Bogleheads on Investing- Episode 031 transcript

Jamie Catherwood

Jamie Catherwood is a financial historian and the publisher of the website Investor Amnesia. He received a history degree from King’s College London in 2017 before joining O’Shaughnessy Asset Management, a quantitative investment firm based out of Stamford, Connecticut. Jamie quickly built his reputation as an expert on the history of money and finance after starting a popular weekly blog that links current market activity and investor behavior to similar events and investor behaviors throughout the centuries. Jamie shared numerous interesting anecdotes in this podcast and draws clear parallels to the current environment

Episode 031- guest Jamie Catherwood

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Rick Ferri, February 25, 2021

Rick Ferri: Welcome everyone to the 31st episode of Bogleheads on Investing. Today our special guest is Jamie Catherwood, a bonafide financial history nerd. Jamie’s research, that he publishes weekly on his Investor Amnesia website showed that we make the same mistakes as investors over and over again.

Hi everyone my name is Rick Ferri and I’m the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by The John C. Bogle Center for Financial Literacy, a non-profit organization. Donations can be made at boglecenter.net. Today we have a special guest, Jamie Catherwood. I first met Jamie at a quantitative analyst meeting that was full of PhD.’s and people a lot smarter than me. And there was this young man captivating all these PhD’s, just coming up with all of this information that I’d never heard of and as I listened to him talk, I  came quickly to the conclusion that he was one of the smartest people in the room. and actually got a little bit nervous when somebody said my name and he looked at me and said, “You’re Rick Ferri!”

That scared me a little bit. I said to myself, “How am I going to  keep up with this guy?” But it turned out great. It was a real pleasure getting to know Jamie and it’s a real pleasure having him on the show today. I’m sure you’re going to enjoy this, so with no further ado let me introduce Jamie Catherwood. Welcome to the podcast Jamie.

Jamie Catherwood:Thank you so much for having me. It’s an honor to be here.

Rick Ferri: I wanted to have you on the show to dig into all of the work that you’ve done. Even though you don’t have your PhD.–I mean you have done a PhD. volume worth of work on financial history and you’ve developed a website called Investor Amnesia–and of course, and really you’ve become quite a widely known expert on financial history at the young age of 26 years old. So before I jump into our discussion about financial history, could you tell us a little bit about your background and what got you to this point.

Jamie Catherwood: It actually kind of goes all the way down the line in my ancestry, particularly on my father’s side. I don’t know how many greats it is, but great great great something grandfather was a guy named Frederick Catherwood and he is known for helping rediscover the Mayan civilization with his colleague John Lloyd Stephens, and this is in the mid to late 19th century. They went through the jungles of, I think, modern-day Guatemala and found these ancient ruins that they had heard about. And what my ancestor did, his role was painting these really elaborate lithographs, and if you just google Frederick Catherwood you’ll see some of these beautiful illustrations. And it was those illustrations that were actually used to help decipher the Mayan language and figure out what these monuments and statues were talking about and representing, and we could decipher the history of the Mayan civilization. Edgar Allan Poe said the book that Frederick Catherwood and his colleague John Lloyd Stephens put out about their adventures was the most important book on travel written in the 19th century.

And then there’s actually another Frederick Catherwood who is my direct grandfather, much more recent. He sadly passed away in 2014 but he has also always been an avid historian and passionate history buff. And he had a fascinating career in both business and politics to the point where he was actually knighted formally by the Queen in 1971, I believe. And so he is technically Sir Fred Catherwood.

Rick Ferri: Does that roll down generations?  Are you a surrogate?

Jamie Catherwood: I wish, I wish. If it did I would have a full suit of armor in my apartment. I would definitely be showing that off all the time. But no it does not, unfortunately, roll down. He from there went on to be a founding member of the European Parliament and European Union and he was elected at first in 1974 to be a representative from Cambridgeshire, and from there he kept serving for decades and eventually ended up being the Vice President of the entire European Parliament in the late 90s into the early 2000s before then retiring afterwards. But he and the greater ancestor have definitely had an influence in my interest in history and business, politics, etc.

Rick Ferri:Well that’s incredible pedigree to actually do what you are now doing, history and economics and politics. Tying those things together is really your work. Can you tell us about your work?

Jamie Catherwood: My work stems more from media interest in college as a history major with my now professional interest as someone who works in the financial services industry at an asset manager of O’Shaughnessy Asset Management and I really wanted to marry my two interests. And I began writing after the recommendation of a friend of mine to join Twitter as a way for networking. And after I joined Twitter I saw that there were a bunch of people like yourself who were putting out great podcasts, blogs, etc. and I missed the process of researching and writing. That was basically my entire undergrad degree at King’s College London, doing history papers.

And so I figured maybe I’ll put together a short series on interesting moments or characters in financial history, and to my great surprise they were very well received and it turned out that there was a quite large base of people that were working in this industry that had an interest in history. And so from there it’s gone from just posting some articles on medium to developing my own website and starting a newsletter that now goes out to, I think, over 11,000 people each Sunday. And in those posts I’m taking together five different scholarly articles on financial history all wrapped around one theme that is relevant to whatever’s going on in the markets that week. So recently I’ve had posts on the history of short selling and market corners et cetera, after the whole Gamestop mania.

I definitely feel that history is helpful for putting everything into context and you can avoid getting swept up by whatever the latest fad is. And to my surprise there are a lot of other people out there who share my nerd-dom for financial history.

Rick Ferri: Your newsletter that you send out every Sunday. That’s a lot of work. Is there a cost to that? If I wanted to sign up, how does that work?

Jamie Catherwood: No it’s completely free. If you just go to investoramnesia.com there is a section just right there on the homepage for you to enter in your name and email and then you’re good to go and you’ll start receiving that newsletter into your inbox every Sunday.

Rick Ferri: And the pictures that you come up with in the charts, and the books that you photograph, and the pamphlets and everything from 100 – 200 years ago, it’s just amazing where you get this information from. It’s really a great resource for people who are interested in financial history, economic history, market history and so forth. One of the things that you make a point of in everything you do, including your course and your lectures that you’re giving —  you’ve given lectures even at Yale University, correct? I mean you’ve been out there quite a bit — is that what history is and isn’t. So all of this work that you’ve done on financial histories and manias and booms and busts, tell us what history is or what it is and what it isn’t, I mean how does it help and how does it not help.

Jamie Catherwood: Yeah so I guess to allude back to my more great ancestor who discovered the Mayan civilization by backpacking through the mountains, the analogy I like to use is history is a compass rather than a road map. I think I do a good job of setting out what history is and isn’t but I feel like some people might read either my site or just financial and economic history in general and think that, ”Oh, I can see that something similar happened before so now I know exactly what’s going to happen in the future.” And so it’s not a road map where you know there’s clearly, there’s previous laid out paths that you can just follow again and you’ll end up at the same destination. There’s no kind of clear route for you to take just by understanding history.

But what you can do with history is that there are some kind of high level and overarching themes that repeat themselves over and over throughout history, which is why I named my site Investor Amnesia, because we never learn as investors. Some of these same things continually happen, especially related to investor behavior. That’s why there’s always booms and busts and bubbles. So history as a compass, I think is a better analogy because, again, you won’t know exactly how things are going to play out moving forward but by understanding and reading history you can see, ok, well when these kind of forces have combined throughout centuries in the past, this has been the general direction that markets have gone moving forward, and it just becomes easier to at the very least orient yourself in the right direction and put things within a broader historical context and not get maybe swept up by short-term thinking and getting sidetracked in the latest fad or innovation that will supposedly revolutionize markets and change  society forever.

Rick Ferri: Well let’s go ahead and start looking into some of your research and it covers many centuries. We hear about Tulip Mania in Holland. I mean with your research, where does this all start?

Jamie Catherwood: So Tulip Mania is kind of my pet peeve because it’s not actually what 90 percent of market commentators think it is. There’s a great book by Anne Goldgar, who is actually at my alma mater King’s College London, called Tulip Mania. It’s not what market pundits think it is. It’s the result of some very shoddy historian, historical sourcing by everyone’s favorite author, Charles Mackay in his Madness of Crowds book. Basically the quick story is that he based all of his source work for the Tulip Mania section of his book on a German author from the 18th century and that German author got everything that he knew about Tulip Mania from these pamphlets that were highly sensationalized and just pure propaganda and false in many cases. Talking about people committing suicide after losing all of their money day trading tulips and families going broke and children starving because their dads were getting drunk in the tavern trading tulips and tulips were going for the the cost of houses and one tulip was traded a hundred times.

But what happened is that that guy the German writer in the 18th century wrote his book stating all those propaganda sources and satirical pamphlets as fact, as if they actually occurred. And then that got passed into Charles Mackay’s book and now we all use Charles Mackay’s book as saying this is what happened in Tulip Mania. But it’s all based on satire and propaganda.

Rick Ferri: Stop, stop. So are you telling me that it didn’t happen?

Jamie Catherwood: So there were people who were trading tulips, but the narrative, that one like that it crashed the Dutch economy is just false. It was like a very small siloed facet of, or kind of section of society. So Anne Goldgar, she spent years in Dutch archives looking through all these original sources, original paper contracts, that have carried on or lasted these few centuries, and the most she ever found a tulip traded like one single tulip was five times. But we always hear stories of the same tulip changing hands hundreds of times. And the other thing is that the way that they worked the contracts was, You know, I would agree to buy a tulip from you in the fall, and then I would receive the tulip in the spring, and so we would agree on a price.

But what happened was that a lot of those high prices, once spring came around those contracts were never actually completed or executed, and so there might have been high prices kind of written somewhere but they weren’t actually executed. And so the one that prices weren’t nearly as high as everyone says they are, because again, they’re being taken from these satirical and propaganda sources. But also a lot of those higher prices weren’t actually ever completed. So no one actually ever paid those prices.

Rick Ferri: So Tulip Mania never really happened, but it was sort of like a Hollywood movie in a way. And so let’s look at real actual history real facts. I mean where does it begin? 

Jamie Catherwood: A little bit earlier in Holland, in 1602, the founding of the East India Company and the stock market in Amsterdam, the first modern stock market was founded in 1609 and the Amsterdam stock exchange is the first modern exchange, and really though for the first kind of good chunk of its existence what’s interesting to think about today is that really the only stock that was being traded was the East India Company, so it’s just bizarre to think about today, if the entire stock exchange was like just Apple. It really was just this one stock. And then from there you had the London Stock Exchange, opened in the later 17th century, around the 1690s and that was the first tech IPO bubble, and then from there you had exchanges pop up around Europe for the rest of the 18th and 19th centuries, but the Amsterdam Stock Exchange in the first decade of the 1600s is where it all begins.

Rick Ferri: The first big tech bubble occurred in London in the 1690s. Can you talk about this tech bubble?

Jamie Catherwood: Yeah, so this is a really bizarre bubble in that it was prompted by a treasure hunt of all things. Basically almost all the financial history, especially for the 17th and 18th and 19th centuries, basically follows a pattern of huge war, government has a lot of debt afterwards, lowers rates, and then speculation abounds.  And so this is kind of the first major example of that, where after the Nine Years War Britain had all of this debt and they lowered rates massively and tried to refinance the debt.  So during the 1690s there was money to invest but people did not want to put it into government assets because the rates were low. Then what happened was Sir William Phipps, he went on a treasure hunt because he had heard that there are rumors of a sunken Spanish treasure ship off the coast of, I think, it’s Honduras, modern-day Honduras, and it was essentially the ship that was going back to Spain to bring all this gold back and then it sunk.

And so he went to London and got some, I called him in the article I wrote, kind of early venture capital investors, and he basically got them to form a joint stock company to finance his voyage, pay for the crew, the ships, supplies etc. and then they agreed what the splitting of the profits would be if he was successful in finding this treasure. And boy was he successful. He eventually found the ship and they hauled up 32 tons of treasure, which is almost hard to even picture how much treasure that is. And this small group of investors in the joint stock company that financed it each received its ten thousand percent return on their investment.

And so once news of this wildly successful treasure hunt and investment spread around London suddenly there was a boom in these new diving technology companies, which were basically predicated on the very simple thesis that they’re all kind of diving apparatuses that would allow a treasure hunter to breathe longer, and the thesis was if you can breathe longer underwater you can look for treasure longer and then increase the odds of you finding treasure. And so you had these booming companies called very straightforward and boring names like The John Williams Company for Treasure Hunting, or the Williams Apparatus Diving Technology Engine and they were all just trying to replicate the success of the original treasure hunter and trying to lure early British investors into these speculative ventures. And none of them worked out. There was never any instance of treasure being found again. Of the companies that were in operation in 1694, by 1697 seventy percent of them had been wiped out so it was not a good time to be chasing returns in a new technology company.

Rick Ferri: Sounds like some of the dot-com companies in the 1990’s.

Jamie Catherwood: Yeah exactly. It’s such a great parallel because they’re both in the 90s. 

Rick Ferri: Well after that then came the next bubble which was the South Sea Bubble and this did happen, correct?  And could you talk about it? 

Jamie Catherwood: Yeah this one did happen, very much so. First there was the Mississippi Company bubble in late 1719, and then going into 1720.  And essentially both the South Sea Company bubble and the Mississippi Company bubble were rooted in the same idea based on John Law, who was master of the Mississippi Company bubble. He came up with this theory that while the French government had so much debt and needed to figure out a way to reduce their debt burden and lower their debt expenses, their interest payments, he devised a scheme where he set up a company, the Mississippi Company, that was going to have exclusive trading rights with the Mississippi territory in the United States. And the idea was if the French government could convince its debt holders to exchange their existing government depositions for equity in this Mississippi Company, then they could reduce their debt obligations, because debt holders were retiring their debt in exchange for equity shares in this Mississippi venture.

So you can see how the kind of incentives quickly became misaligned because the government basically had to keep figuring out ways to pump up the Mississippi Company’s stock price in order to entice investors to part with their existing government debt positions and exchange it for equity. And so there was a mania because they were doing so much to pump up the price of this company. Then you had some investors pouring in to try and get a piece of the Mississippi Company, and inevitably it blew up spectacularly.

But what was really funny and kind of a testament to again investor amnesia and how investor psychology is just so brutal, that the whole time the Mississippi Company affair was going on, the British were pointing at the French and saying “These idiots in Paris, how are they, can’t they see that this is going to blow up spectacularly, and it’s going to fail? Like how could they be so stupid to stop this system of government debt for equity swaps.”

And then they did the exact same thing like six months later with the South Sea Company. It was literally the same. Again the British government tried to retire its debt by getting government bond holders to exchange their debt for equity in the South Sea Company, which was going to have exclusive trading rights with the new Spanish territories that had won independence from Spain. And again it ended up failing spectacularly.  But it was still the second time in thirty years, theme of government lowering rates are coming up with some scheme to try and address that massive debt burden and that fueling speculation. In this case with direct government involvement.

Rick Ferri: But there’s also bubbles that occur in an everyday common thing like beer, for example. Beer has been around for thousands of years and yet in the late 1880s there was a beer stock bubble in Europe and so you know something as common as say beer, which had been around forever, even that can create a bubble.

Jamie Catherwood: Yeah for the brewery stock bubble it was set off by the Guinness IPO. It formed as a joint stock company and began issuing shares in 1886. And that was a really speculative mania when that IPO happened. In those days obviously you had to go hand-submit your order for shares, and the day that the Guinness Company IPO’d the scene outside Barings Bank, who was underwriting the IPO, was just pure chaos. I think the IPO, the shares were oversubscribed something like by thirty times, and there was such a mad sea of investors rushing to submit their order forms that the Barings Bank had to order in a special police unit to barricade and block the doors.

And then what the investors did, it began tying their order applications like their buy orders to rocks, and hurling the rocks through the windows of Barings Bank in attempts to get their orders filled and so that they can invest in the Guinness company. So that kind of set off this whole boom in brewery stocks as a bunch of other domestic brewing companies started to issue shares as well, to take advantage of the speculation. 

Warren Buffett once called it the three “I’s” which is the innovator, then the imitators, and then the idiot. And a lot of bubbles in history follow that exact progression.

Rick Ferri: After beer came bicycles.

Jamie Catherwood: Coinciding with the brewery bubble of the 1890s there was actually a shortened and more intense bubble that was running alongside it, in the form of a different transportation mania than we would recognize today with the electric vehicle speculation going on. Actually it was the bicycle that was really captivating investors back in the 1890s. And what was happening there was before the kind of modern bicycle frame we would recognize now that kind of diamond frame there were the Penny Farthings, which if people don’t know by name those are the bicycles that you see in old movies where there’s the massive front tire and then the tiny back tire. 

And essentially what happened in the 1890s was there’s a few technological innovations in the bicycle industry that led to the creation of the modern frame we recognize now, with the two equally sized tires, and basically exactly what the bicycle frame looks like today is what it looks like 100 plus years ago. And there were some innovations around the tires, the welding of tubes to create the frame, and there were some innovations in the ball bearings that were used. The reality was that bicycles kind of took over the UK population by storm and really had some far-reaching implications for society outside of financial markets in terms of, believe it or not, progressing women’s rights because females were buying the bicycles as well. But they at that time were wearing very formal clothing. It actually modernized women’s wear because they couldn’t ride a bicycle while wearing those huge, like fluffy dresses, you know, with all the frills, because they get caught in the spokes etc.

But for financial markets, as people around the UK started going crazy about the bicycle and buying them en masse, the returns for the initial bicycle companies were fantastic and as usually happens in history that led to an explosion in copycat companies starting up trying to capitalize on the latest fad. And so you ended up having in two and a half years 671 bicycle companies IPO, which is just absolutely insane. I think in the fourth quarter of 1896 there were 156 bicycle companies that went public.

Rick Ferri: Let’s get into another bubble, and this happened in the US also and this is the railway bubbles.

Jamie Catherwood: I think it was Jack Kenneth Galbraith who said that nothing was more fascinating than watching men quickly forget the previous railway mania and go like head first into the next one. Because during the 19th century there were three railway manias in the US and the UK. The first one was in the UK in the 1840s and that was its own spectacular mania and bust. And then in the US there was one in the 1850s and one in the 1870s. And what’s interesting is that the first railway mania in the US was less catastrophic and it’s not even widely recognized in the historical literature. Most people just focus on the second railway mania, but the first one was almost as big and it was not as spectacular a bust as it was for the second railway mania. And there was a lot more money made in the first railway mania without as much of the catastrophic losses.

But in both periods, from 1865 to 1873, there was 30 000 miles of railway track laid. And by the late 1890s, especially in the Panic of 1893, when the kind of financial markets contracted and credit got tight, there was a massive wave of bankruptcies for these railroad companies that suddenly could not get financing for their operations any longer, and their spectacular bust.

But one of the interesting points about railway mania, even though there was this spectacular boom and bust, there was actually a benefit to society afterwards because during that speculative period we laid the groundwork for the railway system in the United States. So even though speculators and other financiers might have been left holding the bag afterwards, they still benefited society because we got to benefit from the railway track that had been laid.

Rick Ferri: Now that’s an interesting point, and you bring this up in one of your lectures is that a disaster for investors is often a real positive for society and even the economy, but people lose money.  In all of these manias that take place there’s so much capital being thrown at a particular industry at one time that it causes innovation which is good for society but a lot of people lose money. I want to read you a quote from Warren Buffett, and Warren Buffett is famous for losing money in the airline industry, and this is what he said in his 2007 Berkshire Hathaway shareholder letter:

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth and then earns little or no money. Think airlines here. A durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed if a far-sighted capitalist had been present at Kitty Hawk he would have done his successors a huge favor by shooting Orville down.”

And he’s right. I mean look at how airlines have really benefited society and benefited the economy and have been a real positive for all of us to get all over the world. And yet, in aggregate, I don’t think any money has ever been made in the airline industry.

Jamie Catherwood: It’s a great quote. Perfect way of illustrating the point we were just talking about, where the speculators, you know, Wall Street investors might be the ones that suffer in the crash but society as a whole, outside of that small group speculating in the industry, benefit from the aftermath. It’s like in the tech bubble when well most companies went bust in the tech sector there’s still the groundwork laid with fiber optic cables etc, that later was built upon the company that survived. And new companies used that groundwork to build more durable companies on top of it right. Right place, wrong time.

Rick Ferri: Yeah, the fiber optic. We’ve got Worldcom, Exo Communications, mean the list goes on and on, these companies that are no longer around today, but they built out the fiber optic network that we currently have that we all run our computers on, and we all can talk to each other. In fact I’m talking to you now over five optic cable because I’m using voice over IP.  Sorry you lost money, but it’s an advantage to everybody that speculators did do this, and we could see it over and over. We probably see it right now in many different industries if we just sit back and we look at it. I mean the space industry, right? I mean this is like a big thing now, all these very wealthy people are putting money into the space industry where, I mean, they can’t all be profitable in the long term. But in the end it’s going to benefit everybody.

Jamie Catherwood: It’s the phoenixes that rise from the ashes, there’s going to be the wipeout, but the companies that emerge and are still around are usually the ones that go on to be the dominant players in the industry. So at this point, I mean, I don’t know anywhere near enough about space exploration to go into any of the companies, but like you said you can imagine that they’re not all going to be here in 15 years but there will be some that remain as the dominant players that are probably already in operation today.

Rick Ferri: There is also innovation when it comes to investing. The first mutual fund was created back in 1774, where the creators of that fund realized that you need diversification. So they innovated products that looked like mutual funds back then. I know this isn’t all another part of your research. If you could talk about the innovations to allow commoners, if you will, to invest in these companies, but do it in a diversified way.

Jamie Catherwood: This first mutual fund in 1774 also came out of a crisis. So basically what happened was there was a Dutch broker that was named Abraham van Ketwich. After the summer of 1773 he saw the East India Company, their share prices tanked and there was a lot of financial ruin in London, but there were also a number of large Amsterdam financial institutions that had been heavily exposed to the East India Company. And so when the share prices tanked it almost wiped out most of the Dutch major banking institutions. And people realized “oh you know maybe it’s not a good idea to just have everything riding on the price of one single stock,” and so while the wealthy elite might have had the ability to buy and sell shares of other companies and then so they could have a diversified portfolio, the average small investor didn’t have a way in that time period to access the market without buying all the individual shares himself. Which put that kind of access out of reach for many small investors. 

And so after the experience of watching this one stock almost take out the entire financial industry in Amsterdam, Abraham van Ketwich decided that he was going to come up with a fund that would be able to offer access to the broader market for smaller individuals who could just buy shares of the fund rather than buying the underlying shares individually and so I’m not going to try and pronounce the Dutch name of the fund, but it translates to “unity creates strength,” which I think is a fantastic name for the kind of first diversified mutual fund because again, unity diversification creates strength. And so what the fund was it was I believe roughly 50 bonds split across 10 different sectors of bonds. So there were some plantation loans, which were kind of interesting because they’re almost an early mortgage-backed security, but there are mortgage loans, kind of canal and turnpike bonds, and then various kinds of local government bonds. But what was interesting is that it was equally weighted across all of these 10 categories, and I think specifically in the prospectus it mentioned that one, it said we will hold these investments as proportionate as possible to maximize the diversification benefits or we will not let any single position be more than I think three percent of the portfolio.

But what was really crazy is well two things. The first is that it was very reminiscent of a modern kind of passive bond fund in the sense that even back then the fees were relatively low, even by modern standards. It worked out to about 20 basis points a year, which I mean now you can get you know probably for two basis points a passive bond fund. But still 20 basis points is fairly low.

But the craziest part about this fund was they recognized that active management, and again this is all in the wake of watching banks get almost wiped out by one stock, so in response to that this fund was heavily focused on no kind of active stock picking, or in this case, bond picking, and no real human element. And so to reduce the ability for the portfolio managers to make rash decisions they bought the underlying shares or the bond certificates and once they held these certificates, to prevent themselves from being able to trade they locked all of the certificates into an iron chest that had three locks, and there were three portfolio managers. So if there was ever a time where one of them wanted to trade they would not be able to get access to it and it was only if all three portfolio managers came with their special keys to unlock this iron chest that they would be able to make active investment decisions.

Rick Ferri: So basically you were talking about here is investment management by committee, which is quite popular nowadays.

Jamie Catherwood: Yes, exactly. It’s kind of a team exercise, and it was interesting but it’s like well and truly because it is low cost diversified and passive. It’s really the first passive bond index fund.

Rick Ferri: And how did it do?  I mean was it accepted? I mean this is a really novel innovation in 1774.

Jamie Catherwood: Yeah, unfortunately it didn’t actually do that well. But it was a huge step forward for the industry and laid the foundation for future funds. What is kind of interesting is that even though he started with this passive bond fund his next fund, Abraham van Ketwich, was in 1779. This one was the world’s first value fund because while the previous prospectus had been talking about how it was strictly going to be kind of passive equally weighted et cetera, in this prospectus for the 1779 fund, it explicitly stated that the fund would seek securities that you were able to buy below its intrinsic value. So explicitly stating that where yeah that the fund would have a value bias. So this guy was really quite the innovator, but it’s funny to me that he moved from passive to active in a five-year kind of time span.

Rick Ferri: So quantitative analysis really began in 1779.

Jamie Catherwood: Yeah, I guess so.

Rick Ferri: Interesting. Let’s fast forward to 1929 where you have isolated this as the next innovation in mutual funds.

Jamie Catherwood: Yeah, so in the same way that I described where in the crisis of 1773 that spawned the kind of first passive bond fund in 1774, after the 1929 crash there were a large group of investors who became disillusioned with the actively managed investment trust that they had been putting their money in because, in their minds, the reason that they were paying these managers the high fees was because they expected their expertise to pay off during a crash like 1929, and, you know, outperform the market and save them money. But in reality most of these trusts were highly levered and did the exact opposite, so a lot of people lost their money despite paying these active fees. 

And so there was a growing frustration and disillusion with the actively managed trust industry. And it was again in that environment where the next iteration of passive funds was born in the form of fixed trusts, which is aptly named because what the fixed trust meant was once they launched the fund they were beholden to those specific investments and were not able to make active decisions. And this was very popular because of the experience that investors had with active funds in the ‘29 crash.

And so quickly you had an explosion in these trusts as both asset managers realized that this was the movement that they should adopt. And so they started pumping out these trusts for people to put their money in. But like I mentioned with the progression of Abraham van Ketwich from passive to active, what was interesting is that the fixed trust quickly became what they called fixed unit trusts where the line between active and passive started to get blurred a bit. 

Because what would happen is if you put out your fixed trust fund in 1930, but there were 50 securities and then some of them ended up getting bought out or going bankrupt et cetera, you still said that you’re going to be invested in 50, so they had to be replaced, and so how do you replace them because you said you were going to be fixed and hold onto those set securities. And so the management teams started coming up with early factors for deciding what securities would be eligible for replacement, and from there you had funds that were then using those replacement rules as their guiding rules for investment.

So there was a fund that said if any security in our portfolio drops below their five-year earnings average then it will be sold out of the portfolio. So I mean right there it’s kind of like an earnings based metric. And so it’s interesting to see this again, passive to active transition, but they were really the first and it’s so little talked about, which I find interesting because it’s not that long ago and it’s around one of the most famous crashes in US history. But they were really the first kind of modern index funds.

And another bizarre example from one of these passive trusts was in general these trusts had a more set timeline which is also interesting. So the fund would exist but it had an end date of say 30 years out. So you couldn’t necessarily hold it for 50 years; there was an end date. And you could roll it into the next fixed trust that they offered. But one trust, and a couple others followed suit, started saying, you know we’re actually going to break up this fixed trust earlier, but we’ll give you the option to roll over your money into one of our actively managed trusts with higher fees. And so you can see that the financial services industry wasted no time kind of misaligning incentives with the smaller retail investors and trying to push them into higher fee funds.

Rick Ferri: But the modern mutual fund, meaning the open-end fund where the manager could just buy and sell at will, I believe the first one was created in 1924, Massachusetts Mutual Trust I believe it was, and this was a little bit different in that it wasn’t fixed — the managers had the ability to buy and sell within the trust, and then that became the popular vehicle for doing mutual funds for well all the way up until the ETF was innovated in 1993, at least in the United States, although the Canadians will argue that they had the first ETF out earlier than that.

Jamie Catherwood: Before I forget. What one interesting point left on this fixed trust is that from a Jason Zwieg article, one of those fixed trusts, I think  from 1935, is actually still in existence. If you just google Jason’s “The Fund That Does a Lot” I’m sure you’ll find the article. But it’s interesting, we can kind of see out of the original 50 stocks or whatever the trust chose in 1935, what’s happened to those securities and how did they perform in the ensuing almost 100 years.

Rick Ferri: In my view the next big innovation occurred in the 1970s and that was the innovation of index funds and that happened for a lot of reasons. But I think there was a change in the securities industry that brought the brokerage firms a little bit to their knees, and actually created discount brokers. And that was the elimination, basically by law, of fixed commission rates, where you didn’t have to pay an arm and a leg to buy shares of stock. So now when that was eliminated you gave fund companies the ability to have massive diversification in their mutual funds and that really helped to create the first index fund which Vanguard and Jack Bogle created. I did a podcast by the way with Jack Bogle, the very first podcast I did Bogleheads on Investing.

Jamie Catherwood: Oh, really.  Starting strong.

Rick Ferri: In fact it was a few months before he passed away so, it was one of the last things he actually did publicly and in there, that podcast, podcast number one of Bogleheads on Investing, we go through that history of the creation of the first index fund and how it all came about. It was really fascinating to listen to him talk about it. There’s some stories there that you just wouldn’t believe. It almost didn’t happen, it’s like a miracle that the first index fund actually happened. But let’s go on to a different topic, and that is: in all of your studies of bubbles and busts let’s put together a laundry list of things that you have found help create a bubble, or get a bubble going in anything, beer, bicycles, railroads, whatever it is. What is the making of a bubble?

Jamie Catherwood: So I’m going to divert your question to an excellent book by John Turner and William Quinn that just came out earlier this year, or last year I guess at this point, called Boom and Bust, and I really like the framework that they put together. They used the fire triangle, which is typically the three sides of the fire triangle are oxygen, fuel, and heat and then there’s obviously the initial spark that sets it all off. But with those three sides of the triangle, oxygen, fuel and heat, that’s what keeps the fire going and spreading. But if you lose one of those then, the fire goes out.

And so they replaced those sides of the triangle and made them more applicable to finance. Where you have the first side of the bubble triangle is oxygen, and in this case for finance its marketability, and by that they don’t mean like marketing and advertising, but the ability to easily buy and sell shares in an asset.

Rick Ferri: You mean like the securitization, like securitizing something.

Jamie Catherwood: Exactly. And so after that you then, I guess, the grease that keeps it going or the fuel which is money and credit. So in this case low interest rates, access to cheap money and cheap credit, which helps sustain a boom and creates a bubble. And then on top of that you have the heat which keeps everything going, which is the speculation. So in addition to all this you have to have the people that are actually going out and speculating in this and keeping it going. And so those three sides are what keep the bubble going. But the spark that initially sets it off, these two authors posit that it’s usually politics and/ or technology that initiates the bubble.

And so some examples from that in history, the technology ones are obvious. I mean the tech bubbles, some of the ones we’ve talked about already with the treasure hunting bubble and bicycle mania et cetera, those are technology based.  But then in terms of the government’s involvement, the South Sea Bubble, which we touched upon, is another great example where that was the government stepping in and really creating a bubble out of nothing by instituting this ridiculous government debt for equity swap where you could exchange your government bond holdings for shares in a government-backed public equity venture in the form of the South Sea Company. 

So obviously this doesn’t apply to every bubble that’s occurred but I think it’s a useful framework for figuring out when and why bubbles occur.  Because in almost all of them you have these three sides and the original spark is usually related to politics or technology.

Rick Ferri: So we have the oxygen which is the securitization, if you will, I mean the availability of the asset that eventually becomes a bubble whether it’s through the IPO market or some new innovation, or in the financial industry, but you actually have the product that is going to become the bubble — the marketability of it, as you say. And then you’ve got the willingness of creditors to loan money on it or give you money to go out and buy this thing. Access to cheap money, as you said people would borrow to buy these things. And then finally you’ve got interest, which is the speculation. I imagine that the speculation or the heat, if you will, is it starts out with a spark, I mean somebody must make a lot of money doing one of these things. And then that’s in many ways the spark that gets everybody going. Like, I recall we were talking about Guinness beer, like that was the first beer IPO that came out, and it was just everybody was familiar with it. Now it was available and people started making money right away, and that was a spark that caused the beer bubble.

Jamie Catherwood: Yeah, exactly.  And I think last year actually, there’s a great example of that where I personally don’t think that it was a coincidence that the kind of explosion in electric vehicle hype coincided with Tesla’s original really impressive run earlier in the year, where by that point, I think by the time Nicola went public via, it’s back I want to say is either May 4th or June 4th, Tesla was already up like a couple hundred percent for the year. And then coupled with stimulus checks and people working from home there was already that kind of speculative presence, and with a name brand like Tesla and younger investors coming into the market and seeing the returns there, then the kind of natural progression was “Where’s the next Tesla?”

Rick Ferri: The imitators.

Jamie Catherwood: And then, ironically, people turn to Tesla which shares the name with the original company Tesla, and it’s just the guy’s first name Nicola, and that ran up, however I think it was up 80 percent at one point, and the company’s first quarterly earnings had revenues of $36,000. And that was all derived from installing solar panels on the chairman’s house, so there was no actual real product or earnings, let alone the meager revenues that were not even related to the company’s main operations. But let alone the stock soared and there’s still a ton of electric vehicle companies going public via SPAC or announcing deals and having kind of astronomical share price returns. 

Rick Ferri: Well we’re going to talk about special purpose acquisition companies in a minute, which are SPACs, but where you hit on something though, and it’s something that Warren Buffett said right you start out with innovation, and then you go to imitation, and then the next step is idiocy. Is that what he said?

Jamie Catherwood: Yeah.

Rick Ferri: And here’s where things get crazy. I was just reading yesterday about a special purpose acquisition company and this came public, this is actual public. Okay they raised 69 million dollars. The tick around this is J- A -A- C so phonetically it’s juliet, alpha, alpha, charlie and it’s called Just Another Acquisition Company, that’s what the name of the company is. Management wrote in an S-1 that Just Another Acquisition Company may pursue an initial business combination target in any business, industry, or geographical location. This is the company and this came public.

Jamie Catherwood: It’s like the famous story from the South Sea Bubble where there was a prospectus for a company but no one is to know what it is.

Rick Ferri: That’s right. Anyway, so again getting back to Buffett, there’s innovation, there’s imitation and then there’s idiocy. And I have to look at that and say this is kind of like pure idiocy. Who am I to know?

Jamie Catherwood: Well the problem is there’s too many examples of idiocy. With these facts it’s hard to pinpoint who the exact idiot is.

Rick Ferri: Let’s get into then the bust. So we’ve talked about what creates the bubble. What then creates the bust? 

Jamie Catherwood: So there are a lot of different ways that the bubble gets pricked throughout history, but again in this boom and bust framework the authors argue that by removing one of those sides then that leads to the collapse of a bubble because you need all three of those to sustain it. And so in terms of cheap money and credit, if rates are suddenly hiked unexpectedly or maybe at a much faster and higher rate than expected, that can help prick the bubble because financing dries up and leads to a credit crunch. If for whatever reason speculation dies down then there’s a just feedback loop where those speculative stocks will drop in price, and they’ll continue to drop in price because then the people still speculating will be less inclined to keep buying it because it’s going down. 

But then also, with the marketability, if something happens and shares suddenly aren’t as liquid as they were previously, that can lead to problems and bank runs if people suddenly aren’t able to as easily buy and sell their investments.

I’ll add a few things here under when people are not able to easily buy and sell investments and sometimes the government will get involved and they’ll clamp down on margin, they’ll clamp down on short selling, they’ll do things that will cause the market to dry up. And that can create a catalyst for the bust. And then another thing, by the way, before we even get to the government stepped in, it seems like a lot of times fraud. 

Yeah, so that’s a great one that I usually mention, and going back to some of the lessons from the online course I put together, one of the lectures was done by Jim Chanos, the short seller, and he has what I find a fascinating kind of framework for looking at fraud and the market cycle. Where he has said that the fraud cycle operates at a slight lag to the market cycle. And you just think about it from an investor behavior standpoint, it makes total sense, and the evidence supports this. Where once the market starts going down a bit, or there’s not as much frenzy and speculation going on, that leads to problems for fraudulent companies because any kind of wrench in the gears brings everything to a halt. And so what you tend to see is that when people start to lose money in a previously high returning but maybe fraudulent company, they start scrutinizing their investments much more and that’s usually when the fraud gets uncovered.

Rick Ferri: Warren Buffett had a great quote here too. He said, “When the tide goes out you get to see who’s swimming naked.”

Jamie Catherwood: Exactly.

Rick Ferri: Let’s move ahead to today. Let’s look at where we are today, and I don’t want to make any market timing decisions, but what do we have going on today that would be reminiscent of boom and bust?

I mean we certainly have low interest rates from even lower than the inflation rate, so that’s one factor of the triangle. I think another factor in the triangle is the oxygen or the marketability when we talked about these special purpose acquisition companies which are nothing more than shell companies which come public for no stated reason. A lot of them are celebrity-backed, like you could name some celebrities.

Jamie Catherwood: I think Shaq has a SPAC.

Rick Ferri: Shaq has a SPAC. And then they go out and they acquire a private company and it’s a backdoor way of getting that company on the market without having to do a traditional IPO. Hundreds of these things have come out.

Jamie Catherwood: And in terms of marketability, you were talking earlier about the end of fixed commissions. Today we have that again to a more extreme level with introduction of commission free trading in the fall of 2019. And that coupled with fractional shares says I don’t know how you could make buying and selling stocks any easier. At this point you can do it on your phone in fractional purchases and with no commission so I don’t know how else you can reduce the friction of buying and selling.

Rick Ferri: So we have the oxygen with the SPACs seeming to continue to come out. We’ve got the fuel which is very low interest rates. We’ve got some speculation going on. New stocks that have very little revenue shooting to the moon. You have to step back and say is the market, the US market getting a little bit fraught.

Jamie Catherwood: I also think it’s just strange how you have this kind of bifurcation and there’s like the dichotomy of bubbles and speculative excess like you just mentioned, but at the same time you now have value after a decade plus of value underperforming, and at the same time that there’s all these bizarre speculative mania’s going on. It’s also at the same period where value is starting to perform well again.

And I feel like with the SPACs and electric vehicles and, you know, Gamestop, etc., those feel bubbly and they’re definitely speculative, but it’s siloed. There’s a, I think James Macintosh at the Wall Street Journal, he recently wrote an article using the bicycle bubble as an example, where he was talking about how even when the bicycle boom bust it didn’t have any broader impact on the economy. And his point was that there can be bubbles that boom and bust but the overall market isn’t affected. And if some of these electric vehicle companies went south that wouldn’t necessarily impact the broader market. It’s different than if every sector in the S&P was feeling speculative, but it’s these small enough industries and sectors that I feel like there are bubblish signs but they’re mini bubbles.

Rick Ferri: So I like the word “silo”. You said a great siloing these things is right. There are bubbles in some areas of the market but will it affect the whole market, maybe not. Jamie this has been really a great conversation. Thank you so much for your time and the name of the website is Investor Amnesia. So I have one last question for you. When is the book coming out?

Jamie Catherwood: Whenever I can have time to write one. That and hosting a financial history podcast are things I often get asked about and I always respond that I would love to do them; I just barely have time to do the work I’m already doing, so I don’t know where a book or podcast are going to fit in.

Rick Ferri: Well thank you again for being on the show Jamie.  I’ve really enjoyed the conversation and look forward to many great things coming from you.

This concludes Bogleheads on Investing episode number 31. I’m your host Rick Ferri. Join us each month as we interview a new guest. In the meantime visit bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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