Friday, July 11, 2014

Book review: "Conquer the Crash" by Robert Prechter

I bought a copy of Conquer the Crash after reading Credit Bubble Stocks's excellent review of the book. My opinions are broadly similar to CBS's, and I strongly recommend his review, especially his discussion of "investing ecosystems."

Prechter describes two big ideas in Conquer the Crash: Elliott Wave Theory and socionomics.

Elliott Wave Theory is a form of technical analysis. It postulates that securities move in patterns and that each pattern consists of five "waves." These patterns are self-similar in the sense that each wave can itself be considered a pattern and divided into five smaller waves. I'm not enthusiastic about technical analysis, and I think EWT is too subjective to have any predictive utility.

Socionomics is the idea that social mood determines the course of economics and finance. Conventional wisdom tends to assume the opposite, e.g. that a stock market crash would lead to a sustained decline in investor confidence. Socionomics is speculative but interesting-- at a minimum, I think the relationship between social mood and financial returns is more of a two-way street than investors generally assume.

Elsewhere, Prechter has written that "When social mood turns, the fundamentals will follow." The idea that fundamentals are a byproduct of more important underlying forces has influenced me greatly.

Many people dismiss Prechter because he's been prematurely bearish or becuase they think EWT is bogus, but that's a mistake. As CBS writes, "Lots of the ideas in Conquer the Crash stand on their own whether or not Elliot Wave theory is true."


New-era thinking

Writing in early 2002, Prechter argues against the idea of a "new economy." He compares the American economic boom of 1942-1966 with the boom of 1974-2000. The second boom had much much weaker economic growth than first, but that the stock market did much better during the second.

He finds the same phenomenon in 1920s America and 1980s Japan: economic growth was slower than during preceding booms, but the stock market rose much more amid talk of a new era.

All of these periods experienced rapid increases in debt. This, not the dawn of a new era, was what increased stock-market returns. Debt's benefits accrued unevenly, however. During late-'90s stock market, tech stocks and blue chips significantly outperformed other kinds of stocks. Stock-market breadth was similarly weak during the Roaring Twenties and Japan's asset bubble. As Prechter writes:

"During third waves, people focus on production to get rich. During fifth waves, they focus on finance to get rich. Manipulating money isn't very productive... In a finance-oriented economy, comparatively few entities benefit."


Parenthetically, higher economic growth doesn't lead to higher stock market returns, but Prechter doesn't claim that it does. Rather, he makes it clear that stories about a new economic era have no basis in reality. They're merely rationalizations created to justify a bubble.


Inflation and the Fed

Prechter argues that the effects of inflation, which he defines as an increase in the amount of money and credit relative to the amount of goods, vary with social mood:

"The inflation of the 1970s induced dramatic price rises in gold, silver, and commodities. The inflation of the 1980s and 1990 induced dramatic price rises in stock certificates and real estate."

He also argues that the Federal Reserve has less control over the markets than most people assume:

"Thus, regardless of assertions to the contrary, the Fed's purported 'control' of borrowing, lending and interest rates ultimately depends on an accommodating market psychology and cannot be set by decree."

"For the Fed, the mass of credit that it has nursed into the world is like having raised King Kong from babyhood as a pet. He might behave, but only if you can figure out what he wants and keep him satisfied."



Depressions

A deflationary depression can occur as a quick, sharp crash or prolonged period of stagnation and financial distress. The Great Depression is an example of the former. Japan is an example of the latter:

"Japan's retrenchment has been long and slow because most of the rest of the world's economies continued their investment manias and economic growth, allowing vigorous trade to provide support during the first decade of its economic decline."

Now that every major economy has high debt levels and is experiencing high credit growth, the next depression is likely to be a crash.

Prechter writes that "Short selling is a great idea at the onset of a deflationary depression, at least from a timing standpoint" but can backfire during major crises. If the financial system becomes so stressed that brokers fail, short sellers could be right and still lose.

This argument is even stronger for credit default swaps, for which large banks are the counterparties. CDS were great speculations when the subprime crisis began, but they became problematic when the crisis spread to the rest of the financial system.


Real estate

Prechter writes about various ways that banks can evade lending restrictions and loan-quality requirements, such as inflated appraisals. He also mentions that real estate doesn't clear quickly the way stocks do, so deflation casts a long shadow:

"Few know that many values associated with property-- such as rents-- continued to fall through most of the 1940s, even after stocks had recovered substantially."

Along those lines, Jim Grant, in his book Minding Mr. Market, writes about the Equitable Office Building Corp, which owned the Equitable Building in New York City during the Great Depression. Equitable had high-quality tenants and comfortably met its debt interest obligations during the most acute phase of the Depression, but its rental income steadily declined as leases came up for renewal. The company had to cut its dividend several times in the 1930s before omitting it and finally declaring bankruptcy in 1941.

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