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Monday, June 30, 2008

Reading List: Wealth, War, and Wisdom

Biggs, Barton. Wealth, War, and Wisdom. Hoboken, NJ: John Wiley & Sons, 2008. ISBN 978-0-470-22307-9.
Many people, myself included, who have followed financial markets for an extended period of time, have come to believe what may seem, to those who have not, a very curious and even mystical thing: that markets, aggregating the individual knowledge and expectations of their multitude of participants, have an uncanny way of “knowing” what the future holds. In retrospect, one can often look at a chart of broad market indices and see that the market “called” grand turning points by putting in a long-term bottom or top, even when those turning points were perceived by few if any people at the time. One of the noisiest buzzwords of the “Web 2.0” hype machine is “crowdsourcing”, yet financial markets have been doing precisely that for centuries, and in an environment in which the individual participants are not just contributing to some ratty, ephemeral Web site, but rather putting their own net worth on the line.

In this book the author, who has spent his long career as a securities analyst and hedge fund manager, and was a pioneer of investing in emerging global markets, looks at the greatest global cataclysm of the twentieth century—World War II—and explores how well financial markets in the countries involved identified the key trends and turning points in the conflict. The results persuasively support the “wisdom of the market” viewpoint and are a convincing argument that “the market knows”, even when its individual participants, media and opinion leaders, and politicians do not. Consider: the British stock market put in an all-time historic bottom in June 1940, just as Hitler toured occupied Paris and, in retrospect, Nazi expansionism in the West reached its peak. Many Britons expected a German invasion in the near future, and the Battle of Britain and the Blitz were still in the future, and yet the market rallied throughout these dark days. Somehow the market seems to have known that with the successful evacuation of the British Expeditionary Force from Dunkerque and the fall of France, the situation, however dire, was as bad as it was going to get.

In the United States, the Dow Jones Industrial Average declined throughout 1941 as war clouds darkened, fell further after Pearl Harbor and the fall of the Philippines, but put in an all-time bottom in 1942 coincident with the battles of the Coral Sea and Midway which, in retrospect, but not at the time, were seen as the key inflection point of the Pacific war. Note that at this time the U.S. was also at war with Germany and Italy but had not engaged either in a land battle, and yet somehow the market “knew” that, whatever the sacrifices to come, the darkest days were behind.

The wisdom of the markets was also apparent in the ultimate losers of the conflict, although government price-fixing and disruption of markets as things got worse obscured the message. The German CDAX index peaked precisely when the Barbarossa invasion of the Soviet Union was turned back within sight of the spires of the Kremlin. At this point the German army was intact, the Soviet breadbasket was occupied, and the Red Army was in disarray, yet somehow the market knew that this was the high point. The great defeat at Stalingrad and the roll-back of the Nazi invaders were all in the future, but despite propaganda, censorship of letters from soldiers at the front, and all the control of information a totalitarian society can employ, once again the market called the turning point. In Italy, where rampant inflation obscured nominal price indices, the inflation-adjusted BCI index put in its high at precisely the moment Mussolini made his alliance with Hitler, and it was all downhill from there, both for Italy and its stock market, despite rampant euphoria at the time. In Japan, the market was heavily manipulated by the Ministry of Finance and tight control of war news denied investors information to independently assess the war situation, but by 1943 the market had peaked in real terms and declined into a collapse thereafter.

In occupied countries, where markets were allowed to function, they provided insight into the sympathies of their participants. The French market is particularly enlightening. Clearly, the investor class was completely on-board with the German occupation and Vichy. In real terms, the market soared after the capitulation of France and peaked with the defeat at Stalingrad, then declined consistently thereafter, with only a little blip with the liberation of Paris. But then the French stock market wouldn't be French if it weren't perverse, would it?

Throughout, the author discusses how individuals living in both the winners and losers of the war could have best preserved their wealth and selves, and this is instructive for folks interested in saving their asses and assets the next time the Four Horsemen sortie from Hell's own stable. Interestingly, according to Biggs's analysis, so-called “defensive” investments such as government and top-rated corporate bonds and short-term government paper (“Treasury Bills”) performed poorly as stores of wealth in the victor countries and disastrously in the vanquished. In those societies where equity markets survived the war (obviously, this excludes those countries in Eastern Europe occupied by the Soviet Union), stocks were the best financial instrument in preserving value, although in many cases they did decline precipitously over the period of the war. How do you ride out a cataclysm like World War II? There are three key ways: diversification, diversification, and diversification. You need to diversify across financial and real assets, including (diversified) portfolios of stocks, bonds, and bills, as well as real assets such as farmland, real estate, and hard assets (gold, jewelry, etc.) for really hard times. You further need to diversify internationally: not just in the assets you own, but where you keep them. Exchange controls can come into existence with the stroke of a pen, and that offshore bank account you keep “just in case” may be all you have if the worst comes to pass. Thinking about it in that way, do you have enough there? Finally, you need to diversify your own options in the world and think about what you'd do if things really start to go South, and you need to think about it now, not then. As the author notes in the penultimate paragraph:

…the rich are almost always too complacent, because they cherish the illusion that when things start to go bad, they will have time to extricate themselves and their wealth. It never works that way. Events move much faster than anyone expects, and the barbarians are on top of you before you can escape. … It is expensive to move early, but it is far better to be early than to be late.
This is a quirky book, and not free of flaws. Biggs is a connoisseur of amusing historical anecdotes and sprinkles them throughout the text. I found them a welcome leavening of a narrative filled with human tragedy, folly, and destruction of wealth, but some may consider them a distraction and out of place. There are far more copy-editing errors in this book (including dismayingly many difficulties with the humble apostrophe) than I would expect in a Wiley main catalogue title. But that said, if you haven't discovered the wisdom of the markets for yourself, and are worried about riding out the uncertainties of what appears to be a bumpy patch ahead, this is an excellent place to start.

Posted at June 30, 2008 00:04