The Diff - Longreads + Open Thread

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Longreads

• Earlier this year, The Diff reviewed The Trading Game, by Gary Stevenson, a story about how the author was born poor but worked his way up to a lucrative job, before being unable to cope with just how he'd made his money. In the book he repeatedly notes that he was Citi's most profitable trader, period. The FT has exhaustively investigated this claim, and found that he almost certainly wasn't, though he did make money. I've personally observed that humility about past gains and paranoia about future losses is a good predictor of the persistence of returns: your track record is always a limited sample drawn from a distribution with unknown parameters, and you're guaranteed to get worse returns if you over-extrapolate your best year. Stevenson looked like a counterexample to this rule, but no, he's an example of it.
• Institutional Investor profiles Cliff Asness, who is frequently linked in The Diff for his pieces on factor investing and PE volatility laundering. Although he's usually averse to market-timing, Asness' career ends up being a great example of it: when he started out, academia and professionals were closer to parity in terms of data access, so he could do research for grad school that turned into profitable strategies. Now, the barrier to entry is higher—but by the time that happened, he was the one hiring ex-academics rather than an academic trying to commercialize what he'd discovered.
• A pseudonymous researcher has an investigation of the infamous Math Stack Exchange user "Cleo," who is notorious for coming up with quick solutions to seemingly-intractable problems. The result is not exactly what Cleo originally appeared to be, but it's an impressive amount of effort to create what is essentially a prank or work of performance art that will only be appreciated by a tiny number of people.
• Gordy Megroz has a fun profile of a professional whistleblower who investigates frauds, reports them to the government, and gets a cut. Whistleblower rewards are a white-collar letter of marque that privatizes some aspects of law enforcement. That creates an incentive to invest effort in catching people, but it has an interesting catch: it creates an incentive to delay reporting in order maximize the size of the reward ($, Diff). That said, whistleblower fees offer a wonderful kind of alignment, where someone trying to do good for the world has variable, performance-based compensation.
• L. Lynne Kiesling on whether the Great Stagnation is a function of technological limits or bad choices. It's very hard for just one set of constraints to be permanently dominant, and a good policy is to be broadly contrarian: when the narrative is about scarce natural resources and physical limits to growth, think about the importance of culture and institutions; when the narrative is global convergence on the US model, it's a good time to start asking which places have the biggest natural resource deposits instead.
• In this week's Capital Gains, we consider the question of what we mean by efficient markets. The efficient market hypothesis is a great starting point for thinking about finance, but it's a self-refuting endpoint—if literally everybody invested in index funds, index funds would turn into a terrible product. But figuring out the exact boundary is hard, and what EMH tells you to do is come up with a story, not just of how mispriced something is, but also of why it got that way (and why it won't stay that way).
• In this week's episode of The Riff, we covered EMH, strategic investments, spinoffs, personal currencies, diversification, and more. Listen with Twitter/Spotify/Apple/YouTube.

Books

The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933: Do you ever read a work of financial history and think to yourself "This book throws out enough data that the author clearly has a lot of it, and I wish they'd shared more"? You will not have that thought while reading The Crash and Its Aftermath. It's an incredibly detailed book that's basically a prose pivot table: for each year from 1929 through 1933, it has a few chapters summarizing the general business and money market environment, and then a section on every major industry complete with valuation ranges and returns on equity for all of the companies in that space. So if you've ever wondered just how cheap stocks got at the depths of the depression, you'll get your answer.

Going through all of this detail adds a lot of texture to the general boom and bust narrative. It's true that industrial stocks and utilities were the big winners in the 20s, but not all of them—the auto sector was already struggling before the peak. But what's remarkable is that the decline didn't hit those sectors disproportionately: industries like steel and paper were doing worse, while utilities actually declined less than other stocks. The paper companies did particularly badly because of competition from Canada, which had always had lots of trees but which now had cheap hydroelectric power; in steel, one of the big problems was Russia, which was industrializing so fast that their steel output grew during the early depression. Meanwhile, the banking sector was hurt both because of defaults and because valuations had gotten completely disconnected, not just from their long-term performance, but from their peak earnings. In 1929, the average bank traded at a peak of 5x book value, despite average returns on equity of 9.7%. Railroads also had a difficult time. In an instance of the market figuring things out pretty fast, the early years of the depression were the first time utility bonds started yielding less than railroad bonds of equivalent ratings, a phenomenon that persisted thereafter.

In the opposite direction, the sectors that were weirdly cheapest were food and tobacco stocks. These companies weren't entirely insulated from the cycle, but since they were buying agricultural products and processing them into finished goods, they benefited from deflation on the cost side which offset some of the revenue hit. And these stocks, which weren't valued at much of a premium coming into the crash, routinely produced 20%+ returns on equity. The market at that time seemed surprisingly indifferent to the cost of capital. (Barrie Wigmore, the author, who once headed corporate finance at Goldman before retiring and writing books, seems actively offended by this discrepancy. It's great.) 

There were two especially useful points of financial history from the book: first, Glass-Steagall's separation of commercial and investment banking was solving a brand new problem: investment banks affiliated with commercial banks managed half of stock underwritings in 1929, but had only done an eighth of them in 1927. It wasn't a recurring feature of the market, but a new quirk that emerged in the 20s. The other surprising thing is that the book is peppered with references to companies buying back their stock, especially investment trusts and holding companies that could buy it for less than book value. This was not at all what I expected—I'd looked into the history of buybacks for this piece, and couldn't find examples that I wasn't specifically searching for prior to the 1950s. And ChatGPT was pretty convinced that buybacks hadn't happened much before then, either. But it turns out that they were part of the 1930s financial engineering playbook, and became a lost art for a while after. And maybe a third: in Deadeye Dick, Kurt Vonnegut describes one character's behavior in the 30s: "He bought Coca-Cola stock, which acted the way he did, as though it didn't even know a depression was going on." That's not completely true, but it did hold up better than rest of the market, and kept paying a dividend

One of the questions that comes up in a story about financial crashes is: who was ahead of the game, and who wasn't? Brokers were optimistic through about mid-1930, and kept buying newspaper ads touting how cheap stocks had gotten. Small investors, as measured by the share of buying and selling done in lots of fewer than 100 shares, were net buyers throughout the Depression. This eventually worked out well for them, but it was a tough slog.

This book is definitely not for everyone, given the absurd amount of detail it sometimes goes into, and the narrow scope. However, it's a good look at the details of an inefficient market, viewed from a much more financially sophisticated perspective.

Open Thread

• Drop in any links or comments of interest to Diff readers.
• Are there any books that go into similar levels of detail on other market periods? Some of Robert Sobel's books come close; this one is a good review of the market leading up to the crash, and is mercifully much cheaper than Wigmore's. And this one talks about the 1960s. (In a testament to the difficulty of timing the market, Sobel called it The Last Bull Market, and it came out in 1980.)

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