Among financial practitioners, there’s a well-known adage that “the market can stay irrational longer than you can stay solvent.” It is ascribed to the successful forecaster and investor Gary Shilling and frequently — albeit apocryphally — connected to John Maynard Keynes, but could have been said by any investor guru of the last century. The saying captures a profound experience in many investors’ lives; you know that your investment case is right, but those pesky stock prices don’t move, or move the wrong way.
Investing only with your own money, you can theoretically hold such loss-making investments forever (or until you’re bankrupt). The only cost is the opportunity cost of better-performing returns elsewhere.
When investing with other people’s money, which almost everyone — whether fund manager, bank, or family office — does to some extent, the limiting constraint is no longer bankruptcy, but your creditors’ patience. Fund managers whose brilliant investment cases don’t pay off will see their investors gradually pull their money from the fund; banks’ creditors, whether on the wholesale market or through deposits, will refuse to roll over debt or withdraw their deposits.
That mechanism makes succeeding in counterintuitive, unpopular, or deviant investment projections — the kinds that make you serious money — very difficult. Your choice of when to sell can be overruled by your investors if they choose to withdraw funds, forcing you to liquidate assets before your investment case pays off. Your well-researched and brilliant investment case, no matter how prescient, goes up in smoke.
It’s a balancing act. And if you’re early, or enough of your creditors disapprove of the meager short-term returns you are producing in the meantime, you’re out. This is why being too early in financial markets makes you wrong. In addition to the qualitative direction (Stock A is going up; there’s a bubble in the housing market; Tesla is overvalued; etc.) — the “what” — you have to make a reasonably accurate prediction about the “when.”
After I wrote “If You Are Early, You’re Wrong,” I received a lot of pushback in personal correspondence as well as on Twitter. The proof is in the pudding, my critics said — and the people who called the housing bubble (and acted on it) made billions of dollars. Thus, they were right.
Let me illustrate the mistake in that thinking and qualify my argument by comparing the successful — and therefore famous — investor Michael Burry with an unsuccessful — and mostly unknown — investor, Alexander Fordyce.
Who Is This Fordyce of Which You Speak?
The Exchange Alley speculator with an unfortunately pun-friendly name would be the poster boy together with the “Ayr Bank” for the 1772-73 financial crisis and was one of many aspirational Scots attracted to London. With trading in an emerging financial market in full swing, you could make enormous fortunes if you could only correctly time the rise and fall of the major instruments — the stocks of the Bank of England and the East India Company (EIC) as well as the 3 percent consol, the perpetuity that constituted most government debt at the time.
Fordyce quickly abandoned his career as an apprentice in the stocking business and began working as an outdoor clerk to London banks and lenders. In 1759 he made partner in the bank (Neale, James, Fordyce and Down) whose ruin in 1772 — much like Lehman Brothers 236 years later — would trigger a credit crunch and financial collapse. For more than a decade before that, Fordyce had successfully weathered the ups and downs of the stock market and made himself a wealthy man. Ray Perman writes in his recent book on Scottish financial history that Fordyce “successfully anticipated the peace treaty [Paris 1763] and movements in the East India Company stock.”
By the late 1760s and early 1770s, Fordyce had a new scoop. The East India Company stock was seriously overvalued, he thought. With the Treaty of Allahabad in 1765, the EIC had received diwani rights, the ability to tax Indian subjects under British rule. British historian Niall Ferguson describes the event in his book Empire and suggests a windfall profit of £2-3 million a year. EIC’s share price exploded. By buying up enough voting rights, activist investors wrested control of the company and hiked the dividend to 12.5 percent in 1767 in anticipation of future incomes. Again, the share price jumped.
Fordyce wasn’t convinced. First, the amount of tax raised in India would probably come in lower than was predicted. Second, collecting it would be much costlier than shareholders were anticipating. Lastly, there was a geographic cash flow problem: these new funds were acquired in India, but payable to investors in London, a problem company had solved in previous years by using a credit line from the Bank of England. Extending that, drawing more bills of exchange on London, or physically sending bullion across the world were all costly options that would eat into any potential profit.
The fundamental story was there: bullish investors seemed to have vastly exaggerated the company’s future earnings. So Fordyce shorted EIC stock — first on his own, then with funds in the bank he was managing. In May-June 1772 the share price quickly advanced 6 percent after a long period of moving sideways, which proved enough to break Fordyce’s massive short position. He absconded to France, and the subsequent evaporation of liquidity associated with his default caused other businesses to fall — of which the Ayr Bank was only the most famous.
Here is the interesting part: the EIC stock price was already on the verge of correcting itself and would fall 30 percent over the next few months. Plunder and famine in India sobered investors to the possibility that not all that glitters is gold, even diwani taxes. The geographical liquidity problem was even more pressing; when Bank of England cut its funding in the fall of 1772, the EIC could no longer sustain its elevated dividend. The share price collapsed.
While we can’t disentangle the effect on EIC stock prices from the credit crunch that Fordyce’s default itself triggered, we can surmise that his qualitative assessment was right; the stock returned to levels around its pre-boom average. In hindsight, the 1765-72 period looks like the bubble Fordyce foresaw.
Fordyce vs. Burry
We don’t know exactly how much Fordyce shorted. Goodspeed reports that he left his banking partners liable for £243,000. A contemporary news article in the General Evening Post reports that the amount of a single trade that Fordyce had to deliver in July 1772 (and probably motivated his default) was £150,000. William James, one of Fordyce’s partners, wrote in 1775 that his banking partnership had had India-stock short positions of £800,000. However you translate those amounts to the present, these were very Big Shorts that went wrong.
Qualitatively, Fordyce was right. He called the EIC bubble and bet massively that its shares would fall. Events in the fall of 1772 proved him right; just a few months after he could no longer hold his positions, the EIC stock price fell massively. But his timing was wrong. And he couldn’t sustain his short position anymore.
Michael Burry, the prescient investor who saw the U.S. housing bubble, used his fund Scion Capital to short the mortgage-backed securities (MBS) that lay at the core of the triggering event for the financial crisis in 2007-8. Burry had the guts to go against prevailing market sentiments and was ultimately richly rewarded for it. Scion’s net return between 2000 and June 2008 was a stunning 489.34 percent (compared to the S&P 500 barely breaking even), most of which was attributable to Burry’s Big Short.
Details on Burry’s trades are scant, but in The Big Short Michael Lewis reports that by October 2005, two years before the first MBS started experiencing problems, Burry’s $500 million fund held credit default swap (CDS) contracts of over a billion dollars. According to Lewis, the premium Burry paid for this was 2 percent per year, but the movie script suggests numbers closer to 6-7 percent.
Lewis likes to portray Burry as a misunderstood genius whose idea was a no-brainer, almost bound to happen. Nothing in financial markets is “bound to happen”; even if prices are outrageously wrong by some metric, there are countless ways Burry’s trade could have gone wrong:
- Counterparty risk: the bankers who sold Burry default protection may themselves go bankrupt, leaving Burry with a worthless insurance policy (illustrated by another investment team in The Big Short).
- Liquidity risk in Burry’s own fund, illustrated by that iconic scene in The Big Short where two of his big investors demand their money back, which would have invalidated Burry’s insurance contracts.
- Macroeconomic risk: actions by the Federal Reserve could have softened credit conditions earlier, or global macro trends could have improved the employability and earnings of the subprime borrowers who thereby could have serviced their mortgages for longer.
Finally, these risks were wrapped in timing — the question of being early. There was no natural law specifying that mortgage-backed assets had to decline in 2007, unleashing the short-term funding chaos that sent the world’s banking systems into freefall and most of the Western world into recession. History as it unfolded could have happened differently — much later or not at all. In those scenarios, Burry would have been nothing but a peculiar hedge fund manager whose once-glorious fund failed. In that history, he’d occupy no more an elevated place than Alexander Fordyce, an obscure icon for overzealous and ultimately bankrupt speculators.
The market price adjustment that proved Burry right came within the time frame in which he still could finance himself. Enough of his investors stuck with him (many of them were locked in and could not withdraw their funds) for long enough that his short could be realized.
What’s the difference between Fordyce and Burry? Burry could finance his mistake, his “earliness,” for long enough to be vindicated by market prices. Fordyce could not.
Even though they were both right on paper about future market trends, only one of them is celebrated as a genius forecaster; the other one is relegated to the financial dustbin of countless failed speculators. The difference between them was not one of foresight, but largely chance; events unraveled within the time period in which Burry could finance his Big Short. Fordyce defaulted a few months before his equally prescient Big Short would have been vindicated.
Being correct about events in financial markets requires you to be qualitatively correct about the direction — the “what” — as well as financing your errors about the “when.”