The Great Crash and Beyond

The worst quarter for stocks since the first quarter of 2009 sent me back to the dusty archives of finance. Amid old tomes, I searched for what I might learn from the dark markets of years past.

I found a collection of articles called The Great Crash and Beyond. They date from 1979, put together on the 50th anniversary of the crash of 1929. Only a handful of years before, the market fell by half (1973-74). Inside, I find writers reflecting on the mosaic of Wall Street history and the continuity of markets across the time.

There are many useful ideas here to keep in mind as our own potential collapse unfolds. If we did suffer another crash, it would be the third in little more than a decade, following on the heels of the 2000-02 and 2007-09 meltdowns. (As I write, the market is down about 17% from its highs on the year.) A few of my favorites follow.

Investors place too much emphasis on economic forecasts. These forecasts are too often in error. They repeatedly miss economic turns and predict turns that never occur. Too often, forecasts are mere extrapolations of current trends.

One humorous example comes from Shepherd Mead’s How to Get to the Future Before It Gets to You. He imagines going back in time to 1860, when horse manure was a health problem in New York City streets. Manure averaged 1 inch in the middle of New York City roads. Ten years earlier, it was half an inch. Therefore, using prevailing growth rates, one would forecast about 170 feet of manure in the streets by 1970.

Such a forecast might lead to investing in horse oat companies. Heeding such a forecast would lead the investor to ruin because it misses that: (1) people would change their behavior well before it got to that point; (2) horses would not exist in such number to produce the required manure; and (3) something might replace horses (i.e., cars).

It sounds ridiculous, but that is the point. People make and believe similar forecasts all the time in markets. Surely, you’ve come across, for instance, forecasts about the world running out of some resource (like oil). But no pattern is perpetual. “The more widely held the belief in the persistence of a pattern,” Arthur Zeikel tells us, “the less likely it is to continue.” (Zeikel was the head of Merrill Lynch’s money managers at the time). His rule of thumb here is useful: If an expectation is taken for granted, then it should be questioned all the more.

As historian Barbara Tuchman wrote, “You cannot extrapolate any series in which the human element intrudes. History, that is, the human narrative, never follows and will never follow the scientific curve.” Human beings are an adaptive lot. Investors often miss the countervailing forces that work to undo trends of all kinds.

Investors put too much weight on their own most recent experiences. Sometimes market rhythms have less to do with economics than psychology, as author Peter Bernstein explained. The great bull markets are never made by investors still smarting from memories of disaster. And the sickening drops of great bear markets are not made by “investors whose happiest hopes are daily being realized.”

“In short,” Bernstein sums up, “collective memories — or lack of memories — of the participants are the ultimate determinants of those key buying and selling opportunities that investors dream about.” The 1929 crash and its aftermath soured people on the market for a quarter-century. Conversely, the steady run-up in stocks from 1982 had people believing in “stocks for the long run.” This helped fuel the manic 1990s. In both cases, ingrained memories ensured investors would miss the big turns.

I think this idea helps explain too why the market swings in 2011 have been so wide. People have 2008 fresh in their memories. They are afraid it will happen again. It makes for skittish investors. Such fears, too, kept many investors on the sidelines in the epic rally from the March 2009 bottom, in which stocks nearly doubled.

The main advice here: Understand that, as human beings, we overweigh our recent experience, which makes us susceptible to missing out on change.

There are always too few true investors. As money manager Robert Kirby wrote, “Today, we make it look as though we are ‘investing’ through our extensive research and computers.” But at the end of the day, many people still flip stocks based on “recent price behavior, rather than a careful assessment of what the company’s future operating performance is apt to be.” Some things never change. This is evident today, in which the average holding period for stocks is scarcely eight months.

Kirby also said you should think about investing in stocks as you would think about investing in real estate. Then you would focus on the asset itself and the return it generates. Cash flows must be paid out or invested wisely. Otherwise, there is little benefit in owning the stock. Also, if you treat stocks like real estate, you know you can’t flip a stock to someone else so easily.

(I know this example is ironic, given the recent blowup in the housing market. It was ironic when Kirby used it in 1979, too. And he knew it. “Growing speculation in real estate is beginning to violate all those time-honored investment rules,” he wrote. Kirby notes, with disapproval, the sale of Aspen condos for a net return of 3% annually to the buyer. This when Treasuries paid 9%, and Fortune 500 companies sold for 6-8 times earnings.)

“When you buy a nonmarketable asset that offers a limited application of the greater fool theory (selling it to someone else at a higher price later on),” Kirby writes, “you have to focus on the return that asset is likely to provide internally, should you have to retain ownership for an indefinite period.”

I love this idea, because I think if people thought of stocks as real estate, they would be more careful about what they bought. They would think longer-term and be better owners. Their results would be bound to improve.

It’s all about the price paid. Bernstein makes a fascinating point about this. If you bought stocks in 1924 and held them through thick and thin until 1936, you would’ve enjoyed a 7.6% annual return, before taxes and not including reinvested dividends. “Meanwhile,” Bernstein writes, “the cost of living had fallen by 20%.”

That’s smashingly good with the Great Depression in the mix. But it all depended on when you bought and when you sold. In 1924, stocks were still cheap, and in 1936, they were dear. And that made all the difference.

But alas, human nature will never change. Most people buy stocks when they are strong and high, and sell them when they are low and weak. Reflecting on a long history of booms and panics, Zeikel wrote: “It was true in 1870, it was true in 1929, it is true today [in 1979], and it will be, to be sure, true tomorrow.” Indeed, it still holds.

This is not bad news for you, however. How so? Here we give the last word to Bernstein. “Inefficiency is good news for investors,” he wrote. “Inefficiency, after all, breeds opportunity.”


Chris Mayer
for The Daily Reckoning