers were not overwhelmed by the euphoria of the time. They believed prices should never have reached the preposterous levels they had, that the crowd was really mad. But they thought things would get madder still; if prices had gone up tenfold and enthusiasm was soaring, why couldn’t they go up fifteen- or twentyfold? Thus wrote a British member of Parliament in 1720 after being bankrupted by the South Sea Bubble: “I said, indeed, that ruin must soon come upon us, but I own it came two months sooner than I expected.”3
In each mania excessively risky actions were justified as prudent. Those who did not go along were considered old fogies or even labeled “dinosaurs.” I received this distinguished title myself from Jim Cramer, the market guru who has a daily show on CNBC. A month before they crashed, he said I did not understand the enormous potential of dot-com stocks. Fortunately for me, Jim’s thinking about the bubble, not mine, turned out to be Stone Age that time round.
In every bubble, once the crowd begins to realize how wildly overpriced the stocks it rushed into are, there is a scramble to escape. A horrific panic ensues as the image changes from euphoria to doom. Rumors always play a major role, at first of fortunes being made and of good things to come and then later of prophecies of doom. Finally, prices fall back to where they started off or lower. The curtain has dropped, and the riveting drama is over.
Perhaps the most curious similarity of all is the sharp percentage drop from each high-water mark—on the order of 80 to 90 percent or more. Tables 1-1 and 1-2 illustrate this.
Have Bubbles Changed over Time?
I’m going to try to make a strong case that they haven’t. If anything, bubbles have become much more frequent since the 1960s, the price swings more violent, and the damage to the financial system and economies, both in the United States and globally, significantly greater.
Table 1-1 shows the price drops from their peaks of four of the classic bubbles in market history: Tulip Mania (1637), the Mississippi Bubble (1720), the South Sea Bubble (1720), and the crash of 1929. The price of the Semper Augustus tulip plummeted 99 percent from its high. The price of Mississippi Company stock also fell 99 percent, while that of the South Sea Company plummeted 88 percent. Finally, in 1929–1932, the Dow Jones Industrial Average made the league of major financial disasters, dropping 89 percent between its high of 381 in September 1929 and its low of 41 in 1932.
Table 1-2 shows the six major market bubbles in the United States between 1960 and 2009. There were no manias between 1932 and 1960, perhaps because investors still carried the searing memories of 1929 and the Great Depression with them.
There were also at least three major real estate manias in this period, including a major S&L crisis in the mid-1980s, a commercial real estate collapse in the late 1980s, and early ’90s (not shown), and of course the mother of crises, the subprime panic only a few years back. Nor does the table include a passel of major real estate bubbles such as the sale of large amounts of swampland in southern Florida in the land bubble of the mid-1920s. So high was the interest of buyers that the Miami News printed one edition of 504 pages that was almost all devoted to real estate ads. After that there was a collapse in real estate prices in the 1930s.
Also not included are numerous minor bubbles, among them several art frenzies (for some months in the late 1980s, Picasso paintings appreciated by about 1 percent a day). There were also stampedes into stamps, collectibles, precious metals, gold, diamonds, and coins, as well as a bevy of bubbles in the early 1990s in the Eastern European countries, after they overthrew their Communist governments. Those bring the
total number of manias into the dozens since 1960, compared with only the three in Table 1-1 in the almost three hundred years prior to the 1929 crash.
Many of the bubbles of recent years that are not shown in the tables were in dollar terms as large as or larger than some of the stock market bubbles shown.
As Table 1-2 also indicates, the dominant trend displayed in the six stock market bubbles since the 1960s is the increasingly prominent role of technology-related stocks, culminating in the infamous dot-com bubble of 1996–2000, by far the biggest technology bubble to this time. Technology stocks have had a special allure. Everyone had a general idea of what a big win IBM had been. It made over 11,000 percent on a buyer’s original investment from 1945 to 1968 and was still growing. Why not buy the next IBM now? The promoters—oops, investment bankers—spun out thousands of new technology issues for buyers to snap up. Computer-leasing companies, for example, could quadruple or quintuple the money they made, buyers were told, by simply purchasing computers from IBM and leasing them at a lower rate. Leasco Data Processing Equipment Corporation and Levin-Townsend Computer Corporation made billions of dollars for their owners and the investment bankers before they went bust. Ten years later, most of those would-be IBMs had collapsed.
In a bubble any torrid concept will work. Investors in each mania have believed and followed pied pipers. One led them dancing to National Student Marketing Corporation (NSM), the hottest stock of the go-go market of the late 1960s. At one time it traded at nearly 100 times earnings because NSM promised to unleash the collective marketing power of hundreds of thousands of college students. What it could actually market—and how well—wasn’t known. The “power” of NSM’s “massive” marketing force consisted of maybe seven hundred part-time college students at its peak, but the story sounded believable, so the stock rose as high as $143 a share before reality kicked in. Then the share price dropped, like a bear on a 150-foot bungee cord, to three and change. But it didn’t spring back.