Valuations in the new era

In 1934, the great investment theorist Benjamin Graham wrote of the pre-1929 stock bubble:

Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

(Source: Four Pillars of Investing – Lessons for building a winning portfolio by William Bernstein)

William Bernstein writes further in “Four Pillars of Investing”, “Even the most casual investor will see the parallels of Graham’s world with the recent tech/Internet bubble. Graham’s $100 stock sold at 40 times its $2.50 earnings. At the height of the 2000 bubble, most of the big-name tech favorites, like Cisco, EMC and Yahoo! Sold at much more than 100 times earnings. And, of course, almost all of the dot-coms went bankrupt without ever having had a cent of earnings.

To see a similar pattern across time periods, across geographies and across asset categories, read the chapter on “Valuation” in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”. There were cases of such ridiculous valuations in real estate stocks in India in 2007-08, real estate prices in Japan in the 1980s, tulip bulbs in Amsterdam, technology companies in the 1999-2000 – such events have occurred at an amazingly high frequency.

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Samudra manthan – Excessive turbulence

Think of all market turbulence as “Samudra manthan”. In the mythological story of samurai manthan, so many things came out, including poison and nectar. The market turbulence is no different. Every market turbulence brings out some poison and some nectar.

The poison kills many investors’ portfolios and reputations of some experts. On the other hand, we have seen in some episodes how the turbulence brought out the best. Some examples of the nectar are:

  • Birth of Securities Exchange Commission, Federal Deposit Insurance Corporation and Federal Reserve bank after the great depression
  • Beautiful tulip gardens of Amsterdam
  • Birth of SEBI, NSDL, NSE after the great Indian securities scam. Innovations like screen based trading, dematerialisation of securities, rolling settlement, etc.
  • Birth of companies like Amazon, Google, etc. in the DotCom boom

Such churning of the ocean is required to bring out the nectar.

Police always comes in the end

We all know that in the Bollywood movies, the police always comes in the end. Ditto for financial markets, too.

SEBI Act was passed by the Indian Parliament after the debacle of 1992. It was only after the scam was unearthed, that the act was passed, though SEBI (Securities and Exchange Boards of india – the regulator for securities markets in India) was set up in 1988.

Even in the US, after the great market crash of 1929-1933, SEC (Securities Exchange Commission – the securities market regulator) and FDIC (Federal Deposit Insurance Corporation – the corporation that insures bank fixed deposits).

The only difference between a movie and real life is that while in the movies the police comes after the villain has been beaten up by the hero, in reality it is the common investor who gets bashed up before the police arrives.

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Memory is far more effective than law

John Kenneth Galbraith wonderfully put in the foreword to his book “The Great Crash – A Classic Study of That Disaster”: “As a protection against financial illusion or insanity, memory is far better than law. When the memory of the 1929 disaster failed, law and regulation no longer sufficed. For protecting people from the cupidity of others and their own, history is highly utilitarian. It sustains memory and memory serves the same purpose as the SEC, and, on the record, is far more effective.”

To add to what Galbraith wrote: Even the law has to be remembered.

Read “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” again and again.

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Market crash or reputation crash?

If you want to see what market booms and busts can do to one’s reputation, Professor Irving Fisher’s statement in October 1929 would be a most appropriate example

Read more in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

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Too much liquidity in the markets

Edward Chancellor writes in his classic book, Devil Takes the Hindmost: “By October 1929, broker loans and bank loans to investors had reached a total of nearly $16 billion. At this level, they represented roughly 18 percent of the total market capitalisation of all listed stocks.”

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Ben Graham’s classic books

I believe it was the experience of the boom and bust of that period, which Benjamin Graham brought out in his 1934 classic “Security Analysis” and the subsequent book “The Intelligent Investor”. Warren Buffett described the latter as the best book on investing ever written.

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