In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Brendan Hughes discuss:
- What Warren Buffett’s Market Cap-to-GDP Indicator Tells Us About U.S Stocks
- The Impact of Passive Investing: Are We Losing Price Discovery in Markets?
- How Labor Unions Are Reshaping Inflation Dynamics: A 1970s Parallel
- How Jensen’s Inequality Can Help You Avoid Hidden Investment Risks
- The Magellan Fund Paradox: Stellar Returns, Average Investor Losses
- Could Antitrust Laws Transform Amazon and Google Into Ten New Giants?
- What Zimbabwe’s Hyperinflation Teaches Us About the Dangers of Printing Money
- How Government Stimulus May Be Shortening Market Crises
- Will the US Return to 0% Interest Rates?
- Lessons From 11 Historical Crises for Investors
- The Unforeseen Consequences of Pandemic Bailouts
- Will China Follow Japan’s Path of Export-Led Growth and Deflation?
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Transcript
Tobias: This meeting is being livestreamed, which means that this is Value: After Hours. I am Tobias Carlisle, joined as always, by my cohost, Jake Taylor. Our special guest today is Brendan Hughes. He’s written a new book called Markets in Chaos: A History of Market Crises Around the World. I’m going to try and hold up the cover here, there we go.
Jake: Put it over your face for a while.
[laughter]Tobias: Welcome, Brendan.
Brendan: Thank you very much for having me on the show, Tobias.
Tobias: Tell us a little bit about you and what prompted you to write the book.
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Lessons From 11 Historical Crises for Investors
Brendan: Yeah. Again, my name is Brendan Hughes. I work for a Maryland-based RIA firm, Lafayette Investments. We have about $800 million assets under management, and we primarily focus on high-net-worth individuals.
And as Tobias said, I wrote a recent book called Markets in Chaos. And I think what prompted me to write this book that goes through 11 detailed case studies about different crises throughout history was the COVID-19 pandemic. And when the COVID-19 pandemic hit, I just wondered after the fact how I could have been better prepared for this, because, on TV every few minutes, people were saying that this was an unprecedented event.
But as I started to dig back through history, that is just not true at all. I started to look at events like the Black Death in the mid-1300s where 30% to 60% of the population in Europe, which at that time was at the center of the world, was wiped out. As I was going through this, I thought that I could have been better prepared. And so, I started to dig back through these different case studies, and I think that it’s beneficial for an investor to learn from history so they can better anticipate the present and future in terms of being able to construct a portfolio that helps to protect them against some of these outlier events.
Tobias: What would you do? Just to put the cart before the horse a little bit. We’ll come to all of the crises in a moment. Well, how could you have prepared for the pandemic?
Brendan: I think that there could have been more of a focus on, to a greater degree, companies that have little in the way of capital required to run their businesses because as we saw during the COVID-19 crisis, some of the capital-intensive businesses, particularly in areas like travel, they were devastated. And a lot more of them would have gone bankrupt if they weren’t bailed out by the government. But I think that people who have studied past crises like this could have derived something like that in advance. And yeah, I think that they could have been better prepared.
Tobias: [crosstalk] Sorry, sorry, JT.
Jake: Well, just having a less levered balance sheet, things like that. Is that what you’re referring to?
Brendan: Yeah, yeah, I mean that’s part of it. But also like for an example, a company like a cruise line, they’re not able to quickly cut their expenses like Microsoft would or something like that. They have a high proportion of their expenses in fixed costs. So, if you are in a situation where you have no revenues or little revenues, it’s very important that you’re able to quickly cut your expenses. And if you have a high percentage of those in fixed costs, you’re not able to do that. No company has 100% variable costs, but the degree to which their expenses can be altered on a relatively quick basis is pretty significant.
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The Unforeseen Consequences of Pandemic Bailouts
Tobias: I think it’s interesting that you’ve included a chapter here on the pandemic. What happened and what are your takeaways?
Brendan: Yeah, I think everyone is pretty well versed on what happened during the COVID-19 pandemic at this point. But we saw a 30% market decline that happened quickly, and then at the end of the year it actually closed higher than where it was during the pandemic. And a lot of that was fueled by an enormous amount of stimulus.
I touched upon some industries like cruise lines, airlines, and travel that were bailed out by the government. It’s unclear as to what would have happened if that didn’t happen. But then after all of that developed, then you had this soaring inflation. And I think a lot of people were confused as to why inflation didn’t immediately take off when we had lockdowns. But the reason was that people were sitting at home not being able to spend the money. And once the economy opened back up and people started going out and throwing money at experiences and things like that, that’s when inflation really began to take off. And that shouldn’t have been surprising for anyone that has gone back and studied these types of things, because that’s how inflation works. If businesses, consumers aren’t actually investing the money, inflation won’t take off. But that’s when inflation started to soar and that was really the second component of the pandemic.
But what developed during the pandemic really built upon a lot of what happened during the post global financial crisis era. We had easy monetary policy and the goal of that was supposed to be to stimulate growth, but that never really happened. We had anemic productivity and what we really had was a bull market in assets, stocks, housing, and things like that, that was boosted by the low interest rates because you had cash that was earning nothing.
Then, we got to the COVID-19 crisis and all of a sudden, companies, governments, their balance sheets got significantly worse because you had to take on debt if you were a cruise line just to weather the storm of not having any revenues. And that really helps explain where we are today with governments around the world, levered balance sheets, things like that.
And I wanted to note something that Howard Marks touched upon earlier this year. He noted that in 2025, there’s this huge wall of debt maturities that people really aren’t thinking about because this is dating back to the COVID-19 pandemic, but we really haven’t seen the full effects of this at this time. So, it’ll be interesting to see as more of these maturities come due when interest rates are not at 0%.
Jake: Do you think we need to– Is this why we need to explore Mars? Because we’ve already levered Earth’s balance sheet enough, we need to find some outside financing?
Brendan: It’s a possibility.
Tobias: If we can just lasso one of those asteroids that comes past, that’s like–
Jake: Ah, all that gold.
Tobias: Don’t have to work anymore.
Jake: We’re all rich. [laughs]
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Tobias: Brendan has, among the financial crises that he mentions, is the Rome, the Financial Panic of 33 AD, which everybody’s likely pretty familiar with that.
Jake: Yeah. That was like a while ago. [laughs]
Tobias: Yeah. Was that tax farming, Brendan? What was the Panic of 33? What caused that?
Brendan: Hold on one second. Sorry. Can we go to the–
Jake: Yeah, sure.
Tobias: Let’s do. I’ve got you out of order, that’s the last one.
Brendan: Yeah.
Tobias: There are two that are sort of most relevant today. Japan’s Lost Decade, and– I’ve just listed it on my list here.
Jake: Zimbabwe.
Tobias: Zimbabwe. We got Zimbabwe. Tell us about Japan’s lost decade.
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Will China Follow Japan’s Path of Export-Led Growth and Deflation?
Brendan: Yeah. I think Japan’s Lost Decade was a really interesting one. And I think there are some parallels that can be drawn to what’s going on with China today. What happened in the late 1980s with Japan was simply astounding. And it’s only been in the past year that Japanese markets have recovered back to when the real estate and stock market bubble imploded at the end of the 1980s. Some consider the Japanese market bubble to be the greatest in history in terms of total market capitalization and recovery time. Just to point out how wild this bubble was at one point, the Imperial Palace, which is the– That would be the equivalent of the White House in the United States, that was reported to have been worth more than the entire state of California, which is just incredible. The Japanese stock market had a PE ratio of over 60 at that time, which most people would say that’s a really high figure. And leading up to the–
Jake: Did the CAPE get up to like 100?
Tobias: I think it did. Yeah.
Jake: Is that right? Yeah.
Brendan: Yeah. I’m not sure about that. But in the real estate markets and equity markets, almost everything was high, and this was a pretty epic bubble. And leading up to the Lost Decade, many were projecting that Japan would one day overtake the United States. And I think that’s where I’ll again draw the parallels to what we saw with China recently, and I’ll touch a little bit on that more later. And similar to China, in the 2000s, Japan saw years of export-led growth that boosted the economy.
The cause of the collapse in Japan should sound familiar to some of the other case studies in my books, Markets in Chaos, like usually happens when there’s a crisis like this. So, there is financial deregulation paired with aggressive lending and poor risk management by companies in the financial sector, an extended period of low interest rates and rapid credit growth, and then an artificially low domestic currency. If you read my book, those things come up at various points throughout the 11 case studies.
And demand for Japanese exports surged in the 1980s. That was aided by the weak domestic currency. And I won’t go too deep here in the banking sector, but I do bring that up in a number of instances in my book because the banking sector usually plays a key role in terms of financial meltdowns. But all of this really started to be put in motion when there was a policy shift that went from loose monetary policy to tightening. And that’s when we saw years later, that caused the Asian financial crisis.
And I want to just touch on a few important topics that are relevant today and are actually similar to possibly what’s going on with the United States in at least a couple of respects. The first topic is deflation. And up until recently, Japan had been stuck in what I would call a deflationary trap for decades coming out of this. We’ll see if this is similar to what’s happening with China as we speak right now. But basically, what happened was Japan kept easy monetary policy, but consumers and businesses weren’t convinced to invest, they just didn’t invest, so we were stuck in this deflationary trap, and it was called what I would say is demand-driven deflation. Now, we’ll see how this plays out in China now, but they’ve been providing all this stimulus recently. It’s unclear if consumers and businesses will actually go out and invest in that market. I think that’s to be seen and something to watch as a parallel to this real estate market meltdown in Japan way back in the late 1980s.
I also want touch on the aging population in Japan, because that’s something that’s relevant in a lot of the developed markets, including the United States, Germany, markets like that. But Japan hasn’t been hospitable to immigrants, at least in terms of allowing them to move there. So, the average person has been getting older and those types of people soak up more of the resources without being as productive. And that’s just something that I wanted to note there.
Jake: So, one positive you could imagine is CAPE in the US is, call it, 35 times, we got a three bagger on our hands still before we can get crazy and become Japan in 1989. So, future is bright.
Tobias: And the China’s stock market’s taken off recently the last few days. It looks like it’s crashing up. Does that indicate that there’s some possibility that the stimulus has actually made something happen there?
Brendan: Yeah, I think it’s unclear. I don’t know what is going to happen. Like I noted, we’ll see if consumers and businesses decide to invest in that market. China’s been a pretty opaque market in my view in terms of how they regulate companies. You saw what happened to firms like to Alibaba. They operate in just a different regulatory environment than some of the other markets I cover, and I really don’t know how all that will play out.
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What Zimbabwe’s Hyperinflation Teaches Us About the Dangers of Printing Money
Tobias: What about Zimbabwe? That’s hyperinflation. Are we staring down the barrel at hyperinflation in the States?
Brendan: Yeah, Zimbabwe was a fascinating case study, and I think that it would be perfect for things like business classes and such because this bout of hyperinflation was ranked as the second most severe period of hyperinflation in modern history behind Hungary in the 1940s, and I documented this in my book. But I think the hyperinflation got so out of control in Zimbabwe in the 2000s that it peaked at a month over month inflation of 79.6 billion%, which is just– So, basically money stopped working.
Now, hyperinflation has a technical definition of rising prices when they’re increasing at 50% per month. But in practical terms, hyperinflation is just when money stops functioning as a medium of exchange. And this was clearly what happened in Zimbabwe. And I did just want to note for the listeners, some of the most famous hyperinflation cases in history also include Hungary in the 1940s, Yugoslavia in the 1990s, Germany in the 1920s, and Greece in the 1940s. Do you want me touch upon what the seeds for the hyperinflation were?
Tobias: Yeah, please.
Brendan: Okay, yeah. I’ll just walk through that briefly. The seeds for hyperinflation in Zimbabwe were planted when the government launched land reforms, and they started seizing farms from the white citizens and transferring property to local black individuals. A lot of them lacked farming experience. This led to a food shortage, which is typical of other hyperinflationary scenarios such as Germany in the 1920s, which I documented. But then, you had foreign investment drying up because people were worried about their assets being seized and real estate values were negatively impacted.
As it is typical in hyperinflationary scenarios, the government was increasing the national debt. And in the 2000s, as Zimbabwe’s economy slumped, basic consumer staples were in short supply, inflation increased, confidence in the local government eroded, and people started leaving Zimbabwe in large numbers. And as usually happens when similar scenarios come to pass, the government responded by printing more money. And this should be a similar theme because it’s been happening all the time recently. And the government resorted to price controls, which is interesting because, as I noted in my book, price controls always increase inflation because then, businesses don’t have any incentive to produce that good or service. And that’s been a recurring theme. And we’ve seen that come up again recently, even though that has never worked, which is just bizarre.
Tobias: It’s good politics.
Brendan: Yeah, yeah. But Zimbabwe has never really recovered from this hyperinflationary period, which is different from– I documented Germany in the 1920s. Germany in the 1920s, they responded this hyperinflation by rolling out a new currency, and people ultimately accepted it. And this is very different from Zimbabwe, where they basically, for the last 15 years, 20 years, have tried various new currencies and they’ve never been accepted. I think the reason being that people just trusted the government more in Germany in the 1920s, and that’s why people ultimately accepted it. Possibly for other reasons as well, local citizens in Zimbabwe have not accepted the various forms of currencies, and they’ve kind of been stuck in this recurring cycle where they’ll introduce a new currency, it’ll disappear, and things like that.
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Tobias: Let me just give a shoutout to the folks at home. Lewes, Delaware, what’s up? Tyler is in Tomball, Texas. Chapel Hill. Lausanne, Switzerland. Bangalore, India. Max in Valparaiso, what’s up, Tampa, Florida. Fallbrook, California. Santo Domingo, Dominican Republic. Toronto. Nashville. Delicate Nobby Oz, is that real? Cincinnati. Sacramento. Savonlinna, Finland. Boneroo. Tennessee. Dubai. Yodfat, Israel. Reykjavík, Iceland. Chiang Mai, Thailand. Mendocino, California. Bellevue. Tallahassee. Dresden, Germany. Gerrards Cross. Everybody stay safe in Israel. Bangkok.
Jake: Yeah, and the southeast storms as well, there seems like it got pretty bad for some people in Western North Carolina. Thoughts and prayers.
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What Warren Buffett’s Market Cap-to-GDP Indicator Tells Us About U.S Stocks
Tobias: Yeah, thinking of you guys. Are there any lessons from all of these crises? What’s the takeaway in your mind? What should we be careful of? What should we look out for? And what do you see when you look out today in the US?
Brendan: Yeah, I’ll start by touching on the US markets today. And I wanted to go back to a Warren Buffett quote in 2001 article where he said, in reference to the indicator that compares the total market capitalization of all actively traded US stocks to the latest estimate of GDP. And he said that is probably the single best measure of where valuations stand at any given moment. I can’t speak for Mr. Buffet, but that probably has at least something to do with his recent selling activity in the equity markets.
US stocks are expensive by historical standards. But as I noted in my book, I do think that dollar cost averaging over long periods of time does help mitigate some of the valuation risks that you see. This is really important because I don’t think it’s almost ever a good idea to jump in and out of the market. Now, you might be more aggressive and less aggressive based on where valuations are, and I think today, it’s more appropriate to be cautious. But virtually all the market returns are earned in the few days per decade when people least expect it. I think that’s really important.
I’m going to go back to a research study that was conducted and it noted between 1930 and 2020, you would have earned a 17,700% return if you stayed fully invested in S&P 500 equivalent. Now, I don’t know if the next 90 years or 100 years will produce anything close to that, but if an investor had missed just the ten best market days per decade over that period, they would have earned a cumulative 28% return compared to the 17,700% return if you just stayed fully invested. And I think that’s important to point out and that’s one of the things that I did note in my book.
But other than things like that I noted earlier by focusing on companies with more flexible capital structures, I think looking at other things, I do think that there is something in the place for a portfolio for country diversification. I know some people argue that you can get a high element of country diversification if you have a US company involved in another market, and that is true, but it doesn’t prevent– I don’t think it fully protects you from some situations where governments start to confiscate assets and things like that, I think you do get a little bit more defense against something like that if you do have some element of country diversification.
And to me, having gone back and studied various financial crises, pandemics, things like that, it starts to rhyme. I think even looking at what’s happening now in the Middle East, I drew some parallels to the 1970s energy crisis. You can go back and look what types of assets did well during that period. For example, defense stocks did very well during that period. You see defense stocks doing well now. So, I think the more an investor goes back and studied what has happened, the better prepared and the more knowledge they have that helps them prepare for the future.
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Will the US Return to 0% Interest Rates?
Tobias: Yeah. I couldn’t agree more. What about in terms of what the Federal Reserve is doing? We had rates pinned to zero for a long period there. They’ve raised rates. I don’t think we quite got to the long-term average, but the politicians don’t like it. People in real estate don’t like it. It seems like there’s a lot of voices calling out for the rates to be lowered. Not a lot of voices on the other side, but what do you think?
Jake: [chuckles]
Brendan: Yeah. I don’t know where interest rates are going to end up, but I think that we probably learned that doing 0% for a long period of time is not the best thing. So, I think it’s probably unlikely that we’ll go back to a 0% world, but I don’t think we can rule it out.
Japan did have very low interest rates for several decades, which I touch upon in my book. So, that is always a possibility. But I think we have to look back and view that as kind of a failed experiment. The whole concept was that were going to do this to stimulate growth, and we’ve really had very low levels of growth coming out of the financial crisis, and it’ll be interesting to see how things play out. I noted earlier, and Howard Marks brought this up, but we’re just starting to see some of the debt maturities. And interest rates aren’t really high at this point, but they’re not zero. And so, I think the next two years will tell us a lot and we’ll see who’s been swimming naked.
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How Labor Unions Are Reshaping Inflation Dynamics: A 1970s Parallel
Tobias: JT, you took a look at the inflation through the 1970s, sort of reared its ugly head. Then, it looked like we had it under control and they dropped rates and then it came back again. Do you see any sort of parallels with today? Particularly, there’s some talk that the longshoremen are going to shut down the ports, and they seem pretty set. They understand that there’s going to be pain over several weeks, and that’s sort of what they’re counting on to get attention to what they’re asking for.
Jake: Yeah. Certainly, there are lots of cards in the deck that could potentially make inflation not as transitory. Like energy, let’s say Middle East devolves further. Supply chain issues with the ports are shut down with a strike. Even deglobalization that had been a really long-term trend for quite a while, and if that goes the other direction, we have to rebuild supply chains that are less Southeast Asian focused, it’s probably going to be more expensive for everything. You’re just not going to have– Each component all along the value chain is going to cost more to get to your front door. And if we have two redundant supply chains built at some point for kind of the world cracking up into different spheres, I think it’s hard to imagine it’s not going to be more expensive.
But on the other side of that, I remain a technological optimist over the long period and that we will figure out how to do more with less as a species. We’ve been pretty damn good at that, especially in the last couple 100 years. I think we’ll keep doing it and keep getting better. Try to stay positive, but also don’t fool yourself that it might be a rough ride to get there.
Tobias: What do you think, Brendan?
Brendan: Yeah. I would like to just note another parallel to the 1970s that people hadn’t thought about for a long time, and that’s the recent strength of labor unions. In the 1970s, you had that memorable moment where it was possibly symbolic, but Reagan fired the air traffic control people who were on strike, and that was what some people said was the beginning of the start of the long decline of labor unions. And just in the past few years, we’ve seen a resurgence in the power of unions and that structurally increases inflation. So, we’ll see to what extent that continues to be structurally higher than we’ve had in recent times.
But I would also like to bring up something that I’ve noticed in the last few years. And this is tied into what Jake was touching upon with deglobalization. But we’ve had ongoing supply chain disruptions every year, frequently since the COVID-19 pandemic. And I’ve come around to the view that this could be something structural, because I keep seeing companies every six months saying, “This is a one-time event.” But when you have increasing conflicts, higher strength of labor unions, things like that, it makes it more likely that these things will persist. And I think that does tend to favor companies that operate primarily on intangibles, because companies that produce physical products, they continue to see these problems. And I’ve just come around to the view that this could be a structural development.
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How Jensen’s Inequality Can Help You Avoid Hidden Investment Risks
Tobias: JT, top of the hour. Do you want to do– give the people what they– [unintelligible 00:30:45]?
Jake: There are dozens. All right, this week, we’re going to be talking about this mathematical concept called Jensen’s inequality. Any familiarity with that, to start?
Brendan: No.
Tobias: Yeah, I know the name, but I can’t for the life of me think what it is.
Jake: That’s a different Jensen, no. It’s this fundamental concept in math, and particularly in convex analysis and probability theory. And convexity, just to make it more simple, is like the shape of the graph, if it curves up in a nonlinear way, it keeps getting steeper. And Jensen provides this insight into how convex or concave functions behave when applied to the expected value of random variables. It’s like, here’s the curve. Let’s try to guess what we’re going to get from that statistically. And it has broad applications across economics, statistics, finance, machine learning, physics. And it really explains how nonlinear functions interact with averages and expectations and gives us some useful tools, especially around risk. So, who is this mysterious Jensen? His full name, and this is quite a mouthful, is Johan Ludwig William Valdemar Jensen, born 1859, died–
Tobias: Is it really Voldemort?
Jake: It’s not Voldemort, but it’s V-A-L-D-E-M-A-R. Died 1925. He was a Danish mathematician. And despite his significant contributions, he’s somewhat of a lesser-known figure. And really unlike a lot of prominent mathematicians, he didn’t spend his life in academia. His primary occupation was an engineer at the Copenhagen Telephone Company. So, in a lot of ways, he was kind of Claude Shannon, before Claude Shannon at Bell Labs.
And so, he worked in telephony and communications in the early 20th century. And you really had to have a deep understanding of electrical engineering, signal processing, a lot of these places where calculus and numbers theory actually played a crucial role. He was this engineer by day and mathematician by night, and kind of makes him an intriguing figure in history. And that’s kind of been ignored largely so. And there’s really not very much recorded about his personal life and hobbies and relationships. So, I don’t have anything there.
But let’s get into some practical examples that kind of illustrate what’s going on with Jensen’s inequality. And imagine that you’ve got two routes that you can go for a road trip, and one is this scenic mountain pass. It’s got steep curves, unpredictable weather, or there’s a really long, flat, boring highway that gets you there. And both routes take the same time to get from point A to point B. Here’s the catch though. One of them has these wild up and downs, the other one smooth. And what Jensen’s inequality says is that when you’re dealing with this curvy path, like in math terms, like a convex function, the average outcome from all the twists and turns is always more extreme than just taking the average point directly.
So, if you’re driving through these curvy mountains, your fuel efficiency, your stress levels are probably going to be all over the place, and you’re perhaps better off choosing the highway if you want this predictable ride. And when things are curvy or convex, the averages of the wild ride will be much more extreme than you would otherwise guess. There’s a mathematical proof of that I won’t get into, because then we’d really be down in the weeds.
Let’s take another example that might help, let’s say food portions. Say you’re at a restaurant and you have two options for the amount of food that you’ll get. One is a fixed 500 calories, let’s call it every time you order. Or you can order this variable portion where sometimes you’re going to get 300, sometimes you’re going to get 700, the average is still 500, okay?
So, according to Jensen’s inequality, even though the average is 500, your satisfaction is going to be lower with the variable one, because some days you’re left feeling hungry with the 300 calories. Other days, you’re too full. You don’t even want to eat it all with the 700. So, the overall experience is worse than just getting the 500 consistency. I’ll leave out kind of hormetic stressor and all of that stuff out of the out of the equation at this point.
But let’s take a last example, study time. You’re preparing for a big exam. There’s two study plans that you can choose from. Plan A is you study consistently for 2 hours every single day. Plan B is you study for 6 hours on some days, goof around the other days. Which one do you think is probably going to get you to a better outcome? It’s probably the more consistent one, more will stick. That irregular study pattern in plan B is going to be more stressful, less retention of information, even if the total amount of study time was the same between the two.
Now, let’s see if we can get back to finance and stick the landing. The world of investing is an absolute playground for Jensen’s inequality. It’s all nonlinearity, reinforcing feedback loops, convexity, it’s everywhere. And let’s say, typically, sometimes you can choose between investing in let’s say a stock that has a lot of potential gain, but also major downside. Well, if you use Jensen’s inequality, when you average out all these ups and downs, the overall return is likely to be lower than if you’d chosen a safer, more predictable route. Because this convexity doesn’t play nice with averages. Anyhow, we’ve covered this kind of before when we’ve talked about ergodicity and variance strain and the difference between different types of averages if you guys remember that.
Basically, if you use convex functions at all, like risk measurements, and you’re assessing these potential losses from different outcomes, Jensen’s inequality tells you it’s generally riskier to average the outcomes first and then apply a risk function rather than calculating the risk of each outcome and then averaging them afterwards. So, the order of operation matters. Basically, anytime you’re dealing with anything curvy, we have to be especially careful when taking averages. Otherwise, you’re inviting errors structurally, mathematically. And the more unpredictable the situation, the more extreme the outcomes, the fatter the tails, good or bad, the more that Jensen’s inequality is going to influence your final result.
Tobias: That’s interesting, JT. In terms of just– one more time, how we apply that. If you have fat tails, what’s the approach to that?
Jake: Taking the average of any kind of thing with fat tails is going to–
Tobias: What is that average?
Jake: It’ll systematically underrepresent the actual risk that you’re taking.
Tobias: That’s interesting.
Jake: Right. And I think this is probably where—like, LTCM probably ran into this.
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The Magellan Fund Paradox: Stellar Returns, Average Investor Losses
Brendan: Could I just tie in an interesting statistic that kind of goes alongside what you were just discussing, because I think that it depends on the individual, but some people have a greater risk appetite for whether it’s just an index fund or specific stocks than other people do. But I think what is common is that people tend to buy and sell, whether it’s index fund, stocks, at the wrong time. A really interesting study was conducted by Fidelity Investments that illustrates this point. And Peter Lynch’s Magellan Fund averaged a return of 29% per year from 1977 to 1990. Now, during this period of historic returns, what do you think the return was of the average investor in this fund?
Jake: Negative.
Tobias: It’ll be flat or negative.
Brendan: Yeah. The average investor lost money in the fund during this period, which is just stunning. So, a lot of this has to do with just staying the course, which is very important. But you have to know yourself. If you know that you get really nervous when we have a COVID-19 situation, you shouldn’t be 100% in stocks, because if you do miss those few great days or decade, you’re going to miss all the returns. The fact that the Magellan Fund produced 29% returns per year and the average investor lost money tells me everything I need to know about the psychology of the average person in stocks.
Jake: This is really important, what you’re saying, Brendan, because right now, I’ve seen that ETF total flows are making new highs. Basically, the “typical retail investor,” let’s call it, I’m not trying to say that disparagingly like people do, but they’re kind of all in right now. Everybody’s pretty well like party time and bull market up. With all the other things you were saying before about valuations and potential places things that could go wrong, that we should be thinking about, trying to tie all this together, I think it’s really important that people kind of check their risk before they get tested on it.
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How Government Stimulus May Be Shortening Market Crises
Tobias: I wanted to talk a little bit about the length of time for all of these crises. We were discussing this before we came on and I thought it was kind of interesting that many of these– There was the Panic of 1873, which was United States and Europe. That was 1873 to 1879. The Mississippi Bubble was four years. Germany post-World War I was 13 years. Japan’s Lost Decade, arguably, that was three decades. I think, before we went on, JT, you said the average– not bear market. How are we characterizing it?
Jake: Yeah, we talked about in the anatomy of the bear segment that we did a couple of weeks ago with Russell Napier’s book, he pointed out the four biggest bear markets that happened in the 20th century in the US, and the average amount of time from peak valuation to trough valuation was nine years for those four. But if you take out the 1929 to 1933, which was actually a really fast drop down which, by the way, gave you 89% loss, which no one has in their models, you take that out and the three other big ones of that century, it was like 13-year average to go from peak valuation to trough valuation. So, these are really long, grinding, difficult periods to go through. And [crosstalk] not sure how many of us are ready for that?
Tobias: Yeah, nobody could even– What do you think, Brendan? Are they getting shorter because the world is speeding up, or is it just [crosstalk]?
Jake: Central banks are that much better than they used to be?
Tobias: Government stimulus straight on the–
Brendan: Yeah. I think some of it could be tied to the government stimulus, and I don’t think we fully know what the long-term effects of this are yet. I know this has been going on a long time and it’s really shifted into overdrive following the COVID-19 pandemic. But I still think that I don’t think we know the full effects of all this central banks now being at the center of everything thing. But yes, I discuss it at least a couple times in my book. But it typically has been the right move for governments to step in following a crisis because when they haven’t and they’ve taken a hard line, it’s tended to play out worse than if there was some form of government stimulus.
But now, it’s happened so frequently that the government balance sheets are so indebted. I do hope that the people don’t lose confidence in money or something like that. I know there’s people out there who are the Bitcoin bulls and things like that. Kind of not rooting for that to happen but also, they may say, “I told you so.” That’s beyond my expertise and level of thinking, and I don’t even think about it. But I’ll be interested to see how all this plays out.
Tobias: The 2000 bubble took a long time to work its way through just the index, but the index has been hitting new highs recently.
Jake: Some people think we’ve never cleared the 2000 bubble.
Tobias: What, on a real basis or adjusted for gold or something like that?
Jake: Right. And also, valuations. If you look at 2008, we got down to kind of a long run average, but never really went below and spent any time underneath the long-term average.
Brendan: The difference between the 2000s bubble and now is that a lot of those companies weren’t producing revenues and some of them didn’t even have a business plan. And I know that some people draw parallels to some of the tech firms today, but I think it’s difficult to compare like Microsoft or something like that to some of what was going on in the 2000s bubble where you had companies like eToys that just completely disappeared. A lot of that was going on. So, I don’t agree with comparing some of the legitimate tech giants to that. That is not similar in my view.
Tobias: Yeah. Just to play devil’s advocate a little bit.
Jake: What does Upstart do?
[crosstalk]Jake: Sorry, you were breaking–
Tobias: So, the lines got– [unintelligible 00:44:56] The 2000 bubble was, I think it’s sometimes more like a blueberry muffin. It was like the blueberries were the dotcom but most of the muffin was just expensive growth. And it was companies that weren’t–
Jake: Large cap too, as much as any of them.
Tobias: Yeah. So, it was like Walmart, which not necessarily a tech company, but it topped out in 2000 and didn’t get back to its all-time highs until 2015. And true for GE and all those big– They were kind of–
Jake: [unintelligible 00:45:24] at 60 times earnings.
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The Impact of Passive Investing: Are We Losing Price Discovery in Markets?
Tobias: Yeah. Then, Microsoft was old economy at that point. So, I do think that it was more of a large growth, and I think we’ve seen more large growth this time around as well. And again, there are some blueberries that are like the interesting things, but it hides the fact that it is still an expensive growth market.
When you look at those long-term averages or the long-term metrics like Buffett’s total market capitalization or you could use Shiller or you could use Tobin’s Q, which is replacement value of assets over market value of assets, all of those sort of seem in varying degrees to point to the same conclusion, that everything is much more expensive than it has been. And I think Cliff Asness had a paper that came out at the end of August, and he said he was looking at the 2000 bubble and the most recent bubble and he said that for all intents and purposes they’re very similar bubbles.
Jake: Like ‘21? Is that what he was saying or right now?
Tobias: I think he was talking about– Yeah, ‘21 is the peak, but the value spread continues to be extremely wide according to his. So, I just wonder, have those metrics lost relevance or are those metrics telling us that we should be humble and there’s something else coming? What do you think?
Brendan: Yeah. I don’t think those metrics have lost relevance. I noted earlier that when you see the US market trading at 200% of GDP, it’s more appropriate to be cautious as opposed to aggressive. But like I also noted, I don’t think it’s a good idea to go 100% cash, then jump back into the market. Because if things do persist, markets continue to go upward, then you might miss those few good–
Now, it’s probably less likely that you’re going to miss one of those epic days from here. But I don’t know, and I don’t think anyone else knows. So, I will say that. But one thing that I don’t think that we have a good understanding of at this juncture that’s playing into this is how passives are playing into this. And I know you’ve touched upon some of the large cap growth. Well, the rally has broadened out a bit recently in US stocks, but it’s still a very concentrated group of stocks at the top. It’s historically concentrated. And I don’t think we understand the element of how passives are playing into this. I think I saw recently that over 50% of ownership in the US stock market is now passives.
Terry Smith of Fundsmith Equity Fund did a very interesting interview recently where he was kind of teasing through as to are we at or approaching the point where markets no longer have a pricing mechanism because of what’s happened with passive investing. I think that’s something really interesting to think about and I don’t know the answer to that, but I think it’s something that people at least need to be aware of and thinking about because where are we in this long curve of increasing passive investments.
Now, 30, 40 years ago, if you went all in on passives, that would have been the right move. I don’t know that is the right move for the next 30 years. I think that a lot of people, a lot more people than they should, are just not even thinking about this and discounting what Terry Smith was teasing through. I think that is something that needs to be thought of because as Terry Smith also alluded to, passive investments in S&P 500 index fund, it’s really an active strategy in that it’s like a momentum strategy. You don’t have a fund manager, but the money is flowing into the largest things that have done the best and that continues to juice the returns of those until that no longer works. I think that this is something that people need to be thinking about, and I know it’s been covered recently in the press.
Tobias: That is one of the things that Cliff touches on in his little note. He said it has some effect, but I think he said he took to, I forget who it was now, but it was like Templeton or someone of that kind of stature, who he asked, someone who was an advocate of passive.
Jake: Bogle probably then.
Tobias: Was it Bogle? Yeah, thanks. Yeah, he talked to Bogle, and he said at what level do you think that there’s too much passive? And Bogle said something like 75%. And he said, “Where’d you get that number from?” And he said, “I just made it up.” I don’t think anybody really knows. I think that his conclusion though was that in a world where everybody goes passive, then it is good to be a factor investor. It’s good to be value and quality and other things like that. And if the characterization of the S&P 500 as being momentum, large cap momentum, I think that’s probably right. We’ve seen plenty of times in the past where that has– In 2000, that strategy came to an end, and it took 15 years for it to recover. Could easily happen again. I don’t know what drives it.
Brendan: I agree.
Jake: Brendan, how did large caps do in Rome 33?
Brendan: [laughs] I’m not sure.
Jake: Oh, okay.
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Could Antitrust Laws Transform Amazon and Google Into Ten New Giants?
Tobias: How were the passive, the factor investors back then? They’re all done really well. I wondered a little bit about the very long time periods where– And I don’t really know why it seems to take decades for these things to play out. But when I look at the performance of the large cap S&P 500 in the States, it’s clear why it has done so well. And that’s because the earnings have been very good and the margins on those businesses are very high, and they’ve exceeded anything that Buffett has said. Anything above 6% of GDP is mean reverting. Jeremy Grantham says the same thing. John Hussman says the same thing. They’re all mean reverting series.
But if anything, they really haven’t been until– I think that October 31 earnings is still peak earnings and we’re off about 13% from peak earnings. But margins are still much, much fatter than they have been for a long time. And earnings are up. And you can see it’s reflected in S&P 500 earnings are up. S&P 400, which is mid cap, are basically flat. And S&P 600, which is the smalls, are down. And that’s why those indexes are flattened down, whereas the S&P 500 is up. So, it’s fundamentally driven if it’s anything in addition to being in the multiples of responding to those fundamentals. So, it really has to be– and what causes the margins and earnings to mean revert back down?
Brendan: Yeah, I’m not sure, and what you touch upon is something that I’ve taken into account as well. Now, some other markets have been less expensive than US stocks but as you touched upon, I still view the US as leading in innovation and that’s reflected in the great mega caps that we have. We’ve done really well in cultivating this environment for our technology firms that has possibly justifiably allowed some of these companies to trade at premium valuations.
I do look at some other markets and you don’t see the Microsofts, the Googles. You have to some extent some counterparts in China but obviously they’ve had some struggles there. And you do have some semiconductor company like ASML and Taiwan Semiconductor in some other markets. But as you noted, the earnings growth of the Googles, Microsofts, Metas, they’ve been really good, and their margins are enormous.
Now, what could be mean reverting? You do now have some government regulation. Now, I think that those fears in the past have been somewhat overblown. Microsoft a number of decades ago went through all those antitrust cases and if you held Microsoft through that the full time, obviously you would have done tremendously well. Now, we’ll see what happens with the court cases this time around. But I think a lot of times what ends up happening is that these court cases get dragged out for a long period of time. Then, there’s some agreement that they’ll make modest reforms and–
Tobias: Cosmetic changes to the UI.
Brendan: Yeah. I mean that’s what tends to happen, but it doesn’t mean for sure that’s what’s going to happen. But I think something interesting to think about too is that the Microsofts, the Amazons, it’s possible that with those companies, you could in the future, possibly because of government regulation, you might end up with like ten different companies coming out of these things. And I think I touched upon it in my book, but that would be similar to what happened with Standard Oil.
Standard Oil actually did phenomenally after it got broken up into a number of pieces. So, I’m not convinced that it wouldn’t possibly be outstanding if you had ten companies coming out of some of these things. I think that is up for debate. We’ll see what happens, but it’s possible, but if there were to be some form of government regulation where mandated at a split-off, it’s possible that investors could see phenomenal returns, possibly way higher returns than if it was one company.
But I guess on the other side of that, companies like Amazon, they have been able to invest just so heavily that other companies haven’t been able to match their investment. And that has been an advantage because of size. Ad I think that this has been a development that has really arisen since the internet more so. I don’t think that the same advantages were available before the rise of the internet that are available now.
Tobias: [crosstalk] got broken up too.
Jake: Imagine if you could just own Excel by itself. Pure play.
Tobias: The foundation of western civilization.
Jake: For sure.
Tobias: Yeah. I don’t know how you break it up. You have the Google California, Google Texas, different search results, something like that. I don’t know. I think it’d be very hard to split it up.
Brendan: You could have a Google Search, a YouTube, a Google Cloud, something like that. I don’t know how you would. You can’t split up a search engine. Nothing’s impossible, but it would be pretty difficult to do that.
Tobias: And don’t forget, the FTC is going after Big Handbag.
Jake: Yeah. All these super important things.
Tobias: So, Tapestry is in trouble. Tapestry is going to be split up into its component bags again. Hitting all the important stuff.
Jake: Yeah.
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Tobias: Brendan, we’re getting close to time. Give us some closing thoughts on the crisis in Rome in 33 AD. No, just kidding. What should we take away from the book and how should we be prepared for the next crisis?
Brendan: Yeah. Again, I would recommend going back and studying various crises, because it does prepare you for what’s coming next. In that, at a minimum, it makes you feel more comfortable that you’ve seen something similar. I noted how a financial crisis develops throughout history has been very similar. So, once you start seeing things rhyme, it at least makes you more comfortable with being prepared and also having a better understanding of the types of businesses and things that do well during a crisis can come out of studying what developed in the past. So, those are just some closing thoughts.
Tobias: BownMarubozu says there’ll be many bag holders, I’m guessing, from the FTC bust up the Big Bag.
Jake: See what you did there.
Tobias: Brendan, if folks want to get in touch with you or follow along with what you’re doing, what’s the best way of doing that?
Brendan: Yeah, you can connect me on LinkedIn, just Brendan Hughes, CFA, Lafayette Investments. If you put that in the search bar, you can find me. And you’re welcome to reach out with me. My book, Markets in Chaos: A History of Market Crises Around the World, is available on Amazon and various other online outlets.
Tobias: Yeah, I have the book here just in front of me. JT, any closing words?
Jake: No, just be good to each other.
Tobias: And check out Journalytic. Thanks, guys. We’ll see everybody.
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