Quote for the Week

One of the important factors behind the fluctuation between bull and bear markets, between booms and crashes and bubbles, is that investor memory has to fail us – and fail universally – in order for the extremes to be reached. John Kenneth Galbraith said, “Contributing to euphoria are two further factors little noted in our time or past times. The first is the extreme brevity of the financial memory…” If people had good memories, if they could call to mind and derive the significance of the events of the past, they would be less likely to repeat or less likely to go to the same extremes. But most people do not have the ability to bear these things in mind. Some of them happened too long ago.

For example, 1929 was repeated in 2007-2008, but by definition you would have to have been born 100 years earlier to be able to make use of that lesson. Most people who were around in 2008 were not born in 1908.

Memory – and the resulting prudence – always comes out the loser when pitted against greed. There is very little man is more likely to believe than that which will make him rich if true. So the prevalence of greed, self-interest, and wishful thinking has great power to overcome memory and caution. As I said before, what the wise man does in the beginning, the fool does in the end. These trends are always taken to excess. The investors who are not aware of them always pay the price. — Howard Marks (source)

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Quote for the Week

When I shifted my focus from beating gambling games to analyzing the stock market, I naively thought that I was leaving a world where cheating at cards was then problematic and entering an arena where regulation and the rule of law gave investors a fair playing field. Instead, I learned that bigger stakes attracted bigger thieves. Madoff’s Ponzi scheme was only the largest of the many that were exposed in 2008 and 2009, with others ranging from eight billion (a “bank”) through hundreds of millions (including several hedge funds), to multimillion dollar real estate, mortgage and annuity scams. I speculate that the size of swindles likely follows a simple mathematical “power law,” like the distribution of high incomes and top wealth discussed in previous columns, with their number increasing as their economic size decreases…

The flood of almost daily frauds, swindles and hoaxes reported in the financial press has continued during my entire investment career and I expect that when you read this months, years or decades later, you’ll find your own profusion of examples. Hoaxes, frauds, manias and other large scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet. — Ed Thorp (source)

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A lot can happen in a few short months in markets. The U.S. market went from a crash to a recovery to new highs in five months.

It began with the announcement of tariff rates not seen since the 1930s. Then they were delayed. A similar pattern has followed since. Threaten tariffs, announce tariffs, delay announced tariffs, delay some more, and repeat.

The market, at this point, seems to be pricing in the existing tariffs with further delays on anything higher. The risk is that the pattern changes.

The other notable issue this year is the declining dollar. Currency risk can enhance or negate returns depending on where and how your money is invested.

For example, the dollar relative to the euro is down about 11% through the first half of the year. The falling dollar explains a portion of the performance of foreign markets this year. Countries in the MSCI EAFE and EM index, that use the euro, are all up more than 11% year to date.

Another way to look at it is the chart below. It shows the dollar-hedged (HEFA) versus unhedged (EFA) MSCI EAFE ETFs. Most investors own unhedged funds, for good reason. It offers currency diversification and avoids needing to predict big currency exchange shifts because it’s difficult to do.

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Quote for the Week

The common thread that runs through all equity bull markets is confident expectations of higher earnings ahead. The common thread that ties the onset of all bear markets together is the loss of those confident expectations of higher earnings ahead. History shows that bull markets can go well beyond rational valuation levels as long as the outlook for future earnings is positive.

Bull markets require economic slack so that companies can grow, and positive trends in real business activity to take advantage of that slack. Remember, stock prices show no consistent relationship to interest rates, exchange rates, inflation rates, budget policy, monetary policy or any of the other things we professionals love to discuss. These forces matter only when they matter to the future movement of corporate earnings. — Peter Bernstein (source)

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Here’s what I’ve been reading for the past three months:

• The Lords of Creation – Adding this again because the notes are finally up. It covers the period from the late 1800s to the Great Depression — the rise of big business, monopolistic tendencies, financial shenanigans, shifting social and political views, impact of WWI, invention and innovation, wealth disparity, and bubbles and busts. Lots of similarities to today. If you’re into financial history, this is a good one. (Notes)
• Innumeracy – The book explains why math is important. A lack of understanding probabilities and randomness can bias our perspective and affect decisions. (Notes)
• The Laws of Simplicity – John Maeda writes about the intersection of technology, business, and design with ten principles on creating simpler systems. (Notes)
• The New York Stock Exchange in the Crisis of 1914 (Free Copy) – Henry Noble, then president of the NYSE, offers a first-hand account of the decision to shut down the exchange at the start of WWI, the problems that arose, how they dealt with it, and the decision to reopen four and half months later. It’s a short read and an interesting bit of market history.
• Medici Money – New book started this week. It looks at the rise and fall of the Medici bank.

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