This is the first book that I have reviewed twice.  I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.

Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,  In it he draws on a number of common factors:

• Loose monetary policy
• People chase the performance of the speculative asset
• Speculators make fixed commitments buying the speculative asset
• The speculative asset’s price gets bid up to the point where it costs money to hold the positions
• A shock hits the system, a default occurs, or monetary policy starts contracting
• The system unwinds, and the price of the speculative asset falls leading to
• Insolvencies with those that borrowed to finance the assets
• A lender of last resort appears to end the cycle

The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).

The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.  What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.

Quibbles

Hindsight is 20-20.  If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.  I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.

Who would benefit from this book: Most investors would benefit from this book.  It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.  If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Bubbles are easy to spot.  Wait, don’t most people say that bubbles are impossible to spot?

I’ll say that again: bubbles are easy to spot.  Why?  People have the wrong theory on bubbles.  They listen to those that don’t understand the efficient markets hypothesis, and think, “Prices are always fair predictors of the future.  I don’t have to think about the future as a result.” (It would be better to say that current prices are the short-term neutral line against which bets are placed.)

Don’t listen to academics on bubbles.  There have been booms and busts as far back as we can see.  If markets tend toward equilibrium, that is very well hidden — please require economists to take courses in history.  I mean this; I am not joking.  Neoclassical economics is not  a science; it is a religion, and with much less historical evidence to support it than Christianity has to support the historicity of the resurrection.

Why do I write on this? Partly because of Jason Zweig’s piece in the WSJ.  I ordinarily like what Jason writes; this is a rare exception.

Spotting bubbles gets easier when you don’t simply look at rising prices.  It is better to look at what is driving the rising prices.  How are players financing the purchase of assets is more important to view than even price trends.

It is hard to get a bubble without having an increase in debt-finance.  Financing with debt is cheaper, and riskier than financing with equity.  Financing long-term assets with short-term debt is even cheaper and riskier than financing with debt that matches the term of the asset.  Most bubbles end with some sort of financing time-mismatch, where the inability to renew short-term indebtedness in order to hold the asset leads to a panic, which leads some to say, “This is a liquidity crisis, not a solvency crisis.”  When you hear that leaden phrase, ordinarily, it is a solvency crisis, with long-dated assets of uncertain worth, and near-term liabilities requiring cash.

This is why the simplest way of looking for bubbles is to look for where debt is increasing most rapidily, and where the terms and conditions of lending have deteriorated.

But where do we have these issues today?  Let me offer a few areas:

• We have a chain of financing arrangements in the Eurozone where many banks might have a hard time surviving the failure of Greece, Italy, Portugal, and perhaps some other nations as well.  Failure of those banks might lead to bailouts by national governments and/or a significant recession.  Anytime financial firms as a group would have a hard time with the failure of a company, industry, government, etc., that is a sign of a lending bubble.
• There is a major imbalance in the world.  China trades goods to the US in exchange for promises to pay later.  Creditor-debtor relationships are meant to be temporary, not permanent as far as governments are concerned.  There may never be a panic here, but so long as the US retains control of its own currency, it is safe to say that they will never get paid back in equivalent purchasing power terms as when they exported the goods.
• China itself, though opaque, has a great deal of lending going on internally through its banks, pseudo-banks, and municipalities, a decent amount of which seems to be for dubious purpose at the behest of party members.  The government of China has always been able in the past to socialize those credit losses.  The question is whether covering those losses could be so large that the government follows an inflationary policy to eliminate the debts amid public discomfort.
• AAA and near-AAA government debt has been the most rapidly growing class of debt of late.  Maybe AAA governments that are unwilling to cut spending or raise taxes are a bubble all their own.  Remember, when you are AAA, the rating agencies let you make tons of financial promises — think of MBIA, Ambac, FGIC, AIG, etc.  Only when its is dreadfully obvious do the rating agencies cut a AAA rating, but once they do, it is often followed by many more cuts as the leverage collapses.

Now, my view here is both qualitative and quantitative.  To find bubbles there are indicators to watch, such as:

• Low credit spreads and equity volatility
• Low TED spreads
• High explicit/implicit leverage at the banks
• High levels of short term lending/borrowing (asset/liability term mismatches)
• Credit complexity and interconnectedness
• Poor Credit Underwriting
• Carry trades are common (many seek free money through seemingly riskless abritrages)
• Accommodative monetary/credit policy

All manner of things showing that caution has been thrown to the winds and lending is done on an expedited/casual basis is a sign that a bubble may be present.  Kick the tires, look around, analyze the psychology to see if you can find a self-reinforcing cycle of debt  that is forcing the prices of a group of assets above where they would normally be priced without such favorable terms.

Not that this analysis is perfect, but it follows the broad outlines of Kindleberger and Chancellor.  Speculative manias are normal to capitalism; don’t be surprised that they show up.  Rather, be of sane mind, and learn to avoid participating in manias, long before they become panics or crashes.

This book grew on me. Think of it as “How I hit a home run in investing.”  Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.  In a few cases, the “greatest” made one (or a few) good decisions.  In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.  The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.  No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.  Imagine an investor that made some amazing gains , but then craters.  There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.  They may not earn that much, but the skill level is really high.  But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?  He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.  Information on Templeton is repeated.  Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.  They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.  It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.  If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

One of my readers posted the following comment, and I felt it was worth following up:

I continue to struggle with the Growth vs Value designation (never mind where to invest). According to Buffet’s letter, they are joined at the hip (growth being an important part of value), whereas you indicate that there is a real difference between Value and Growth.

Does “Value” as a category of stock arise from the way it is priced or is it solely dependent upon the condition of the company? Is the “Growth” designation simply a function of the rate of change of earnings (or some other financial measure) or is it related to the eagerness of buyers?

If I am reading you right, you are saying that value applies to a stock (not a company), and that value investing does not require (earnings) growth to be successful, whereas growth investing is paying a premium, and thus requires sustained, substantial earnings growth to be successful (because you are paying so much for the shares).

It always seems like “value” stocks are the one’s investors don’t want (if people are paying a premium, it is not a “value” stock). If few people are interested in buying the stock right now, when the underlying business is fine (or at least unimpaired), why would they be willing to pay more in the future? It seems like that would only happen if earnings grow (so it is a “growth” company?) or if people decide they would like to pay more for the same earnings. Are future buyers going to pay more because they see that earnings simply aren’t falling? Or is most of the return going to come through dividends and/or share buybacks?

This seems like something very fundamental, but the amount of confusing comments (around the internet) about these terms seems second only to confusion related to the term “risk”.

Imagine for a moment that you had the influence over a company such that you forced them to liquidate it.  Going out of business.  Selling everything.  With a company characterized as a value stock, you would make money off of such a venture.  With a growth stock, you would certainly lose.  Growth stocks are going concerns, and need to continue in operations in order to increase their value.  Even a value stock does not generally want to liquidate, but they don’t need to grow much to maintain the value of the enterprise.

With value stocks, most surprises are positive, because expectations are low.  With growth stocks, most surprises are negative, because expectations are high.

Buffett is right.  Value and Growth are joined at the hip.  What he means by that is that a company with predictable growth deserves a higher valuation, with which I totally agree.  The stereotyping of growth and value stocks stems from human prejudices where people segment the market into two or three areas:

• Buy the fastest growing companies, at any price.
• Buy growth at a reasonable price.
• Buy companies that will do okay even if they don’t grow.

Value is a question of price only.  There is no such thing as a bad asset, only a bad price.  I like buying growth companies, and I do so when they are offered to me at bargain prices.  I will pay up a little for a growth company, in the same way that I would pay up for bonds of higher credit quality, while losing a little yield, but not a lot of yield.

This is not to say that all value investing will succeed.  I have my share of failures.  The idea is to tip the odds into your favor by buying things that are out of favor relative to their current assets, or likely future earnings (or free cash flow, for the advanced).

Risk is a question of permanently losing capital.  That is the downside on which all investors should focus.  Though I do lose money on some stocks that I buy, my goal is to lose money on none of the stocks.  If I cover the downside, the upside will take care of the rest, because the goal of a value investor is to not lose money over the long haul.

Have a look at this article.  He makes the case as to why leveraged ETFs should not be held over the long term, as I have argued before.

There is a problem with this.  Imagine for a moment that all users of leveraged ETFs extinguish their positions daily.  There would be no shares to be sold the next morning to those who want to take a position. Where would the shares come from to be bought or sold?

Leveraged ETFs rely on those that will not use them over one day only. They provide the supply/liquidity for everyone else.

Maybe there should be a tiny dividend accrued/paid to holders at the end of each day to equalize for the rebalancing losses.  I don’t know for certain, but I suspect that would ruin the economics of running a leveraged ETF.  It would add to the daily costs of hedging, which are already significant.  But maybe the overall costs would be borne more equitably with dividends corresponding to the hedging interval.  It would also deter paired shorting of leveraged ETFs.

But maybe losses for levered speculators is its own best reward.  The ability to take levered positions shouldn’t be free; someone trying to do it on his own would incur costs.

It’s paternalistic, but maybe these products should be barred on public policy grounds.  On net, they guarantee losses to holders.   If people want to construct these strategies themselves, and bear the costs explicitly, fine.  But to have the costs borne implicitly by fools is another matter.

We limit market leverage partly for systemic reasons, but also because it prevents people from harming themselves.  As for me, I would not object if the regulators eliminated leveraged ETFs.  They serve no long-term useful purpose.

Some friends of mine asked me if I could create an insurance-centric hedge fund.  I said that it was unlikely because I’m not good at shorting.  They pressed me on it, because they knew if I had good longs, with my quantitative skills, I could create a credible short position that might hedge the longs.

Ugh.  I don’t want to do it, but maybe I could make this work.  I certainly could use the revenue.  So what would I focus on in such a fund?

• Relative valuations
• Management quality
• Reserve releases/strengthening from prior year claims
• Momentum — yeh, momentum.
• Long-term underwriting profitability

My goal is to make money for average people, not the wealthy, but if that is the only way that my firm can survive, I will set up a hedge fund in the insurance space.  I love insurance; I know it intuitively, but I know that once I  begin to take big bets, I may fail badly.

If you know me well, you know that I only take prudent risks.  I’m not risk-averse, I like taking risks when the odds are in my favor.

So I am puzzled at this point.  I have done better in evaluating the broad markets than the narrow insurance markets, but if I have to be a narrow investor in order to survive, I can do that.

If you have advice for me here, I will receive it with thanks.

What is this graph?  I’ll give you a hint — it has something to do with technical analysis where investors look for signals near turning points.

Ideas?  Let me know in the comments.  I’ll have a post on this later.

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.  Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.  I usually put in a number of gaps close to the square root of the dominoes.  Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.  Any jolt to the system will topple most or all of them.  Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.  Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.  These thoughts are my own, though others have uttered them as well.   In order for there to be a panic that destroys a large portion of the financial system, there has to be:

• High levels of leverage.
• Leverage that is layered, where many parties are lending, and carry trades are common.  Parties borrow to lend more aggressively.
• Collateralized lending — financial entities lend far more when lending is collateralized.  Most of the time, the existence of collateral prevents defaults.  But when things get really bad there is no protection with most collateral.
• Problems with highly rated debt.  When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
• There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
• Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.  That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.  Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.  It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.  Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.  The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.  Maybe we’ll get there in another 2-3 years.

Why do we do time-weighted returns for analysis of portfolios?  Because we are lazy, and they are simple to calculate.  We don’t want to be bothered with the effects of cash flows.

Besides, mutual fund managers don’t make decisions to move money in and out of their funds.  They should not be held accountable for the actions of their shareholders.

Really?  I think that is only half correct.  The good fund manager takes account of his implicit liability structure.  When will people leave, when will they come?  For almost all funds, investors are trend followers.  And the the greater the degree of volatility, the worse the investors are at following the trend.  Thus a manager of a volatile fund should run with more of a cash buffer, particularly when markets are moving down hard, because he will have more of his clients cashing out.  The manager of a volatile fund should also avoid taking concentrated positions, because when he is doing well, his own buying may drive the stocks he owns up, only to see them fall harder when he is forced to liquidate positions when the market is doing poorly, and shareholders are leaving.  Wise managers concentrate near bottoms, and diversify near tops.

Now for my poster child, the Legg Mason Value Trust.  Bill Miller is a very intelligent guy, and has a very talented staff.  My main criticism of his management is that it neglects the core concept of value investing, which is “margin of safety.”  The core concept is not cheapness, or as Bill Miller was fond of saying “lowest average cost wins.”

Legg Mason Value Trust enthused investors as they racked up significant returns in the late 90s, and the adulation persisted through 2006.  As Legg Mason Value Trust grew larger it concentrated its positions.  It also did not care much about margin of safety in financial companies.  It bought cheap, and suffered as earnings quality proved to be poor.

Eventually, holding a large portfolio of concentrated, lower-quality companies as the crisis hit, the performance fell apart, and many shareholders of the fund liquidated, exacerbating the losses of the fund, and their selling pushed the prices of their stocks down, leading to more shareholder selling.  I’m not sure the situation has stabilized, but it is probably close to doing being there.

But now to the point: what did Bill Miller earn for shareholders?  The earliest date that I could get data for was 3/31/1993, probably due to the creation of EDGAR in the mid-90s.

On a dollar-weighted basis, he earned 2.71%/year for investors through 10/31/2010.  But for those stout-hearted souls that bought and held, they earned 6%+ more, 8.78%.  But those that did that had to be patient, even Stoic, people who had no need for liquidity, and no propensity for panic.  (There is always enough time to panic. )

Legg Mason Value Trust was a volatile fund, and as such, it is no surprise that the difference between time-weighted and dollar-weighted returns are so large.  But what does this imply about Bill Miller? He beat the S&P 15 years in a row.  But as posts like this point out, did he go from first to worst?

His neglect of the core idea in value investing, margin of safety, allowed him to do well as the lending bubble expanded, and low quality companies prospered.  But when the tide went out, he was found to be swimming naked.  Far from following Buffett’s principles, or Graham’s, he was just a growth investor masquerading as value investor because “he bought them cheap.”  And they got a lot cheaper, and he had to sell them cheaper still.

So what are the lessons here?

• Focus on margin of safety in investing.  Analyze balance sheets.
• Avoid investing in popular funds, even excellent managers make mistakes when lots of money is coming in.
• Stick to your knitting.  Don’t engage in all manner of fancy logic once you achieve success.  Stay humble.
• Remember that your timing in investing makes a difference.  Don’t be quick to add to a winning fund.  Better to find a fund with good ideas that is temporarily underperforming.
• Buy-and-hold often beats the average investor over the long haul.  Some traders might do better, but have you developed that skill?
• Avoid managers that say a lot of clever things, but can’t deliver on returns.

So be wise, and realize, you are still responsible for your investment success or failure, even if you hand it off to others.

I received a question from a friend of mine and want to give an answer:

Background: I teach high school physics.  In my AP class, I have some cross-registration with the Micro-econ & Personal Finance classes.  In those classes, they play the “Stock Market Game” in which they’re given $25k and compete for the semester for the highest total.  Inevitably, discussion of economics, stocks, and that game finds its way into my class where I am incapable of _not_ getting involved.

Problem 1: The game only lasts for a semester (4 months).  Result: very short term thinking

Problem 2: The teacher pushes stock-chart reading, “200 day average vs 50 day average”, looking at price movements, etc.  There is little (if any) balance sheet reading, company growth investigation, or stock price evaluation going on.

Relevance for here: The kids immediately turn to penny stocks thinking to make a quick buck- “If I buy 50,000 shares of this company at $0.25, I can sell it for a huge profit when it goes up to $0.50.

Question: Do you have any recommendations for short quips / talking points to reveal their folly to them? 

(I had a kid last year almost not graduate when he became so enamored with playing the stock market that he thought he could “crack the code” and make a fortune off penny stocks.)

I have only experienced one good investment contest in my life.  It was in 1983-1984, when Value Line sponsored a contest offering significant prizes.  They did something unique: they divided the market into 10 groups sorted on volatility, and told investors that they had to pick one stock out of each of the ten groups.

Brilliant. this eliminated the ability of people to just pick risky stocks, and bet on getting lucky turning the whole thing into chance.

A portfolio of ten equally-weighted stocks demonstrates more ability than a single pick.  For any single stock, or concentrated portfolio that does well, the answer should be that they got lucky, as humans see it.

As it was, in the Value Line Contest, I finished just short of getting a prize.  My returns were less than a percent behind the lowest winner.

Now as to what you should do, dear friend, in the short run, momentum matters more than valuation, most of the time.  The teacher may be giving them the right advice for the contest.  Personally, I would go to the teacher, rather than the students, and tell him to do a contest more like Value Line did.  If he needs help with the volatility groups, I can provide the data.

But the two main things to point out on penny stocks is this: 1) Most people investing in penny stocks lose a lot of money, because the stocks seem cheap, but they have little in assets or earnings relative to their price.  2) There are penny stock promoters who tout penny stocks so that others will buy at a higher price, so they can sell to them, and the new buyer can experience the losses.

If the contest is structured properly, it should have a minimum capitalization limit, and a diversification requirement.  Tell the other teachers to consider this.