Category: Book Reviews

Book Review: The Trouble With Prosperity

Book Review: The Trouble With Prosperity

Posted on by David Merkel

In principle, I make a pittance off of any book sales from clicking on the links in any review that I write.? But I will write about books that are “out of print” as well (no money there); whether in print or out of print, my goal is to serve readers by bringing important investment ideas to their attention.

Presently, I am reading Money of the Mind, by James Grant, but I have also read The Trouble With Prosperity, which is important to understanding our present circumstances.? Both analyze monetary and other economic policies in the past, with an eye toward what it implies for us today.

In The Trouble With Prosperity,? Grant’s main theme is what happens when monetary policy is perverted from trying to preserve purchasing power, to trying to assure a perpetual prosperity.? He wrote this in 1996, when the US was recovering from the severe Fed tightening in 1994, which resulted from lax monetary policy 1991-1993, where the Fed funds rate was stuck at 3%.

As with most things, James Grant is right in direction, but early.? Back in 1996, he could not envision a 1% Fed funds rate, much less the mysterious hypothetical helicopters of Chairman Bernanke.? Capitalist economies are quite resilient, and can survive considerable mismanagement.? Today we are far closer to what he worried about eleven years ago.

A central bank trying to assure continued prosperity will always be biased toward inflation.? How the inflation manifests is a function of demographics.? With a younger population, goods inflation will be stronger (buy more, save less), and asset inflation for an older generation (buy less, save more).? At the same time, such a central bank will be biased against major losses in financial institutions.

The trouble is, the likelihood of the Federal Reserve rescuing troubled financial institutions raises the odds that the institutions will get into trouble.? It skews the payoff to financial executives, and makes them more willing to take risk, because the institution will not be under threat if they fail.

In The Trouble With Prosperity, Grant walks us through:

  • The puzzle of the markets in 1958, given the rise in interest rates and inflation
  • A tall building that characterized the troubles of the Depression.
  • The Japanese real estate and stock bubbles, and their deflation (still early in 1996)
  • The S&L crisis in the early 90s
  • Willingness to sponsor speculative ventures in the early 1990s, with a focus on gambling.

My opinion: low Fed funds rates foster speculation in healthy assets.? Lever them up more, because we can.? Ignore risk, and focus on the income one can generate today.? Of course, the eventual risk is that the US ends up in a liquidity trap similar to the which the Japanese have been in for the last 17 years.? Of course, the US economy is more flexible than that, but the risks are still significant.

Don’t view soft FOMC policy as a panacea.? Eventually we will have goods inflation as a result.? For now, the market is rejoicing in an accommodative Fed.? Enjoy it while it lasts, buy inflation is coming.

Book Review: What Works on Wall Street

Book Review: What Works on Wall Street

Posted on by David Merkel

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

  1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
  2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
  3. Value and Momentum both work as strategies. They work best together.
  4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

  1. Low P/B
  2. Low P/E
  3. Net Insider Buying
  4. Significant Declines in the Stock Price (anti-momentum)
  5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Book Review: Triumph of the Optimists

Book Review: Triumph of the Optimists

Posted on by David Merkel

Good investors are typically skeptical. They don’t buy every idea that comes their way, but they test and probe to find ideas with compelling value that are misunderstood by others. That said, the best investors are prudent risk-takers. They continue to search for good investments even in environments that seem to have a negative investing climate.

Skepticism can degenerate to permanent pessimism, particularly because most news coverage tends toward the negative. How does an investor remain bullish in the face of news flow that is predominantly negative? By looking at the broader tendencies of equity markets to flourish in the face of troubles over the long run. One good book for that is Triumph of the Optimists. [TOTO]
TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

  1. Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
  2. This was true regardless of what presently developed nation you looked at. (Note: survivor bias… what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
  3. Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
  4. Returns were higher globally in the last quarter of the 20th century.
  5. Downdrafts can be severe. Consider the US 1939-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
  6. Real cash returns tend to be positive but small.
  7. Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
  8. Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
  9. International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
  10. Small caps may or may not outperform large caps on average.
  11. Value tends to beat growth over the long run.
  12. Higher dividends tend to beat lower dividends.
  13. Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even…)
  14. Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
  15. Returns in the latter part of the 20th century were artificially high.

The statistical chapters on the 16 developed markets are amazing, but now almost seven years dated. Still, you can glean a lot from them.

This is an expensive book, and one that may not be for everyone. A cheaper book that covers many of the same issues is Stocks for the Long Run, by Jeremy Siegel. Now going into its fourth edition (I have a signed first edition), it covers many of the same issues, but with more of a US-centric approach, and going back another 100 years (with spotty data).

As I like to say, stocks do well, absent war on your home soil, out-of-control socialism, and severe recession/depression. These books will help you stay in the market even when times are hard. After all, who can tell when the market will turn up? Or down?

Dimson, Marsh and Staunton

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Jeremy Siegel

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Full disclosure: I get a small commission from any book sales through these links.

Book Review: The Intelligent Investor

Book Review: The Intelligent Investor

Posted on by David Merkel

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

  1. Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
  2. Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
  3. Stocks provide modest compensation against inflation risks.
  4. Avoid callable bonds. Avoid preferred stocks.
  5. Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
  6. Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
  7. Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
  8. Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
  9. Growth is worth paying up for, but be disciplined. Don’t overpay.
  10. Be wary of mutual funds.
  11. Be wary of experts.
  12. Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
  13. Review average earnings of cyclical companies.
  14. Buy them safe and cheap. Don’t overpay for growth and trendiness.
  15. Avoid highly acquisitive companies.
  16. Watch cash flow, and question unusual accounting treatments.
  17. Be careful with unseasoned (new) companies.
  18. Strong dividend policies, in companies that can support the dividends, are an indicator of value.
  19. Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….
Classic:

As Revised by Jason Zweig:

Book Review: Navigating the Financial Blogosphere

Book Review: Navigating the Financial Blogosphere

Posted on by David Merkel

Russell Bailyn is a Wealth manager who wrote a basic book on finances, but gave it a twist to emphasize what resources were available on the web, and at financial blogs specifically. He covers a wide number of areas in a basic way, sometimes giving answers where “one size fits all,” or almost all, and sometimes explaining to readers what the right questions are when answers are situation-dependent.

Some of the areas he covers are:

  • Banking, budgeting and credit.
  • Financial planning and tax-deferred savings/investment
  • Investment types
  • Life insurance and annuities
  • Retirement and portfolio management

The book isn’t long at 220 pages, so as you might imagine, this book is wide, but not deep. I would recommend this book for people who are getting started in managing their finances, and want to take a more active hand there. Alternatively, it could benefit those who want to hire a financial planner, because they would better learn how to choose a planner, and better evaluate the advice that their planner gives them.

Because I am aware of most of the areas in the book, this is a book that I skimmed. That said, as I looked at critical ideas in the book, I found that I largely agreed with his ideas. As a trivia note, Alephblog and I get featured on page 177, in the chapter on portfolio management. If I had to featured in any chapter, I’m glad it was that one, because managing risk through proper portfolio management is near and dear to my heart.

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