In his 2014 book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” author Mebane "Meb" Faber took on the issue of stock market bubbles and found a solution in value investing. As the title indicates, his focus is on value stocks outside the United States.
The author is the CEO, chief investment officer and co-founder (with Eric Richardson) of Cambria Investment Management. He is the author of five books and is a frequent media commentator. In a brief GuruFocus review of “Global Value” in 2014, Charles Sizemore wrote, “I consider Faber one of the most innovative strategists in the business today, and I found his research on shareholder yield to be compelling enough to make the Cambria Shareholder Yield ETF (SYLD, Financial) a core, long-term holding in multiple ETF portfolios I manage.” Shareholder yield, according to Sizemore, refers to the sum of dividends, share buybacks and debt repayment.
What are stock market bubbles? Are they real phenomena or simply slang terms that have no meaningful value? Questions such as those are the subject of the book’s introduction and first two chapters.
Faber cited the Merriam-Webster definition of a bubble as “a state of booming economic activity that often ends in sudden collapse.” Some investors might say it is a divergence between a company’s fundamental value and its market price. Extreme emotions, including fear and greed, are often factors in booms and bubbles; as the author puts it, a bubble exists when irrationality starts to guide our decisions about investments. Robert Shiller, a Yale economist and Nobel Prize winner, has likened a bubble to a mental illness.
But could such ideas about bubbles be exaggerated? Faber cited an article by Cliff Asness of AQR Capital Management in 2014. Asness argued in the Financial Analysts Journal that the word “bubble” has been diluted. Rather than representing a pattern of investment behavior, it has come to represent anyone’s idea of overvaluation.
Some scholars claim that market bubbles don’t really exist or are meaningless to investors. Eugene Fama, one of two academics behind the Efficient Market Hypothesis, has written that he doesn’t know what the word bubble means. "It may have become popular," he claimed, "but only has meaning in hindsight."
With this confusing state of affairs, Faber moved on to chapter one. There, he reported that his fellow student of bubbles, Jeremy Grantham (Trades, Portfolio), had found more than 330 bubbles in his historical research. Grantham also observed that’s it hard to know when bubbles are occurring. In Faber’s words, “In other words, when is this time really different?”
Perhaps we can learn something from history. According to Faber, the three most famous bubbles in history were:
- The South Sea bubble, between 1711 and 1720.
- The Mississippi Company bubble, of 1719 to 1720.
- The Dutch Tulip Mania in the early 1600s.
Each of these bubbles delivered devastating drawdowns between 80% and 99%. Chapter one focused on the South Sea event, which is responsible for the coining of the term “bubble”.
The South Sea Company was the brainchild of a Lord Treasurer in the British government and was created to help the government manage its very large debt. It provided new shares of stock to the holders of government bonds. In exchange, the company received a monopoly on trade with South America and interest payments of 6% per year from the government.
As Faber noted, this was supposed to be a win-win for everyone. Investors in the South Sea Company saw the gold coming out of South America’s gold mines, and that could be traded for European goods at very large profits. Perhaps that would have happened had the company been allowed more than one ship per year. Nevertheless, there was a speculative frenzy, which produced many secondary offerings that further inflated stock prices. The shares of these secondary stocks were called “bubbles.”
Those who recall the dotcom bubble may recognize what was happening during the South Sea bubble. In his 1841 book, “Extraordinary Popular Delusions and The Madness of Crowds,” Charles MacKay wrote of one company that had the mission of, “carrying on an undertaking of great advantage, but nobody to know what it is.”
According to Faber, the South Sea debacle was one of history’s first “pump and dump” schemes. Its managers knew little about their business, but a lot about promoting stocks. That fed the desire among ordinary citizens for more shares, and also left them high and dry when management quietly began selling out at the peak. Among those impeached or sent to prison, not to mention having their estates confiscated, were the Chancellor of the Exchequer and the Postmaster General.
The author concluded that investment bubbles have been with us for centuries and that most of us can’t resist jumping into them when we see our friends and neighbors apparently getting rich. Just ask Sir Isaac Newton, one of the smartest people ever and a victim of the South Sea bubble.
Both of those conclusions lead to the inevitable question, “How can I avoid being swept up in a bubble?”
Conclusion
Mebane Faber began his book about global value investing with an exploration of stock market bubbles, which is his starting point for an in-depth discussion of ways to avoid them.
From the Dutch Tulip bubble of the early 17th century to the dotcom bubble, too many investors have succumbed to the temptation of getting rich quickly. Although Faber has covered only the South Sea bubble here, there is a pattern to the bubbles, beginning with unrealistic expectations and speculation.
The author’s solution, which will be developed in the following chapters, involves embracing the ideas of some prominent skeptics, including Benjamin Graham and David Dodd.
Disclaimer: This review is based on the book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market” by Mebane Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in these reviews are those of the author.
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