Monday, March 14, 2011

Review of Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression (Second Edition) By Robert R. Prechter, Jr.

I just finished Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression by Robert Prechter, the author and stock market analyst who has popularized Elliott Wave Theory. Prechter gets a lot of flak because his market predictions are typically "too early", i.e. "wrong" for the American investor addled by television and a short attention span.

Elliot Wave Theory (EWT) is the idea that prices unfold in specific patterns called Elliott waves. The theory is named for Ralph Nelson Elliott (1871–1948), a professional accountant who developed the theory in the 1930s. Prechter has extended the theory to collective human psychology, which he believes develops in natural patterns, via buying and selling decisions reflected in market prices.

I am agnostic about the actual EWT. The most suspect part of the theory is the idea of "wave counts", which are really tenuous sometimes. The wave counts may seem obvious retrospectively but are never so clear prospectively, and so practitioners of the theory cannot consistently identify when a wave begins or ends. As David Aronson writes in Evidence-Based Technical Analysis, the theory's ability to "fit any segment of market history down to its most minute fluctuations" is because of its "loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude".

What is interesting is that if the waves exist, they would meet the definition of a fractal, a geometric shape that can be split into parts that are smaller copies of the whole, which is a property called self-similarity. The fractal nature of prices is good theory and has been written about by other researchers (e.g. Mandelbrot).

I tend to agree more with John Hussman, who notes in this week's letter that a parabolic bubble tends to look like a cosine wave fluctuating at increasing frequency, so that corrections become shallower and more frequent within the parabolic trend. But as he put it, "I think it's a bit ambitious to use log-periodic functions and other purely mathematical tools to identify bubbles and gauge crash hazards. We prefer more fundamental approaches."

But Prechter, and Conquer the Crash, are much more than Elliot Wave Theory. His more interesting idea is socionomics, a term he coined to describe his hypothesis that social mood drives financial, macroeconomic, and political behavior, in contrast to the conventional notion that such events drive social mood. The rationale for the effect of social mood on markets is that when investors value financial assets, they form "judgments in sympathy with or in reaction to the opinions and behavior of others. This surrender of responsibility makes them participants in a collective. (p25)"  [My review of Prechter's 1999 work on socionomic theory, The Wave Principle of Human Social Behavior, will be forthcoming.]

I also appreciated Prechter's discussions of the long-term deterioration in economic performance in the United States. He notes that the economic improvement in the great bull market since 1982 (i.e. a "wave five formation") has not been commensurate with the stock market increase during that time. It is interesting to read articles about decaying infrastructure in the U.S. with that in mind:

The stakes are particularly high not just for Mr. Brassell and the other 4,000 residents of Lake Isabella, but for the 340,000 people who live in Bakersfield, 40 miles down the Kern River Canyon on the edge of California’s vast agricultural heartland. The Army Corps of Engineers, which built and operates the 57-year-old dam, learned several years ago that it had three serious problems: it was in danger of eroding internally; water could flow over its top in the most extreme flood season; and a fault underneath it was not inactive after all but could produce a strong earthquake.
How can we have these life-threateningly derelict pieces of critical infrastructure if we are so rich? But Prechter's explanation for this incongruity is that "third waves are built upon muscle and brains. Fifth waves are built upon cleverness and dreams. During third waves, people focus on production to get rich. During fifth waves, they focus on finance to get rich. [...] A prime symbol of the deterioration... is General Electric... its vaunted company [is] a cardboard edifice of credit services. It is the United States in microcosm. (p48)"

Prechter's discussions of market sentiment and cycles are second to none. His socionomic theory predicts the ephemeral federal budget surpluses that occurred at the end of the Clinton administration: "government surpluses generated by something other than a permanent policy of thrift are the product of exceptionally high tax receipts during boom times and therefore signal major tops. They're not bullish; they're bearish and ironically portend huge deficits...(p254)"

But Conquer the Crash has a broader and very important intellectual significance: a framework for thinking about market cycles that includes severe bear markets and crashes. Most investors do not have a theoretical framework for this.

I often write about mainstream asset managers like Buffett, Ken Fisher, and Bill Miller, whose investing styles expressly disconsider the possibility of severe bear markets/depressions. Most investors - and all long-only investors - are resigned to failure and capital impairment should a severe bear market occur.

This doesn't bother them because they figure they will "make it up" on the next wave up. And, as Prechter puts it, "most of the time, ill-timed optimism is harmless because most of the time, recessions are indeed mild and brief. [...] Small, mild retrenchments occur more frequently than large ones so forecasting errors are only mildly damaging. (p66)"

This led me to a very important realization about investor genotypes in an investing ecosystem. Think about an investor's "style" (i.e. decision rules and heuristics) as a genetic code. Evolutionary theory predicts that selection will operate whenever variants differ in characteristics that are transmitted through some form of retention or differential culling of variants and whenever these characteristics are consistently related to performance of the entities in which these variants are expressed.

I have often thought about the number of lines of computer code it would take to model an investor's decision processes or style. For some, it has become almost as simple as "buy the dip."

The investors whose styles produce the best results are selected in favor of those whose styles produces inferior results. As Wolfgang Sterrer put it, "an organism represents a hypothesis of its environment, continually tested by selection for its predictive value and modified by adaptation for a better fit."

The problem with investing is that this is measured on the wrong timescale. The different parts of economic cycles occur so infrequently that the intervals between them exceed the working lifespans of investors. As Geerat Vermeij describes it in Nature: An Economic History, "The key to economic control is to affect, and respond adaptively to, conditions on the longest and largest scales of time and space possible (p37)."

For example, during the bull market (1982-2000) within a bull market (1932-2000), any style that stopped to consider the possibility of a bear market would have been maladaptive. If you think about it in terms of expected value, for any value of caution regarding a bear market, such a framework would only have lowered expected value and could only have been maladaptive.

As a result, this "genotype" has largely been purged from investing. If you were cautious, this means your boss took you aside and explained that you just didn't "get it" about how the new economy worked and maybe managing money wasn't for you. It also took the form of investing tropes about "stocks for the long run", "buy the dips", and the equity risk premium.

In contrast, people who "got it" for whatever reason have gotten constant, positive, psychic feedback for three decades. They have been carefully programmed to ignore the types of issues that we discuss on Credit Bubble Stocks. Buying the dips always seems like a sure thing, because they have been investing for their entire careers during a "cycle wave V during a supercycle wave V", that is, a bull market inside of a bull market.

The result is that quite a few investors with really lame investing methods feel like geniuses. For example, The Big Short tells a story about "two guys and a Bloomberg terminal in New Jersey," which was "the Wall Street shorthand for the typical CDO manager. The less mentally alert the two guys, and the fewer questions they asked about the triple-B-rated subprime bonds they were absorbing into their CDOs, the more likely they were to be patronized by the big Wall Street firms."

Another example is the investing philosophy variously described as trend following, momentum investing, or relative strength. This is the idea of buying securities with high recent returns (regardless of fundamentals) and selling securities with poor recent returns. Richard Driehaus, the "father" of momentum investing, once said that "far more money is made buying high and selling at even higher prices." During the recent earnings season, we saw one of the the downsides of the relative strength strategy: the price-insensitive buyers become price-insensitive sellers.

So now, the investing genome is a monoculture of permabulls. They say things that make us hit our head against the wall. We have seen how they performed since 2000. It is going to be more of the same until they are purged from the business.

Unfortunately for them, the bull-market only investing genotype is going to be an evolutionary dead end. Investors need a money manager whose style contemplates severe bear markets, otherwise they are doomed to severe capital impairment. Picture a plane crashing into mountain with full afterburners on.

If our thesis is right, we will be able to make a lot of money at the expense of the dip buyers before they figure out what is happening. As Prechter writes,"the presumption that the old uptrend and expansion are the natural order of things remains as firm as ever. (p61)"

Lots of the ideas in Conquer the Crash stand on their own whether or not Elliot Wave theory is true. I am giving it 5/5.


EconomicDisconnect said...

I read the older version years ago. Great review.

CP said...


I think Prechter is so underrated.

It's funny; his own theory basically predicts that his theory would be least appreciated at the end/top of a cycle.

Stagflationary Mark said...

I read that book when I turned bearish in 2004.

Although parts of it were right (real estate in particular) this is and was my biggest problem with it.

I'm speaking from memory so please correct me if I am wrong in what follows.

If you knew a deflationary crash was coming, then why sit in short-term Treasuries or cash? It made no sense to me. Why not lock in a good long-term interest rate before interest rates fall?

TIPS would have been right out. Who needs inflation protection. And where were I-Bonds? 2004 was a great time to be buying. The government still allowed you to make major purchases at rates higher than today. Good as cash in a deflationary downturn and yet they still have inflation protection long-term.

In hindsight, the CPI-U is 17% higher than when I read that book over 6 years ago.

I don't recall him mentioning the #1 threat in that book either. In the Great Depression we ran a trade surplus. We now run a massive trade deficit. Comparisons to that era therefore need more than a few disclaimers.

And lastly, for what it is worth I am athiest/agnostic on his wave theories. That strikes me as more technical analysis mumbo jumbo. Like you, I lean much more toward's Hussman's theories and fundamentals.

CP said...

I think the go-to-cash advice is designed for the vast majority of people who aren't ready, willing, or able to make more complicated investments.

Remember, Prechter did call for people to be maximum leveraged short at one point.

CP said...

Yet with the decline, decay and collapse of so many of our cities, Detroit, Buffalo, Cleveland, etc. this looks like something more than just a supercycle. We are in a Grand Supercycle down wave. but unlike the 97% crash of 1723, fiat currency money printing will make this follow R. N. Elliot's "principle of alternation" producing an extended flat with 50 years of corrections like the 2001 and 2007 episodes we have just been through.

CP said...

CP said...

For instance, a value investing newsletter I subscribe to recently published a list of 'never sell' stocks - regardless of price. Yes, this from a service that purports to be value oriented - an investment strategy that is defined more than anything else by its price vs. value ethos. (I don't mean to pick on them - I'm a subscriber, and they are smart, open to debate, and have some great content which I enjoy reading, but this 'quality over price' ethos is something I disagree with strongly, and is so emblematic of a lot of what I've been seeing in the world of 'value' everywhere I turn lately, that I couldn't help writing something about it).

Predictably, the list of stocks is populated by high quality, resilient businesses with capable management that have delivered steady growth and high returns on capital in the past, while maintaining solid dividend payouts. However, they also have another very important thing in common: the stocks have all performed exceptionally well over the past decade not only due to their quality/business performance, but also because they started at reasonable multiples, and have experienced a decade of multiple expansion - typically from about 15x to closer to 30-50x (less for some lower-multiple industries).

The combination of solid growth, good dividends, and an incessantly rising multiple is always a heady combination in markets, and has ensured a decade of fabulous returns. However, the most important psychological outcome of this experience has been that any decision to sell/reduce such stocks over the past decade - due to the exercise of 'price discipline'/'value consciousness' - has proven - ex post - to have been the wrong one. Consequently, the lesson the newsletter has drawn from this experience is that it is a mistake to sell good businesses, regardless of price. You should buy good businesses and never sell. Why? Because the past decade of market experience proves it.