Source: A Century of Evidence on Trend Following
From the Archives
The Rationale of Market Fluctuations (1876)
History is not a road-map, but a compass.
Reading all the financial history in the world will not allow you to accurately predict everything that will unfold in markets over the near term. There is no historical road-map outlining the specific events that will occur today simply because of what’s happened in the past. However, history acts an invaluable compass for steering investors in the right direction in challenging times. By recognizing the patterns that repeat themselves over the course of centuries, we can better position ourselves for whatever lies ahead. I hope that this week’s edition of Sunday Reads acts as a useful ‘calibration’ of this historical compass.
Without going into too much detail, these are some of the largest events and themes that have occurred since the Pandemics & Markets post I shared on March 1st.
- The S&P 500, Dow Jones Industrial Average, and NASDAQ indices all entered bear markets.
- For the S&P 500, this was the fastest bear market entry on record, taking just 16 trading sessions to fall 20% from its peak.
- The largest stimulus package in history was passed on March 27th, totaling $2 Trillion.
- The airline industry received a $50 billion bailout as part of the stimulus package.
- Regulation was passed banning buybacks for companies that received government aid.
As a result, the links below dive into:
- Long run consequences of pandemics.
- The political ramifications of financial crashes and crises.
- What three centuries of data tells us about what to expect after market crashes.
- The potential of new securities regulation as a result of recent events.
Before we get to this week’s links, I wanted to share an inspiring story from a previous American crisis (1906 San Francisco Earthquake) that I came across while researching a new article.
The story is of A. P. Giannini, a.k.a. the founder of Bank of America (which was actually named The Bank of Italy until 1930). As this article tells it, Amadeo Peter Giannini was the son of Italian immigrants, and founded a small bank in an Italian neighborhood of San Francisco in 1904. While most banks at the time were strictly focused on servicing the wealthy, Giannini focused on convincing the ‘unbanked’ (mostly immigrants) to put the money under their mattresses into a bank account, where it would be safer and accrue interest. Great guy, right? Well, it gets even better.
“On the morning of April 18, 1906, a massive earthquake hit San Francisco. The ensuing fires burned down the large banks. Their superheated metal vaults could not be opened for weeks- lest the cash and paper records catch fire when oxygen rushed in.
As flames threatened his one room bank, Giannini spiritied $80,000 in coins out of town. He hid the precious metal under crates of oranges and steered his wagons past gangs of thugs and looters in the streets.
As other banks struggled to recover, Giannini made headlines by setting up a makeshift bank on a North Beach wharf. He extended loans to beleagured residents “on a handshake” and helped revive the city. The innovative bank welcomed small borrowers who might otherwise have to use high-cost loan sharks. Most banks at the time regarded people with modest incomes as credit risks not worth the paperwork. But experience had taught Giannini otherwise: that working class people were no less likely to pay their debts than the wealthy….
On November 1, 1930, the Bank of Italy in San Francisco changed its name to Bank of America. The bank today has the same national bank charter number as Giannini’s old bank – #13044. When A.P. Giannini died in 1949, the former single-teller office in North Beach claimed more than 500 branches and $6 billion in assets. It was then the largest bank in the world.”
I still can’t get over how incredible a story this is, and how perfectly it encapsulates the American spirit. Amazingly, the story gets even better! In addition to being a literal hero during the San Francisco earthquake aftermath by providing loans to those in need, he also:
- Providing financing for the Golden Gate Bridge.
- Financed Walt Disney’s first first full-length feature: Snow White and the Seven Dwarves.
What a guy.
Now let’s get into this week’s links!
Longer-Run Economic Consequences of Pandemics
This is the article that many of you have been searching for since the coronavirus pandemic first broke out. This article looks at the return on assets over 12 major pandemics since the 14th century.
“How do major pandemics affect economic activity in the medium to longer term?… We study rates of return on assets using a dataset stretching back to the 14th century, focusing on 12 major pandemics where more than 100,000 people died… Significant macroeconomic after-effects of the pandemics persist for about 40 years, with real rates of return substantially depressed… Using more sparse data, we find real wages somewhat elevated following pandemics. The findings are consistent with pandemics inducing labor scarcity and/or a shift to greater precautionary savings.”
Specifically, the authors look at the “natural rate of interest”, which is ‘the level of real returns on safe assets which equilibrates savings supply and investment demand—while keeping prices stable—in an economy.’ Their findings are summarized below:
‘Figure 2 contains our main result, and displays ˆt (h), the response of the natural rate to a pandemic, 1 to 40 years into the future. Pandemics have effects that last for decades. Following a pandemic, the natural rate of interest declines for decades thereafter, reaching its nadir about 20 years later, with the natural rate about 2% lower had the pandemic not taken place. At about four decades later, the natural rate returns to the level it would be expected to have had the pandemic not taken place. These results are staggering and speak of the disproportionate effects on the labor force relative to land (and later capital) that pandemics had throughout centuries.’
The author’s then went a step further and compared the impact of pandemics to another category of events that take many lives: war. The outcomes were very different, as ‘wars tend to leave real interest rates elevated for 30–40 years and in an economically (and statistically) significantly way.’
Going to Extremes: Politics After Financial Crises (1870 – 2014)
Many people are already starting to think about the political ramifications of coronavirus, particularly following the $2 trillion stimulus package. In addition to the existing partisanship rampant across America, which can affect how one views Trump’s response to the crisis, the bailout of industries like Airlines have stirred some of the anti-executive / anti-Wall Street sentiments prevalent in the Great Financial Crisis of 2008. The 2008 crisis spurred the Occupy Wall Street movement, the rise of the Tea Party, and some would argue global populism in general.
This article provides helpful context on the historical relationship between political movements and financial crises / market crashes. Across 20 developed countries, this paper assesses the political consequences of financial crises over the last 140 years through studying more than 800 general elections. Their analysis finds that ‘On average, far-right parties increase their vote share by 30% after a financial crisis.’
Equally interesting is their conclusion that only Financial Crises have this large impact on the political process:
‘Financial crises are politically disruptive, even when compared to other economic crises. Indeed, we find no (or only slight) political effects of normal recessions and different responses in severe crises not involving a financial crash. In the latter, right wing votes do not increase as strongly and people rally behind the government. In the light of modern history, political radicalization, declining government majorities and increasing street protests appear to be the hallmark of financial crises.’
In so far as people blame central banks for exacerbating inequality through quantitative easing, the authors end their article by acknowledging this argument:
‘As a consequence, regulators and central bankers carry a big responsibility for political stability when overseeing financial markets. Preventing financial crises also means reducing the probability of a political disaster.’
Negative Bubbles: What Happens After a Crash
I shared this article in the March 1st post on Pandemics & Markets, and it has only become more relevant since then. Since March 1st, the three leading US stock market indices officially entered bear markets, and US markets have endured some of the most volatile periods since the Great Depression. All that said, now that we’ve had a legitimate ‘crash’, this paper is an excellent guide for what investors can broadly expect to occur in markets moving forward.
‘We identify 1,032 events for which a market declined by more than 50% over a 12-month period. Conditioning on these events, and controlling for a range of other factors, we find that markets tend to rebound in the year following the crash. We refer to this pattern of crash-and-rebound as a “negative bubble.” Interestingly, the pattern only holds for large crashes – declines of lesser magnitude exhibit persistence, not reversal. This non-linearity presents a challenge to standard econometric forecasting techniques and suggests that something more complex than mean-reversion is at work.’
William Goetzmann and Dasol Kim’s research finds two patterns:
‘First, markets experiencing a large crash of -50% or more have a high probability of a rebound, and the average return following such a crash is nearly 14% higher than returns with a positive return in the prior year.
Second, market declines of up to -40% are more likely to be followed by another decline, and the magnitude of this decline is approximately 6% to 9% in the following 12 months.
In short, above and beyond mean reversion patterns in stock returns, a small decline in a market leads to a much larger drop, and a large drop precedes a large rebound.’
The Economic Impact of the Black Death
This week we revisit the Black Death once more, because there is no other outbreak of disease that compares. In this article, the authors leave readers with a few key conclusions.
First, the primary post-plague winners were peasants:
‘In the countryside, a freer peasant derived greater material benefit from his toil. Fixed rents if not outright ownership of land had largely displaced customary dues and services and, despite low grain prices, the peasant more readily fed himself and his family from his own land and produced a surplus for the market. Yields improved as reduced population permitted a greater focus on fertile lands and more frequent fallowing, a beneficial phenomenon for the peasant. More pronounced socioeconomic gradations developed among peasants as some, especially more prosperous ones, exploited the changed circumstances, especially the availability of land. The peasant’s gain was the lord’s loss.’
The post-plague economy also benefited European consumers:
‘In trade and manufacturing, the relative ease of success during the high Middle Ages gave way to greater competition, which rewarded better business practices and leaner, meaner, and more efficient concerns. Greater sensitivity to the market and the cutting of costs ultimately rewarded the European consumer with a wider range of good at better prices.’
In general, the Black Death ‘fostered the possibility of new economic growth’. While that came at a heavy price, it’s true nonetheless.
‘In the long term, the demographic restructuring caused by the Black Death perhaps fostered the possibility of new economic growth. The pestilence returned Europe’s population roughly its level c. 1100. As one scholar notes, the Black Death, unlike other catastrophes, destroyed people but not property and the attenuated population was left with the whole of Europe’s resources to exploit, resources far more substantial by 1347 than they had been two and a half centuries earlier, when they had been created from the ground up. In this environment, survivors also benefited from the technological and commercial skills developed during the course of the high Middle Ages. Viewed from another perspective, the Black Death was a cataclysmic event and retrenchment was inevitable, but it ultimately diminished economic impediments and opened new opportunity.’
What Causes New Securities Regulation? 300 Years of Evidence
According to the research of this article, investors should prepare themselves for increased regulation:
‘If new technology doesn’t cause new securities regulation, what does? In a nutshell, crashes. All of the 18th-century English regulation, and even all of the 18th-century proposed regulation, came immediately after sustained price declines. The first significant American securities regulation, passed in 1792 in New York, followed the big crash of that year. And of course the federal securities acts of the early 1930s came soon after the crash of 1929. This is just a general trend, not an absolute rule. There have been sharp price declines without subsequent regulation, and of course there has been regulation without immediately preceding price declines. But most of the major instances of new securities regulation in the past three hundred years of English and American history have come right after crashes.‘
Much of what the author outlines in this article is relevant to the narratives we hear today surrounding negative public sentiment towards financiers and corporate executives. For example, picture everything you’ve heard/read on the recent controversy and outrage surrounding airline buybacks. Now read this:
‘The political power of speculators-their incentive and perceived ability to nudge public policy in the direction that will push securities prices up or down-has been a constant source of public concern. The belief that securities trading is a nonproductive sphere of the economy, one that drains resources from more fruitful activities, has been ever present. These strands of thought were pervasive in England in the 1690s, and they are still pervasive in the United States today.’
Right or wrong, this is a pretty accurate description of the narrative today. The author also points out that this push-back against speculating and financiers often comes after a crash. This is similar to the Kindleberger-Minsky model, which suggests that fraud lags the market cycle, meaning frauds are discovered after a market crash because people exercise greater scrutiny over their investments when losing money.
‘As long as the market has been rising or at least holding steady, however, these strands of thought have been kept in check by the simple fact that too many people have been making too much money to favor regulation restricting trading. But when prices drop, much of that opposition to regulation is removed. People who were proponents of securities trading in good times become critics in bad. The result, more often than not, is that new legislation gets introduced, and often that legislation gets passed. New securities regulation thus tends to follow crashes.’
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