And although, as has been previously written about, we have learnt what makes a great company is a very fundamental aspect to investing, the historical nature of the very markets we focus on is equally as important. This drew us to our fifth book at the prestigious book club, anatomy of the bear by Russell Napier.
Anatomy of the bear dissects the four main stock market crashes in the 20th century in the US – 1921, 1932, 1949 and 1982. Napier’s view is that if you learn from the systematic mistakes that have previously occurred, then hopefully one will be able to successfully avoid slipping into the generic mistakes investors make in a capricious bear market.
Napier offers a fastidious backdrop of the political, social and economic events leading up to the upcoming bear market, using empirical data of the time to graphically display the movements in the economy. Moreover, he also focuses on the news of the day, to understand the euphoria, or lack of, at the time of the bear. This gives a great insight into what news, be it positive or downright negative, was circulating the investment world at the time to understand key characteristics from the period.
There are three main take homes from what was a very heavy and in-depth book. Firstly, the effects of monetary policy are fairly fundamental in driving the stock market, for the better or worse. In the cases of the 1921 and 1932 crashes, they were largely fuelled by the gold standard, which essentially meant that the value of the dollar was determined by the supply and flows of gold. In the time of World War I, this meant that as investors flocked to safety the dollar was artificially overvalued by the exogenous gold standard. The current account of an economy measures the capital inflows and outflows, and is the single biggest determining factor for the exchange rate. Having a gold standard meant that, during war-time periods, the US had a large influx of gold into the country and outflows after the war as world trade picked up. This had huge ramifications to various factors, such as inflation levels, the interest rate and value of the dollar, all of which affect the equity markets. Having a freely floated exchange rate is one factor that the book highlights and can easily be compared to the dire state the peripheral countries in Europe are in with the Euro.
Another aspect of monetary policy’s effect in the bear markets was when the money supply did not cause a market equilibrium due to the intervention from the central bank. The central bank heavily impacts the supply of money, which like the exchange rate and the interest rate affects the value of the dollar. Prior to the 1932 bear market, the Fed cut the money supply by 20%, due to a tightening of interest rates. In doing so, the value of the equity market tanked, triggering the bear market. It is very hard for the central bank to make something so complex, and with an abundance of knock-on effects as the money supply efficient. We can draw parallels today in the US, where the Fed failed to raise rates in 2013, when many believe they should have, leaving them trapped now at the zero-lower bound.
Secondly, Napier highlights the importance of remaining logical when at the bottom of the bear. This is where the news clippings come in very handy, as they report the day-to-day news when the stock market was down 80% at times. One would think that as turmoil broke out, all news would be dire, yet the evidence really does not support that. An example of this is on the 1st August 1921, still a month until the Dow bottomed, consumer demand was reported to be “as good as or better than at this time last year.” This suggests that fundamental economic activity was not accurately reflected by the stock market. It may come as no surprise that investors are not entirely logical, especially in a bear market. But it is crucial that ‘hard’ data should be held at a higher regard than consensus ‘soft’ data. In today’s market this has never been more applicable. Whilst Purchasing Managers Index (PMI) survey data suggests that Europe, for example, is moving into an era of growth, unemployment remains at near 10% and many economies are in or near recession. Animal spirits, as Keynes put it, make it easy to think illogically and join the ‘herd’ mentality.
Finally, the book highlights the use of the “Q ratio”, which is the market cap ÷ replacement value of assets – essentially a raw way of working out whether the market is overvalued. Napier uses this to give a clear indication as to whether the market is in the midst of a bear market. It’s very hard to quantitatively figure out whether the market is bottoming, else we would all do it, right? However, Napier does use this proxy to argue that the general nature of the value of the stock market was clear to see.
Fundamentally, the book follows the general Dow Theory, which states that when a market hits a ‘bearish’ stage, the market will discount everything. This comes regardless of the core value of the business, in terms of profitability and revenue growth. The Dow Theory can be traced back to 1900, and is said to underpin modern-day technical analysis.
This book turned out to be a lot more challenging than the others the book club had previously read. However, despite the added brain power needed to get through the 297 pages of analysis, it did offer a good breakdown of what to look out for in a bear market. Of course, each bear in the book had their own individuality, but, as Keynes stated, animal spirits are all around. In today’s market, equities have been inflated by excessive Quantitative Easing and the hope that Trump will kick-start global growth again. With the S&P up c.20% in the last year, and on traditional valuation metrics such as Price-to-Earnings, it is easy to see that animal spirits live on. I think after reading the book, we all agreed it would be great to read the bull version, just to cover all angles…
The JM Finn Investment Book Club was convened in the hope that, month by month, some of the wisdom of investing gurus such as Warren Buffet, Charlie Munger, and Mohnish Pabrai might rub off on the participants eager selves.