Episode #24: Learning to Love Investment Bubbles
Guest: Episode 24 is just Meb.
Topics: Episode 24 brings us back to our most controversial episode format: the “solo Meb” show. Listeners seem to either love and loathe this style of show. If you fall into the “loathe” camp, it’s a short episode so the pain is limited. But hopefully you will listen, as Meb dives into the fascinating, and possibly timely, subject of bubbles. The quick takeaway? Using a trend following approach would have helped you reduce drawdowns as popping market bubbles ravaged portfolios. And this would have helped you achieve investing’s main goal: surviving another day. Meb then dives in, first defining bubbles, then referencing three of the most famous bubbles in history: the South Sea Company bubble, the Mississippi bubble, and the Dutch tulip mania, each of which saw drawdowns of 90%. Meb dives deeper into the South Sea Company bubble. In short, the South Sea Company was a huge pump-and-dump scheme – catching none other than Sir Isaac Newton in its carnage. From here, Meb discusses strategies for capturing the upside of bubbles while protecting yourself from the fallout. One solution? Trend following, using the 10-month simple moving average. It does a great job of reducing volatility and drawdowns, and improving returns. Meb ends the show by revisiting the South Sea Company bubble, this time putting an actual figure on Newton’s losses, and comparing them to what a trend follower would have made. What’s the difference? Find out in Episode 24.
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Links from the Episode:
- “Learning to Love Investment Bubbles: What if Sir Isaac Newton Had Been a Trendfollower?” – Faber
- “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever”, GMO
- Contrarian Investment Strategies, Dreman
- Extraordinary Popular Delusions and the Madness of Crowds, Mackay
- “I Want to Break Free, or, Strategic Asset Allocation Does Not Equal Static Asset Allocation” James Montier
- “Where the Black Swans Hide” – Faber
- Why Stock Markets Crash: Critical Events in Complex Financial Systems – Didier Sornette
- The Misbehavior of Markets by Benoit Mandelbrot
- Fooled by Randomness and The Black Swan: The Impact of the Highly Improbable by Taleb
- Finding Alpha – by Eric Falkenstein
- Market Volatility – Robert Shiller
- Optimal Portfolio Modeling – Philip McDonnell
- Fractal Market Analysis – Edgar Peters
- More Than You Know: Finding Financial Wisdom in Unconventional Places – Michael Mauboussin
- The Failure of Risk Management: Why It’s Broken and How to Fix It – Douglas Hubbard
- Famous First Bubbles – Garber
- Manias, Panics, and Crashes by Charles Kindleberger
- Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay
- Irrational Exuberance – by Robert Shiller
- A Short History of Financial Euphoria and The Great Crash 1929 – John Kenneth Galbraith
- The Panic of 1907: Lessons Learned from the Market’s Perfect Storm – Mark Bruner
- The Little Book of Behavioral Investing – James Montier
History of Markets:
- Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, and Mike Staunton
- Stocks for the Long Run by Jeremy Siegel
- Reminiscences of a Stock Operator by Edwin LeFèvre
- When Genius Failed by Roger Lowenstein
- Capital Ideas, Capital Ideas Evolving, and Against the Gods by Peter Bernstein
- Ibbotson Yearbook by Ibbotson Associates
- The CRB Commodity Yearbook by Commodity Research Bureau
- The Essays of Warren Buffett by Warren E. Buffett and Lawrence A. Cunningham
- Fortune’s Formula by William Poundstone
- The Myth of the Rational Market – Justin Fox
- The Great Game: The Emergence of Wall Street as a World Power: 1653-2000 – John Gordon
Transcript of Episode 24:
Welcome Message: Welcome to The Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations he will not discuss any of Cambria funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Meb: Hello friends and welcome to the show. Today we have the second in a series of audio book style podcasts. The first one garnered a lot of interesting feedback. People either really loved it and said, “Meb, I’m never going to read any of your white papers or books but I love listening to the podcast. This was perfect.” And also I got, on the flip side, some people saying, “Meb, lad, my nightmare is listening to you alone for an hour. Please don’t ever do that again.” So if you’re in the latter, you may as well click off now and if you’re in the former, this is an interesting one because today we’re talking about learning to love investment bubbles.
We’re also talking about trend following and Sir Isaac Newton. Before we get started I want to talk about two housekeeping items. Speaking of feedback, we’ve gotten a lot of feedback. It’s wonderful. Keep it coming. I love the reviews on iTunes, if you haven’t left one, take five minutes and leave one. We really appreciate it. You can send e-mails for the Q&A episodes. We’ve gotten lots of great questions. Some more of those coming up. E-mail address is email@example.com. I want to read another feedback Tweet we got which I thought was pretty funny. And it says, “I prefer to listen to the Meb Faber podcast for content and the fact that he always sounds like he smokes at least five joints beforehand.” I don’t know about five, maybe three or four. Just kidding, we have had a few beers on some of the podcasts but there’s a perfect solution to this. If you’re listening, many of you might not know this, on iTunes’ podcast app as well as on Overcast and other apps, you can actually listen to the podcast at one and a half, or probably for me, two times speed.
Pretty cool feature. It sounds a little bit like a chipmunk but it lets you put down these in about half the time. So check it out. Good way to listen to podcasts. I use it that way. Second, if you haven’t checked out the Cambria Digital Advisor, go take a look. It’s at cambriainvestments.com. We feature an automated low cost tax efficient global asset allocation. A lot of people found it wonderfully helpful. Think you’ll check it out. That’s how I manage all of my investing assets. We’ll do updated blog posts here soon. So the topic of this piece is September 2011 white paper we wrote, titled “Learning to love investment bubbles. What if Sir Isaac Newton had been a trend follower?” Now I’m going to read the entry abstract and then get started.
It said, “Investment manias and financial bubbles have likely existed for as long as humans have been involved in financial markets. In this research piece we take a look at some of the more famous market bubbles in history and the extreme volatility in draw-downs these experienced. When we examine a simple trend following approach investors could use to manage their risk across 12 market bubbles, we find that a trend following system would have improved returns while reducing volatility. Most importantly it would have reduced draw-downs significantly leading to the most important rule in all of investing, surviving to invest another day. What exactly is a bubble? The dictionary defines it as a state of booming economic activity that often ends in a sudden collapse. But perhaps the most commonsense definition of a bubble is a scenario where the general public is sucked into an investment in which they have no business being involved. It was a good sign a bubble exists when everyone was talking about Internet stocks back in 1999. Listeners can remember back CMGI, pets.com, all the high flying Ciscos of the world or buying tulips and tulip futures worth as much as a house in the 1600s or even flipping real estate as more recent as 2007 or buying the BRICs when they were trading in CAPE ratio’s, 10 year p/e ratios before the GFC in 40s and 60s. Some other people define a bubble as a deviation from the long term price trend while others declare a bubble when price decouples from an assets fundamental value. In many cases fundamental value is subjective of course. How much that Van Gogh are a ’67 Corvette is worth may be very different than how much it’s worth to someone else.”
Steve Cohen certainly finds $10 million worth of value in the shark installation, “The physical impossibility of death in the mind of someone living”, while I mostly see a dead and rotting shark. Financial assets are a little different than muscle cars and shark sculptures in the sense that they generate stream-of-cash flows that act as an anchor to an estimate of fundamental value. We always talk about stocks as buying into part of a company as well as bonds kind of like being the bank. At the very end of the rope lies the emotions of greed and fear which determine the vast majority of asset price movements in the short term. There’s been a lot of talk in bubbles over the past decade after two big bear markets. Investment bubbles have likely been around as long as trading has occurred in markets. A fellow student of bubbles, Jeremy Grantham of Grantham, Mayo, & van Otterloo, also known as GMO money managers, collected data on over 330 bubbles in historical studies and he points these out in a research piece called “Time to wake up. Days of abundant resources and falling prices are over forever.” And he talks about one of the key difficulties in distinguishing when a bubble is indeed occurring or when there’s actually a paradigm shift. When is this time really different? We’ll link to that piece as well as others in the show notes. Three of the most famous bubbles in histories are the South-Sea Company bubble of the early 18th century, the Mississippi bubble around the same time and the Dutch tulip mania of the early 17th century all of which saw draw-down’s which we define as a peak to trough loss of at least 90%.
We’re not going to review or link these bubbles, as many have done a wonderful job already and we’re including a reading list at the end of this piece and we’ll link to it in the podcasts for further enjoyment. One of my favorite books, there’s a lot of them, but “Extraordinary Popular Delusions and the Madness of Crowds”. Highly worth reading. So while tulip mania and the Mississippi Company are both fascinating bubbles, this podcast focuses on the South Sea bubble of 1711 to 1720. Since the term bubble was actually coined during this period. The South-Sea Company was a British company founded by a high ranking government official by the name of Lord Treasurer Robert Harley. England amassed a large national debt during the war of Spanish Succession and the company was founded to help the fund the government debt in a roundabout way since the Bank of England had the only joint stock banking charter at the time. The South Sea Company issued new shares of stock to existing bondholders of the government debt. In exchange for assuming the debt the government granted the company monopoly on trade with South America, while continuing interest payments on the debt in the amount of 6%.
In theory this was a win win for all parties. The company received cash flows to fund ops in the form of government bond payments. The government reduced their interest payments and the holders of government debt received shares in a company founded with a built in monopoly and staffed by high ranking government officials. The South Sea Company continued to acquire more debt over the next few years with lower and lower interest payments. What could possibly go wrong? The investors in South Sea Company stock were convinced that the troves of wealth coming out of the South American gold mines would be traded for Europe’s fine textiles and other refined goods all at an obscene profit. Unfortunately profits from the shipping monopoly which also included rights to deliver slaves to South America never materialized as only one ship was allowed transport per year.
This reality did not stop a speculative frenzy from ensuing as many secondary offerings of South Seas stock were initiated with politicians receiving shares and options thus incentivizing them to inflate the stock price further. As speculative trading in South Sea Company’s stock increased, other joint stock companies were launched on the London exchange. Charles Mackay reviews some of these in the book I mentioned earlier “Extraordinary Popular Delusions”, including one company that was founded with the purpose of “carrying on an undertaking of great advantage but nobody to know what it is”. In effect, none of these investors knew what the company’s business model was. The founder collected £2000 for the share offering and the next day promptly skipped town, never to be heard of again. If this scenario seems implausible, recall the rabid popularity of so-called special purpose acquisition corporations also known as SPACs, from 2005 to 2007 which were essentially blank check companies that raised a whole lot of capital based on a vague and imprecise business plan often in order to try to acquire a certain company later.
Another company during this period planned to build floating offshore mansions for London’s elite. Sounds a little bit like Peter Thiel’s country ideas, and yet another had a formula to harness energy by reclaiming sunshine from vegetables. These newly forded stock issuances were called bubbles at the time. Eventually the South Sea Company convinced members of parliament, many who have already line their pockets with their stock to pass the Bubble Act on June 9th, 1720 which prohibited the existence of any joint stock company not authorized by a Royal Charter. South Sea Company had been granted a Royal Charter and the Bubble Act passed before the peak of the run up in South Sea Company stock helped forming the bubble by making these shares all the more valuable. Trading the shares was one of the earliest pump and dump schemes in history.
The management lacked any relevant shipping and trading experience but were shrewd stock promoters that took office space in the finest area of London’s financial district and appointed their offices with opulent furniture and art. In the end when the insiders knew that the company’s earnings would be abysmal, management began quietly selling at the height of the market. South Sea Company shares began to plummet and to make matters worse, company officials allowed shareholders to borrow money to buy more shares effectively granting them margin. When the share prices fell, investors were forced to sell even more shares while the stock price began the year around £100 before racing to a peak of nearly a £1000. That’s a ten bagger or nine bagger before crashing all the way back down to 100 pounds a complete round trip. A number of high ranking officials were impeached or imprisoned and estates confiscated for their corruption including Chancellor of the Exchequer, Postmaster General and heads of ministry. Trading in South Sea Company shares translated from all walks of life from these high ranking officials, to everyday craftsmen, to one very prominent scientist who said, “I can calculate the movement of the stars but not the madness of men.”
This aforementioned quotation is attributed to Sir Isaac Newton an unfortunate speculator in South Sea Company during the period. Mark Farber has compiled a chart of Newton’s trading ability and the prior figure which will show in the show notes that it illustrates a few key points that have withstood the test of time meaning, it shows when Newton invested a little bit before the price had run up, he exits after about a double. Wonderful investment in a short period of time. However he sees the stock price and then double again, so all of his friends are getting rich, the price keeps going up, he’s got what modern day technical term called FOMO. Everyone else is getting rich except for him. He enters with a lot near the peak and of course exits when the stock price has gone down 90%. So a few key points. Investment bubbles have been around for centuries too. It’s nearly impossible to stand aside while everyone else including your neighbor, is getting rich. Ironically enough the company continued to operate until the 19th century far outlasting all of the original shareholders.
So we don’t have a list of all Grantham’s bubbles. We took a look at 12 bubbles from a piece that one of his co-workers wrote, called James Montier. “I want to break free or strategic asset allocation does not equal static asset allocation.” Some pretty famous bubbles the ASM peak in the 20s, Japan in the 80s, some other commodity markets and a handful of currencies as well. And so we examined all 12 bubbles. On average, returns over the bubble periods were meager because of the big losses in the end, you had about three and a half percent nominal. Volatility was high, twenty two percent per year. Think about normal stock volatility usually around 17, 18% so this is even higher and let’s include currencies and commodities and the max draw down typically was around two thirds, that’s a lot.
We had another research piece entitled “Where the Black Swans hide” that demonstrate the impact of market outliers as well as the tendency of big price moves to come in batches. These volatility clustering occurs after markets have already begun declining and is due largely to the behavioral properties of the human condition, namely we hate to lose money but love making it, and we use different parts of our brain when doing both. To examine a simple way in which an investor could have attempted to profit while also protecting themselves from these wealth destroying bubbles, we examined how a simple trend following measure would have performed in these 12 bubbles. We used the 10 months simple moving average which we published and talked about way back in 2006 and 7. It’s the monthly equivalent of the 200 day moving average and it probably the most famous technical indicator out there and examine returns both including T-bills as well as stashing cash under the mattress meaning the portfolio is invested in a specific market when the price is above the 10 month moving average and out of the specific market when the price is below meaning, moves to cash or the safety of bonds.
We also look at nominal and real returns to kind of compare apples to apples. And while GMO made some adjustments to their bubbles such as de-trending the stock moves we just look at the return on all returns and in the manner an investor would have experience some of the time with their own real money. So we look at it, we take a first example and we’ll publish this white paper link on the blog and we look at it for a very common and simple example, the S&P. We’ve looked at it since 1990 which had the Internet bubble, ensuing crash and then the 2000 mid-2000 real estate bubble and ensuing crash in stocks. But the timing model did a great job of reducing the draw down from the large bear market declines in both periods as well as reducing volatility. Now the thing about trend following is you’ll also notice there’s under-performance at certain periods as well almost by definition nothing can really outperform a strong roaring bull market unless you’re using leverage because the turn volume model will simply be long and so at most it can match but more or likely it will under-perform when invariably during this bull market you will have the dips which you will get out to protect capital and then get right back in.
So if you look at for example the S&P over that period did about 7% a year. Timing actually did better, about 10 percent a year. But that’s not typical. Typically timing gets very similar to buy and hold returns, sometimes a little bit better. But in general more often the two big benefits are reducing volatility. So the S&P buy and hold during that period had about 14 vol which is low by the way for the S&P. Timing was down near 10%, but more importantly the draw down usually gets cut in half. And so how it overlaying the trend volume model worked across GMO 12 historical bubbles and stocks currencies and commodities. Our research demonstrates that a trend following approach both improved returns in every bubble except one and reduced volatility and draw down in all 12. So we show this improvement the trend follower would’ve enjoyed, overall over the buy and hold investor, in the paper if you want to really dive down, but our summary basis if you look at the return improvement was over two percentage points per year nominal for the timing model reduced vol by about a third and reduced draw down by almost half so 40% and that’s a pretty big deal. If you think about it because draw down is its vol, no one really cares about volatility. They care about down volatility.
So they care about losses and really almost all the research I’ve seen shows that down about 10% in a portfolio market people start to get uncomfortable, down 20 you start to really see behavioral problems. You see people start to close their accounts, start to panic and then of course anything down 20 more than 20 it gets exponentially worse as investments go down 40, 60%. If they go down much more than that you have some of the opposite effect where people simply say write it off as a total loss and forget about it. But again if you if you include T-bills if you move to cash that’s one thing because you don’t earn zero return. But if you say T-bills or T bonds, bonds are long term Treasury bonds you can add additional return and tamp down volatility even more.
So a quick summary of this sort of white paper podcast. First market timing with quantitative measures isn’t sexy. From a behavioral and psychological standpoint it is often most difficult to employ when it is most useful. Strong discipline would have been required to sell technology stocks in 2000, real estate in 2007 or South Sea stock in 1720, especially when one’s colleagues, friends and neighbors were making money hand over fist. In the end, for those who imposed such discipline, it was the prudent choice. Now let’s revisit the granddaddy of all bubbles and see what Newton’s South Sea portfolio would have looked like if you had to turn far and if you really want to examine the portfolio take it out tonight, 1736 and you can there’s data you can download online that’s kind of fun because it showed you would have gotten back in at some point. But in general the buy and hold investor who bought early on, say at the beginning of 1719, would have endured a roller coaster up and down ride and would have had mildly negative compound returns of say about negative 3% per year or total loss of about 15% over the period. The News of the World sucked into the frenzy at ever increasing levels would have had a maximum loss around 90%, basically an entire destruction of capital. Newton’s niece, Catherine Conduit reportedly told friends that Newton lost 20,000 pounds, equivalent of about 3 million pounds in today’s terms. And sadly, trend following the South Sea stock would have performed much better although the trend following approach would have still resulted in a 44% loss or draw down. Shouldn’t say loss, a draw down.
Strategy would have produced a large overall profit and the investor would have quadrupled his money. So from the early purchase price, would have quadrupled his money to speculate another day. All that really matters is surviving to invest another day. You may not acutely notice the difference between eight and 10% return but you will certainly notice the difference between a 40 and 90 percent loss.
This is a short one today, 20 minutes. We’ll read a few more of these in the future. If you love it or hate it let us know. As a reminder you can always find the show notes and other episodes at mebfaber.com/podcast. Shoot us e-mails at firstname.lastname@example.org. You can subscribe to the show on iTunes, Overcast, lots of other networks and if you’re enjoying the show, please leave a review. Thanks for listening friends and good investing.
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