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In the long run we know that investing can result in values multiplying over time and potentially providing enough income for investors to live happily ever after. But we also know that over the course of a typical lifetime, there is a good chance of a financial crisis (sometimes related to war) that can threaten people's financial lives. The coronavirus crisis that exploded in 2020 is the most recent example. Whether crisis and crashes can be predicted reasonably well in advance is debatable, but it is reasonable to do stress tests and ask how investments and portfolios may be impacted during times of crisis.
There are many very worthwhile books documenting the history of human created bubbles, manias, and crisis including the following.
- Extraordinary Popular Delusions and The Madness of Crowds (first published in 1841 by Charles MacKay)
- Manias, Panics, and Crashes: A History of Financial Crises (first published in 1978 by Charles Kindleberger)
- A Short History of Financial Euphoria (first published in 1990 by John Kenneth Galbraith)
- Devil Take the Hindmost: A History of Financial Speculation (published in 2000 by Edward Chancellor)
The list of manias, bubbles, and crisis includes the following.
- Tulip Mania 1634-1637
- South Sea Bubble 1719-1921
- Mississippi Bubble 1718-1720
- The roaring stock market in the 1920's prior to the Great Depression
- Japanese Stocks 1982-1992
- Technology and internet bubble 1994-2002
- Global Financial Crisis - Financial Stocks Crash 2006-2009
- Bitcoin and cryto-currencies 2014->
Over a decade has passed since the critical events of what has come to be known as the Global Financial Crisis (GFC). Younger readers may have little or no memory of the crisis, but more experienced investors likely still have memories of the housing crash and financial crisis that followed. An enormous amount of time and effort has been spent attempting to determine what went wrong, the primary causes of the crisis,1 who should have been held accountable, and how to safeguard the financial system going forward.
I started a list of the books written about the housing crash and global financial crisis on my web site and although the pace slowed dramatically a few years ago, there have been more than 400 books and dozens of “best-sellers” with substantive discussions on the topics. I’ve also surveyed dozens of authors of crisis books and published papers about their opinions about the crisis causes (plus what they believe can be done to prevent them in the future). While most agree that there were multiple causes, and many parties were at fault, there are many different narratives regarding the primary causes. The U.S. government created the Financial Crisis Inquiry Commission (FCIC) to determine the primary causes and it issued a final report in 2011. The FCIC final report included one report issued by the majority appointed democratic Commissioners and two dissenting views from the republican appointed Commissioners. Similarly, in my surveying of crisis commentary authors, there are multiple narratives about what were the primary causes of the GFC.2 Many blame “Wall Street,” many blame government, and many blame individuals, or a combination.
There is plenty of blame to go around for contributing to the GFC, especially in the financial industry and many government roles, and there has been some relatively research recently potentially shifting some of narratives. In a paper published in 2018, researchers documented evidence that inflated house-price expectations led households across all income groups (not just subprime borrowers) to increase their demand for housing and mortgage leverage.3 Another group of researchers published a paper in 2017 that documented credit growth during the run-up being concentrated among prime borrowers, not just subprime borrowers. Middle-class and wealthy house flippers played a big role in the run-up and subsequent collapse of housing prices. This has led many to conclude speculators across the wealth and income scales participated in fueling the real estate bubble that eventually deflated.4
There have been many discussions about the unpredictability of the crisis and the failure of many models to account for unexpected or outlier events (for instance, Nassim Nicholas Taleb published The Black Swan: The Impact of the Highly Improbable). Crisis Economics co-author Nouriel Roubini is credited with warning in 2006 of much of what later occurred (although Roubini's overall track record has been criticized by many). I'm also not swayed by the "no one predicted this" argument since some like Robert Shiller predicted the real estate bubble bursting (and I personally cut out a July 5, 2006 Wall Street Journal article in which Ken Heebner predicted a major price drop in hot real estate markets). In fact, there are more than 50 individuals that warned publicly about major problems to come prior to the start of the crisis.5
For those that have already purchased or that are curious about Bitcoin and so-called crypto currencies, I suggest you consider the following. You might notice that I did not say "invest" in Bitcoin or crypto currencies? Currencies (including the United States dollar) are not investments and they tend to lose value over time due to inflation (incidentally the IRS does not consider crypto-currencies to be "currencies"). Gold and commodities tend to appreciate over the long run with inflation, and investments like bonds tend to appreciate over the long run with inflation plus interest, while investments in stocks and real estate appreciate over the long run with inflation, plus a risk premium.
The more accurate question is should you "trade" or "speculate" in Bitcoin or other crypto currencies. You should probably only consider them if you have funds you can afford to lose, are knowledgeable in the technology involved, and have the appropriate resources and tools to acquire and safeguard the transactions and holdings. The vast majority of "day traders" have lost money, whether trading in U.S. stocks, derivatives, or foreign currencies (as documented in chapter eight), and net of costs that is likely to be the case in the long run for crypto currencies as well. I mentioned in Chapter 16 Bankrate.com’s survey of best long term investments. In 2019 they added bitcoin/cryptocurrency to their annual survey and it was the least chosen at 4% (gold and other precious metals was chosen by 11%).6
Is blockchain a revolutionary technology that will significantly impact business? It hasn't significantly so far, but maybe some useful evolution will play out. In an efficient and competitive business environment, new processes and tools don't necessarily translate into a profitable or proprietary business. The fact that so many new crypto currencies have been created implies there is a virtually unlimited potential for supply (which is not surprising since they are created out of virtually nothing) and it may be difficult for more than a few to reach a critical mass and become accepted over the long run. It doesn't appear that there are any significant reasons why large organizations (if threatened by them) would not create their own versions. Facebook’s announcement of plans to launch Libra was interpreted by some as a justification of the cryptocurrency movement, but given that it is proposed to be linked to a basket of currencies, it may undercut many of the crypto-currencies that have no link to other currencies, or assets. Any model that depends on others to buy something for more than the current owners paid is highly suspicious. The following is a sample of warnings I’ve seen about Bitcoin and crypo-currrencies which support my grouping them in the bubble category."We think the sharp rise in crypto-currency valuations in recent months is a speculative bubble."UBS (10/12/2017)7
"I think it’s a pyramid scheme."Dick Kovacevich, CNBC (1/16/2018)8
"The cryptocurrency boom is as obvious a speculative mania as markets have ever seen."Merryn Webb, Financial Times (1/18/2018)9
"Cryptocurrencies are almost a perfect vehicle for scams."Kevin Werbach, New York Times (2/5/2018)10
"Bitcoin is 'probably rat poison squared.'"Warren Buffett , CNBC (5/5/2018)11
"Bitcoin has no unique value at all ... It is a delusion, basically."Warren Buffett, CNBC (2/25/2019)12
If those comments aren't enough to scare you away from trading crypo-currencies, consider the fact that Nouriel Roubini was probably the most recognized individual to publicly warn in advance of the Global Financial Crisis and he has written emphatically against the crypto-currencies."I must say I’ve never seen in my life people who on one side are so arrogant in their views, who are total zealots and fanatics about this new asset class, while at the same time completely and totally ignorant of basic economics, finance, money, banking, central banking, monetary policy."Nouriel Roubini "The Mother and Father of All Bubbles" (3/6/2019)13
See also my recent posts Reasons to Buy Cryptocurrencies, My Bitcoin Related Purchase, and a page about the lessons from Cybercash.
Returning to the question of whether crisis and bubbles can be identified in advance, researchers concluded in a 2017 paper that low volatility was a predecessor of a crash in approximately two-thirds of the forty bubbles they studied, implying there tends to be a “lull before the storm.”14
For investors, a critical question to ponder is whether the fundamentals have changed to suggest that the historical data no longer applies. For instance, some argue that the experience of capitalism and the United States are unique in history and it may not be reasonable to assume future economic growth and evolution will continue at the same pace. After periods of relatively low growth and low stock market returns, those become common discussions. Yet there are also plenty of studies that show returns following crisis tend to be strong which is consistent with the idea that you should “buy when there is blood in the streets.”15 In “Investing during crisis,” Eric Tyson referenced John Templeton (via Investing the Templeton Way, by Lauren Templeton and Scott Phillips) who stated "Bargain hunters embrace the timeless lesson from history that crisis equals opportunity."16
On the other hand, in “The 11-Year Itch: Still Stuck at Dow 10000,” Jason Zweig pointed out that "investors need to remember that stock markets can go nowhere for ages, as they did in the U.S. from 1929 to the end of World War II, in Germany from 1900 through 1957, and in Japan since 1989."17
There is a common tendency to predict a continuation of recent experiences, so investors are often pessimistic after periods of negative (or relatively low returns), and optimistic after periods of high returns. Following the global financial crisis many were pessimistic and many investors were too scared to be invested in stocks (others simply had no money available to invest). The decade prior had seen the continental United States being attacked on 9/11 and two subsequent wars, and then the world experienced a near collapse of the financial system near the end of the decade. Yet, looking back a decade later, the period toward the end of the global financial crisis turned out to be a great time to invest.According to the International Monetary Fund, the United States began the century producing 32 percent of the world’s gross domestic product. We ended the decade producing 24 percent. No nation in modern history, save for the late Soviet Union, has seen so precipitous a decline in relative power in a single decade. The United States began the century with a budget surplus. We ended with a deficit of 10 percent of gross domestic product, which will be repeated in 2010. Where the economy was at full employment in 2000, 10 percent of the labor force is out of work today and another 7 percent is underemployed or has given up looking for a job.Pat Buchanon “A Decade of Self-Delusion,” December 29, 200918
Laurence Siegel noted in 2010 that "From 1 January 1969 through 28 February 2009, the S&P 500, including reinvested dividends, had a slightly lower total return than the Ibbotson index of long-term U.S. Treasury bonds (on the basis of data from Ibbotson Associates [now Morningstar]). Forty years and two months is a long time to wait for the equity risk premium to be realized, only to be disappointed with a realization marginally below zero. (Because of the subsequent fast recovery in the stock market, this condition did not last long; but stocks are still underperforming the long bond over historical time horizons lasting decades.)"19
Yet, Laurence Siegel’s main argument was an optimistic one and that positive outlook (similar to other commentators like Jeremy Siegel, that are often described as “perma-bulls”) as of 2019 certainly looks more right, than wrong. Laurence Siegel concluded his article with the following.
"I am pretty sure that global growth will continue to surprise on the upside, but not with low volatility and not because of macroeconomic policies but despite them. Growth will happen because people, left to their own devices, will do almost anything they can to make better lives for themselves and their children."
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