#读书笔记 #1 A Random Walk Down Wall Street (Chapter 4)

Chapter 4: The Explosive Bubbles of the Early 2000s

1. The Internet Bubble

Most bubbles have been associated with some new technology (as in the tronics and biotech booms) or with some new business opportunity (as when the opening of profitable new trade opportunities spawned the South Sea Bubble). The Internet was associated with both: it represented a new technology, and it offered new business opportunities that promised to revolutionize the way we obtain information and purchase goods/service. 

Bubbles are "positive feedback loops" - Robert Shiller (Irrational Exuberance).

In the first quarter of 2000, 916 venture capital firms invested $15.7 billion in 1,009 startup Internet companies. An astonishing 159 IPOs had been completed in the previous quarter. As happened during the South Sea Bubble, many companies that received financing were absurd. IN earlier times, one needed actual revenues and profits to come to market with an IPO. Some Internet companies had neither. We learned that investors would throw money at businesses that only five years before would not have passed normal due diligence hurdles.

Security Analyst $peak Up

Security analysts always find reasons to be bullish. They seldom utter the "sell" word, because they do not want to endanger current or future investment banking relationship or to offend corporate chief financial officers. Traditionally, ten stocks were rated "buys" for each one rated "sell". But during the bubble, the ratio was almost 100:1. 

New Valuation Metrics

Somehow, in the new Internet world, sale, revenues, and profits were irrelevant. In order to value Internet companies, analyst looked instead at "eyeballs" - the number of people viewing a Web page or "visiting" a Web site. Particularly important were numbers of "engaged shoppers" - those who spent at least 3 minutes on a website. "Mind share" was another popular non-financial metric.

Special metrics were established for telecom companies. Security analysts clambered into tunnels to count the miles of fiber-optic cable in the ground rather than examining the tiny fraction that was actually lit up with traffic.

The Writes of the Media

The bubble was aided and abetted by the media, which turned us into a nation of traders. Like the stock market, journalism is subject to the laws of supply and demand.

The Internet itself became the media. The Internet had democratized the investment process, and it played an important enabling role in perpetuating the bubble. Online brokers were also a critical factor in fueling the Internet boom. Trading was cheap, at least in terms of the small dollar amount of commissions charged.

Cable networks such as CNBC and Bloomberg became cultural phenomena. Across the world, health clubs, airports and bars were permanently tuned into CNBC.

Fraud Slithers In and Strangles the Market

Speculative manias , such as the Internet bubble, bring out the worst aspects of our system. Many businesses were managed not for the creation of long-run vale but for the immediate gratification of speculators - "obliged" high short-term earnings, "creative accounting, etc.

Enron was only one of a number of accounting frauds. Various telecom companies overstated revenues through swaps of fiber-optic capacity at inflated prices.

Should We Have Known the Dangers?

Fraud aside, we should have known better. We should have known that investments in transforming technologies have often proved unrewarding for investors. In the 1850s, the railroad was widely expected to greatly increase the efficiency of communications and commerce. It certainly did so, but it did not justify the prices (collapses in August 1857). History tells us that eventually all excessively exuberant markets succumb to the laws of gravity.

Many villains: fee-obsessed underwriters; research analysts that could be pushed by commission-hungry brokers; corporate executives using "creative accounting" to inflate their profits. It was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand.

2. The US Housing Bubble and Crash of the Early 2000s

This bubble was undoubtedly the biggest US real estate bubble of all time. Moreover, the boom and later collapse in house prices had far greater significance for the average Americans than any gyrations in the stock market.

In order to understand how this bubble was financed and why it created such far-reaching collateral damage, we need to understand the fundamental changes in the banking and financial systems.

The New System of Banking

Old system is "originate and hold" system. Banks would make mortgage loans and hold those loans as assets until they were repaid. In such an environment, bankers were very careful about the loans they made. This system fundamentally changed in the early 2000s. New system is the "originate and distribute" model of banking - e.g. mortgage-backed securities, CDS (second-order derivatives), etc.

Looser Lending Standards

The financiers created structured investment vehicles, or SIVs, that kept derivative securities off their books, in places where the banking regulators couldn't see them. In the new system loans were made with no equity down in the hopes that housing prices would rise forever. NINJA loans were common - loans to people with no income, no job , and no asset.

The government itself played an active role in inflating the housing bubble. Under pressure by Congress to make mortgage loans easily available, the FHA was directed to guarantee the mortgages of low-income borrowers. Indeed, almost 2/3 of the bad mortgages on the financial system as of the start of 2010 were bought by government agencies or required by government regulations. No accurate history of the housing bubble can fail to recognize that it was not simply "predatory lenders" but the government itself that caused many mortgage loans to be made to people who cannot afford them.

3. Bubble and Economic Activity

The bursting of bubbles has invariably been followed by severe disruptions in real economic activity. The fallout from asset-price bubbles has not been confined to speculators. Bubble are particularly dangerous when they are associated with a credit boom and widespread increases in leverage both for consumers and for financial institutions. Credit boom bubbles are the ones that pose the greatest danger to real economic activity.

Are the markets inefficient?

"The stock market is not a voting mechanism but a weighing mechanism." - Benjamin Graham (Security Analysis). Valuation metrics have not changed. Eventually, every stock can only be worth the present value of the cash flow.

Market prices must always be wrong to some extent. But at any particular time, it's not obvious to anyone whether they are too high or too low. Markets are not always or even usually correct. But no one person or institution consistently knows more than the market. (???)

#读书笔记 #1 A Random Walk Down Wall Street (Chapter 3)

Chapter 3: Speculative Bubbles from the Sixties into the Nineties

By the 1990s, institutions accounted for more than 90% of the trading volume on the NYSE.

1. The Soaring Sixties

1.1 The Growth-Stock/New-Issue Craze

In the 1959-1962 period, "Growth" was the magic word. Growth companies such as IBM and TI sold at more than 80 multiples of P/E (A year later they sold at multiples in the 20s and 30s). It was called "tronics boom", because the stock offerings often include some garbled version of "electronics" in their title. The tronics boom came back to earth in 1962. Yesterday's hot issue became today's cold turkey.

1.2 Synergy Generates Energy: The Conglomerate Boom

Part of the genius of the financial market is that if a product is demanded, it is produced. The product that all investors desired was expected growth in earnings per share. By the mid-1960s, creative entrepreneurs suggested that growth could be created by synergism.

In fact, the major impetus for the conglomerate wave of the 1960s was that the acquisition process itself could be made to produce growth in earnings per share - manipulation of P/E multiples. The trick that makes the game work is the ability of the electronics company to swap its high-multiple stock for the stock of another company with a lower multiple.

The aftermath of this speculative phase revealed two disturbing factors. First, conglomerates could not always control their far-flung empires. Second, the government and the accounting profession expressed concern about the pace of mergers and about possible abuses.

An interesting footnote is that during the 1990s and early 2000s, de-conglomeration came into fashion. Many of these sales were financed through a popular innovation, the leveraged buyout (LBO).

1.3 Performance Comes to the Market: The Bubble in Concept Stocks

"Performance" fund concentrated the portfolio in dynamic stocks, which had a good story to tell, and at the first sign of an even better story, they would quickly switch. Performance investing took hold of Wall Street in the late 1960s. "Since we hear story early, we can figure enough people will be hearing it in the next few days to give the stock a bounce. even if the story doesn't prove out."

Why did these stocks perform so badly later on? One general answer: their price-earnings multiples were inflated beyond reason. These companies were run by executives who were primarily promoters. not sharp-penciled operating managers.

2. The Nifty Fifty

In the 1970s, Wall Street's pros vowed to return to "sound principles". Concepts were out and blue-chip companies were in. "Big capitalization" stocks (Nifty Fifty) meant that an institution could buy a good-size position without disturbing the market. Hard as it is to believe, institutions started to speculate in blue chips. They once again proved the maxim that stupidity well packaged can sound like wisdom. The craze ended like all other speculative manias.

3. The Roaring Eighties

The high-tech, new-issue boom of the first half of 1983 was an almost perfect replica of the 1960s episodes, with the names altered slightly to include the new fields of biotechnology and microelectronics. During the late 1980s, most biotechnology stocks lost three-quarters of their market value. Even real technology revolutions do not guarantee benefits for investors.

4. What Does It All Mean?

Styles and fashions in investors' evaluations of securities can and often do play a critical role in the pricing of securities. The stock market at times conforms well to the castle-in-the-air theory. For this reason, the game of investing can be extremely dangerous.

5. An International Example: The Japanese Yen for Land and Stocks

One of the largest booms and bursts of the late 20th century involved the Japanese real estate and stock markets. From 1955 to 1990, the value of Jap. real estate increased more than 75 times. By 1990,  tot. value of Jap. real estate was estimated at ~20 trillion - equal to >20% of the entire world's wealth, or about double the tot. value of the world's stock market, or five times as much as all American property. The high value of Jap. land was "explained" by both the density of Jap. population and the various regulation and tax laws restricting the use of habitable land.

Jap. stocks sold at >60 times earnings, almost 5 times book value, and >200 times dividends. In contrast, US stocks 15 P/E; UK stocks 12 P/E. Supporters of the stock market had answers to all the logical objections that could be raised. One being that the book values did not reflect the dramatic appreciation of the land owned by Jap. companies. (Sam: "what is the relationship between real estate and stock ?")

Weakness of Jap. economy at that time:

1) Even when earnings were adjusted, the multiples were still far higher than in other countries and extraordinarily inflated relative to Japan's own history;

2) Jap. profitability had been declining, and the the strong yen was bound to make it more difficult for Japan to export;

3) although land was scarce in Japan, its manufacturers  (e.g. auto makers) were finding abundant land for new plants at attractive prices in foreign lands;

4) Rental income had been rising for more slowly than land values, indicating a falling rate of return on real estate;

5) The low interest rates that had been underpinning the market had already begun to rise in 1989.

The BOJ saw the ugly specter of a general inflation stirring amid the borrowing frenzy and the liquidity boom underwriting the rise in land and stock prices. And so the central bank restricted credit and engineered a rise in interest rates. The hope was that further rises in property prices would be choked off and the stock market might be eased downward. INSTEAD, it collapsed. The fall was almost as extreme as the US stock crash from the end of 1929 to mid-1932.

The rise in stock prices during the mid- and late 1980s represented a change in valuation relationships. The fall  in stock prices from 1990 on simply reflected a return to the price-to-book-value relationships that were typical in the early 1980s. The air also rushed out of the real estate balloon during the early 1990s.

#读书笔记 #1 A Random Walk down Wall Street (Chapter 1-2)

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A Random Walk down Wall Street (10th Edition)

By Burton G. Malkiel

About the author

Burton Malkiel is Emeritus Professor in Department of Economic at Princeton University. He is a leading proponent of the efficient-market hypothesis and in general supports buying and holding index funds as the most effective portfolio-management strategy. He also spent 28 years as a director of the Vanguard Group.

Chapter 1: Firm Foundations and Castle in the Air

Inflation

In US and most of the developed world, inflation fell to 2% in the early 2000s, and some believe that relative price stability will continue indefinitely. (True? What affect inflation?) What is the possibility that inflation will accelerate again at some time in the future? Productivity growth accelerated in the 1990s and 2000s, but history tells us the pace of improvement has always been uneven. Moreover, productivity improvement is hard to come by in some service-oriented activities (like musicians, surgeon, etc).

Firm-foundation Theory

It relies on some tricky forecasts of the extent and duration of future growth (dividend, cash distribution, etc.). An influential book is Security Analysis (by B. Graham and D. Dodd).

Castle-in-the-air Theory

The castle-in-the-air theory concentrates on psychic values ("greater fool" theory).

Every investor should remember: Res tantum valet quantum vendi potest (A thing is worth only what someone else will pay for it).

Chapter 2: The Madness of Crowds

GREED RUN AMOK

has been an essential feature of every spectacular boom in history. Remember the movie Margin Call ? "I am here for one reason and one reason alone. I am here to guess what the music might do a week, a month, a year from now. That's it. Nothing more..." Unsustainable prices may persist for years, but eventually they reverse themselves.

Tulip-bulb Craze and South Sea Bubble

Part of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it.

Options provide one way to leverage one's investment to increase the potential rewards as well as the risks. Such devices helped to ensure broad participation in the market. The same is true today.

As happens in all speculative crazes, prices eventually got so high that some people decide they would be prudent and sell their bulbs.

Big losers in the South Sea Bubble included Isaac Newton, who exclaimed, "I can calculate the motions of heavenly bodies, but not the madness of people."

Wall Street lays an egg (1929)

Calvin Coolidge - "The business of America is business." Stock market speculation was central to the culture.

Specialist could be so valuable to the pool manager. The book gave information about the extent of existing orders to buy and sell at prices below and above the current market. Wash sales created the impression that something big was afoot.

Monday, October 21, 1929: The stage was set for a classic stock market break. The declines in stock price had led to calls for more collateral from margin buyers. Unable or unwilling to meet the calls, these customers were forced to sell their holdings. This depressed prices and led to more margin calls and finally to a self-sustaining selling wave.

The crash in the stock market was followed by the most devastating depression in history. History teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability. Even if prosperity had continued into the 1930s, stock prices could never has sustained their advance of the late 1920s. In addition, the anomalous behavior of close-end investment company shares provides clinching evidence of wide-scale stock market irrationality during the 1920s. From January to August 1929, the typical closed-end fund sold at a premium of 50%.

An afterword

It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored.