We Study Billionaires - The Investor’s Podcast Network - Classic 05: A History of 5 Stock Market Crashes w/ Scott Nations

Starting point is 00:00:00 You're listening to TIP. On today's classic episode, Preston and I decided to play episode 280 that originally aired back in February 2020. We felt it was very timely to choose this specific episode as the stock market has been crazy volatile lately, with the S&P 500 in correction territory, and the NASDAQ continuing to slide. In this episode, Preston and I speak with Scott Nations.

Starting point is 00:00:23 Scott is the author of the book, A History of the United States in five crashes. If you are a financial history buff like Preston and May, you're going to love this discussion. So without further ado, let's explore what you can learn for history and how it applies to us today. You are listening to The Investors Podcast, where we study the financial markets

Starting point is 00:00:46 and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Hey guys, welcome to The Ammasters Podcast. I'm your host, Stake Broderson, and as always, I'm here with my co-host, Preston Pish. Today we hear with best-selling author Scott Nations to talk about his book, A History of United States in Five Crashes. Scott, welcome to the show. Thanks so much. It's great to be with you.

Starting point is 00:01:22 So, Scott, in this episode, we're going to be talking about the crashes of 1907, 1929, 1987, 2008, and the flash crash of 2010. I'm sure some, if not all of those years are very familiar for a lot of people in our audience. but let's start all the way back to 1907. And for people not familiar with this crash, J.P. Morgan was a key character in this crash. So talk to us a little bit about him and talk to us about the characteristics of the 1907 crash. J.P. Morgan was a fascinating man. He was a fascinating man. He was a man of privilege. He was born into privilege. His father was Junis Morgan, who was, well, essentially made the family even more wealthy by selling Civil War bonds in. London during the American Civil War. J.P. Morgan was educated, as you would expect somebody of his

Starting point is 00:02:14 wealth. He had a peripatetic education. He was obviously educated in the United States, but also in Switzerland and in Germany. As a young man, in Germany, he developed an appreciation for art, actually a love for art, which informed his private life. But J.P. Morgan was really raised be a banker. In the early part of the 20th century, he was by far the wealthiest man on Wall Street. Well, maybe not the wealthiest, but certainly the most powerful. He was absolutely the most powerful man on Wall Street. He was called the Zeus of Wall Street. And he really was involved in every aspect of finance in the United States in the first part of the 20th century. Now, if we go back to October 1907, the market crashed almost 50% from the previous year's peak.

Starting point is 00:03:07 The panic might have been even worse if it hadn't been for JP Morgan. And he pledged some of his money and convinced others to do the same. Perhaps you could tell us some of the factors about what caused the crash, but also the story about Morgan's intervention in the market. It's a very fascinating story. Before 1907, the United States was really beginning to understand that it was going to be the American century. It was powerful. It was probably at that point the most powerful country on the globe.

Starting point is 00:03:41 And so, frankly, the United States got carried away with itself. And we'll talk about some of the specifics of some of these crashes and how these shared some similarities in a bit. But you asked specifically about Morgan's intervention. the market. This was before the U.S. Federal Reserve existed. In fact, the panic of 1907 was the cause the Federal Reserve was created. But if you were worried about the market, you were worried about the panic of 1907, the person you went to see was J.P. Morgan, because, again, he was so powerful. And one example occurred in the midst of the panic on Thursday, the 24th of October of 1907, when the president of the New York Stock Exchange went to J.P. Morgan at the time his office

Starting point is 00:04:29 was directly across the street from the New York Stock Exchange. Very simply, Mr. Morgan, we will have to close the exchange early. There's simply too much selling. And J.P. Morgan understood what that meant. His question was, how in the world do you ever reopen a stock market that you've been forced to close because there's too much selling? And so, J.P. Morgan asked, when do you normally close? Well, sir, we normally close at three o'clock, but we can't get there. There's too much sign. He said, then you will not close one minute early. And his confidence was, it was not naked. He rounded up bankers in the Wall Street area, got him all into his office. It was a time when if J.P. Morgan called, you came running. And he told the assembled bankers, you have 15 minutes to raise $25 million to save the stock market. $25 million back then was a colossal amount of money. But J.P. Morgan essentially said you have 15 minutes to raise this money or the stock market is going to close and who knows when it will ever reopen.

Starting point is 00:05:38 And that's just one specific story of his involvement. That's not the first time he did something like that. Probably the most immediate. But within 15 minutes, they had raised actually more than $25 million. dollars. Officials were able to go on the floor and say, we have $25 million to lend to investors who are in trouble. People were so desperate to get this money that the clerk who was responsible for recording borrowers and amounts had his suit coat ripped off of him in the turmoil. So J.P. Morgan was really the man, the single man, who managed to save the stock market in

Starting point is 00:06:14 1907. So, Scott, you briefly mentioned that the panic in 1907 was the reason for the creation of the Federal Reserve. Talk to us a little bit more about that idea. It became obvious to everybody after things had settled down after the panic of 1907. The United States government needed a way to inject liquidity into the system and didn't have it. And that there needed to be a lender of last resort, if you will, for the financial market. And that didn't exist. And that didn't exist. before 1907. And so the Federal Reserve was created in 1913 because everybody realized, if nothing else, J.P. Morgan's not going to live forever. And we can't rely on one man, one person, to essentially bail out the stock market in times of stress.

Starting point is 00:07:01 Let's turn to the next crash. The crash in 1929. And to really understand what happened, And we also have to understand how crazy the market behaved in 1927 and 1928. And I think you do a fantastic job of that in your book explaining everything leads up to the crash. In 1928, the Dow closed in 300, which probably to the list is out there seems outrageously cheap, but it was definitely not the case. And this was at the end of the second biggest two-year run ever. It was actually more than 90%. So, Scott, what drove the all-time highs leading?

Starting point is 00:07:40 up to the crash in 1929. In the late 1920s, actually much of the entire decade, but particularly in the last half of the 1920s, there was simply a euphoria at work in the United States that was not just financial. It had to do with the United States place in the world and from a military point of view, also from an industrial point of view. So as you pointed out, in 1927 and 1928, the stock market gained more than 90%. we had come out of World War I.

Starting point is 00:08:12 We felt great about our place in the world. But there were also some other things that work. For example, in a situation like that, with an economy roaring like that, a stock market booming like that, you would expect the Federal Reserve, which it was new at the time, you would expect him to raise rates. One Federal Reserve officer at one time described it as taking away the punch bowl when the party really got going.

Starting point is 00:08:37 And the Federal Reserve did not do that. They kept rates low, they kept rates too low, largely because they wanted to help England return to the gold standard after World War I. That was a tragic mistake, keeping rates that low. There was also a roster of new technologies that were unleashed following World War I. Radio would probably be the biggest, but also the automobile industry really got going, really came into its own. And then America just felt good about itself.

Starting point is 00:09:07 And so all of those things spawned this euphoria that eventually made its way into the stock market. And the stock market got carried away with itself. It's very interesting, and you mentioned that before here with the Federal Reserve. Could you talk more about which actions did they take? You already, again, briefly touched upon that. But if you should outline and put some years on, like before, during and then, especially after the crash, It was very interesting the type of monetary policy that the Federal Reserve decided to carry out. The Federal Reserve really started making errors in policy in 1924 when they were essentially begged by the British government to help them get back on the gold standard by lowering interest rates here in the United States.

Starting point is 00:09:53 And they did that. And they continued that sort of policy. And eventually the Federal Reserve simply lost control of the monetary situation in the United States. there was so much money being made by industry and individuals that they were happy to loan that money to stock market speculators. And that's sometimes called the call money market. All money is money that's available to investors to speculate with. And for a long time, that money had been provided by banks. And now outside investors were providing it. And they did it in droves because interest rates were so low otherwise. And the bubble was undeniable. In the late 1920s, American brokerage firms

Starting point is 00:10:38 paid $100,000 to put a brokerage office on a single transatlantic liner, the Berengaria, $100,000 just the opportunity to open a brokerage office. Another brokerage firm opened a tent at the U.S. amateur golf open in Pebble Beach, the stock market was such a phenomenon and the rally was such a phenomenon that people didn't want to get away from it. Scott, do you see any parallels between what's happening today and what was happening back in the 1920s? I think that's a great question. I think that given our stock market, the American stock market, is at all time highs

Starting point is 00:11:18 and that our economy is doing pretty well, not great, but pretty well. I think it's easy to say that interest rates here in the United States as guided by the Federal Reserve are too low. The Federal Reserve, I believe, is responsible for the crash in 1929 by keeping rates too low in the late 1920s. And I think they did the same thing in the decade of the 2000s, just before the crash in 2008 and 2009. They kept rates too low for too long. So I think there's real concern. Before we turn to the next crash, Scott, I just have a quick follow-up question. What happened in 1929 was just so, so many interesting things happened. And we still talk about it today.

Starting point is 00:12:01 We still talk about the Great Depression. Now, what is the one thing? If you can just name one thing that all listeners should learn from that interesting period as stock investors. What is that thing that they can learn from? I think that the thing to take away from all the crashes actually is that they are all hauntingly similar. The crashes are all hauntingly similar. And that's really the reason I wrote the book. But they're also extremely rare. Crashes are extremely rare.

Starting point is 00:12:33 It was more than 20 years from the first to the second that I write about. And then more than 50 years from the second to the third and then again 20 years from the third to the fourth. I think that those are the two things that I would leave investors with. Unfortunately, they're also inevitable. Crashes are inevitable. Why is that? It's because our greed runs away with us and we lose sight of fear. And every investor should have a reliable balance of those two things.

Starting point is 00:13:02 So it's unfortunate that we do have crashes because they do inflict a monetary and a psychic cost. But over time, the stock market is a great place. to provide for educations or retirements. So I guess the lesson is don't get caught up in the hype. And if you think that there's hype going on right now, well, don't get caught up in it. So Scott, let's talk about the really famous 1987 crash. But before we get into the meat of all the information surrounding it, I think it's important for people to understand that this decade was full of activism.

Starting point is 00:13:38 call it to Carl Iconne style of corporate governance raiders. Talk to our audience a little bit about this and what was going on back during this decade. Certainly. Before the 1980s, businessmen were seen as gentlemen. J.P. Morgan would have thought, first and foremost, that he was a gentleman. And they did not believe in essentially rocking the boat. When they did business, they wanted to do business together. They wanted everybody to agree.

Starting point is 00:14:09 The 1980s, things changed. And we ended up with what we'd end up calling corporate raiders. People who were happy to rock the boat, who realized that corporations were holding this hidden value. And that only somebody was willing to rock the boat could unleash that value. And the example, one of the first examples from the 1980s is an example from T-Boon Pickens. Key Boom Pickens ran a small, small-ish petroleum firm, Mesa Petroleum, essentially drilling for either crude oil or natural gas. And obviously he paid attention to the bigger firms in the business. And one of the firms that he saw was a company called Cities Services, which had been around for a long time.

Starting point is 00:14:58 And Key Boone Pickens did a little math and realized that the price at which City Services stock was trading, meant that all of the crude oil reserves that they had were selling for about $5 a barrel. So if he could have bought the whole company at the current stock price, he would have bought a whole bunch of proven oil reserves of crude oil for about $5 a barrel. Well, T-Boon Pickens also knew that the industry finding cost, that is the cost to go out and do the geology, drill a test well and the like, was $15, $1, $5. and that crude oil was actually trading on the commodity markets for $30.

Starting point is 00:15:40 So crude oil, as reserves for city services, were trading at a huge discount to what the crude oil was really worth. And so T-Bone Pickens realized the best place to find crude oil was on Wall Street. And he drilled for it by trying to buy city services because he realized that as an activist, that the value of the company was grossly understated by the stock market. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future.

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Starting point is 00:20:09 That's Shopify.com slash WSB. All right, back to the show. Before we go on, I just want to give a quick hand off talking about cheaper pigs. We did a thorough review of his book, The First Billion is the hottest, and I'll make sure to link to that in the show notes. Now, very interesting, Scott, the way that you explained activism and the role in terms of driving up the prices. Now, a new concept I would like to introduce to the audience here today, together with

Starting point is 00:20:43 you, is the technique of portfolio insurance. And there was something that was pioneered by Hein Leland and Mark Rubenstein back in 1979. Now, this is a hedging strategy developed to limit the losses an investor might face from a declining basket of stocks without having to sell the stocks themselves. Now, all of that being said, because it sounds like a great product, like why wouldn't we have that? But keeping that in mind, could you please talk to us how this seemingly risk-reducing product led to a 22.6% decline. The biggest one day percentage loss in history, that crucial day in 1987. I had actually just started my career when the crash of 1987 happened, and it was certainly

Starting point is 00:21:31 something to live through. I talked about every crash having some sort of financial contraption, and portfolio insurance was certainly the financial contraption for 1987. So portfolio insurance was certainly the contraption for 1987. What is portfolio insurance? Because it sounds like a wonderful idea. Sounds like a wonderful concept. The map of options on stocks can get pretty rigorous.

Starting point is 00:21:59 But some academics realize that if you were to trade a portfolio of stocks in small slices and in a very particular way that you could replicate the performance of an insured portfolio, hence portfolio insurance. And these academics realized that if they used this, really rigorous math, that theoretically they could limit the risk on a portfolio. And again, that sounds like a wonderful thing. They used stock index futures to do this eventually. The problem is that portfolio insurance and the math at the heart of it rely on some

Starting point is 00:22:39 assumptions about our market, which just are not valid. it assumes that there's essentially an unlimited amount of liquidity, and we know that in times of stress, liquidity dries up. So portfolio insurance called for selling tiny slivers of a portfolio in the form of stock index futures as the market fell and continuing to sell small slivers as the market continues to fall. And eventually, if it falls enough, you have to sell more slivers and larger slivers. So that's what happened in October of 1987. Investors were entranced by this concept of portfolio insurance, and so they used it to a huge degree. They also invested more money in the stock market because of portfolio insurance that they would have otherwise. They

Starting point is 00:23:32 felt confident that this insurance would save the day, essentially. And so what happened is that there was just this cascade of selling from portfolio insurance as more and more and more had to be sold. Liquidity dries up in an environment like this. And that's what happened. The market was essentially trying to sell billions of dollars worth of stock, and there were simply no buyers. So, Scott, you were just starting out during this period of time.

Starting point is 00:24:02 So what was that like to live through? I had just started as a clerk on the floor of the Chicago Board of Trade in the financial futures markets. I was a young guy, so I had the benefit of not having a lot of responsibilities. I didn't know if I would have a job the next day. I worked for a wonderful man who was a legendary trader, and he was able to navigate it very easily, but you never know what else is going to happen. Is the market simply going to close down?

Starting point is 00:24:33 or am I going to have a job? Fortunately, it worked out, it worked out well. It certainly didn't work out well for investors. Again, there was a lot of psychic and financial damage. But it was something interesting to live through because it explained, it shows in sharp focus that markets often behave irrationally, that the market can fall farther than you believe it can, and that the worst time to try and right-size your portfolio is during a panic.

Starting point is 00:25:06 How did it change your investment approach, if it changed your investment approach, to experience something like that so early in your career? That's a great question. It really drives home the idea that markets can fall farther than we believe, and that some of these, again, financial contraptions have problems. And I didn't really understand the idea of the financial contraption across stock market crashes at the time. But I came to realize that some of these great ideas that people have are flawed at their very core. And so you have to be a little bit, we'll call it dubious.

Starting point is 00:25:46 You have to be a little bit dubious about some of these great ideas. So talk to us about the rebound, Scott. How long did it take? What was the sentiment through that period of time? The interesting thing to take away is now that our equity market has what we would call circuit breakers. So it would simply not be possible for our stock market to drop by 22, almost 23% in a single day. The market would close down before that would happen. And because these are engineered in such way that everybody knows what they are, these secret circuit breakers, what they do is they tell everybody,

Starting point is 00:26:20 let's just stop and think about what we're doing, and let's just not sell because we're in the middle of a panic. So that sort of a loss for a single day is simply not possible anymore. And that's important for an investor to realize. Doesn't mean it couldn't happen over the course of a month or two, which would be pretty ugly. But things are a little bit different. I think we also have an understanding now that about the interaction of some of the our markets and we didn't understand how some of our markets interacted back in 1987. So we're certainly a lot smarter about some of those issues than we used to be.

Starting point is 00:27:02 Now, Scott, we can definitely talk, I mean, almost an entire episode, if not more, about ease of these crashes. But let's jump to the next crash here in 2008. Now, that is the story of new financial products that changed the financial markets. What I really like in your book, you talked about bistro. that was first introduced in 1997. And it's not as delicious as it sounds. It was the predecessor of the synthetic collateralized debt products that just grew in popularity and was contributing to causing this major, major crisis.

Starting point is 00:27:36 Now, Scott, could you please explain the relationship between the various debt products and the financial crisis? A few decades ago, a mortgage on a home was a very different sort of thing. For example, the mortgage that my parents had on the home I grew up in, they got from a local savings and loan, it was down the street. That's where they dropped off their check every month. The savings and loan kept that mortgage. They kept that loan.

Starting point is 00:28:03 It was an asset for that savings and loan. My parents knew some of the people who worked there. They probably knew the banker who made them the mortgage. That relationship changed fundamentally over the last, say, 20 or 30 years. instead of a mortgage being an asset that a savings and loan would keep on their books, bankers realize it's really an asset that can be sold off. And once it's sold off, it can be combined with a bunch of other mortgages. And that makes sense.

Starting point is 00:28:34 There's no reason that an investor, let's say an institutional investor, might not want to own a big portfolio of, say, 10,000 mortgages. They're going to take the risk with their all. are going to reap the interest rate rewards. So that is an interesting concept. Unfortunately, we got to the point where we wanted to divide up that portfolio of mortgages in different ways to satisfy different needs, and we lost sight of the risk. But really what happened was that there was this enormous appetite for mortgages from

Starting point is 00:29:07 financial, essentially from investment banks, to put into these mortgage-backed securities, which could then be diced up and sold to investors. And the problem with that is that this appetite for mortgages means that everybody lets their guard down a little bit. The homeowner is able to get a bigger mortgage than they might otherwise. The mortgage broker gets paid for writing the mortgage. The bank that originally makes the mortgage gets paid when they sell it. Everybody gets paid except the end investor. And so, again, some financial engineering got a little ahead of itself, and we ended up with these products that destroyed the link between the end investor and the person who was actually

Starting point is 00:29:56 borrowing the money for a mortgage. And I think it's that destruction of that link that really caused the problems in 2008, 2009. So let's talk a little bit more about the mortgage-backed securities and all the key players that had their hands in this crash and how they were incentivized. what were the key motivations and catalysts? It seemed that everybody had the incentive to get paid. And it seemed like everybody was going to get paid. The homeowner was going to get a big mortgage.

Starting point is 00:30:26 The rating agencies were going to get paid by the banks, who paid them to rate these deals. The investment bankers got paid when they bought these mortgages, put them into mortgage-backed securities, and then sold them to investors. And policymakers got paid to the degree that they were able to have satisfied their personal opinions about how involved government should be in these sorts of things. The best way to express that everybody was getting paid and that there was

Starting point is 00:30:54 that the link of trust had been broken is one of the phrases that some of the mortgage brokers used and that some of the investment bankers used. And it was very, very simply put, I'll be gone, you'll be gone. And what they meant was that we're going to get paid for these deals now. We're going to get paid for writing mortgages or buying mortgages or packaging mortgages and selling them. We're going to get paid now. And when the problems rise because people aren't able to pay their mortgage, you and I will be gone. We will have cashed the check, we'll be wealthy, maybe we'll be retired, but we'll get paid and I'll be gone and you'll be gone. Very interesting, the way that you phrase that, you can probably still make the argument

Starting point is 00:31:43 that a lot of people want to put blame of everything that happened back then. Is that the right lens to look back at all the events back there saying, these people are to blame? How do you look at that? They all got paid. That means that they were all greedy. To the degree that were greedy for more money or more love or more free time, seems that everybody wants more of something. those people wanted more money. So to look back and say that we're going to try and regulate greed or legislate against greed, I think, is a mistake. There were lots of problems that were made. There were lots of mistakes that were made.

Starting point is 00:32:26 Problems were generated. But to a certain degree, they're human. I mean, Warren Buffett is the first one to talk about fear versus greed. And those are purely human emotions. So, Scott, is it even possible to regulate greed, or is there something? something else that can be done? No, you simply can't. I talk about every crash being abetted by some new sort of contraption.

Starting point is 00:32:49 The contraptions just changed. The contraptions change. They get much more sophisticated as time goes on. The contraption for the very first crash, 1907, was a savings trust. It was called a savings trust. And what could sound better than that? Two wonderful words put together to mean something entirely different. It was really intended to be a savings and loan or a bank.

Starting point is 00:33:13 Ultimately, it became essentially a savings and loan that was grafted onto a hedge fund. So the worst sort of thing. But the point is that these contraptions, they all, they evolve. They become much more sophisticated. They feed people's greed because people are getting paid or believe that it reduces risk. And there's simply no way to legislate against that. Let's take a quick break and hear from today's sponsors. No, it's not your imagination.

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Starting point is 00:37:19 only around 3% of the total EU economy. How would you best describe the Greek economy leading up to 2010? And why was the Greek economy all of a sudden a problem for the entire financial system? That's a great question. And let me preface this by saying that people often ask, why did I write about the flash crash in 2010? Because it happened very, very quickly. And it was over almost as soon as it started. It's certainly not as familiar to everybody as 2008, 1987, 1929. And probably more people have heard of the panic of 1907 than remember the flash crash of 2010. But I write a, about the flash crash of 2010, I write about that because the next crash we have, and I don't know if it's going to be a week from now or two decades from now, but the next crash we have is going to look much more like the flash crash than it's going to look like anything else. It's certainly going to look more like the flash crash, and it's going to look like 1929. So that's why I write

Starting point is 00:38:25 about the flash crash. Now, specifically Greece and the Eurozone economy, the best way to described the Greek economy in period from say 2000 to 2010 was a lie which was built on a disaster. And what do I mean by that? Well, the Greek economy was a disaster. It was absolutely a disaster. It was underperforming. There were a few jobs. Tax avoidance was not just something that was a problem. It was essentially an avocation for every Greek citizen. They felt like It seemed that they almost felt like it was their job to avoid taxes. And it was tough to fund an economy or a government that way. And even though they didn't have revenue coming in, the Greek national government spent money like it was going out of style.

Starting point is 00:39:18 One example in the book, the Greek National Railroad one year had revenues of 100 million euros. The total money that they pulled in was 100 million euros. But their expenses were seven times that. their expenses were 700 million euros. And the Greek finance minister calculated at one point that it would be cheaper for the government to simply shut down the Greek National Railroad and pay for every passenger to take a taxi cab. So that was the Greek government. But they obviously couldn't shut down the railroad for political considerations. But when it came time for them to try and get into the Eurozone, that is, the community of countries that uses the common currency, the common euro currency, the Greek government was desperate to do so because of the benefits that they thought which would ensue, but they weren't even close to being able to meet the objective standards for inclusion, standard like the size of the government deficit, the amount of government debt.

Starting point is 00:40:20 they simply started lying about these things to their European brothers. And so eventually Europe let them into the Eurozone. When the problem, the size of the problem in Greece became obvious, that's when everybody sat up and took notice because there's no provision for divorce in the Eurozone. There's no provision for somebody for an economy to leave the Eurozone. And so now the question becomes, is the entire experiment going to collapse? And if it does, what does that do to France? What does it do to Germany? What does it do to other Eurozone economies? And what does it do in the United States? And so that is the uncertainty that caused the flash crash on May 6th of 2010. Scott, let's talk more about this flash crash that happened on May 6th, 2010. In your book, you talk about how the algorithms misunderstood the liquidity in the market,

Starting point is 00:41:14 and this was really fascinating stuff. So describe this to our audience. Yeah, it's a great question because, again, the next crash. is going to look like the flash crash. There were certainly reasons to be worried about our stock market in early May of 2010. And there was one institutional investor in particular who was worried. And so they wanted to reduce their exposure for their investors. They wanted to do so by selling stock index futures, which now trade almost exclusively

Starting point is 00:41:45 electronically. In 1987, it was a bunch of guys and bright red jackets, jumping around in a pit. And in 2010, it was almost exclusively electronic. And so this investor wanted to sell electronically. They wanted to sell a bunch of futures contracts, which is perfectly reasonable way to hedge. But they wanted to do so in size. That is, they wanted to sell a lot of contracts. But that means that they also wanted to sell in a way which would not drive the price down via their own selling. So they turned to an algorithm. Actually, they turned to three different algorithms. Eventually, they said that we're going to sell a certain number of contracts every

Starting point is 00:42:26 minute equal to the volume of the market in the previous minute. And the problem with that is that their own selling ballooned the volume. They had overconfidence in the liquidity that's provided via electronic trading. And they essentially tricked themselves into believing that the market could sustain a bunch more selling than it actually could. And so within the span of just a few minutes, their lack of understanding of real liquidity in the market led them to sell so many futures contracts, overwhelmed the liquidity in the market, and drive the Dow Jones Industrial average down by 10% again in just a matter of minutes. That's an absolutely amazing story. And keep in mind that you just, as you mentioned before,

Starting point is 00:43:13 that crashes would probably look different than they have historically look more like 2010? How should investors position themselves knowing that? That's a question I get a lot. What should I do? What should I do to protect myself? Well, many of vehicles that exist are pretty expensive. I spent my time on the trading floors of Chicago as professional option trader, and you think that options are insurance, I can buy insurance and protect myself. The problem is that insurance ends up being very expensive. So what can you do?

Starting point is 00:43:50 What you can do is not get carried away. So right now the stock market is doing very well. This may be a time to be more fearful than greedy. In early 2009, the market looked horrible. When it looks horrible is probably a time to be more greedy than fearful. In addition, there are certain good old-fashioned ways of approaching the stock market. Have your money spread around. That's called diversification.

Starting point is 00:44:15 Have a little bit of money in the stock market. Have a little bit of money in fixed income. We know that diversification is the only free lunch in investing in that it can increase your risk-adjusted returns. So, unfortunately, there's no silver bullet. There are great vehicles that didn't exist 20 years ago, like exchange traded funds, which are much cheaper for the average investor to use than an old-fashioned mutual fund, take advantage of those, but also realize that liquidity dries up during a panic. So if you think that when panic hits, I'm simply going to sell, well, you're going to be really

Starting point is 00:44:59 unhappy with your results. It's important to realize that stocks have been a great way to build wealth for millions of people, but one of the reasons that stocks do so well is that sometimes you are just along for the right. That is, you're not going to be able to get out during a panic. So how would people position themselves? Kind of old-fashioned, logical, fear versus greed, diversification is really the best way to do it. So one of the key takeaways, or I guess two of the key takeaways that took from your book, was how much more financial markets are now becoming integrated and how fast everything is today.

Starting point is 00:45:44 This is not like the old days where you can do arbitrage between London and New York by calling in by telephone. Believe it or not, that actually did happen once. But what does the increasing financial integration mean for us as investors? That's a wonderful question because you're right. there was a time when you could call from Chicago or New York to London, and that was considered essentially instantaneous. Now, as an example, we are traders, high-frequency traders, are bumping up literally against the speed of light. That is now the problem that they have. That's the hurdle that they have when it comes to executing trades. For example, most

Starting point is 00:46:30 that are sent between New York and Chicago or Chicago and New York are done via microwave. They're not done by fiber optic cable because fiber optic is too slow. So it's done via microwave. And those firms can tell you what the weather is like between Chicago and New York because their trades will be slowed down by a few nanoseconds if the weather is bad, if it's raining between Chicago and New York. that will give you an indication of how speed is now critical. But speed cuts both ways.

Starting point is 00:47:08 And it's necessary for a high frequency trader, but it doesn't really take anything away from the long-term investor. So when you read about these things or you hear about these things, as a long-term investor, you should be interested, but it doesn't put you at a disadvantage. The best advantage you have is, again, the right sort of diversification, a strategy that makes sense for you, discipline, and using products that are lower costs for the investor. That's what people should be doing,

Starting point is 00:47:41 and that's how they can make the stock market work for them. Scott, do you have a broader concern for our financial markets today? That's a great question, because as a young person, as an investor, I came up in a time when there were people who required to provide liquidity. For example, in the New York Stock Exchange, there were specialists who had a really lucrative franchise to trade stocks. Here in the United States now, there is no person, no body, no trader, no investor who is required to provide liquidity.

Starting point is 00:48:19 And I think that that is probably the biggest weakness that our stock market, our financial markets in general have right now. And we've seen that, we saw that during the flash crash. We saw that some high-frequency traders not understanding what was going on simply refused to participate and they're not required to provide liquidity despite the fact that they have access to some of these markets that other investors don't. I think that would be the larger concern that I would have. This has been absolutely amazing, Scott. The name of the book is A History of the United States in five crashes. And I highly recommend everyone here in the audience to pick it up. Now, Scott, where can the audience learn more about you, your company, and your book? Well, Stegg, as you know,

Starting point is 00:49:06 I'm a contributor to CNBC so they can see me on CNBC. They can also go to the author website. Author website is scottnations.com. And I also have a presence on Amazon author page. Scott, this has really been fantastic. I have thoroughly enjoyed this conversation. and we'll be sure to provide links to all those resources in the show notes. Thank you so much for taking time out of your busy day to talk with us. Wonderful to be here. Thanks so much for bringing this story to investors around the world. All right, guys, so at this point in time on the show, we'll play a question from the audience,

Starting point is 00:49:40 and this question comes from Hermann. Hello, Preston's Day. This is Hermann from Argentina, and I wanted to thank you for your amazing show. I listen every week. my question is specifically on sector ETFs. I found some areas in some sectors there they have some value and I was researching some

Starting point is 00:50:04 stocks but then I thought why not invest in the sector which has all the best stocks already into the ETF. My question specifically is would be better to invest in stock, in value stocks, or in sectors, ETF of the same sector. I hope that question makes sense. And I thank you again for your amazing show. Thank you.

Starting point is 00:50:33 So, Hermann, this is a very interesting question you bring up. Let's talk about an example that is relevant today. Whenever I'm looking in my screen here on TP Finance, I see a lot of financial companies that are relatively undervalued. So, what? An approach surely is to buy a sector ETF just with financial companies. Now, what you said was that the sector had the best stocks. The way the sector ETFs work is that they are typically market weighted, meaning that bigger banks like Bank of America and Wells Fargo would take up a larger part of the ETF than smaller banks.

Starting point is 00:51:10 John Greenblan, who you might know, have shown that equal weighted sector ETFs perform better than a market cap index because the stocks that are temporarily out of favor would go up in price and stocks that are overvalued would go down in price, which would be under and overrepresented in a market capitalized index respectively. So if you want to go the sector ETF route, you might consider doing an equal weighted index. But generally, I don't think that sector ETFs is a bad idea if you choose the most undervalued sector, which right now would be financials and energy. But let me give you another suggestion. If you would buy Vanguard value ETF, you can get it for as cheap as 0.0% in expense ratio, and you would already

Starting point is 00:52:01 have that over-representation of financial stocks. For instance, you would have 23.6% compared to 15% in the S&P 500. And you would have the added benefit of. of not having to rebalance. Because when you rebalance or outright permanently sell your SECTF, you will have to pay taxes. So if you stay within a solid value ETF, you would save the taxes.

Starting point is 00:52:24 Of course, the drawback is that you won't be as concentrated in that sector. But if you do plan to hold a few sectors, which it sounds like on your question that you are, you really have to be good at picking those sectors and sell them at just the right time to outweigh the extra cost and cost. taxes. The reason is that if the value ETF is selected probably, it would automatically

Starting point is 00:52:47 overrepresend the most undervalued stocks and therefore rebalance for you. Hernan, Stig knocked this one out of the ballpark. I don't have anything else valuable to say on top of what he's already put out there. But for asking such a great question, we're going to give you free access to our intrinsic value course for anyone wanting to check out the course. Go to tip intrinsic value.com. That's T.com. TIP intrinsic value.com. The course also comes with access to our TIP finance tool, which helps you find and filter undervalued stock picks.

Starting point is 00:53:21 If anyone else wants to get a question played on the show, go to Asktheinvestors.com, and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stuff. Thank you for listening to TIP. To access our show notes, courses, or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network.

Starting point is 00:53:47 Written permissions must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - Classic 05: A History of 5 Stock Market Crashes w/ Scott Nations

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