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In every book I read, I try to find a few nuggets that can help my understanding of the stock market or the economy. These two recently released books fit the bill.
Unexpected Returns: Understanding Secular Stock Market Cycles
by Ed Easterling, provides an excellent summary of the stock market over the past century and its various cycles as they relate to GDP growth, inflation, earnings growth and dividend yields.
The basic premise of Easterling's thesis is that the stability of inflation and the trend in price-to-earnings ratios are intimately linked. He talks about what he calls the "Y-Curve Effect" and demonstrates that periods of high inflation or deflation are marked by abnormally low P/E ratios, while periods of steady low inflation (as in the late 1990s) are marked by periods of high P/E ratios.
He follows this up with a breakdown of the rise in equity prices in the bull market of 1982-99. He divvies up the ultimate return as a function of the average GDP growth, average dividend growth, average EPS growth, inflation and P/E expansion. P/E ratios expanded from the low 10s to the low 20s, accounting for as much as 8% per year of the total return during this period.
His argument now is that with inflation instability looking increasingly probable in the next few years, this P/E expansion is unlikely to continue. He says that this will significantly impinge stock market returns between now and the end of the decade and that bonds will not be that much better.
Like John Mauldin in
Bull's Eye Investing
, Easterling recommends looking at sophisticated absolute return strategies that can be found in hedge funds. Using a diverse group of hedge funds spread out across all hedge fund strategies would be a successful strategy for low-volatility absolute returns.
If you're not using hedge funds, he also walks you through his "financial physics" model. This examines the correlations between GDP growth, inflation, EPS growth and dividend yields to build a predictive model of the markets.
I don't agree with everything in the book, and I look forward to having a discussion with Ed about the points with which I disagree. But the hundreds of charts, statistics and studies spread throughout the book make this an incredibly valuable resource for any investor.
Economics Are Freaky
Another book that I found particularly relevant for the markets, even though it doesn't mention the stock market at all, is
. I got a call a few nights ago from my friend Stephen Dubner, who co-authored the book with Steven Levitt, an economist at the University of Chicago who recently received the John Bates Clark Medal. This prize is awarded every two years to the best American economist under 40.
We engaged in idle chitchat for about a minute before he suggested I check out the Amazon ranking on
. The Amazon rank of a book is an addictive activity for authors. (My latest book,
Trade Like Warren Buffett
, is stuck in the 4 or 5 digits after making a brief high at No. 85 thanks to
Cody Willard and Norm Conley.)
I went to the
page on Amazon, figuring it would be around 500 or 600. Then I saw it.
"Number Two!" I yelled at him. "Only Harry Potter is ahead of you!"
"How many copies do you think it's selling?" he asked me.
"I have no idea, but are you going to get 10 million bucks on your next advance?" I said, realizing my jealousy might know no bounds.
My competitive jealousies aside, it's a great book. He and Levitt teamed up to write a book that provides a step-by-step guide on how to be a contrarian, a discipline I wish I could find consistently in my own dealings with the markets. They apply the discipline of economics to a dozen issues and turn them upside down and uncover the contrarian truths that lie underneath each of these issues.
One of the more controversial topics is a study of how the low crime rates New York City experienced in the 1990s can be directly linked to the Supreme Court's
Roe vs. Wade
decision in 1973. The authors examine all of the possible reasons for the decrease in crime and basically refute most accepted theories while narrowing in on
Roe vs. Wade
. Looking at the unobvious from a variety of angles also happens to be the only survival method in the stock market.
My favorite chapter is "Why Do Drug Dealers Still Live With Their Moms?" The authors break down the hierarchy and economics of a drug-dealing "gang." The hierarchy, bureaucracy and turf battles remind me of a typical brokerage firm.
Other chapters include "How Is the Ku Klux Klan Like a Group of Real Estate Agents?", "What Do Schoolteachers and Sumo Wrestlers Have in Common?" and finally, the first chapter, "The Hidden Side of Everything," which is directly applicable to the stock market in its discussion of why conventional wisdom is so often wrong.
James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of
Trade Like a Hedge Fund
Trade Like Warren Buffett. At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback and invites you to send it to
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