-Caveat Lector-
Investors need to know Economic History.
THE POST-WAR PERIOD
by Raymond DeVoe, Jr.
I have been keeping a list of the stupidest things said on CNBC. The list
is lengthening. But the one that gets into my mind the way those "Golden
Oldies" do are the comments that start with something like: "In the postwar
period, the economy (or stock market) has always (or almost always...)"
...and then they go into what either always, or almost always, was done in
the period since 1945.
To fill in some of the blanks following those "postwar period" lead-ins:
"[The economy]...responded to Federal Reserve interest rate cuts and was
recovering 6-9 months later"; "[The market] anticipated the recovery and
was substantially higher when the economy bottomed"; "[The stock market]
was X% higher on average six months after the economy turned Y% higher a
year into recovery)"; "bear markets average about 11 months, so we should
be..." etc.
My reaction to this is the same as when the people on TV state something
like, "The stock market has been higher 65% of the time on the Friday
following Thanksgiving, so there is a 2-to-1 probability that it will rise
on November 29, 2002." This goes into my "Rule (or, Misrule) of History",
which goes, "If the stock market regularly repeated past patterns, the
richest people on Wall Street would be librarians and historians - and
that's just not true."
My reaction to those "postwar period"-citing analysts and strategists is:
what is so special about the postwar period? Why should the period since
World War II ended in 1945 mean that everything will follow those economic
and stock market patterns?? How do they summarily dismiss everything that
happened prior to 1945??? Could it be that what is going on now is quite
different from "postwar period" conditions, that it really is different
now????" For the latter - think theme music from "The Twilight Zone" - all
is not what it appears to be. Recently, I did an interview for the December
issue of a financial magazine profiling "The 30 Smartest Investors on Wall
Street." I don't know how they got my name, since I have done very little
personal investing - and my attempts at bottom-fishing have not been
particularly successful. I asked who the other 29 were - I couldn't imagine
that many brilliant people this year, since "Genius is a strong bull
market", and the opposite is true of a bear market. The interviewer
wouldn't name the others. Since the article was for the December issue, I
told her that the Annual Wall Street Christmas Pageant had already been
cancelled - they couldn't find three wise men, or a virgin.
I was asked who the smartest person was I had met in the investment world.
That was easy: my professor and guidance counselor at Columbia Business
School, Prof. David Dodd of Graham and Dodd's Security Analysis. Then she
asked what I thought was the best book about investing, and why. I thought
about it, and answered the question somewhat differently - if there was one
book that every novice investor should read, my nomination would be Manias,
Panics, and Crashes - A History of Financial Crises by Charles P.
Kindleberger.
Why? Behind my reason was the fact that before you can drive a car or fly a
plane, you have to have a certain amount of training with an experienced
instructor. Then you have to take an examination and a test drive or
flight, where you can fail, before you get your driver's or pilot's
license. For the latter, you also have to keep up with continuing
education. To qualify for night, instrument, or non-visual flying, you have
to take additional instruction.
Yet neophyte investors, some unable to articulate the difference between a
stock and a bond, are allowed to "pilot" their life savings and/or intended
retirement portfolios without any form of instruction or training. All they
have to do is open a brokerage or mutual fund account and give some
(frequently confused) indications about their financial resources and
investment objectives. Since this neophyte investing is almost always
started in favorable weather, a bull market, they are totally unprepared
for what might happen when a storm arrives.
Worse, they have been conditioned (brainwashed?) into believing the mantras
of "buy on the dips", "hold for the longer term", and that "there is no
long-term risk in stocks, only short-term volatility".
Mr. Kindleberger's book may not prevent people from making financial fools
of themselves, or losing a lot of money. But it will give a new investor a
warning and a sense of history. Manias are nothing new and have occurred
regularly. However, the one that popped on March 10, 2000 (Nasdaq Composite
5048), others that may be hssssing now, and the housing bubble to deflate
some time in the future, in combination, may constitute the largest
financial mania in history. A new investor reading Manias, Panics, and
Crashes would be alerted to the fact that no mania goes on forever - that
some have panics, some have crashes - and others can be followed by years,
sometimes decades of stocks going nowhere. I always point out that in the
18 years prior to this bull market (1964-1982), the Dow Industrials sold in
the 800-900 area at some point during the year.
This may not prevent a new investor from being caught up in a mania, but at
least they would be aware of what always happens (i.e. there is never a
"New Era") and possibly get out in time or limit their losses. "The market
always comes back," another mantra, has been true - but it took 25 years to
do that after the 1929 peak. Still, many stocks do not come back. I knew a
man who bought Radio Corporation of America (now part of GE-$25.28) in 1928
when it was the cutting-edge technology growth stock of the time. It
tripled to the 1929 peak. He held it for over 40 years, until the color TV
mania of 1968, so that he could break even. Others were not so fortunate,
since thousands of stocks were wipeouts. Overstaying a mania, particularly
"holding for the longer term" has approached an ominous point now. Today's
Wall Street Journal has an article by Ken Brown titled "Investors Seem No
Longer To Be Big Dippers" that indicates investors no longer "buy on the
dips" - but rather, could be poised to sell if the market declines further.
James Bianco of Bianco Research tracks the profits and losses of equity
mutual fund investors since the final stage of the bull market began in
1990. "When the market hit bottom earlier this month, falling to five-year
lows, mutual fund investors, in the aggregate, had a slight loss on all the
money they put into domestic stock funds since October 1990", Mr. Bianco
reports.
The low point that month in 1990 on the Dow Industrials was 2365.10, vs.
8443.99 now. The reason for the near break- even condition of equity mutual
fund investments, with the Dow Industrials 257% higher than 1990, is that
very little money was invested in the earlier stages of the bull market,
when values were more reasonable. Most investments were made near the top -
in 1998 and 1999. In addition, large amounts were switched into previously
"hot" mutual funds just as they peaked. Mr. Bianco cited his "casino
theory": that investors are much more aggressive with stocks when they have
large profits ("playing with the house's money") and are more likely to
become very conservative when their own capital is at risk.
Following my magazine interview, I decided to take my own advice and
re-read Mr. Kindleberger's book. It's not long, just 197 pages before
appendixes and footnotes. My first edition copy (1978) is looking rather
dog-eared, marked-up, and the paper has turned orange - so I bought the
1996 third edition. It has an ominous quotation from Prof. Paul A.
Samuelson of Massachusetts Institute of Technology (MIT) on the paperback's
cover: "Some time in the next five years, you may kick yourself for not
reading and re-reading Kindleberger's Manias, Panics and Crashes." It took
only about four years from 1996 to March 10, 2000 for people to start
kicking themselves about Nasdaq. The first three chapters, entitled
"Financial Crisis: A Hardy Perennial", "Anatomy of a Typical Crisis" and
"Speculative Manias", document almost four centuries of boom-and-bust
financial cycles.
The main difference in the third edition is that it includes the rise and
fall of the Japanese stock market and property boom in the 1980's - and the
bust that followed-up to 1996. In his "Introduction to the Third Edition",
Mr. Kindleberger warned "....and what looks, in the fall of 1995,
suspiciously like a bubble in technology stocks." In the book he lays out
the classic pattern of boom-and-bust cycles. 1) a fundamental change, such
as war or new technology occurs - which creates new investment
opportunities, 2) investment expands, often fueled by easy bank credit, 3)
investment becomes more speculative, based on overoptimistic expectations
of potential growth and earnings, 4) in the latter stage, investment is
totally detached from reality and becomes a mania, frequently spreading
globally, 5) the excessive borrowing to finance overinvestment brings about
excess capacity - and a collapse in prices, 6) eventually the mania ends in
a crash, with widespread investor revulsion as investors flee falling
markets, and 7) authorites are then left with the problem of how to
stabilize and then fix the financial system, with the discovery of
extensive corruption and financial manipulation.
Sound familiar? Appendix 'B' at the back of the book is entitled "A
Stylized Outline of Financial Crises, 1618- 1990" and lists 42 "crises"
that occurred during that period. Only four of them are in the "postwar
period," including the Japanese speculative peak of late 1989. These
"crises," not necessarily recessions or bear markets, include the
OPEC-induced recession caused by the embargo and quadrupling of crude oil
prices in 1973, the Federal Reserve-induced recession of the early 1980's
to bring double-digit inflation under control, and the "panic" of October
19, 1987, also related to the Fed's raising interest rates to suppress
inflation.
Raising interest rates is what started the decline from the peak of 2722 in
the Dow during August 1987. The 508 point decline of October 19th was
brought about by a combination of other factors - including the estimated
$90 billion in stocks that was "protected" by portfolio insurance. When the
triggers were hit on this huge amount of stock, massive dumping occurred,
and it overloaded the system. Actually, the one-day decline could have been
worse, in my opinion, if the options and futures' traders had continued to
make a market. Instead they disappeared - removing the other side of the
"insurance", - and stocks that should have been sold were removed from the
market. He labels that a "crisis", which was a one-day bear market, but no
recession followed. Thus, two of the three U.S. postwar "crises" were
attributable to exogenous variables.
In any case, almost every one of the pre-1945 "crises" listed in the
Appendix to Mr. Kindleberger's book are of the "boom-and-bust" variety. And
virtually every recession since 1945 in this country has been brought about
by the Fed's raising interest rates to suppress inflation. Question: how
many major stock market bubbles have occurred in "the postwar period?" Only
one, during the 1990's.
There have been other speculative manias, but they were confined to
individual sectors - I can list at least four in technology (or, in "The
Great Garbage Market of 1968," anything that appeared to be technology, or
had a name that suggested it. That was similar to the "dot-com" mania when
companies added ".com" to their names and the stock prices soared.) There
were others in bowling stocks, uranium, airlines, color TV - but they were
confined to those sectors. When the bubbles burst, the major damage was
generally limited to the participating stocks, with some fallout. There is
always some spillover, since when a bubble bursts, many of those former
high-flyers are virtually un-sellable. The liquidity disappears, and large-
capitalization stocks with good markets are sold instead.
This time, it really is different. This is not a "postwar period" type
situation - it is a "post-stock-market bubble period." The London Economist
in a 28-page pullout ("The Unfinished Recession - A Survey of the World
Economy, September 28, 2002") points out about Central Bankers: "They do
not seem to grasp that this economic cycle is different from its
predecessors". As they state, "postwar recessions have been principally the
result of increasing inflation. Last year's recession and current economic
stagnation are not the result of inflation, but the result of burst
economic and stock market bubbles." This is the first of that type in the
entire "postwar period" - and why the economy has not responded to 11
interest rate cuts - which has always stimulated traditional Fed-induced
"postwar" recessions and brought about economic recovery.
Thus, this is not a normal, "garden variety" postwar recession. This is
more comparable to the traditional boom- and-bust "crises" Mr. Kindleberger
has documented for about 400 years. The late Rudi Dornbusch, another MIT
economist, once remarked that "none of the postwar expansions died of old
age; they were all murdered by the Fed". With the exception of 1973-74,
which was due to exogenous variables (OPEC's embargo and the quadrupling of
oil prices) - and the current ongoing experience, every recession since
1945 was preceded by a sharp rise in inflation that forced the Fed to raise
interest rates to cool off the economy. There were always two policy
errors - allowing the economy to overheat in the first place, then hitting
the brakes too hard.
That Economist pullout "The Unfinished Recession" is another suggested
reading, not only for a post-mortem of the 1990's bubble, but for a sober
assessment of the current state of the U.S. and world economies. As they
state in the introduction, "This is no traditional business cycle, but the
bursting of the biggest bubble in America's history. Never before have
shares been so overvalued. Never before have so many people owned shares.
And never before has every part of the economy invested (indeed,
overinvested) in new technology with such gusto. All this makes it likely
that the hangover from the binge will last longer and be more widespread
than is generally expected."
This "post-postwar period" is different from the other recessions and
recoveries since 1945. This is the only time that a bubble in both the
stock market and economy has occurred in 73 years, and burst. As pointed
out previously in other reports, investment has fallen for seven
consecutive quarters. That's the longest in the entire "postwar period".
Stocks haven't fallen for this long in that same span. Household net worth
rose every year in the "postwar period", until 2000 - and is likely to
shrink this year for the third year running. But most significantly, never
during the "postwar period" have we had the unwinding of a massive
speculative bubble.
Regards,
Ray DeVoe,
for The Daily Reckoning
P.S. Those limiting their analysis to the last 57 years are arbitrarily
ignoring all previous history of financial crises - as documented by Mr.
Kindleberger's analysis of almost 400 years of "crises". This is an
economic "Twilight Zone" fluctuating between recession and recovery - with
very poor visibility. It will be different - not necessarily better, or
worse, just different - and will take longer to recover from than is
generally expected.
Editor's note: Raymond F. Devoe, Jr. is the writer, editor and creative
genius behind The Devoe Report, published by Legg Mason Wood Walker. Ray is
also a frequent contributor The Daily Reckoning and:
<A HREF="http://www.ctrl.org/";>www.ctrl.org</A>
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