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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Intellectual and emotional level understanding

On an intellectual level, most investors have no trouble understanding the notion that high past returns result in high prices, which, in turn, result in lower future returns. But at the sam time, most investors find this almost impossible to accept on an emotional level. By some strange quirk of human nature, financial assets seem to become more attractive after their price has risen greatly. …

… If prices fall drastically enough, they become the lepers of the financial world. Conversely, if prices rise rapidly, everyone wants in on the fun.

William Bernstein wrote in “The Four Pillars of Investing – Lessons for building a winning portfolio”.

Eventually, it’s all in the mind. The value of an asset is always in the way it is perceived. When you think of market price, it often gets misleading. The crowd sets the prices of the assets and the crowd depends on the same. This often becomes a vicious or a virtuous cycle. The crowd leads itself astray.

Here is an excerpt from the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

Speculative euphoria as the Pied Piper

Large-scale speculation in any asset is a recurring phenomenon. History suggests that every now and then, we will witness euphoric activities – the asset may change, the people may change, the place may change; but there will always be some such events at an amazing regularity.

This is the period when common sense takes a back seat. Incidentally, the current indicators, all point in only one direction – that of the current momentum. The Pied Piper of speculation is at work. Just like the story above, the music is heard only by those who get into the spell of the market and they cannot control themselves from following it. In the story, the Pied Piper took the children to the other side of the hill never to return. In real life, the Pied Piper of speculation takes investors’ money to the other side of the mountain (called expensive markets).

People chase the hottest fad assuming that this is never going to end. The immediate past is extrapolated into infinite future.

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Pillar two: History of financial markets

William Bernstein wrote a classic “Four Pillars of Investing”. It is a must read for any student of investments.

In the chapter “Introduction”, he writes that the second pillar of investing is knowledge of history. He writes:

… a study of previous manias and crashed will give you at least a fighting chance of recognising when asset prices have become absurdly expensive and risky and hewn they have become too depressed and cheap to pass up.

… the investor who is unaware of financial history is irretrievably handicapped.

Those who are interested in removing this handicap cannot ignore studying the history.

And this is what I have written in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”:

In the beginning, all the events looked different. In spite of the apparent differences between the origins, as discussed above, there were too many common threads and parallels. It was hard to ignore the signals and still the world ignored ouches to ignore them. And that  confirms to what Bishop Desmond Tutu or Jeremy Grantham said. Remember the golden words of Sir John Templeton, “The four most dangerous words in investing are: ‘this time it’s different.'”

Ignore the history at your peril. Learn the lessons and remember those. If required, re-read the book.

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The real value of history in the world of investing

William Bernstein writes in his classic Four Pillars of Investing – Lessons for building a winning portfolio: “The real value of the historical record is as a gauge of risk, not return.”

Still, majority of discussions focus on which asset class has outperformed or underperformed which other asset class. The focus is too much on the returns generated rather that the risks taken or avoided.

Read history to understand the risks. Read history to understand what can go wrong. Read history to understand what you can do to protect and nurture your investment portfolios.

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