The Panic of 1873 and the hard trade.

Many people know the story of Baron Nathan Rothchild telling clients to buy when there’s blood in the streets, even if it’s your own. However, many people don’t know when the quote is from, nor the context in which it was made: The Panic of 1873.

Here in the US, the Panic of 1873 (which started in 1869) was a combination of railroad speculation, a run on physical gold, and brand-name bank and brokerage houses failing.

Across the pond, in Europe, it was much, much worse. And it gave one of the world’s most legendary capitalists the chance to make a fortune for himself and his friends.

I’m talking about Baron Nathan Rothschild. Rothschild was a respected French investor who became the stuff of legend during the financial crisis.

There are numerous resources describing the Panic of 1873 as THE big depression experienced by the world. Writing in 2008 in the Chronicle of Higher Education. Scott Reynolds Nelson wrote:

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad. Britain, the biggest importer of wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872 kerosene and manufactured food were rocketing out of America’s heartland, undermining rapeseed, flour, and beef prices. The crash came in Central Europe in May 1873, as it became clear that the region’s assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.

He concludes with:

In the end, the Panic of 1873 demonstrated that the center of gravity for the world’s credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India.

I would encourage readers to click through to the entire (short) read here .

Now, here are two pictures:

(from the Panic of 1873)

(Spanish workers protesting austerity. From the Telegraph yesterday.)

The article in the Telegraph points out:

Socialist leader Alfredo Rubalcaba said the cuts would push the country over the brink. Over the next year we are going to see the destruction of 600,000 jobs, taking us deeper into depression, he said. Unemployment is already 24.4pc, topping 32pc in Extremadura.

There is no money left to pay for services, said treasury minister Cristobal Montoro, calling for years of hard sacrifice. We have to raise VAT to stay in Europe. There is no other option. All alternatives are worse. This has gone beyond ideologies.

I guess when there are no options, even bureaucrats realize there are no options. All seems so bleak, and readers already know I think the euro is doomed. Which means that it might be time to look to Europe for our opportunities as that is really THE HARD TRADE!

So let’s talk about valuations, forward expectations, and some hard trades.

On May 4, the Financial Times quoted Russell Napier and Andrew Smithers, both great researchers with a long term perspective. Andrew Smithers has been quoted here often for his work on the bringing Tobin’s q-ratio into the mainstream.

From Napier:

…Napier, I’m sorry to tell you, damns the idea of value with very faint praise. He uses the cyclically adjusted price/earnings ratio (Cape, which takes ten years of earnings into account) for the simple reason that it (along with the Q Ratio of stock market value relative to the replacement cost of net assets ) is just about the only valuation measure with any history of predicting long-term returns.

Right now, the US market Cape ratio is 22 times. It’s been more expensive than that. But 22 times is near the top of the range. the average over the period 1881 to 2012 – and the level that suggests real returns of 6 per cent over the following decade – is more like 15 times.

Buy at 22 times, says Napier, and you can expect to make only 0-4 per cent a year over the next decade.

Worse, Cape isn’t much good at telling you what will happen in the short term, so there is every chance that, on the way to making very little, you might lose a lot several times.

What you really want to do is to wait and buy when the market hits – or falls below – a Cape ratio of 10 times. Investors who have bought there (in 1929, in 1937 and in 1977) saw real returns of between 11 and 23 per cent in the following 10 years.

For a full chart of the US CAPE using data from Robert Shiller. click on the chart below:

Not at the highest it’s ever been, but certainly not at the most attractive levels by a long shot.

What about using the q-ratio?

Again, the q-ratio shows the market around 25-30% overvalued relative to its long term average. Of note in both cases is just how long the under/over-valuations can last. Certainly as timing tools, both CAPE and q-ratio are lacking at best. That doesn’t make them less useful; indeed, for setting strategic allocations and long term plans, they are one of the key tools.

Tying it all together, we know that we should be buying when there’s blood in the streets, and at the same time US markets look to be overvalued on long term valuation metrics. How do other markets stack up using the same metrics?

On June 1, the Financial Times wrote a follow up piece, quoting Russell Napier again:

Russell Napier of CLSA (who provided me with the Cape numbers) tells me that Portugal, Ireland, Italy, Greece and Spain are all well into buying territory if you look at them on a ten-year view (this is, to be clear, not the case in the UK or the US).

Greece is on a Cape of 1.8 times (the long-term average for most markets is around 15 times). Buy at a Cape of under 10 times, and history suggests you’ll see a compound annual growth of more than 14 per cent in the next decade.

Then, Mebane Faber took it a step further:

I was reading an article from one of the banks that was talking about how low Greece’s CAPE was (the article cited around 2). I wanted to examine what happens when a CAPE was really, really low. So, we looked at the database for all instances where CAPEs were below 5 at the end of the year. We only found nine total out of about 1000 total market years.

US in 1920

UK in 1974

Netherlands 1981

South Korea 1984,1985,1997

Ireland 2008

and…Greece in 2011

Can you imagine investing in any of these markets in those years? Me neither. In every instance the newsflow was horrendous and many of these countries were in total crisis.

Now what would happen if you invested in these markets, the literal worst of the most disgusting terrible markets/economies/political situations? Below are local country real returns (net of inflation):

Conclusion: In the next few days and weeks, as the newsflow becomes ever-worse, I’ll be increasing our allocation to Europe through a variety of vehicles, focusing mainly on the most beaten down countries, with the lowest valuations metrics, and the most investor fear. I’ll allocate out of our best performers, including the high yielding sectors that have done so well for us, including utilities and some real estate exposure. I am probably early, and the moves will feel risky, and against conventional wisdom being peddled in the advisory world. That makes me all the more confident that the moves are correct. The numbers and the sentiment suggest that the shifts are correct for our long term investors.

Editors Note: Yaron also writes and edits The Hard Trade. a financial newsletter focused on risk and asset allocation, behavioral finance, contrarian investing, global macro-economic themes, and geopolitics.