TIP520: Investing Through Post-bubble Markets w/ Jamie Catherwood

Financial historian Jamie Catherwood draws parallels between the 1920s and today, with similarities in progression and timeline laid out from the Spanish flu, summer protests around race, surging demand after reopening, sharp and severe recession and then the roaring twenties. However, the question remains if we are going to keep following the path laid out by the 1920s or experience something different with a longer time to rebuild the economy and reach pre-COVID levels. Catherwood also highlights the importance of understanding history to inform our understanding of the markets today, how market regulations were developed in the US and how the crypto market resembles the early days of the stock market.

Factors tend to hold up well in inflationary regimes. Inflation does not always correlate with the performance of stocks. In high inflation regimes, momentum and energy sectors have historically performed the best, while the size factor and consumer staples sectors have underperformed. The fraud cycle lags the market cycle, and bad business models tend to suffer during downturns. Investors need to consistently perform due diligence, even during bull markets. Crypto, like equities in the 1920s, is a largely unregulated asset class and is subject to speculation. Inflation does not always mean lower equity returns, and shareholder yield, momentum, and value historically hold up well in moderate to high inflation periods.

In a bull market, companies can skate on hype and momentum, but in a bear market, questionable business models and frauds get exposed. A stock price is the best prosecutor and defense you can have, making you untouchable in a good market, but susceptible to questions when the market is bad. Companies need facts and statistics to gain market favor when people are losing money. Even private startups with questionable business models get found out in a bear market. The downfall of Bernie Madoff and FTX are great examples. Therefore, companies and investors need to be cautious and understand the realities of their business models, employee count, and offerings before making tough decisions in a bear market.

The term bankruptcy comes from the broken bench of Venetian bankers who went insolvent in the 14th century. Similarly, the equity markets in the 18th and early 19th centuries were also a cesspool of frauds and scams before getting regulated finally in 1929. Today, cryptocurrency is facing similar issues, but they are happening at a faster pace due to technology and social media. Insider trading was legal before 1909 and court cases hardly led to any regulations. Stenographer at a mining company used insider knowledge to short her company's stock, which was legal at that time. So, we must learn from the history of financial markets and take regulatory actions to safeguard people's money from frauds and scams.

The democratization of financial markets in the 19th and 20th centuries led to the participation of retail investors through bucket shops, but lack of regulation left them vulnerable to market manipulations and frauds by speculators and robber barons, resulting in the devastating 1929 market crash. The crash led to the establishment of regulatory bodies such as the SEC to protect retail investors. Today, the crypto community is against government intervention and regulation, but history has shown that regulation is necessary for the protection of investors in democratized markets.

The lack of regulation in the crypto industry is a major concern as it leaves investors vulnerable to scams and frauds. Although regulation and crypto do not go hand in hand, some level of regulation is necessary. It will be beneficial in the long run to have a framework in place for digital assets, which will make it safer for investors to make their first investment, and the asset class as a whole will become less sketchy and dangerous. Decentralized Bitcoin is different from other coins like FTT, which are just made out of thin air from FTX. The dynamic of Wall Street has not changed a lot for retailers, and despite moving from bucket shops to exchanges, the same wash sale idea persists.

Bucket shops in the past manipulated stock prices by placing sell orders at a lower price to avoid paying out winnings to their customers. This fictitious trading provided a link to the real stock exchange, where the real market was being moved by sketchy speculative activity in these bucket shops. Similarly, in the crypto world, sketchy activities affect the entire system and move Bitcoin because it is the main asset that companies use. To cut this link, more regulation is needed, as it ensures a higher level of company on average in the market, catching more of the frauds and sketchy companies that would have gone public before regulation. The Securities Act had a significant impact on the quality of companies trading on stock exchanges.

The Security Act of 1933 brought significant change in IPOs on non-New York Stock Exchanges, where the average five year return for IPOs before the Act was negative 52%, but after the Act, it changed to a positive 5.7%. This was due to the fact that prior to the regulation, there were no rules around prospectuses and anything like that, and thus there was nothing discouraging companies from launching sketchy or shady IPOs, which contributed to terrible average returns. The introduction of regulation brought much-needed quality to the market, where the worst 25% of companies like straight scams and frauds have already been removed. This lack of regulation in the crypto landscape is worrisome, where blind investments are not recommended due to uncertainties.

The 1906 San Francisco earthquake highlighted the downsides of relying on gold as the base of a monetary system and the need for a central bank as a lender of last resort to prevent financial crises. The earthquake caused over 50% of the fire insurance companies in San Francisco to be British, leading to a lot of gold needing to be moved and causing financial markets to become more fragile. Britain ended up sending 13% of their gold supply to San Francisco to pay out insurance claims, tightening up markets and causing knock-on effects for global markets, specifically in New York. JP Morgan acted as the Federal Reserve during the crisis, leading to the creation of the Federal Reserve in 1913 to prevent relying on a single person in future crises.

The founder of FTX provided liquidity and saved struggling crypto companies similar to how JP Morgan bailed out struggling companies. The Bank of Amsterdam is believed to be the first central bank and it influenced the way other countries structured their own central banks. Throughout history, there has been a cyclical pattern of three stages for competitive advantages in markets: access, speed, and analysis. Carrier pigeons were once used as a method for faster access to market information. However, over time, these methods get arbitraged away. Today, information has become democratized and analysis has become the primary competitive advantage in the age of information.

In investing, competitive advantage goes through three stages: speed, receiving information faster; technology democratizes information so everyone gets it at the same time; analysis, using information more effectively than competitors. Once a cycle completes, a new data set or technology resets it. For example, curb traders in the mid-1800s drilled a hole in the New York Stock Exchange building to spy on the wealthy elite's trading sessions. This access was an edge until the ticker was introduced, and everyone got the same information at the same time. The investing world then moved to the speed component, and eventually, the cycle reset. Today, the analysis phase is key, and investors must use the widely available information to gain better insights and outperform the competition.

The ticker, a recorded history of the market, revolutionized the way investors gathered and analyzed information in the 19th century. It provided everyone access to real-time price information and helped investors spend more time analyzing trends instead of just trying to gather information faster. Today, tools like de Lupa automate data gathering and synthesizing processes so that investors and analysts can spend more time analyzing and generating insights. Companies are dedicated to helping investors do more analyzing than just gathering data or gathering it faster. The optical telegraph, used before the ticker, communicated price information using different shapes. The ticker through Telegraph cables technology distributed the information, making it easier for investors to access and analyze. This was a revolutionary way to get real-time information without being physically present near the New York Stock Exchange.

Custom indexing is becoming a great competitive advantage for financial advisors. The ability to personalize each individual account, to boost investor returns is unique. This technology may eventually be available to the retail investor. With the power of custom indexing, advisors are able to personalize each client's individual account for things like taxes. The impact of personalized investment through single stocks and personalization is much higher than that through commingled funds. Using the canvas platform, advisors can deliver custom solutions to their clients, making it necessary for the industry to evolve. Osam's canvas platform and custom indexing, offering personalized solutions to individual investors are great examples of how the industry is evolving.

Custom Indexes allow investors to sell stocks at a loss, which offsets tax bills on other stocks in the index that went up. This can lead to tax alpha and higher after-tax returns. In the first half of 2022, harvesting losses across Canvas accounts generated a hundred million in net losses and added 170 basis points in tax alpha. While tax optimization can make a big impact on investor returns, there are also other benefits of customization at scale. To learn more about financial history, the Investor Amnesia website has financial history courses with renowned experts like Jim Chanos and Neil Ferguson. Canvas allows investors to create customized indexes, leading to tax optimization, and other potential advantages.