The Most Anticipated Recession, Checklists for Fraud & The Japanese Bubble

Market Talk, Edition 64, December 4th 2022

Dec 4, 2022

Once every second Sunday I will curate the most interesting things I have consumed during the previous two weeks. These will be bucketed into 5x must-reads (works I wish to highlight and comment on) and other items of interest (an assortment of other works I have consumed).

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As the year draws to a close, I find myself feeling grateful that much of the world will soon be afforded some downtime with family. This year I became an uncle for the first time, which ought to spritz a refreshing splash of excitement for Christmases to come; a holiday which is made special when viewed through the eyes of a child. This year I got to be out of my home country for ~2 months, visiting a new continent and am grateful for the perspective that brought me. I need travel to ground me and remind me that the bubble I dwell in isn’t so special. I am also grateful that this newsletter has survived another year, soon to be its third come Spring. The number of readers has more than doubled since last December. To put that into perspective, we’ve gone from filling out the Royal Albert Hall of London to surpassing the capacity of the Centre Court at Wimbledon.

(Left) Royal Albert Hall London, Capacity ~6,000 (Right) Centre Court, Wimbledon, Capacity ~15,000

I am not sure what triggered it, but these last couple of weeks have seen a relative uptake in the number of readers supporting the newsletter (from 2→7) which has been awesome. I wanted to express my gratitude for that. At the close of each year, I tend to send something out that reflects on the year as a whole, for the newsletter. I began reading through the last two years of entries, and am excited to share something similar as the month draws to a close. In other news, my recipe newsletter,

Facile et Délicieux

, attracted its first 100 readers, which is a nice milestone to hit for my secondary passion in life, cooking. Two of my favourite recipes that I shared in November (sorry mushrooms haters) were simple shiitake ramen and wild mushroom soup.

Something which made my day on Friday was seeing the first example of someone replicating a recipe of mine out in wild. A gentleman called Akash replicated my oyster mushroom & garlic omelette (I swear I cook more than mushrooms) and I can’t express how awesome I found that.

Recent Publications: Memos I have shared since the last Market Talk.

• Get Your Macro Fix w. Joey Politano

• A Curator's Curation

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5x Must Reads

In every edition of Market Talk, I share a number of readings that I have consumed over the past two weeks. Here are 5 that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.

To access the suggested article, click the purple link after the source subheading.

1) Roaring Eighties: The Japanese Bubble

Length: Moderate

Source: (Voss Capital)

I love financial history. Understanding the variables that lead to economic expansion and contraction and learning about how the inputs to those cycles can influence the behaviour of a country’s inhabitants, or in some cases alter the entire fabric of a generation, is deeply intriguing to me. I believe that is why I found the study of economics so appealing as a young adult. The “Japanese Bubble” which occurred in the mid-1980s to early 1990s was one of these fascinating and ultimately destructive periods. At its peak in 1988, the Japanese stock market accounted for ~29% of the total value of global equities, during a time when there was a worldwide belief that the nation would soon take over the world (perhaps akin to similar sentiments regarding China in the 2010s). But the joys were short-lived. Today, Japan’s stock market is closer to 6% of the total value of global equities.

Table is taken from an **article** by Dividend Growth Investor

The Japanese bubble is like an onion; for it wasn’t the outcome of mere stock market speculation. One has to peel back the layers, take a trip back in time, and understand how decades of macroeconomic policy resulted in a tipping point that spread the contagion of speculation across the entire country. Following the collapse of Japan’s banking sector proceeding the second world war, the nation’s banking reforms led to some tremendous post-war GDP growth over the following decades; “by 1955, Japan's GDP had recovered to its pre-WWII levels and then grew 144% during the 1960s”. The economy then gradually opened its doors to the rest of the world, seeing tremendous success with exports, and in 1985 the Japanese signed the Plaza Accord; agreeing to increase the value of the Yen relative to the US Dollar through loosening monetary policy and deregulating their financial markets (amongst other things).

“To offset the negative effect reduced government spending would have on GDP growth, the government strongly encouraged more consumer and mortgage lending. The Bank of Japan's discount rate dropped from 5% in 1985 to 2.5% in 1987 despite GDP growth exceeding 3% every year from 1981 – 1987. Cultural stigmas against borrowing money faded as household debt to GDP went from 52% in 1985 to 70% in 1990”. With looser regulations and low rates, a land grab ensued. So too, did a frenzy in public equities.

Charts are taken from the **article** by Voss Capital

There was a period in 1987 when the valuations in the Japanese stock market became so high, that Western investors began to exit the market. The Ministry of Finance’s actions (a powerful entity in Japan, alongside their central bank, in this period) would prolong the eventual bust, however. As selling pressure ensued, the Ministry ordered the country’s largest banks to begin “supporting” the stocks of some of the nation’s largest companies. “This practice was generally known by the public and added further credence to the general populace’s notion that the government would never allow the stock market to fall”. The following year, the government would unleash an additional $2.25 trillion into the system through personal tax reforms. I am sure you can imagine what happened next.

I chose the article by

Voss Capital

to share today as it was succinct enough to be digested in the space of 5 minutes and captures a high-level understanding of the build-up, the absurdity at the top, and the eventual crash. If you are interested, I have compiled a handful of other resources that I found to be useful when studying this subject.

Paper: The Asset Price Bubble and Monetary Policy, Japan’s Experience in the Late 1980s and the Lessons
Paper: The asset price bubble in Japan in the 1980s: lessons for financial and macroeconomic stability
Documentary, The Princes of the Yen
Article: Power from the Ground Up: Japan’s Land Bubble

Thanks to

Michael Fritzell

Frederik Gieschen

, and

Ayesha Tariq

for recommending a selection of the resources that I shared today.

“Stocks stabilized for a few months before collapsing 30% in August and September. By October 1990 the TOPIX was down 46% from its peak ~10 months earlier. The equity price crashes reduced banks' capital reserves which forced them to tighten lending. Governor Mieno publicly expressed a desire for property prices to fall as well, by a very precise 20%. He raised interest rates five more times very quickly until they reached 6% in August 1990. New regulation was introduced in 1990 limiting loans to real estate companies. Real estate owners tried to resist selling but ultimately many were forced to. By late 1992, Tokyo real estate prices had fallen by 60%. The fall continued until 1995 when prices leveled out, down 76% and back to ~1980 levels. The Ministry of Finance had manipulated the market on the way up and with the bubble now popped they tried to control its descent.”

2) Global Banking Annual Review 2022

Length: Dense

Source: (McKinsey & Company)

In “the year everything changed” for global banking, the folks over at McKinsey & Co have shared a pretty solid annual review on the state of global banking and how the sector has changed with the onset of a higher interest rate environment. It’s a review that is global in nature, with a nice little segment on the Indian banking environment, as well as other emerging markets.

There is also a great deal of commentary afforded to the digitalisation of banking, fintech disruption, and shifting customer demographics. If you own any stocks in the banking sector or simply have a keen interest in this segment, then I’d recommend this as something that may tickle your pickle. If the PDF version doesn’t download, you can find the original web-based report here.

“Over the past 12 years, the global banking sector has experienced a remarkably flat period. Return on equity hovered at or below the cost of equity. Revenue growth remained below GDP growth, and margins were slowly eroded by low interest rates and rising competition, including from well-funded fintechs and bigtechs. Emerging markets, thanks to their strong performance, closed the gap with advanced economies; China featured as a consistent outperformer. Asset values rose seemingly inexorably, fueled by low interest rates, and some high-risk asset classes, including cryptocurrencies, soared to new heights. Even a once-in-a-century pandemic made barely a ripple in these predictable trends. Then came 2022, and suddenly almost everything changed. Interest rates leaped from their historic lows, and with them, bank margins increased after a decade or more of contraction. At a global level, banks’ return on equity edged above the cost of capital after years of languishing below it”.

3) Common Sense Investing: The Papers of Benjamin Graham

Length: Dense AF

Source: (Ben Graham)

I’ve been on a bit of a Ben Graham kick recently, you might have noticed. Like many investors, he was one of the first authors that I stumbled across when beginning my own journey. I never found much solace in the practical aspects of his investment process, but I have always benefitted a great deal from the way he educates the investor on the mental facets of the game. Divided into two parts (the investor & the market and the investor and the business) this PDF compiles a range of Graham’s work on both of those topics.

“Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings-- incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble--i.e., to give way to hope, fear and greed.”

4) Venture Capital Red Flag Checklist

Length: Light

Source: (Above the Crowd)

In a recent bankrupt filing John Ray, the new CEO and Chief Restructuring Officer at FTX, would claim that “never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here”. This is coming from a man who supervised situations involving criminal activity, malfeasance, and cross-border asset recovery with firms like Enron, Residential Capital, and Nortel. Seemingly so obvious in hindsight, everyone is now wondering how all of FTX’s fraudulent and deceptive activity slipped under the radar for so long. Surely this is something prospective investors should question ante facto and not post facto? Nevertheless, a good rule of thumb is utilising the fraud triangle framework.

Is there ample opportunity to commit fraud in the organisation, whether because of loose governance or other factors? Is there an incentive to commit fraud? Can it be reasonably assumed that bad actors are able to rationalise the fraud they might be committing? When all three of these factors create red flags, then the likelihood of fraud should be a concern. That said, it’s not always the case. In light of FTX’s deception, Bill Gurley decided to post his first blog entry of 2022; a short memo which rounds off ten red flags to watch out for in venture-backed companies. My favourite is number 5; unique financial data representations. While authored with venture capital in mind, I believe this checklist is applicable to most businesses, even those which are currently floating on our stock exchanges today. For more on the understanding of fraud, I recently discovered an article titled “Anatomy of a Fraud” by

Trust, but verify (Doveryai, no proveryai)

that you might enjoy too.

“The most dangerous scenarios are the ones where the company is claiming a significant paradigm shift. Founders, employees, and investors intent on disrupting the status quo start believing in a new reality even in the absence of empirical evidence or actual results. It’s one thing to be a successful startup, but it’s quite another to claim to be rewriting the rule book for a whole category of business, with seeming immunity to the fundamental laws of business reality. The investors believe, the press believe, and the politicians believe. In such a world, an incremental investor has zero reason to doubt the legitimacy of the organization because 100% of their data suggests the exact opposite of fraud or incompetence — it is held up as a shining beacon of success. Be wary of the situation that is “too good to be true.” It often will be.”

5) The Behaviour of Small vs Large Caps in Recessions & Recoveries

Length: Moderate

Source: (North American Journal of Economics & Finance)

A somewhat dated study (2010) but one that I feel still holds some relevance when considering its topic matter; the relative performance of small caps vs large caps in the lead-up & follow-on from recession and recoveries. Moreover, the case study is based in Northern America, a region which had its last standard recession (excluding the incredibly short one in 2020) in 2008. If the economists are to be believed, then the States (as well as other blocs) may well be heading into a recession next year; queue the quote about history not repeating, but often rhyming. It’s pretty light (16 pages) and might provide some food for thought to a number of readers of Investment Talk. Of particular interest, you can see Tables 4 and 5 where the former shows return data in the year commencing with the onset of a recession and the latter shows one-year return data for the month commencing the “official” trough of the recession.

Tables are taken from ‘The Behaviour of Small vs Large Caps in Recessions & Recoveries’

In the year of a recession, small caps do considerably worse. In the year following the end of a recession, they tend to carry a considerable premium to that of the large caps. They recover faster and more violently. Putting the performance of small vs large caps across different stages in the market cycle aside for a moment, I shared some thoughts on Commonstock this Thursday. If we are to have a recession, then it might just be the most anticipated one in history. According to "professional forecasters”, which I believe is just another term for astrologists in business attire, the likelihood of a recession in the next 12 months has never been higher since the late 1960s.

The relationship between the spikes in anticipation of a recession and actual recessions might appear to be correlated at first glance, but notice that decades have passed when nearly a fifth of professionals, at some point during the period, feel a recession is imminent. There have also been periods when the anticipation of a recession has plummeted, right before one actually begins. I believe the outcome, sadly, rests mainly in the hands of the Federal Reserve and other associated central banks. Nonetheless, I can't help but feel contrarian here and have a feeling that fears of a recession may turn out to be parboiled. I am likely to be woefully wrong, and have, over the course of 2022, positioned myself with recessionary environments in mind. I briefly elaborate on that in this post, detailing why I have been buying Greggs PLC, but plan to write something more concrete on this business in the coming weeks.

“Table 5 below shows the behaviour of large cap and small caps over the recovery period, defined as the twelve month period subsequent to an economic trough. Small-caps provide substantially higher returns than large caps over this time frame. The differential return to small caps is positive for all of these recoveries, except for the June 1938 trough, for which small caps had a one-year holding period return of 27%. While small-caps generate relatively high returns in the year subsequent to a trough, in the year prior to the peak (i.e., the year preceding the onset of the recession), small-caps often lagged, as is shown in Table 6.”