📖[PDF] Contrarian Investment Strategies de David Dreman | Perlego (2024)

Part I

What State-of-the-Art Psychology Shows Us

Chapter 1

Planet of the Bubbles

DO YOU REMEMBER the days when investing was fun? I do. For me the late 1960s were a great time to be in New York City and in my midtwenties, just the right age. I started working as an analyst barely a year before the Go-Go Bubble developed. Anything we bought went up, not just 20 or 30 percent; hell, those didn’t even count, they were a waste of our capital. Computer service companies, health care, semiconductor stocks, and scads more shot up ten-, twenty-, even a hundredfold. We were all becoming wildly rich—or so my young colleagues and I co*ckily thought for the next eighteen months.

We were a new generation, and this was a new market unlike any that had existed before. We laughed at the old fogies who bought blue-chip stocks and who shook a warning finger at us to sell before the bottom dropped out. Didn’t they realize this was only the beginning? More and more analysts were recommending these sizzlers, and all the hot mutual funds were piling into them as their funds soared. Once again, as in the distant 1920s, everyone was buying stocks. As they continued to move higher, our euphoria was endless.

One of my friends (let’s call him Tim) was at that time in group therapy—he said to straighten himself out, but from our talks it seemed more likely that he wanted to meet new interesting women. Whatever the case, the red-hot market permeated the group. Tim, intelligent, articulate, and not in the least reluctant to express his views, quickly became the center of attention. The sessions, led by a psychoanalyst who was an avid investor himself, turned more and more into stock-picking seminars. One group participant, a diffident middle-aged businessman still under Daddy’s thumb, believed himself a financial failure. He bought one of Tim’s suggestions—Recognition Equipment—as the price doubled, doubled again, and doubled yet again. He was suddenly the ultimate business success, a multimillionaire. The transformation in his self-confidence was amazing, so much so that Tim now had trouble maintaining his position as the group guru.

But the businessman’s newfound financial empire was not destined to last. Suddenly the market turned down sharply, and he was heavily margined. When Recognition Equipment began collapsing, the stock quickly led him to bankruptcy, whereupon Tim was made to return the Piaget watch he had been given in appreciation. At that point my friend turned to the First Avenue bar scene, which he hoped would provide better self-realization. Still, we all remained confident. The market drop was only a sharp correction, we were certain. The stocks we held, unlike those of other investors, were sound. And had to go higher . . .

None of us escaped.

Most of my friends lost all of their gains and much of their capital. As the markets screamed downward, I slowly remembered that I was a value analyst and got out with a modicum of my gains still intact, as well as what I thought was a newly acquired ulcer; it turned out to be just badly shaken nerves. But I had been taught a lesson. The ride up was magnificent, but the ending was horrific. Despite my training and knowledge of bubbles, I too was zapped.

Though bubbles provide almost endless jubilation on the way up, the way down is like entering Dante’s eighth circle of Hell. And bubbles are not simply market aberrations, occurring only occasionally. No, they are far more integral to market behavior than that, as we shall see. They sharply magnify overreactions that occur in markets and work persistently against investors’ best interests. The dynamics of bubbles, and of the market reactions when they burst, have also stayed remarkably consistent over time. Unfortunately, we have not been good at learning from our mistakes.

Consider this scenario.

For almost two months the market continued to slide on increasing volume. The near-universal confidence that investors were simply beating through another correction in a market destined to move much higher was gradually changing into doubt. When rally after rally failed, that doubt turned to a deepening anxiety. Could something be very different this time?

Next came the margin calls! Financial instruments at the heart of the nation’s growth and expansion plummeted for no apparent reason. Not just 2 or 3 percent but often 10 percent or more in a day. What was going on?

Rumors were rampant that now one major institution and now another was on the brink of collapse. Something had to be done to stop the stampede that threatened to turn into a panic on a scale no one had ever seen before. The president, reluctant to interfere, was called on by his top advisers to make a statement that the economic outlook was sound and to assure the nation that major prosperity lay ahead after this brief hiccup.

Assisting him in his efforts to calm the markets was his highly respected secretary of the Treasury, previously the head of one of the most formidable investment firms on Wall Street and a legend in his own time. Many other powerful market figures also threw their financial heft and hard-won reputations behind the secretary and the president.

The Treasury secretary worked with the leaders of some of the largest banks and with leading investment bankers in the country in an attempt to head off what was beginning to look like a financial disaster. A gigantic bailout plan was put together by the banks for immediate execution. The news sent stock prices soaring. Battered investors hoped this action would save the market and the financial industry, but the rally fizzled within a week and prices began to nose-dive. If the banks and the big-money pools couldn’t find a fix, who could? Many professionals now saw the possibility, even the likelihood, of complete financial disintegration.

Surely this happened just prior to the infamous 2008 crash, right? But wait, this description also fits the tumultuous events before the October 1929 crash. Amazingly, the president could be either President George W. Bush or Herbert Hoover, and the Treasury secretary could be Henry “Hank” Paulson or Hoover’s secretary, Andrew Mellon. (Mellon, who served through three administrations, was formerly the head of the Mellon Bank and the leading financier and industrialist of his day, with an income behind only those of John D. Rockefeller and Henry Ford.)

How badly did these crashes affect us? The 1929 crash and the ensuing Great Depression sent shock waves through the U.S. economy and global economies that radically changed Americans’ tolerance of the Wall Street they knew. Within several years after 1929, major legislation was passed to stop many of the egregious abuses that had been identified. Still, none of the reforms restored confidence in the financial system for decades. As the nation approached World War II and Selective Service was reintroduced in 1940, stockbrokers were designated the ninety-ninth out of one hundred least important categories to be exempt from the draft. Unemployment was near or over 20 percent for most of the 1930s, while the value of the companies making up the Dow Jones Industrial Average dropped from $150 billion in market value in 1929 to $17 billion in 1932, down 89 percent.

The crash of 2007–2008 was as devastating in many ways, taking financial stocks down 83 percent in a little more than twenty-one months—slightly more than half the time it took stocks to reach their lows of 1932. The free fall in the value of assets so frightened lenders that they refused to lend to banks that needed to borrow, and credit, the indispensable financial lubricant that had driven the wheels of commerce for centuries, froze. Jean-Claude Trichet, the president of the European Central Bank, remarked that it was the worst drop in credit since the Industrial Revolution. The industrial world was on the brink of a credit seizure it had not experienced since the Dark Ages.

“Why Bother with Bubbles and Panics?”

That’s what Fred Hills, an outstanding former editor at Simon & Schuster, asked me in 1997, when I submitted my last manuscript to him. “Even my twelve-year-old daughter knows about bubbles and panics,” he continued. Fred was dead-on. I’m sure that virtually every reader knows about manias and crashes. You’ve probably read about investors in Holland in the 1630s scrambling frantically to buy tulips and paying the equivalent of $75,000 for a Semper Augustus, a rare bulb, during Tulip Mania. Maybe you know the story of the printer in the 1720 English South Sea Bubble. Envious of the promoters all around him who were coining money by starting companies “to bring up hellfire for heating” or “to squeeze oil out of radishes,” he hatched his own scheme: “A company for carrying out an undertaking of great advantage, but nobody to know what it is.”1 When he opened his door for business at 9 A.M. the next day, long lines of people were waiting patiently to subscribe. The printer took every pound offered and wisely took a boat to the Continent that evening, never to be heard from again.*2

Perhaps you’ve even heard of the Mississippi Bubble in France in 1720. The Mississippi Company promoter John Law was an expert at painting the canvas of concept. As one of his numerous spectacles to hype the stock, he marched many dozens of Indians through the streets of Paris bedecked in gold, diamonds, rubies, and sapphires, all supposedly coming from the almost unlimited mines of gold and precious stones in the mountains of Louisiana. The stock appreciated four thousand times before it collapsed in 1720.

When our forebears left for the New World with the hopes of escaping tyranny and persecution and finding a better life, Mr. Bubble took the perilous voyage with them and flourished as much as anyone on the journey. Bubbles and market meltdowns have occurred regularly since the nation’s founding; the panics of 1785, 1792, 1819, 1837, 1857, 1873, 1893, and 1907 and the crashes of 1929, 1967, 1987, 2000, and, of course, 2008. Depending on the technical definition, more could be added.

These stories are all too familiar, it’s true, but we will not be looking at bubbles through the eyes of an economic historian or simply retelling tales of the almost unbelievable levels of folly and self-delusion investors can reach. The purpose here is very different; a discussion of bubbles is essential to the investment methods we will examine in the book.

Contagion and crashes are, in fact, the starting point for our understanding of psychological behavior in the markets. After all, if everyone knows about financial bubbles, how can they keep on happening? Shouldn’t economists have figured out by now how to watch for the equivalent of the engine warning light coming on?

We all know that it’s very hard to pinpoint exactly when dangerous financial overheating will blow up the financial structure. We realize that stocks can become enormously overvalued, but still, most people don’t fold their cards and walk away with their mounting piles of chips. We just can’t seem to get the timing right. This situation has not been helped by the prevailing wisdom touted by economists.

Economists following the efficient-market hypothesis (EMH) state that bubbles are impossible to predict. Market bubbles are something like stealth bombers, they say; you can’t pick them up on radar, and you won’t know what’s hitting you until your investments are getting shellacked. No less an authority than Alan Greenspan, the former chairman of the Federal Reserve and the “prophet” of prosperity, concurs with this economic thinking: “It was very difficult to definitively identify a bubble until after the fact—that is, when its bursting confirmed its existence.”2 There is widespread agreement by economic scholars with his statement. But even worse, the popular theory states that bubbles are rational. In short, absurd pricing is always justified by the actions of totally rational, nonemotional investors, who keep prices exactly where they should be. As we’ll see, this is an easy out. But it certainly protects the Fed’s and academics’ reputations. To accept it means that we are not capable of ever valuing anything accurately. So bye-bye to all theories of valuation, whether you are buying a home, purchasing stocks, or building a new plant. Any price is good—until it isn’t. We will go into this rather tortuous logic in some detail later on, but it’s obvious that investors often do not, in fact, keep prices where they should be.

Our purpose in this book is to change this thinking or at least to help change your thinking, and your investing decisions, by revealing its folly. In this chapter we’ll take a quick ramble through history to show you a dozen of the main causes of bubbles and convince you that it is vital to come to a better understanding of how to spot them and avoid their carnage. Most of us looking back at earlier manias think that we could never make the same silly mistakes. I know I did when I first came to Wall Street in the late 1960s. In researching my earliest work, I logged a lot of hours at the New York Public Library and pulled out virtually every book I could find on bubbles and panics; I then read the daily financial section of both The New York Times and The Wall Street Journal for several years preceding the 1929 crash to get a real feel of these events. At first it looked so easy to make a killing by going against the obvious madness of these silly investors in the era of speakeasies, flagpole sitters, and “jazz babies” with short skirts and boyish figures. Didn’t they know markets couldn’t go up endlessly? Taking advantage of such folly would be a cinch.

It wasn’t. It bears repeating that within a year of starting my career on the Street, I got caught up in the exact same foolishness, in the 1966–1969 Go-Go Bubble. That is a personal reason why I know that it is only through thoroughly understanding what causes manias, along with the continual overvaluations of popular stocks, that you can protect and possibly enhance your capital.

Some Common Characteristics of Manias

As we noted earlier, one of the most remarkable characteristics of speculative manias is their similarity from period to period, even if hundreds of years apart. Take the excessive use of credit as the first of many destructive characteristics most bubbles have in common.

Let’s flash back again briefly to the 1929 and 2007–2008 crashes. Enormous leverage was employed in both periods, as it was in many bubbles in the past. In 1929, investors could buy stocks on 10 percent margin. Many investors back then bought investment trusts, which themselves employed large amounts of borro...