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Lessons from Wall Street’s Four Great Bottoms

Professor Russell Napier spends most of his time studying financial markets. Author of The Solid Ground investment report for institutional investors and co-founder of the investment research portal ERIC, Russell has been writing global macro strategy for institutional investors since 1995.

He’s also a student of financial mistakes. He set up the not-for-profit Library of Mistakes in 2014, a library dedicated to avoiding mistakes. The professor set the Libary up with the simple goal of educating the financial world about its past mistakes. 

Napier has used his knowledge of the markets to compile a book of the greatest bear markets of all time. 

Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms, was first published in 2005. It was later updated to include the lessons of 2008. It is a must-read for anyone that wants to understand why markets crash, and the indicators of a potential market recovery. 

Napier studied over 70,000 articles from the Wall Street Journal written in 1921, 1932, 1949 and 1982 (the Four Great Bottoms) to try and identify if any of these market bottoms had anything in common, which could help investors in identifying similar situations in future. 

In all cases, one factor stood out: Deflation. 

“The appearance of or the real risk of deflation marks the big bear market bottoms. Deflation has always been associated with falling corporate cash flows and this can threaten the very existence of equity given that it questions whether the company can meet its liabilities. A material rise in the risk of debt default raises the issue of whether corporate equity is worth anything!” — Anatomy Of The Bear: Interview With Russell Napier

When the risk of deflation starts to emerge, it’s a great time to buy stocks:

“What happens with equities is that sometimes they get so cheap that there is virtually only one way for them to go, which is up. And what I discovered in the research for that book is that ultimately they get cheap because of deflation — not world wars, not nuclear armageddon, not bird flu, but the risk of deflation.

Those who’ve read about the 1929-1932 period will know that deflation threatens reduced corporate cash flows and the eradication of equity. Corporations become bankrupt. That’s what you have to fear most of all. In 2007-2009 clearly that is what we were worried about; that’s why equities got so cheap.

So the history of a nation which holds itself together as a private property owning nation is that sometimes the pain of deflation is so much that you can expect a remedy. The remedy we’ve just had is quantitative easing. The remedy we had in 1982 was to abolish money supply targeting. The remedy after World War 2 was to create more inflation to try and shift government debt. So societies find a remedy to too much economic pain. And if equities are cheap, then you buy them.” — How To Avoid Investment Mistakes — Russell Napier 

With the benefit of hindsight, it’s easy to identify these trends. It’s challenging to judge the risk of inflation in real-time. 

That presents a big problem for investors. How do we invest so make sure we’re prepared for all environments? 

Napier has offered the following advice:

“In general, I think it doesn’t really matter if you’re buying things when they’re cheap. So that’s a very simple and easy solution — buy things when there are cheap. The problem is you don’t always get that opportunity. So retail investors should be worried about having a good asset allocation among different asset classes…So buy things when they are cheap, hold them, diversify across a wider range of assets and markets, but truly try not to do very much at all.”

It is impossible to predict future stock market moves. The market will go up and down. 

All investors can do is try to protect themselves from uncertainty and be ready to act when opportunities present themselves. Asset allocation among different asset classes is Napier’s solution to this problem. 

Diversification across asset classes, bonds, stocks, real estate, gold, and cash may reduce returns (compared to equities), but it could protect against uncertainty and volatility. 

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