And the crisis came.

This post has been a long time coming (the terrible pun was, of course, intended!).

"Sooner or later, bubbles always burst."

Last year, a good friend generously gifted me a copy of The Return of Depression Economics by Paul Krugman. In his accompanying note he reflected on the ‘historical insight and broader application’ captured in this marvellous book. Well, I’ve finally got around to reading it, and I couldn’t have put it better myself; the book is quite simply chock-full of ‘historical insight and broader application’.

In my post, I will attempt to capture some general principles and recurring themes pertaining to financial markets and investing. I will inevitably do Krugman’s rattling good book a disservice; but here goes…

#1 We keep reinventing the wheel.

People in finance keep on reinventing the wheel. I think there might be a pattern here: repackaging leads to enlivening – and a deathly ignition. We renamed the ‘third world’ as ‘emerging markets’ to make it sound more attractive to invest in. And we renamed ‘junk bonds’ as ‘high yield bonds’ for the same reason. And because words have power this rebranding drove up the relevant assets’ prices. The problem is that “the good opinion of markets can be fickle” because “today’s good press doesn’t insulate you from tomorrow’s crisis of confidence”. When tides turned, the former was – at least partly – responsible for the Asian crisis, and the latter ended badly in the US in 1989. People invent new, fancy jargon, hailing a good idea as the new genius rainmaker, only to rediscover that credit is credit – and risk is risk – regardless of what it is called. Similar things have happened repeatedly in history, and there is no doubt they will happen again.

#2 Moral hazard abounds.

“Modern nations...cannot find it in their hearts to let widows and orphans lose their life savings simply because they put them in the wrong bank, just as they cannot bring themselves to stand aside when the raging river sweeps away houses foolishly built in the floodplain”. This creates the expectation that governments will guarantee depositors’ money, and creates a situation of moral hazard. This sets in motion an obscene chain of events, which guarantee that the government will ultimately have to deliver on this promise, whether explicit or implicit.

#3 Bad things happen to good economies (all the time).

Risk = (Hazard x Vulnerability)/Capacity to Cope. Or at least, that’s what I was taught. Why is this relevant? Well, it distinguishes between a hazard or bad event and the factors that determine the level of risk posed by this event. A strong economy, by which I mean a fundamentally sound economy (and not one that is on a euphoric credit-binge, or which is overwhelmed by a false sense of indestructibility), has a higher capacity to cope with a bad event, and may even be less vulnerable to a bad financial event. However, if the event is significant enough, in terms of magnitude, then it can still wreak an incredible amount of havoc. This is why “bad things can happen to good economies”.

#4 Be wary when people say this time is different. It rarely ever is.

Just when a recession starts seeming like an impossibility, that is when it is most likely to strike “out of a clear blue sky”. As I mentioned in my post based on A Short History of Financial Euphoria, a sense of progress brings a (justified) sense of optimism. And then, even the most sensible investors (quite literally) sell their brains, unable to take a long view when everyone around them is getting rich. What once started as insightful optimism is transformed into mania – or as Krugman puts it, “hype springs eternal, and people [become] willing to suspend their rational faculties”. This is when people, having forsaken reason, start spouting nonsensical explanations for why this time is different. At this point, there is too much money chasing too few deals. Well, that is when you know a crisis is coming. Reality, time and time again, has shown that “all financial crises tend to bear a family resemblance to one another”.

#5 Because believing makes it so.

If people expect a recession and so consume less, other people earn less. So, they may be unable to make interest payments on existing debt, let alone borrow more money. And because one person’s spending is another person’s income, this would have a ripple effect. This deleveraging is part of the credit cycle. 

Similarly, a loss of investor confidence, results in falling asset prices, and falling liquidity. As losses mount, confidence falls further, and all the air can go out of the bubble. This can be particularly acute due to margin lending. The quantitative strength of the feedback loop matters.

This is why Krugman explains how there are panics and then there are panics. Sometimes a panic is just a panic: an irrational reaction on the part of investors that is not justified by actual news. Much more important…however, are panics that, whatever sets them off, validate themselves – because the panic itself makes panic justified. He later goes on to reiterate that “When an economy is vulnerable to self-validating panics, believing makes it so”.

#6 Permabears all over the place!

Paul Samuelson once quipped that declines in U.S stock prices had correctly predicted nine of the last five American recessions. I personally like to replace ‘declines in U.S stock prices’ with another phrase: ‘so-called experts’. You might think that this must make people risk-conscious – and if you do, you would be wrong. Because “ever since the 1930s there have been people predicting a new depression any day now; sensible observers have learned not to take such warnings seriously”.

Not only do permanently bearish, ominous statements become impotent, they also lead to bad decisions. People might justify being a permabear by saying “better safe than sorry” but, in the long run, they will just be left feeling stupid – and sorry. That is not to say that we should be blindly optimistic. Quite the opposite: investors must seek to be optimistic whilst approaching everything with a healthy dose of skepticism.

Expert Opinions: Signals vs. Noise

Today, when I read the news or browse through social media, I notice a deluge of confident expert opinions and ‘scientistic’ forecasts (too readily) available in our information age.

This is why I am fascinated by the reliability — or lack thereof! — of expert opinions and forecasts. This interest was further developed through my IB Theory of Knowledge presentation, which explored the extent to which it’s possible to make reliable economic predictions. I learned that we frequently derive false security from precise numerical forecasts, which are often based on data that can be conveniently measured rather than the most important parameters (which might be difficult or even impossible to measure).

Hayek’s speech titled ‘The Pretence of Knowledge’ further led me to conclude that economists can make directional predictions, not precise forecasts. Hans Rosling’s Factfulness even describes a quiz in which chimpanzees outperformed so-called experts. I learned that forecasts reported in the media are often made by overconfident pseudo-scholars — and even when made by a genuine scholar, forecasts are still bound by any model's limitations.

Yet thoughtfully developed predictive forecasts remain important for effective decision-making, which (particularly in the investing world) requires an implicit consideration of a necessarily uncertain future. Experts’ analytical, frequently imaginative statements about the future are powerful tools that allow us to build models and glimpse through a translucent lens into a potential future.

During my exploratory journey in the world of value investing, I have learned that investing requires us to distinguish meaningful signals from the cacophony, generated by experts and media pundits and amplified by social media, surrounding the global economy. I am certain that our ability to separate the wheat from the chaff — or, more appropriately, the signals from the noise — is what will determine whether or not we are able to generate alpha over a long period of time. 

As I once said Leave it to the Experts (Don't)!!!

Howard Marks' Latest Memo: You Bet!

I have read pretty much all of Marks' memos, and this one is one of the best yet. The key implication for (equity) investors, if I understand correctly, is that a great businesses can be a poor investment at the wrong price, whilst a terrible business can be a great investment at the right price. Instead of trying to identify winners, we must seek to identify - and capitalise on - 'mispricings'.

A Short History of Financial Euphoria, by John Kenneth Galbraith

I first read this book, a perfectly-worded reflection on the most iconic (if I may use such a word!) speculative episodes in human history, after studying the Great Depression and the New Deal at school. I am fascinated by the mass insanity and “the associated financial deprivation and larger devastation” of every speculative episode; the infectious boom, is always accompanied by “desperate and largely unsuccessful efforts to get out”. There is almost no doubt in my mind that “speculative episodes end not with a whimper but with a bang”. In this post I will try to highlight a few insights I picked up from this brief and impactful must-read.

• There is no such thing as financial innovation - only credit. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” This is why Galbraith advises, “when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is the time for caution.” 

• Any association of money with intelligence is nothing short of “specious”. People are entranced “by the great financial mind” because there is a “feeling that with so much money involved, the mental resources behind them cannot be less.” This belief leads to the bidding up of asset “values [and] confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash”.

• Crowd behaviour and FOMO spread the infection. “Anyone taken as an individual is tolerably sensible and reasonable - as a member of a crowd, he at once becomes a blockhead. - Friedrich Von Schiller, as quoted by Bernard Baruch.” When irrational herd behaviour sets in and a mood of excitement (or god forbid, euphoria!) ripples through the market, speculation (quite literally!) “buys up...the intelligence of those involved.”

• The financial memory is extremely brief. “Dementia comes forward to capture the financial mind” every ten years (rule of thumb?). This “is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius”.

• As Buffett says, “What the wise do in the beginning, the fool does in the end.” Booms often begin because there is a kernel of truth in the so-called innovation, but they quickly escalate into episodes of mass insanity.

• I am fascinated by the way in which we seek to apportion blame after the inevitable bang that marks the end of a speculative episode. Instead of looking at the way in which market participants were foolish, we instead seek to fault governments, banks, and institutions (to blame the public's mass insanity would be cruel, cold-hearted, and politically incorrect).

The Pretence of Knowledge

This post is based on Friedrich August von Hayek's lecture titled 'The Pretence of Knowledge' to the memory of Alfred Nobel, on December 11, 1974. Adapted quotations may be used without quotation marks.

Key Learnings

Investing, like economics, is essentially complex. This is because outcomes do not depend only on the relative frequency of individual actions or occurrences, but also on the manner in which the individual actions are connected with each other. For this reason we cannot replace information about every individual actor (human being) with statistical information, and require full information about each actor if we wish to derive specific predictions about individual events. 

All of the particular information possessed by every one of the participants in the market drives the value of assets (or goods). This means the price is determined by a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain. This is the source of the superiority of the market order, and the reason why free markets are the most efficient allocators of resources using information which only exists in dispersed form. 

Our inability to assimilate all of this data means that investing and economics must not be treated as Physical Sciences. In fact, Hayek says that a scientistic attitude is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed. As mentioned above, we do not have the ability to access (or even measure) all of the necessary data. This is why economists and investors with scientistic attitudes frequently treat the data which happens to be accessible to measurement as important that – not necessarily the best data. We know, for example, that good quality management is essential for a good business to grow sustainably. However, there are shades of grey in measuring the quality of management. This is why a purely numbers-based/scientific approach to investing would only take measurable quantities into account, proceeding on the fiction that the factors which can be measured are the only ones that are relevant.

Without access to all the necessary information, we are confined to making directional predictions – predictions of general attributes, but not containing specific statements. It is possible to say, for example, that a company will be worth substantially more over a long time horizon; however, we must not – or more precisely, cannot – predict the exact value and the time at which this value will be attained.

Implications for Investing

Hayek's paper does not criticise the use of numerical evidence to help put the magnitude and implications of forecasts into a context. However, he cautions against the dangers posed by the false sense of comfort that numbers can give us, and critically aware of the arrogance that (successful) precise predictions can engender. This is why he refers to the "danger [posed] by the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, 'dizzy with success', to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will." His speech culminates with a reflection on the importance of humility when dealing with essentially complex phenomena: "The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilisation which no brain has designed but which has grown from the free efforts of millions of individuals." All of this means there are a few key things we must remember as investors.

• The market is typically efficient because it is the sum of all of our viewpoints. This is why it is important for investors to ask themselves: Who doesn't know that?
• Trying to be overly scientific, particularly with insufficient data and knowledge, is dangerous.
• Rely on first principles thinking as opposed to blindly using correlations. These correlations are directional – not deterministic – and only work when the ceteris paribus condition holds, till an unexpected event leads people to stop believing in their determinism. In the real world, there are many variables at play, and simple relationships are only useful oversimplifications.
• A great many (important) facts cannot be measured and so, are disregarded. The idea that only facts which can be measured are relevant, is fantastical.
• You must have an understanding of the Narrative and Numbers of the business.
• We must use numbers directionally (as a reality check), and try to avoid being seduced by the false sense of comfort that numbers may offer. 

Is this changing?

To an extent. We are becoming more able to collect data. Not only do firms such as Facebook and Google target advertisements based on our online interactions and search history, but Amazon has a record of our purchases, Netflix a record of what we watch, and Spotify a record of what we listen to. Investors can (or might eventually be able to) analyse traffic in parking lots outside malls, the weight of bags being carried by consumers, lexical choices in transcript, and even the expressions and tones of voice of CEOs to determine their confidence and honesty levels. This is both, good and bad; we will have more data to test hypotheses, but we will also risk becoming more comfortable and more arrogant as we make misleadingly precise predictions.