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I was talking with professor Minis before we started and we talked about the fact that the the economy if you graph it out kind of looks like this. It's an upward sloping line that grow it has an innate uh secular growth uh rate underlying and small fluctuations. So the economy grows 2% a year on average.
Sometimes three, sometimes one, sometimes maybe four, sometimes maybe minus two. But clearly the range of outcomes is is modest. So if you do it on the right scale, the fluctuations are small. Then if you graph corporate profits, they look like this. Corporate profits fluctuate much more than the economy.
Even though the the most of the movements in corporate profits are determined by the economy. Why? Why do they fluctuate more? And the answer is that companies have leverage. They have financial leverage which means that a certain change in the re in the profits of the company at here after paying off the bond holders makes the return to the uh shareholders much more volatile and they have operating leverage since a bunch of the costs are fixed.
If the if the volume doubles the profits quadruple if the volume goes in half the profits disappear. So companies are leveraged and profits are much more volatile than earnings. Then if you graph the stock market, it looks like this, you know, up and down crazily. Um, and uh that's what investors really care about in the short run.
Why are stock prices so much more volatile than corporate profits? Which if you think about it, when you buy a stock, all you're buying is a share of corporate profits. Shouldn't they reflect the same volatility? Why should the the price of a share of profits be more volatile than the profits themselves?
And the answer is that uh you know Richard Feinman the great physicist once said that uh physics is easy physics would be much harder if electrons had feelings. The market is composed of one thing. any market people have feelings. So they get excited and they bid the value of a share of corporate profits very high.
Then they get depressed and they price it very low. So naively uh people think that the changes in stock prices are determined by corporate events by fundamentals. And if you watch TV, the announcer says the stock market was up 200 today because uh Tesla had a great announcement or the stock market was down 200 today because it looks like inflation is is raging.
The proper answer is the market was up 200 because today people became more optimistic or it's down 200 because people became more depressed. It is psychology that that determines. So what a lot of my attention in my senior status is directed at trying to figure out what's going on in the market today in terms of investor psychology and behavior and what does that tell us about the proper uh behavior for ourselves?
U and so you you knew I was going to get to your question sooner or later. So in 05 and and six I detected uh optimism, excessive optimism, accept excessive eagerness, excessive order uh insufficient uh risk aversion um uh insufficient fear uh and consequently uh that implies that asset prices are probably too high.
That was it. That was it. And as I wrote a memo and I wrote a call and it says uh there they go again talking about the fact that investors were behavior were engaging in some of the uh ill-founded behavior that I've seen in past crises and it basically said this is a time for caution and and uh of course that was 05 06 07 the global financial crisis started to occur.
08 is when Lehman uh reached its bankruptcy and the uh the worst of the financial crisis started to occur. So, you know, it's really a ma I recorded a podcast about this yesterday. It it's really a matter of just extremes, you know. Um the economy goes like this, profits go like this, stock prices should go like this.
But uh but sometimes they don't because of people's emotionality. So if you can gauge the emotionality, then you could say, I'll bet it's, you know, it seems too heated, seems too cold. I wrote a book called Mastering the Market Cycle and I consulted my son who's a very smart uh investor uh about some of the ideas and at one point I said to him, you know, Andrew, I think my market call, here's a guy who doesn't believe in forecast.
I said, I believe my market calls have been correct. He says to me, yeah, Dad, that's because you did it five times in 50 years. Extreness, that's the word that that came out of my podcast yesterday, extremess. Five times in my 54 years or maybe was six or four or seven or something like that. Five times the market was either up here crazy high or down there crazy cheap.
And on those occasions the case for a call was overwhelming in my opinion and the probability of success was high. Mhm. But if I had tried to do it 50 times in 50 years or 500 times in 50 years or 5,000 in 50 years, I couldn't have had a very high batting average. Uh so um but but oh 056 was one of those times I just you know what I learned here among other things but one of the most important things I learned here is that risk aversion it has to be a fundamental part of of a market.
It is risk aversion that makes people demand higher return, higher return potential from investments that appear riskier, which is of course the only thing that makes sense. It is so if you think about it, it is risk aversion that keeps markets safe and sane. And if I'm in a environment where I detect that risk aversion is inadequate, that's fertile ground for excessively high prices.
Sometimes, like in '08 after the Lehman bankruptcy, I can get a sense that risk aversion is excessive and thus prices are probably too low. That's a time to become a buyer. So, you know, as I said, we came in on September 18th with 10 billion dollars on the shelf. Should we invest it? Well, let's analyze whether the financial system is going to melt down.
No such thing. How did I make a decision? What I decided was this. It's hard to predict the end of the world. Never happened before. And so, you don't have a very good decision-making system. It's hard to do so. and assert a high probability that you're right. It's hard to if if you make a prediction that the world's going to melt down, it's hard to know what to do about it.
What do you do? You know, how you going to live? You going to walk around with a gold bar and and peel off a little to to buy the stuff you need? And it's hard to act on it. And most of the time, the world doesn't end. So it was very hard to reach that opinion and I said rather if we invest today and the world melts down it won't matter.
The money on the shelf won't do any good anyway. But if we don't invest today and the world doesn't melt down then we didn't do our job. So to me it was a very easy decision. and Bruce uh you know we we we hashed these things out together but we were in agreement. So he invested for that fund I mentioned $450 million a week on average for the next 15 weeks $7 billion over a quarter almost all the fund and it it turned out that the world didn't melt down the the you know Bear Sterns had disappeared uh um Maril Lynch had disappeared into the clutches of BFA Wakovia Bank uh Washington Mutual Bank AIG Lehman Brothers We all knew that Morgan Stanley was next and Goldman Sachs was after that and it looked like a downward spiral roughly the year you were born.
No, a little earlier. There was a movie called The China Syndrome starring Jane Fonda and it was about a nuclear reactor that gets out of control and they're concerned that the reaction will go through the earth and come out in China and that's the name. That's ergo the name and but you you couldn't prove that it wasn't going to be true.
But fortunately uh I think people were so motivated by the bankruptcy of Lehman Brothers that that they they arrested the downward cycle and here we are. Um but you know you you you can't make these decisions based on provable hypothesis. Sometimes you just have to make a judgement.
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