25 November 2023

On today’s episode, Clay is joined by Brendan Hughes to chat about his new book – Markets in Chaos. The book explores various market crises including the covid-19 pandemic, hyperinflation in Zimbabwe, the stock market bubble in Iceland during the great financial crisis, and much more.

Brendan is a Registered Investment Advisor for Lafayette Investments and has more than a decade of industry experience in investments and public finance. Lafayette Investments has $720 million in assets under management and primarily caters to high-net-worth individuals. 

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  • What a market crisis is.
  • Why it’s important to study history as investors.
  • What led to hyperinflation in Zimbabwe.
  • The market crisis in Iceland that led to their stock market falling by 95%.
  • The lost decade of Japan.
  • Potential parallels between the bubble in Japan and markets in the US today.
  • Brendan’s biggest takeaways from studying market crises.
  • The US energy crisis in the 1970s.
  • Companies that perform best during inflationary periods.


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

[00:00:00] Clay Finck: On today’s episode, I’m joined by Brendan Hughes to chat about his new book, Markets in Chaos. Markets in Chaos covers various market crises, including the COVID 19 pandemic, the Latin American debt crises, the South Sea bubble in France, Germany’s hyperinflation, post World War I, and many more cases.

[00:00:18] Clay Finck: Brendan is a registered investment advisor for Lafayette Investments and has more than a decade of industry experience in investments and public finance. During this chat, we cover why it’s important to study history as investors, what led to the massive hyperinflation in Zimbabwe, the market crisis in Iceland that led to their stock market rising by 900 percent and then swiftly falling by 95 percent during the great financial crisis, The lost decade of Japan and the potential parallels Brendan sees between the Japanese stock market bubble and the markets in the US today and much more.

[00:00:52] Clay Finck: This was a very interesting discussion that really makes you take a step back and consider how we can best preserve our hard earned capital during the most extreme market periods. With that, I bring you today’s episode with Brendan Hughes.

[00:01:08] Intro: You are listening to The Investor’s Podcast where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:01:29] Clay Finck: Welcome to the Investors Podcast. I’m your host, Clay Finck, and today I am thrilled to be joined by Brendan Hughes. Brendan, thanks so much for joining me today. 

[00:01:38] Brendan Hughes: Thanks a lot for having me, Clay. I’m very happy to be a guest. 

[00:01:42] Clay Finck: I just finished reading your new book. It’s titled Markets in Chaos, a History of Market Crises Around the World.

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[00:01:50] Clay Finck: And this book received praise from Tom Gaynor and Lauren Templeton, both who have been guests on the podcast in the past. So I’m super excited to dive into this. At the start of your book, you say this book is useful for those seeking to learn about the history of market crises and individuals who want to learn about protection against downside risks for an investment portfolio.

[00:02:12] Clay Finck: So I think a good place to start is how about we start with defining what a market crisis is in the first place. 

[00:02:19] Brendan Hughes: I would define a market crisis as a shock to the price of assets. And my book, Markets in Chaos, the history of market crises around the world, documents case studies tied to different types of crises.

[00:02:31] Brendan Hughes: The book covers classic financial crises tied to the banking system in Iceland, Indonesia, Chile, the United States and Rome, Italy. And these are scenarios where basically there’s an extended period of easy monetary policy and loose oversight. And then there’s booming credit creation that coincides with rising asset values.

[00:02:50] Brendan Hughes: It’s a very similar story in each case. And eventually interest rates are increased in an attempt to quell inflation. And then all the companies and. Things that were doing crazy things when money was cheap end up getting into trouble. And we’ve seen that right now after about 15 years of easy monetary policy following the global financial crisis.

[00:03:12] Brendan Hughes: And then the other types of market crises are cases that review. Market bubbles in France and Japan where the quoted price of assets just far outstrip fundamentals citing an example that I know in my book in the epic market bubble in Japan in the late 1980s, with some considered to be the greatest in history in terms of total market capitalization impact and recovery time, the imperial palace, which, if you don’t know, the residents of the emperor of Japan was reported to have been worth more than the entire state of California, which is.

[00:03:45] Brendan Hughes: Just hard to comprehend, but this was a crazy time in Japan. And then there’s also crises documented that are tied specifically to macroeconomic event triggers, such as COVID 19 in the United States and a few hyperinflationary scenarios, such as in Zimbabwe and Germany. In citing example in the German hyperinflationary episode in the 1920s.

[00:04:09] Brendan Hughes: It was reported that the price of meals at restaurants was different by the time someone received their food as compared to when they were ordered. Now, that’s just almost impossible to fathom and if you’re living in a developed country and things have been relatively stable, but we’re talking about Germany.

[00:04:27] Brendan Hughes: We’re not talking about some small country. So those types of things can happen in anywhere. But yeah, the book covers those types of situations and. I think it’s a good reminder that a lot of people look at what they’ve seen in their lifetime, and they say that this is what always happens, but that’s not the case.

[00:04:46] Brendan Hughes: Sometimes what’s happened recently and more broadly in someone’s lifetime that can in fact be an aberration. And I think that’s important to think about. And that’s one of the main reasons that I wrote this book. I think it’s important for people to know those types of things. 

[00:05:02] Clay Finck: I totally agree.

[00:05:03] Clay Finck: You have some great points there just to give people an idea of what types of things can happen. And people, I think just generally have this bias where these terrible things that happened to other countries, oh, that’ll never happen in the U S and people just have this sort of buy.

[00:05:21] Clay Finck: Where things tend to be the way they’ve recently been. I also think just people look at even just the past decade, if an investor started investing just in the past decade. And they’ll be like, Oh this works really well during the 2010. So they assume that it’s going to continue to work before we dive into some of the examples here.

[00:05:42] Clay Finck: I love for you to just talk more about this importance of studying history, because you mentioned the recency bias that people tend to have, but talk more about these benefits. that we can receive from studying broader history and diving into some of these more extreme examples of market crises.

[00:06:01] Brendan Hughes: I think it’s really important to study history and Mark Twain is often credited with coining the phrase, history doesn’t repeat itself, but it often rhymes. As I was working my way through writing this book and for any listeners out there, you start to notice. Patterns that have happened for thousands of years.

[00:06:18] Brendan Hughes: It’s actually crazy how similar some things have happened and it’s just really interesting. But as an investor, I think it’s critical to have an understanding of what happens in the past. So we can better anticipate the present and future in terms of potential ranges of outcomes in terms of what happens to assets.

[00:06:35] Brendan Hughes: government responses, and investor psychology. And some may be surprised that the Roman response to the financial crisis in 33 AD, so that was over 2, 000 years ago, was very similar to what happened to the United States in what they did in the response to the global financial crisis. And that’s inject massive liquidity into the system and keep interest rates very low.

[00:06:59] Brendan Hughes: So you see like in a span of 2000 years, people are doing the same things. And that’s a recurring theme that I cite throughout markets and chaos. And during the COVID 19 pandemic, we kept hearing that this was an unprecedented event. I don’t want to downplay some of the negative things that came out of COVID 19 in any way.

[00:07:20] Brendan Hughes: But with the press kept saying that this one unprecedented, and that’s just a very untrue statement. And I. I cite the black death as a reference because in the mid 1300s, between 30 and 60 percent of all Europeans were estimated to have been killed. And that’s a wide range because we don’t, they didn’t have the same ways of tracking data that we do now in the mid 1300s and also between 75 million and 200 million.

[00:07:46] Brendan Hughes: People globally were reported to have been killed in the pre pandemic population, which is 475 million at that time. So obviously this was a world altering event and it really, it took 150 to 200 years for the populations to recover from this event. So I don’t want to downplay what happened related to COVID 19, particularly for the people that knew someone that died or something of that manner.

[00:08:11] Brendan Hughes: But we’ve seen these things before. Each time they’ve impacted the world in different ways. Most recently, like related to COVID 19, I think some things that came out of that were to some extent hybrid work is here to stay, like things like mobile ordering and such. Those trends were already in place before the pandemic, but they were accelerated and looking back at scenarios, like the black death in the mid 1300s.

[00:08:39] Brendan Hughes: There was huge world altering forces. There was a labor shortage that lasted for hundreds of years because of this. So in some ways it’s difficult to compare an event like that so long ago to what happened now. But I think it’s important to just look at it and I think you can better. Project the range of things that can happen coming out of it, if you have that knowledge going into it, 

[00:09:07] Clay Finck: let’s dive into one of the somewhat more recent ones.

[00:09:11] Clay Finck: You mentioned Rome and the black death. Let’s dive into Zimbabwe and their hyperinflation event and. This is actually considered to be the second most severe period of hyperinflation in modern history behind Hungary’s hyperinflation event in the 1940s. How about we define what levels of inflation are considered to be hyperinflation, and then Also paint a picture to how often do these sort of occurrences happen throughout history, these hyperinflation type scenarios.

[00:09:45] Brendan Hughes: Hyperinflation is often defined as a period of rapidly rising prices for goods and services when price increases usually measure 50 percent month over month. But really in practical terms, hyperinflation is basically when money stops being useful. I think that’s a better term, like when citing that example in Germany in the 1920s, where you order food and then the price is different.

[00:10:09] Brendan Hughes: 15 minutes later, the money is not useful in those situations. And as I documented in my book markets in chaos in 2008 at the peak. Of the Zimbabwean hyperinflationary crisis, inflation was reported to have been 79. 6 billion percent month over month. That’s difficult to comprehend when in a country where people are complaining about what inflation was 10 or 11% that’s not good either, but slightly below 80 billion percent.

[00:10:41] Brendan Hughes: And I noted some of the most notable hyperinflationary episodes in recent history, meaning like the past a hundred or so years, and that includes Germany in the 1920s, Hungary in the 1940s, Yugoslavia in the 1990s, Zimbabwe in the 2000s. and Greece in the 1940s and hyperinflation usually occurs as a result of some combination of war, economic turmoil, high national debt levels, excessive money printing, political instability, and loss of confidence in the monetary system.

[00:11:12] Clay Finck: And how did this end up happening in Zimbabwe? We see these cases of just terrible things happening for different countries, but to see hyperinflation this is a very extreme type of scenario. So how did this end up playing out for Zimbabwe? 

[00:11:30] Brendan Hughes: Yeah, so I can walk through the hyperinflation events in Zimbabwe.

[00:11:34] Brendan Hughes: The seeds for hyperinflation in the country were planted when the government launched land reforms that resulted in Zimbabwe seizing white owned farms and transferring this property. To local black individuals that lacked farming experience. So once this happened, there was a food shortage and a foreign investment dried out because people didn’t have confidence and that their assets weren’t going to be confiscated.

[00:11:59] Brendan Hughes: And then. Real estate values were obviously negatively impacted by this, and as is typical in hyperinflationary scenarios, the government was increasing national debt. So in, in the two thousands, the Zimbabwe’s economy started to go downhill. Basic consumer staples were in short supply, like its typical in hyperinflationary scenarios.

[00:12:20] Brendan Hughes: Inflation increase in confidence. And the local government eroded and people started leaving Zimbabwe in large numbers. As usually happens when these types of scenarios start to play out, the government responded by printing more money. And this is a classic response to these types of scenarios and it ultimately leads to more inflation.

[00:12:42] Brendan Hughes: As previously mentioned, inflation was estimated to have peaked around 80 billion percent month over month. And during this hyperinflationary period, some economists estimate that between 75 and 90 percent of the local population was unemployed. That’s, again, difficult to wrap your head around.

[00:13:03] Brendan Hughes: Almost nobody in the country was working. And Zimbabwe has never really recovered from this period. And I think that is tied to trust in the government and the corruption that has persisted. They’ve periodically attempted to implement various new currencies and they haven’t worked out. And international investors and lenders have You know, largely neglected the markets for a long time now, and I think rightfully you mentioned just the trust eroded and when citizens of a country, they lose trust of the political establishment. That’s when the release valve is let go and it’s gone. Like they can’t sever. Once trust is lost in a currency, you really can’t get it back. And it reminds me of countries today that have higher levels of inflation, but they don’t have quite the levels of what would be defined as hyperinflation.

[00:14:00] Clay Finck: Turkey and Venezuela are two countries that come to mind. What do you think keeps enough trust in a currency that like that, the sort of in between where it’s not stable, it’s not hyperinflating, what’s keeping that release valve from being let go? 

[00:14:14] Brendan Hughes: I think it has a lot to do with confidence and in the government itself.

[00:14:19] Brendan Hughes: And laterally that flows over to. What’s going on with the currency. I talked about that when I was documenting Germany in the 1920s, because I was comparing and contrasting the German and Zimbabwe and hyperinflationary scenarios. And ultimately Germany got their hyperinflation under control.

[00:14:39] Brendan Hughes: And I think that has a lot to do with people have more confidence in the German government as compared to Zimbabwe. And you can throw modern day Venezuela in there as well. Because. Germany, they ultimately rolled out a new currency and they said that it was backed by hard assets. But if everyone went to go said, we’re going to go try and retrieve these hard assets all at once.

[00:15:02] Brendan Hughes: There’s no way that they would actually been able to fulfill on that. So I think it had a lot to do or it has a lot to do with the trust in the political institutions. 

[00:15:14] Clay Finck: Another one of the chapters you dive into Iceland. This is a quite small country and. This isn’t a story that I had heard of before. A lot of people have heard about the story of like tulip mania, even Zimbabwe.

[00:15:28] Clay Finck: People hear about the hyperinflation event there, and people are quite familiar with COVID 19 since it’s so recent. So please tell the story of Iceland and some of the things you picked up in studying their crisis. 

[00:15:42] Brendan Hughes: The story of what happened to Iceland during the global financial crisis in 2008 and 2009 is really interesting.

[00:15:48] Brendan Hughes: And if you want to dive more into the global financial crisis, I would recommend looking at Iceland. Even though it’s a small country, as you noted, there are 375, 000 people. country GDP is about 26 billions. And so in other words, it’s a very small in terms of both population and size of the economy.

[00:16:06] Brendan Hughes: But the story of what happened there in 2008 and 2009 is really interesting. And I think business classes can learn a lot from studying it. Iceland was one of the hardest hit countries during the global financial crisis, and like the seeds were leading up to the global financial crisis. Like between 2003 and 2004.

[00:16:25] Brendan Hughes: The Iceland stock market skyrocketed 900 percent in the span of one year. And this is a recurring theme that I document throughout my book, but there’s a period of easy money, which as we saw during the most recent 15 year period, where there was easy money, when this happens, people pile into basically anything but cash because cash doesn’t pay a lot.

[00:16:48] Brendan Hughes: So people buy out everything else and the money supply in Iceland expanded by tenfold. In the 14 year period ending with the global financial crisis. And I think a lot of these types of events have really been possible because I tie it back to the huge moment in 1971 where the United States severed the US, the link between the US dollar and gold.

[00:17:12] Brendan Hughes: And that is really. I think facilitated a lot of these ultra easy monetary policies and also just piling on massive amounts of debt at the federal and business levels. 

[00:17:25] Clay Finck: Yeah, so what happened with the banking system within Iceland and then ultimately led to the collapse of this massive bubble in the stock market and their economy?

[00:17:37] Brendan Hughes: Yeah, so what happened in the banking sector was astounding, even by historical banking sector collapses, the entire banking sector in the country basically fell apart in one week in the course of just three days. The government effectively nationalized the 3 largest banks and the 3 largest banks made up the vast majority of the entire banking sector, but 1 of the core issues that led to the demise of the Icelandic banking system was.

[00:18:09] Brendan Hughes: The banks started to increase their reliance on foreign deposits. We’ve seen this happen and I documented this, like this was going on during the Asian financial crisis as well, but leading up to the global financial crisis, capital flows to Icelandic banks exploded. And this was owing to investors searching for yield during the easy monetary when interest rates are low in a lot of countries, they’ll go to places that are offering a bit more yield, like in this case, Iceland.

[00:18:38] Brendan Hughes: So when things start, when it started to become apparent that there was trouble brewing around the world and in the global financial crisis, these. foreign deposits quickly fled and these were deposits that these banks were now relying on for stability. So you also have various problems, like there was increasingly exotic financial instruments, such as CDOs, which are collateralized debt obligations being rated as investment grade.

[00:19:04] Brendan Hughes: and similar to what we saw in the United States. Things like that. 

[00:19:09] Clay Finck: Related to Iceland, in your book, you also talk about how the fractional reserve system is essentially it’s a very flawed system. And this is really relevant to Iceland because it isn’t the only country in the world that has a fractionally reserved system.

[00:19:25] Clay Finck: It applies. Globally and including in the US. So could you talk more about these flaws that you point out in your book of the fractional reserved banking system? 

[00:19:37] Brendan Hughes: Fractional reserve banking is the commercial banking system that’s still employed around the world today. And I’m pretty sure the average citizen isn’t even aware that.

[00:19:46] Brendan Hughes: When they deposit money into a bank, the bank often lends this money to someone else. So the entire system is predicated on the idea that not too many people are going to go and try and claim their deposits at the same time. But as we know from studying various events in history, this It’s often not the case, not often, but it happens during crises, people go and try and get their deposits, but a quick summary of the fractional reserve banking system and in terms of numbers, is it banks effectively earn 1 to 2 percent return on assets, and then they leverage these low returns approximately at a 15 to 1 ratio so they can.

[00:20:34] Brendan Hughes: Stig Bordersen, Preston Pysh, William Green, Clay Finck, Patrick Donley, Robert Leonard, Kyle Grieve, Warren Buffett, Charlie Munger, Robert Leonard, Kyle Grieve, Warren Buffett, Charlie Munger, But one of the core issues with the modern fractional reserve banking system is that the interest. of private commercial banks and central banks.

[00:20:56] Brendan Hughes: They’re just not aligned. Private commercial banks care about how much profit they produce, irrespective of how their money creation impacts the health of the domestic currency or financial system. So banks inevitably get into trouble owing to their flawed business models, and when this happens, governments look to these institutions and they ask is this company too big to fail?

[00:21:18] Brendan Hughes: And we saw this in the United States during the financial crisis as well. And if the answer is no, these firms are allowed to declare bankruptcy and consumers are then reimbursed up to a certain amount if they’re insured by the FDIC or whatever the. local equivalent of FDIC is. And if the firm is deemed to be too big to fail, the government bails these companies out by borrowing huge amounts of newly created paper money and then lending it to this firm.

[00:21:44] Brendan Hughes: And most consumers aren’t aware of what happened, but they’ve just been taxed by the government in the form of higher inflation. And this is a, it’s frustrating to read about this and study it because this is just a recurring cycle that keeps happening. And I don’t think that Most people are aware that they’re being taxed in this manner.

[00:22:04] Clay Finck: Yeah. I had a comment here related to Iceland. You mentioned in one year, their stock market went up by 900%. And then if I’m remembering correctly from your book, it proceeded in the collapse of the banking system. The stock market fell by 95%. I think it’s like such an important reminder to keep in mind of our recency bias and remember that.

[00:22:28] Clay Finck: Ever since the great financial crisis, we’ve very much been in a period of easy money in the United States. And because of this easy money period, you see this credit expansion rising debt levels and the money supply is essentially expanding and expanding. Part of that at least is going towards.

[00:22:46] Clay Finck: The growth of financial assets. And I think it’s just important to really tame expectations and just remember that credit, this credit expansion can lead to essentially the illusion of wealth. You might feel wealthy checking your accounts and checking your investments, but just know that when that expansion goes away, then Your investment values might not be a year from now as near as much as what they’re worth today.

[00:23:11] Clay Finck: And that’s not like me calling for a stock market correction or anything. It’s just to, I think, tamper those expectations and keep in mind where we are at in history and how that relates to past periods, such as what happened in Iceland. Yeah, 

[00:23:25] Brendan Hughes: I think that’s a great point, Clay, and thanks for bringing that up.

[00:23:29] Brendan Hughes: We have extended periods of easy monetary policy. It often leads to asset price inflation. And this is not a type of inflation that is, is covered. Like when CNBC and those channels, they’re covering consumer price inflation. That’s what they’re always citing as what inflation is. But asset price inflation is very real.

[00:23:50] Brendan Hughes: Like things like real estate values and such, and that’s not captured. And consumer price and inflation. And it’s when people say just consumer price inflation as being inflation, that’s not a remotely close to a full depiction of the whole picture as to what’s going on. 

[00:24:09] Clay Finck: I wanted to move on to Japan.

[00:24:12] Clay Finck: You studied their last decade from 1991 through 2001. Japan’s stock market, it peaked around a P. E. of 60 in 1989, and people are pretty familiar with this lost decade of Japan as recently we’ve seen that still today, there’s the Nikkei trades below where it was in 1989, and it points to what can happen over when a market’s in a bubble and then they’re facing all these issues that we’re going to be diving into there.

[00:24:41] Clay Finck: And what led to their stock market crashing and correcting was the central bank raising interest rates and tightening financial conditions. And from the end of 1989 to the bottom of the market, all the way in 2003 very choppy ride along the way, but it ended up bottoming in 2003, the market fell by 80%.

[00:25:03] Clay Finck: So talk to us about this Japanese bubble and the last decade that followed for them. 

[00:25:09] Brendan Hughes: Yeah. So I’m pretty sure the Japanese index just in the past few months, like maybe in June past surpassed the levels in 1989. So you basically for over 30 years, you would have earned effectively nothing in inequities in a country.

[00:25:25] Brendan Hughes: And I think that this is a very important point. to hone in on because US investors have only ever known.

[00:25:36] Brendan Hughes: And I think one of the takeaways from my book is to think more about country diversification, just because of this example in Japan, but at the peak of the Japanese bubble in 1989, Japanese real estate was valued at 1. 5 billion. At four times the value of the United States real estate, despite Japan only being 4 percent the size of the United States.

[00:25:58] Brendan Hughes: And as you mentioned, the equities in the country also had a PE ratio of 60. The imperial palace was valued more than the state of California. It was by any measure an epic bubble, even compared to some of the more memorable bubbles in history. But my big takeaway from this entire series of events is to think more about country diversification because history suggests that a variety of factors can prevent equities or real estate in a given country from perpetually rising like we’ve seen in the United States for long period of time.

[00:26:35] Clay Finck: People talk a lot about inflation, especially nowadays, but you don’t hear too much about deflation. Deflation is actually something Japan has been, it feels like fighting tooth and nail ever since the mid 1990s, and deflation especially brings its own host of issues as inflation does as well, and you’d think after a certain period of time that a country as developed as Japan would be able to figure this out, so what makes it so difficult for them to manage their economy, And manage that deflation that they’re working against.

[00:27:13] Brendan Hughes: Yeah. And I think I used the term in my book, they’ve been stuck in a deflationary trap that has lasted for several decades. And what’s happened is that a lot of money was printed, but people, businesses and individuals in Japan have just not been convinced to invest this money. So they came to believe that at least for several decades, That cash will be worth more tomorrow than it is today owing to these deflationary pressures.

[00:27:38] Brendan Hughes: So it becomes really difficult to convince businesses and people to invest when they haven’t seen a return on assets for a really long time. So it becomes somewhat of a self fulfilling prophecy that people just keep hoarding cash not investing it because they don’t see any reason to because. In, in recent history, nobody’s earned a return on it.

[00:28:02] Brendan Hughes: And that is been a short synopsis of the deflation that Japan has faced for a long time. 

[00:28:11] Clay Finck: And then what are the key factors that make deflations playing a role in Japan? Whereas for example, the United States, we’re dealing with inflation. What are the key drivers there? 

[00:28:23] Brendan Hughes: Yeah I want to point out that there’s two different types of deflation.

[00:28:28] Brendan Hughes: The deflation that we’ve seen in Japan for several decades is the more dangerous kind of deflation. And that’s a demand driven deflation. And that’s where, as I talked about people in businesses choose not to Invest, the government can print more money, try and do things to get people to invest the money, but they’re saying, we’re not going to invest.

[00:28:48] Brendan Hughes: We haven’t seen a return on this. We’re just going to hoard money. This is really different from supply side deflation in the U S in the 2010s. We didn’t have deflation. We had low inflation and that was due to. A lot of it was tied to things like globalization, but there’s also been technological advances where it’s kept inflation relatively low.

[00:29:11] Brendan Hughes: You had companies like Alphabet where they would just they’re offering their services for at least free and monetary costs, they’ll use an advertising business model, but those things kept inflation relatively well along with what I think has been a long trend of. Globalization that’s being somewhat reversed now, but this is similar to the supply side deflation that we saw in the United States in the 1870s and in the 1880s, it was also tied to technological innovation at that time.

[00:29:42] Brendan Hughes: And you had some of the business luminaries of that age Rockefeller, Carnegie and Jay Gould, they effectively. opted to take additional market share instead of raising prices similar to some of the technology giants today. And I don’t view the supply side deflation as being a bad thing.

[00:30:04] Brendan Hughes: A lot of cases I don’t know, a lot of people are not going to complain about getting free shipping. That’s not a problem. Whereas it’s a big problem. If people are not investing money and in the demand driven deflation as a. A final way to wrap this up. There’s fewer dollars chasing the same amount of goods and services that leads to a decline in prices.

[00:30:27] Clay Finck: Do you think that population growth plays a role here? Because when you think about an expanding economy, you can have increasing productivity and then you can just have more people in the workforce. And the U. S. has had this tailwind of. Foreigners coming in and moving to the country, whereas Japan, it seems like their birth rate is essentially leading to their population.

[00:30:49] Clay Finck: I haven’t looked at the longer term charts, but maybe their population is declining. Is that, is population also an important factor here? 

[00:30:56] Brendan Hughes: I think that can tie into perhaps the psychology, like that could probably feed into people being more pessimistic about the business prospects and leading them to not invest.

[00:31:09] Brendan Hughes: So I think in an indirect sense, you’re correct in that line of thinking. 

[00:31:14] Clay Finck: And we’ve talked about the easy money policy and the way this sort of. Plays into these market bubbles, market corrections that follow. And I can’t help but think the Japanese bubble it halted because of came crashing down because of tightening monetary conditions, higher interest rates.

[00:31:35] Clay Finck: Do you see any parallels between Japan? at that 1989 period in the U. S. say in 2021 2022 where the U. S. has now raised interest rates and obviously seeing some headwinds on that front and tighter monetary conditions. 

[00:31:50] Brendan Hughes: I do see some general parallels between the United States and in Japan, like in the present day and a few similarities that I know are.

[00:32:00] Brendan Hughes: The bloated fiscal structure, like Japan has perennially been one of the most indebted countries and the United States balance sheet, at least in the present day, is not in good shape either. So they’re similar in that sense. And we also both have. Aging populations that’s an issue and the recent policies in the United States have been less hospitable to immigrants and Japan has for a long time now been one of the least hospitable countries in terms of immigration.

[00:32:30] Brendan Hughes: It’s very hard to immigrate to Japan, but in a more optimistic.

[00:32:39] Brendan Hughes: I do want to say what I think is an important difference, and that’s tied to innovation. One of the problems that I find when I’m looking at Japan is if I want to have a quick idea of what’s going on in a country in terms of innovation, I’ll just, I’ll look at the list of most valuable companies. Cause I can tell you a lot about what’s coming out of the country.

[00:32:57] Brendan Hughes: What are they producing? When I look at the list of Japan’s most valuable companies, there’s not a lot of what I would deem to be good companies and sectors that I would seek to have exposure to. There’s a few ones like Sony and Nintendo, but most are in the old world economy, like automobiles, like similar to what’s happened to Germany.

[00:33:21] Brendan Hughes: I remain very optimistic about the United States in the sense that I have high conviction that A lot of the best innovation is still coming out of the United States, at least in terms of sectors that I deem to be attractive, like technology you look at the list of United States, most valuable companies, you have a lot of good companies in the technology sector, which have more attractive.

[00:33:47] Brendan Hughes: financial attributes as compared to old world companies like automobiles. 

[00:33:53] Clay Finck: After reading this chapter on Japan in your book I couldn’t help but wonder is that where the U. S. is at today? And I wanted to share some statistics that I pulled here. We mentioned that Japan’s P. E.

[00:34:06] Clay Finck: peaked at around 60, so it’s very high. Levels that offer very low perspective returns without these very high growth assumptions in the future. And today in the U. S., the Shiller PE is around 29. And you hear so many people calling for, some call it the super bubble. It’s just this massive bubble in light of the easy money era.

[00:34:30] Clay Finck: But I would also argue that. these great companies that the US has, the Microsoft’s, the Apple’s Amazon’s, I would argue that many of these great companies, they deserve to trade at higher prices especially when you’re comparing to many of the older economy companies. I would argue that apple deserves the straight.

[00:34:48] Clay Finck: A higher P. E. than many auto manufacturers. And you can’t just compare a company and there how old… Richly valued or overvalued. They are solely based on the PE. I think that is one really important thing that so many people just overlook. Or if someone has a view of the super bubble, they’ll just point to the PE.

[00:35:06] Clay Finck: And you have to be very careful with making these very basic and simple assumptions, in my opinion, at least. And just before we hopped on the call, I noticed that your book mentioned that the Japanese stock market, it increased by 900 percent in the 15 years leading up to the bubble.

[00:35:24] Clay Finck: And I’m like. Let’s see what the U. S. has done in the past 15 years. So I’ll first mention that this is like a 15 years. It’s a cherry pick number because 15 years ago was the depths of the financial crisis. So stocks were very low at that period, but regardless, just for comparison’s sake, the S& P 500 is up just over 360%.

[00:35:45] Clay Finck: And then I’m like, okay let’s look at the NASDAQ. Cause that’s much more heavily weighted towards the companies that did exceptionally well. And the NASDAQ is up over 1100 percent since that time. So with all that said, I’m curious if you agree that us markets are nowhere near where Japan was in 1989, and it’s much more reasonable valuations.

[00:36:06] Brendan Hughes: I want to start by saying that I actually don’t look at PE ratios when looking at valuations. I know that’s different because a lot of PE ratio is almost universally considered to be the most quoted metric in terms of valuation. But I struggle personally to understand why this is the case. Like I look at a free cash flow yield.

[00:36:28] Brendan Hughes: That to me is the most important metric because not all And this is contrary to popular belief, but not all earnings arrive in cash. If the earnings don’t allow you to repurchase shares, pay a dividend, invest in the business or make an acquisition, I don’t understand what good these. Suppose earnings are, but relative to earnings cash flows are much harder to manipulate because over time, the cash that comes in the door is just the cash that comes in the door.

[00:36:55] Brendan Hughes: Whereas accounting earnings can be manipulated by a variety of factors such as under saving impairment, which is a rampant in sectors, such as. Banking and changing the classification of operating expenses to extraordinary expenses and things like that. So looking at free cash flow. Yields in the U. S.

[00:37:14] Brendan Hughes: market today. I don’t think it’s at least in my view, a bubble like Japan in the 1980s, but not bargains like during the global financial crisis. But as you alluded to, that’s a blanket assessment. It varies a lot based on individual companies, but. What I will say is I don’t think that some investors that have been investing since well before the arrival of the Internet have come to appreciate the growth that can be seen in some areas, such as software that you alluded to in your statements.

[00:37:46] Brendan Hughes: At times justify what could be perceived as maybe a relatively high valuation, like just to provide a little context on that before the advent of the internet, it would not have been possible for a company to go from being invented to having hundreds of billions of dollars of profitable cash flows in the span of a couple of decades or less.

[00:38:08] Brendan Hughes: And we’ve seen companies do that. The Netas, the Googles in the span of. Just a few decades or in Google’s case, a little bit longer, these companies have amassed hundreds of billions of dollars in profitable cash flows from nothing like, so most of the time you would have looked at those types of companies and said, Oh, this is expensive.

[00:38:32] Brendan Hughes: Sometimes those companies can grow at rates that justify those multiples. Now the difficulty is projecting these types of companies is more difficult than like a legacy consumer staple. But if you hit on one or two of these, it can make up for a series of moderate misfires elsewhere. And I think in terms of valuations, you also have to be certainly careful in looking at valuations by sector, because it’s perhaps counterintuitive, but sectors like semiconductors where there’s inherent cyclicality, often they’re the most undervalued when their cash flow ratio, their near term price to cash flows is the highest. So saying, I don’t pay that much attention to what is going on in the overall market in terms of what is the headline P.

[00:39:27] Brendan Hughes: E. or price to cash flow. I’m looking at more individual situations and things like that. 

[00:39:33] Clay Finck: You alluded at towards the start of our conversation that what the Romans did 2000 years ago are the same things, a type of Policy decisions, policymakers are making today. And these cycles of human nature playing such an important role in human nature generally doesn’t change.

[00:39:53] Clay Finck: And people aren’t going back and learning from these past mistakes. And human nature is just underpinning what’s going behind these decisions. And I’m super curious in studying all these periods, what are some of the most universal things that are probably the most important to take away in studying all these market crises?

[00:40:15] Brendan Hughes: Yeah, that’s a great thing to bring up. And I Talk about that some at the end of my book, I include a list of what I think are some important takeaways. And I think perhaps the most important, if not one, one of the most important thing is I never attempt to time the overall market because.

[00:40:34] Brendan Hughes: And this happens during every crisis, like people get scared and they sell out at the bottom during these market events, and then they miss all the returns for the next 20 years. The statistics on the way the returns work over time are just staggering. All of the returns an investor earns are just in the few days.

[00:40:54] Brendan Hughes: That nobody expects the markets to go off. Like I included a data point between 1930 and 2020. If you had just stayed invested in an S& P 500 equivalent over that period, you would have earned roughly a 17, 700 percent return. But if you were an investor who just set out the 10 best days. Of the market per decade over that period, you would’ve earned a cumulative 28% return.

[00:41:22] Brendan Hughes: So if you miss the few best days, you are nothing in equity. So you can’t, if you are going to invest in equities, you can’t panic when these types of things happen or else. You shouldn’t be invested there. You won’t earn anything. And my book goes through various implosions in the banking sector across countries in timelines.

[00:41:45] Brendan Hughes: And at least to me, that’s why I choose not to seek out businesses that require leverage to earn a return just because that they go bust quickly when things go south and aside from banking, some other sectors where this is applicable include I don’t know if you’ve seen what’s been going on in China in the last few years, but the property developers have a lot of the, a lot of them have been going bust because of the inherent leverage.

[00:42:14] Brendan Hughes: And then I have a lot greater appreciation after going through this exercise for businesses that require little in the way of capital to run their business. And that’s because capitalized businesses can quickly adjust their cost structure. In times of crisis, and this was really important during the recent COVID 19 crisis because companies weren’t bringing in any revenue for a period of time.

[00:42:36] Brendan Hughes: So if you’re not bringing in any revenue and you can’t adjust your cost structure, that’s a problem. But these types of things do happen. And that to me is certainly important. Look for businesses with strong pricing power. That’s because businesses with pricing power can push through price increases.

[00:42:53] Brendan Hughes: And in times of elevated inflation. So if you have crazy scenarios really high inflation, if your product is important to a consumer, you can charge more for it. Country diversification is important, particularly after studying Japan, where nobody earned a return in equities and bonds for over 30 years.

[00:43:13] Brendan Hughes: And I also cited a few other examples, South African and Zimbabwean property at various times. You would have had your assets confiscated there. So I think country diversification is important. And I think it’s also important to challenge conventional wisdom from my studies. It’s people generally tend to assume what’s happened recently or in their lifetime is what always happens, but it’s possible in a, like a longer historical context, what happened recently could be the aberration.

[00:43:42] Brendan Hughes: So it’s important to at least understand that because then if you see some structural shift. You can understand is this actually a weird thing? Maybe what was happening recently was out of the ordinary. And I think citing a recent example, the extreme monetary policy of the last 15 years, that was weird.

[00:44:05] Brendan Hughes: People that grew up in that, they would have said, Oh this is normal free money everywhere for a really long time. That’s normal. But if you studied markets over a long time that’s not normal. And just to wrap this up I think studying all these things and being able to say, we’ve seen this before.

[00:44:25] Brendan Hughes: You can better construct an all weather portfolio that can withstand extreme shocks and be more comfortable operating in a crisis when it does strike. Because fundamentals usually go out the window when it does happen, and you can take advantage of some opportunities. 

[00:44:40] Clay Finck: I love how you mentioned the recent period could be an aberration, just like a total outlier in the broader data set.

[00:44:47] Clay Finck: And it reminds me of the chapter in Morgan Housel’s book, The Psychology of Money. I believe the chapter is titled, No One’s Crazy. And essentially everyone, not everyone, but like a lot of people invest based on their experience at some certain point in their lives. So like when you think about someone that lived through the great depression, there’s probably a good reason why they are so financially conservative.

[00:45:10] Clay Finck: They can see what can happen in these more extreme scenarios and you can see, Oh, this person’s going out and taking crazy risks, buying a profitless companies or whatever else that they say are going to. triple overnight. And it was like, Oh they’ve seen that in their experience in the markets.

[00:45:27] Clay Finck: And they think of course it’s going to happen again. And having that recency bias. And I think it points to just why it’s so important to read these books and read about these perspectives of others and what’s happened in other countries and just learning about Japan, for example, and how their market’s gone nowhere in 30 years.

[00:45:44] Clay Finck: Like it just really humbles you. And again, like I mentioned earlier, just a reminder to tamper expectations. So Brendan, I also think it’s important to touch on the energy crisis from 1973 through 1980 in the United States and how that may be relevant to the U. S. ‘s future. current situation today.

[00:46:07] Clay Finck: So talk to us more about the energy crisis from the 70s and how this may or may not have parallels to today. 

[00:46:16] Brendan Hughes: Yeah, and I’ll just walk through what happened in that period. There are a lot of parallels and some things that are directly applicable to what have happened the last few years. Kicking off, there were a few important differences between today and the 1970s and for one, The global energy market looks a lot different.

[00:46:33] Brendan Hughes: The United States is a much bigger energy player today. And that’s because energy production in the U S really took off with the rise of shale oil. I think it was about 15 years ago, but the other key difference today relative to that period is that government balance sheets are in much worse shape than they were at that time, but the 1970s was an era that.

[00:46:55] Brendan Hughes: Most people think about as a stagflationary era and stagflation is a period of low growth and high inflation. And during the years, 1973 and 1982, there were 3 technical recessions. So the economy was constantly in and out of recession, but 1 of the parallels that is strikingly. Similar to today in 1973, Syria and Egypt attacked Israel and what would become known as the Yom Kippur war in light of what’s happened in the last few months, it’s the parallels are obvious, but at that time, this really was a, sent shockwaves through the oil market, given OPEC’s huge influence at that time.

[00:47:38] Brendan Hughes: And this was before the United States became a huge. But in 1973 and 1974, over that 1 year period, the price of oil went from 2. 50 to 11. 50. And I think that today, there’s been a more muted impact on oil owing to the more diversified sources. Like the United States can ramp up production if needed. If OPEC was the only game in town, I think that you may have seen something similar to this rise that we saw, but at that time there were widespread oil shortages and governments responded with price and wage controls, which I document throughout my book, and that always increases inflation and another important topic that’s relevant to.

[00:48:25] Brendan Hughes: Today is labor unions and at that time, labor unions, they were in full force and that was putting upward pressure on inflation. And when president Reagan in early 1980s, he launched a well documented campaign against labor unions and attempt to stifle inflation. And most people think that was really the start of the long term decline of labor unions that only really has retrenched in the last few years.

[00:48:53] Brendan Hughes: And we’ve seen. Some wage inflation, I think, at least if it persists, that’s going to be structural, but Reagan also, he attempted to stabilize energy prices by deregulating the price of oil and that led to the non OPEC producers. They were then incentivized to produce oil, so they ramped up production.

[00:49:13] Brendan Hughes: And yeah, I don’t think that should be particularly surprising, given that they were then incentivized to do but to wrap up this this scenario in the 1970s and 1980s I’d be, I have to at least mention Fed Chairman Paul Volcker, who is very famous, people always cite Volcker these days because he raised interest rates to 20%.

[00:49:37] Brendan Hughes: In 1981 to stamp out inflation and that all of this was ultimately successful. And by 1983, after a decade of elevated inflation, it did eventually come down to about 3%. 

[00:49:53] Clay Finck: Since you mentioned the wage inflation potentially being structural in light of the recent rise of labor unions, I’d love for you to touch more on that and why you, in your book, you talked more about.

[00:50:06] Clay Finck: Wage inflation, instead of just inflation in the broader economy in general. I’d love for you to talk more about that. 

[00:50:14] Brendan Hughes: Yeah, it does seem like at least one element of inflation appears to be somewhat structural and that is tied to the labor unions, as we just noted. But also, it does seem to me like some of the globalization the last…

[00:50:30] Brendan Hughes: 30 years is in a degree of structural retrenchment. And so to the extent that we are having like more manufacturing in the United States people here are going to command way higher wages than. People making goods did in China for the last 30 years. So to the extent that a decent amount of that is structural, it’s inevitable that element of inflation will remain elevated, at least relative to what it has been for the last 20 years or so.

[00:51:07] Brendan Hughes: And I think that I’m pretty confident that a portion of that is structural. It’s difficult to say how this is going to play out with. What’s going on with the unionization? For a lot of younger people’s lives unions weren’t, were not even relevant at all. And it’s really just in the last several years that we’ve seen this.

[00:51:29] Brendan Hughes: And to the extent that persists, that will also. That will be a structural tailwind upward on, on inflation. I don’t really know how all of that is going to play out, but there are some, there’s some counterinflationary forces as well. Like you’re seeing a lot of countries or a lot of companies, like big companies like Apple now investing big in India.

[00:51:53] Brendan Hughes: You are going to see some manufacturing and job shift there that are from China and they have low cost of labor. And we also have ongoing technological innovation that is going to continue to be a deflationary force. But at least to me, it does look like that some of this wage inflation is going to be structural.

[00:52:15] Clay Finck: And since you manage money professionally, I’m curious if you could. paint some color on maybe business models that what you look for in businesses in light of higher wage inflation, or maybe just potentially higher inflation in general. You mentioned the pricing power earlier. I’m curious if there’s anything else worth highlighting here.

[00:52:36] Brendan Hughes: Yeah, I think During periods of elevated inflation, the companies that tend to perform the best are, as you alluded to, ones that are able to pass the cost along to the consumers, and inversely, the ones that do the worst are the ones that are not able to, because then their profitability is eroded.

[00:52:54] Brendan Hughes: The last few years, you’ve seen Sectors like the lower quality retailers, like things like that. They’re not able to pass costs along there. They go from a really low net profit margin to a loss really quickly. And that’s what always happens, but there are sectors where their product is really important to people and they’re able to pass along those costs.

[00:53:18] Brendan Hughes: Some of the higher quality consumer companies like Pepsi, like they’ve been. Raising prices like crazy the last few years and their consumers have continued to buy their products because it’s apparent from their behavior that they don’t view, they view the switching costs as being high. So that’s how I think about it from a business context.

[00:53:40] Clay Finck: I wanted to switch to a more unrelated, broader point here. One thing that stands out when looking at today’s markets is the U. S. ‘s interest expense just exploding higher, becoming one of their Biggest expenses in light of interest rate increases and a lot of the debt that was issued at near zero is now rolling over and being issued at four, 5 percent and that’s making a huge impact given where U.

[00:54:12] Clay Finck: S. debt levels are today. I’m curious if you have a view on in studying these, past crises in history and past civilizations such as the Roman empire. If you have a view on the longer term implications of this exploding interest expense that it’s now in the trillion dollar range.

[00:54:32] Brendan Hughes: The implications for what’s going on with the deficits and interest as a result of it, particularly tied to the higher interest rates now, they’re enormous. And to provide a baseline for this, what we’re walking into is a situation where mandatory spending in the United States, which includes things like social security, Medicare, that made up 61 percent of federal spending in 2019.

[00:54:57] Brendan Hughes: And this figure in 1970 was only 30%. So when we factor in the higher interest expense, we arrive at least the way things are currently constructed at a scenario where a hundred percent of the federal budget is now going to things that are not, that have nothing to do with investing for the future and in terms of growth.

[00:55:19] Brendan Hughes: So we’re really left with these options. And I know these in my book, we can. Try and grow our way out of these deficits, which is what happened to a large extent after World War II. But where we are now that’s much more unlikely because population growth now is much lower than after World War II.

[00:55:39] Brendan Hughes: So that’s going to make it a lot harder. You can’t just have ongoing productivity gains at 10 percent a year in perpetuity. That’s just not a realistic expectation. One of the other options is to. Significantly raise taxes, and I don’t think that there’s really a doubt that at least to some degree this will happen, but this will in the process will also hinder economic growth.

[00:56:02] Brendan Hughes: And one of the other options is we can have sustained cuts to federal expenditures. But at least from what I’ve seen, this really is almost never an option because sustained budget cuts are always politically unpopular. And politicians don’t really have an incentive to do this because usually. When things blow up it’s after they’ve already left.

[00:56:24] Brendan Hughes: And so it’s not on their watch. I don’t know if you saw in this past year, when France tried to raise their, they introduced a bill to try and raise their retirement age from 62 to 64, which is, I don’t think that should have been a very big deal, but riots. And protests broke out across the country.

[00:56:44] Brendan Hughes: So once you give someone something, it’s difficult to take that away. And then the last option, which we’ve done a lot of in recent years is to print more money. And that doesn’t resolve any of these. problems, but it does kick the can down the road. And I don’t have any doubt that we’ll continue to do that.

[00:57:05] Clay Finck: Brendan, it’s a very interesting book. I’m glad I had the opportunity to read it and bring it on the show to discuss it before I let you go. How about I just give you a chance to. Share any parting thoughts that you feel that are important that we haven’t touched on today. 

[00:57:22] Brendan Hughes: Yeah, I don’t know that I have anything that we haven’t already touched on other than I think it’s important for people to learn from the past.

[00:57:32] Brendan Hughes: And I hope that our listeners out there are constantly trying to learn from history and applying that to today and the future. 

[00:57:42] Clay Finck: Awesome. Before I let you go, I want to give you a chance to let the audience know how they can get connected with you and find out more about the book.

[00:57:52] Brendan Hughes: Thanks, Clay. So you can find Markets in Chaos, a history of market crises around the world. If you just search on Amazon, it’s also available through my publisher, Business Expert Press, along with various other retail channels. And if you want to connect, you can find me on LinkedIn. You can just search, brandon Hughes, CFA, and then type in Lafayette Investments my company or my book, Markets in Chaos, and I’m sure it’ll come up. 

[00:58:20] Clay Finck: Wonderful. Thanks again, Brandon. Really appreciate it. 

[00:58:24] Brendan Hughes: Thanks a lot for having me, Clay.

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