June 5, 2002
Baccarat, now a ghost town outside the western side of Death Valley in California, is also the name of the town at the center of Australia's gold mining industry. This is no coincidence.
Apparently, an Australian miner seeking his fortune in California thought the geology and topology at Baccarat were remarkably similar to a place outside Melbourne, Australia. According to legend, the miner returned to his Australian canyon and discovered the gold that sparked Australia's own gold rush.
Reasoning by analogy has been called the lowest form of reasoning. However, as the above example indicates, it sometimes is effective.
Today some investors are using the same form of reasoning to determine what they should be doing with their investments. They try to find an historical period that appears to be similar to conditions today. They then examine what happened as events unfolded historically. If investments today are showing the same pattern, they assume the similarities will continue.
More than thirty years ago, Nobel Laureate Robert Lucas wrote a compelling paper suggesting that all future economic events are unique. His argument is that expectations as well as existing conditions determine the behavior of people.
Even if the same conditions reappear, expectations will be different as the events unfold. This occurs because today's people know what happened last time, while those in the earlier period did not. That knowledge makes at least one important variable (expectations) different between the two periods.
In the gold example, expectations do not alter the placement of gold deposits. Therefore, similar conditions can lead to similar outcomes.
However, there is one caveat to the uniqueness claim by Robert Lucas. What if the expectations held in the earlier period proved to be justified? Would not the same expectations be formed today, thus making the analogy valid?
The reason why this discussion may be important for investors is because there are similarities between some investment performance today and in the aftermath of the last recession in 1991.
As the economy fell into recession in 1990 low credit bonds showed substantial price weakness. At their nadir early in 1991, "junk" bonds had established almost a 10 percentage point gap above treasury bonds of the same maturity.
This gap was justified because of huge defaults, almost 10 percent of all "junk" bonds issued. The higher returns were needed to attract investors to the low credit quality bonds.
Early this year, a 10 percentage point spread had emerged again in the "junk" market. Not surprisingly, defaults once again were above 10 percent of all issues.
When the 1990 recession ended early in 1991, defaults slowly began to decline. By the end of 1992, the default level had declined to less than 5 percent of all issues. But investors were getting compensated for much higher defaults. In 1992 and 1993, total returns from high yield bond investing rose toward 25 percent per year as investors sought the high yields of low quality bonds.
This year, high yield bond funds once again are outperforming almost all other investments (except gold stocks, but I do not see any analogy there). Indeed, high yield emerging market funds have been ahead of almost all other investments except Asian stocks.
Will the compensation for default once again prove to be excessive, as investors are assuming? Does this mean that "junk" bond investing will again provide strong returns in the next two years?
There are economic reasons suggesting that high yield bonds may again outperform for a period of time. Those companies offering huge supplies of high yield bonds, such as energy marketers and communications companies, are trying to upgrade their balance sheets by cutting capital spending and selling assets.
The same pattern existed in 1990, when the real estate developments and industrial mergers subsided in another round of balance sheet enhancement.
Also, many junk bonds are created from higher quality bonds that have deteriorated. This supply certainly increases in a recession, but ends by the end of the first year of recovery. Furthermore, the weakest have died so survival rates begin improving soon after the economy begins to recover.
Nevertheless, few investors anticipated the strong returns in 1991. They do today. Investors' expectations are decidedly different between the two periods. Therefore, analogy could fail this time.
I see more similarities than differences between the two periods. Yet, Lucas never gave us guidance on the degree of uniqueness that each observation may have. Perhaps, that is why financial investment never will be a science, while mineral exploration is.