Investors to get slapped by the invisible hand

The great American economist Benjamin Anderson wrote Economics and the Public Welfare: A Financial and Economic History of the United State, 1914 – 1946. Most mainstream economists get the history of that period, especially the Great Depression, wrong. If you want to know what really happened and why, read Anderson's book. In a chapter on the stock market crash of 1929, Anderson related the following story:

One able Jewish investment banker said in the summer of 1928 that he did not understand what was going on. He said, “When I do no understand I do nothing.” He had withdrawn from the market. He had turned his holdings into cash, and he was waiting until he understood.

After the crash in 1929, a speech was made before the Chamber of Commerce of the State of New York to explain what had happened, which discussed, among other things, the phenomena of mob mind which had been so manifest in the year and a half that had preceded the crash. The speaker made the generalization, familiar to social psychologists, that the more intense the craze, the higher the type of intellect that succumbs to it. The investment banker, seated near the speakers' table, nodded his head emphatically as he heard about this generalization.

Later he was asked about it. He said that he had reluctantly gone back into the market under the pressure of repeated advice from his associates and others, and that as stocks went higher and his friends and associates were borrowing money to increase their holdings he too had borrowed money. He said that he had gone to London in the spring of 1929, had learned some things there that made him much concerned, and had cabled orders to New York to his associates to sell everything that he had bought. But they protested and told him that the move was not nearly over, and he had reversed his instructions and had stayed with the market.

He said that he had come into the crash carrying stocks bought at high prices with $4,000,000 of borrowed money. He was prepared to subscribe to the generalization that the wilder the craze, the higher the type of intellect that succumbs to it. He had a high I.Q., and he knew it.

The banker's story reminds me of John McAfee, the antivirus software inventor. McAfee developed his software in the eighties, resigned in 1994 and sold all of his stock two years after the company went public. At the peak, he was worth $100 million. His fortune had declined to $4 million in 2009. He said in an interview on television that he had noticed the profits others were making in real estate and decided to build several mansions on spec, that is, the speculation that he would find buyers. He didn't.

Investors don't suddenly go crazy in the same way that most voters did in the latest presidential campaign. Central bankers have made it clear: they know that their low interest rate policies have encouraged excessive risk taking by investors. Such policies always have. Part of the reason is that most investors use mental linear regression to forecast the future. That means they think the good times will last forever. They should think about cycles.

In addition to linear thinking, one of the reasons investors lose so much money in the stock market is that they can't stand alone. If you're out of the market today, you have endured a great deal of scorn from those still invested as the market sets one record after another.

Profits bounced a little last quarter, they haven't improved enough to reduce the altitude of the PE ratio for the S&P 500. The highest average PE ratio for the decade of the 1920s was 18, just before the crash of 1929. In January 2000 PE hit 29 in advance of the crash and in 2008 it rose to 21. The PE was 72 in 2009 because profits had fallen so much. Today it's about 26, or 28 according to Shiller's calculations.

The principles of economics haven't changed because they are based on human nature and that hasn't changed in millennia. But one of these days the bulls are going to get slapped by the invisible hand.