Jul 2007
| IN BRIEF: Like the ancient Greeks, the wise investor is a student of history. The practical value of history falls under two broad categories: exploitable patterns and avoidable mistakes. Two enduring aspects of market history are time frames and behavior cycles—the first being a subset of the second. The British railroad mania of the 1840s, and the telecom mania 150+ years later, offer some enduring lessons. |
THE GIFT OF FORESIGHT is highly prized in the investing trade.
An image that comes to mind is that of the keen-eyed ship's captain, using his spyglass to scan the far horizon. But the ancient Greeks offer a simpler, more humble perspective… one that we as investors can learn from.
These days, it is fashionable to be considered forward-thinking. To be described as "backwards" is typically deemed an insult. Yet the Greeks held a different view.
Rather than looking ever forward, the Greeks saw themselves as walking backwards through history. By this way of thinking, the landscape of the past is always laid out before you; the future sneaks up from behind, never in plain sight.
This perspective (no pun intended) offers a few key advantages for investors. It encourages humility, reminding us that no one can be completely certain what tomorrow holds. And it encourages patience, as it is harder to rush when walking backwards (and generally not advisable in the first place). Most importantly, an orientation to the past places strong emphasis on the value of history.
Why is history so important?
Why is it so important to learn from history?
First, because the past offers up a bountiful crop of knowledge to those willing to harvest it. In many respects the affairs of men have gone unchanged for thousands of years; in matters of love, war and politics, for example, there is little new under the sun.
As a result, major market events tend to unfold in predictable, exploitable patterns that, while never repeating specifically, repeat in general fashion over and over again. The specifics differ, but the form remains.
If you doubt the longevity of such patterns, consider how the roots of modern market behavior predate the birth of Christ. In his excellent history of speculation, Devil Take the Hindmost, Edward Chancellor observes:
For the earliest known historical cases of speculation we must turn to ancient Rome during the Republic of the second century BC. By this date, the Roman financial system had developed many of the characteristics of modern capitalism: markets flourished because Roman law allowed the free transfer of property, money was lent out at interest, money changers dealt in foreign currencies, and payments across the Roman territories could be made by bankers' draft. Capital concentrated in Rome, as it later did in Amsterdam, London, and New York. The idea of credit had also developed, along with a primitive form of insurance for ships and other forms of property. The people of Rome exhibited a passion for the accumulation of wealth, matched by an extravagance in its display and consumption. Gaming was common.
The second reason to walk backwards is because "those who do not learn from history are doomed to repeat it." Most everyone knows that old George Santayana chestnut (if not the name of the man who said it), but few have considered the deeper implications.
| For investors, what is new and different is often less important than what has stayed the same. |
The two reasons are linked. To speak of exploitable patterns and avoidable mistakes is to highlight the fact that ongoing events have a sameness, for lack of a better word, even when the circumstances appear different.
For investors, what is new and different is often less important than what has stayed the same.
Going back to Santayana's gruff observation: learning from history is akin to learning from the blunders of others. Needlessly repeating the mistakes of others is akin to reinventing the wheel. To the degree that an investor learns from history, then, he (or she) gets an education without having to pay the tuition fees. (We all have to pay some tuition, no doubt, but it only makes sense to minimize the cost.)
Without an understanding of the mistakes others have made, it is all too easy to fall into the same traps they did. With a surface level understanding, it becomes possible to avoid the obvious mistake, yet fall prey to what Jesse Livermore called "one of the ten thousand brothers or cousins of the original."
As Livermore went on to add, "the Mistake family is so large that there is always one of them around when you want to see what you can do in the fool-play line." An intelligent study of history —including one's own mistakes as well as others—is the best guard against this.
Time Frames and Behavior Cycles
| Two enduring aspects of market history are time frames and behavior cycles. Both reflect on deeply embedded tendencies that influence how markets work. |
Two enduring aspects of market history are what I refer to as time frames and behavior cycles. Both reflect on deeply embedded tendencies that influence how markets work.
Time frames are important because it is so maddeningly easy to get them wrong. Humans in general, and investors in particular, are terrible at estimating the amount of time it will take for an anticipated event to unfold.
As project managers everywhere know, we are congenitally optimistic; it is regularly assumed things will happen faster than they actually do. Furthermore, time frame issues are really a subset of broader behavior cycles—those tidal waves of greed, fear and disdain that sweep through markets with majestic regularity.
When it comes to transformational technology and "paradigm shift" type ideas (think automobiles, airlines, telephones and the internet), investors tend to act like the little boy allowed to stay up on New Year's Eve. They get so jazzed up in the early stages, and expend so much energy hooting and hollering, that exhaustion sets in by ten PM or so. When the transformational moment actually rolls around, investors are long asleep and snooze right through it.
As a rule of thumb, the crowd is impatient early and oblivious late. Once the masses "get" a new and exciting concept, they assume a near-instantaneous unfolding of all the good things so confidently expected in short order. Hope and hype are overblown; enthusiasm reaches nosebleed heights; capital is overinvested, the market gets overextended, and the situation implodes. Ultimately the original thesis is tossed aside, like a child's discarded toy. Then things get interesting.
Railroads and Telecoms
Examples of time frame and behavior cycle folly are legion; the two examples we will use here are the British railroad mania of the 1840's and the telecom mania 150 years later.
In the aftermath of the railway mania, Britain's economy was in ruin and the debtor jails were full. The spectacular boom, with all its flamboyant excess, had turned to spectacular bust. Chancellor again observes:
By January 1850, railway shares had declined from their peak by an average of over 85 percent, and the total value of all railway shares was less then half the capital expended on them. Owing to overconstruction of railroads and increased competition, the average receipts per mile of rail track were a third less than those before the mania... many railroads in the 1840s produced only poor returns, until they were eventually killed off by the arrival of the automobile.
An average 85 percent decline does not sound like fun (unless you are short); and yet the railroad mania was not all bad news. Chancellor goes on to note:
With over 8,000 miles of track in operation by 1855, Britain possessed the highest density of railways in the world, seven times greater than that of France or Germany. This brought great benefit to the Victorian economy in terms of faster and cheaper transportation for passengers, raw materials, and finished goods.
How many British investors were well positioned to take advantage of the later, follow-on boom in various areas... the one made possible by the laying of all that track in the first place? Not many; the majority destroyed their portfolios in the first disastrous go, and were probably gun-shy to boot.
A similar drama unfolded in telecom more than 150 years later. In his book Origins of the Crash, journalist Roger Lowenstein explains:
Why, then, were telecoms (and their financiers) so reckless? First, the notion of limitless growth blinded them. Companies from WorldCom to Enron dug up the nation's thoroughfares and dove to the ocean floor to lay millions of miles of fiber that, for the most part, would remain dark. Executives were so caught up in the talk of galloping demand that they didn't think about galloping capacity.
...The cumulative investment marked the greatest binge in the history of private finance. In the half-decade after deregulation, telecom companies borrowed $1.6 trillion from banks and enlisted Wall Street to sell $600 billion in bonds. They raised billions more in stock sales. Most of this money was spent on woefully redundant networks.
We know how that all turned out. In July of 2002 The Economist wrote, "The telecoms bust is some ten times bigger than the better-known dotcom crash: the rise and fall of telecoms may indeed qualify as the largest bubble in history."
And yet, as with British railroads, the telecom debacle seeded life in the aftermath.
All that excess fiber dramatically lowered the cost of overseas communications, which, in turn, enabled the rise of outsourcing, opening doors for IT service providers in India and global growth on the whole. Multinational companies of all stripes have benefited. The fiber glut also made bandwidth-intensive business strategies possible, fueling the fires of Google, Yahoo, YouTube, Skype, and others.
If we see videoconferencing take off in the next few years (lower transportation costs anyone?), the cost barrier will be lower, too, thanks to that initial fiber binge.
Streams and Shovels
There is another lesson here. More often than not, it makes sense to avoid the popular connection and look for downstream effects instead. Try to figure out who will ultimately win or lose as a result of transformational change, discounting the obvious choices.
Ralph Wanger, the mutual fund legend affectionately known as "the dean of small cap stocks," talks about downstream effects and technology in his book, A Zebra in Lion Country.
As Wanger puts it, "going downstream—investing in the businesses that will benefit from new technology rather than the technology companies themselves—is often the smarter strategy."
Another way to sidestep the crowd is by focusing on suppliers and third-party beneficiaries. When a gold rush is on, who is most likely to get rich? Not the miners themselves... those guys are hit or miss. The ones selling pickaxes, shovels and other supplies are often a better bet.
Levi Strauss followed this line of thinking; he moved from New York to San Francisco in 1853, near the height of the California gold rush, with a plan to sell durable overalls to miners and prospectors. The rest is history.
Bubble Blindness
Those who understand the inevitability of behavior cycles are not surprised when enthusiasm peaks prematurely and bubbles burst; as students of history, they know the ideal time to get interested is when everyone else is bored or distracted or afraid.
In light of all the evidence, it is remarkable how many Wall Street professionals continue to conduct their business as if behavior cycles did not exist. They channel Will Rogers, having never met a set of market conditions they didn't like. Human behavior is absent from their rigorous analyses, even when it is the factor that dominates all others.
These champions of bubble-blindness routinely argue that XYZ is "different this time" because of the "compelling story"... completely oblivious to the fact that a "compelling story" is a necessary precondition for bubble formation in the first place!
| Simply by being aware of time frames and behavior cycles, it is possible to gain an edge on the many investors who aren't. |
Simply by being aware of time frames and behavior cycles, it is possible to gain an edge on the throngs of investors who aren't. By recognizing that sweeping trends unfold in stages—almost never all at once—it is possible to prepare for each stage.
In the early rush of enthusiasm, one can prudently stand aside or, for those with a little more daring, take a page from George Soros and "ride the false trend until it is discredited." When the stomach-churning downward whoosh comes (and nearly all great market moves have them, like the bridge in the middle of a song), one can wait patiently, again stand aside, or even go short. And finally, when the crowd has burned out on the original thesis, one can position for the lucrative later stages, where safer profits are made.
Whatever the chosen course, getting fancy with market timing isn't the key point. Simply getting a handle on how things work can help bolster emotional stability and personal conviction levels, in turn helping the general decision-making process.
Lasting Lessons
So… ready to start walking backwards? Here's a quick recap:
– Look for exploitable patterns and repeated themes. For investors, what's new and different is often less important than what has stayed the same.
– Be a student of history; learn from other's mistakes. Try to minimize your tuition cost—your portfolio will thank you for it.
– Be cognizant of time frames and behavior cycles. Don't be surprised when enthusiasm overshoots, time frames get compressed and bubbles burst; this has all been part of the game since time immemorial. Be wary of those who ignore time frames and behavior cycles in their general analysis.
– Look for third-party beneficiaries and downstream effects. Don't assume the obvious; try not to dig where everyone else is digging. Even if there's treasure in the popular spot, you'll have to share it with a whole bunch of folks. (And who makes those shovels anyway?)
– Cultivate a sense of patience. Truly big ideas need time, and transformational changes don't play out overnight. Worthwhile developments frequently take longer than expected.
