In his book The Intelligent Investor, Benjamin Graham uses a famous metaphor to describe how financial markets work. Mr. Market, according to Graham, is a highly emotional person who is always ready to purchase or sell shares in any company at whatever price the market is quoting that day.

The great thing, according to Graham, is that Mr. Market doesn’t care whether or not you accept his offer to buy or sell; he will always be back the next day ready for a transaction at that day’s price.

Those who think metaphors such as these are relics of the past with limited current value would be advised to consider the behavior of markets the past couple of years. In 2007, Mr. Market (who is clearly active in credit as well as equity markets) was willing to lend money to individuals and institutions of extremely low credit worthiness at very attractive rates. Sub-prime borrowers, investment banks with 30:1 leverage, consumers with multiple credit cards all charged up to the maximum, are just a few examples. Then, the crisis came and Mr. Market’s mood swung the other way. Suddenly, the most credit worthy customers had trouble getting loans. Investors who had previously purchased high yield credits with expected returns of just a few percentage points above Treasuries now required a premium of as much as 20%. At the other end of the risk spectrum, investors were now willing to purchase U. S. Treasuries at yields of zero just for their safety value. Otherwise intelligent people we know contemplated installing safes in their homes, presumably to store their cash and ammunition.

Such was the situation in March of 2009. Sentiment was terrible and the outlook for the economy was bleak. In the midst of this darkness, though, a few financial institutions commented that their profitability was improving. Citibank made comments that its first quarter had been very good, and these results were echoed by other firms. Essentially what banks were saying was that, with their cost of funds near zero (due to an accommodative Federal Reserve), and with Mr. Market now paying them a very good return on their loan book, their profitability had gone through the roof. At some point, this increased profitability became more significant for their earnings outlook than the huge write-offs which seemed to ruin each weekend during the second half of 2008. The cycle had once again turned. With Mr. Market about as negative as ever, the stage was set for a huge rally. As is common, the leaders in the rally were the groups which had been most decimated during the decline: financials, emerging markets, small cap value, and junk bonds. Safer, high quality stocks mostly lagged in 2009.

Economic performance was much better than expected in 2009, in both developed and emerging economies. It is hard to recall, but at the beginning of 2009 most economists were predicting the recession/depression would last well into 2010 or beyond. We now see that the recession ended most likely in the third quarter of 2009. The emerging economies of Asia, which had experienced dramatic slowdowns in 2008, experienced true “V” shaped recoveries. The recovery has been more mixed in other developing regions such as Eastern Europe, but the overall picture has certainly improved.

The outlook for 2010 is fairly good in our view. While the recovery in financial markets has been substantial, it is worthwhile to remember that it came from very depressed levels. Prices are still in the range of fair to attractive in our view. Financial market recoveries often precede economic recoveries by a substantial amount of time and that could very well be the case in 2010. (For example, recall that the stock market bottomed in the fall of 1990 but the economy was still weak enough two years later that the U.S. voted out the first President Bush.) Interest rates are likely to stay low for some time which will be good for profitability in many sectors. If history is any guide, banks will soon start to loosen their lending practices again which will provide a stimulus to growth as the impact of government programs wears off. As several commentators have pointed out, severe slowdowns in the U. S. economy have often been followed by very strong recoveries (the evidence isn’t as clear following financial crises such as this one). In our view, a strong recovery in the U. S. could be the biggest surprise of 2010. And the continued strong growth in China and India, with their demand for commodities, capital equipment, luxury goods and capital will also support the economies around the world.

There has been a lot of talk in recent years about the profusion of “bubbles” in the global economy. Technology stocks, real estate, hedge funds, the stock market, emerging markets, etc. have all been included in this category. Two questions which are almost never addressed are: 1) How does this tendency keep happening? and 2) When is the next one is and what will it be? As to the first question, readers would be well advised to read George Soros’ book from the 1980’s, The Alchemy of Finance. The first few chapters, especially the one called Anti-Equilibrium, give the best description of how financial bubbles form and play out, as we’ve seen. It is truly a blueprint for what happened over the following quarter century. The following is a drastically simplified statement of his views. According to Soros, bubbles are the result of self-reinforcing processes which cause an investment idea (which may have been sound at the beginning) to be taken to extremes. As an example, he cites the REIT boom of the early 1970’s. An interest in real estate led to increased interest in real estate securities known as Real Estate Investment Trusts. In turn, these companies were able to raise more capital which they then invested in real estate which caused further appreciation. A cycle of this nature can continue until prices reach ridiculous extremes. In the most recent cycle, lenders in the residential real estate sector justified increasing valuations on recent transaction values but failed to understand the extent to which their lending activity was one of the key reasons prices were going up. The problem was exacerbated by the fact that lending standards were steadily falling all through the cycle. Soros argues that these cycles are difficult for most analysts to spot because they fail to understand the nature of these self-reinforcing processes. Analysts are trained to look at their profession using a scientific model which assumes there is a correct “equilibrium” price which markets are constantly seeking. They, therefore, are generally wrong at market extremes when prices can always be supported by the data but are out of touch with reality.

If Soros is right, financial bubbles will always be with us, sort of like a chronic condition. However, even chronic conditions can be improved through treatment. We’d like to suggest one which could be helpful in this case: education. In their recent outstanding book called This Time is Different, Reinhart and Rogoff have studied 800 years of financial crises and attempted to draw some parallels and lessons from them. Reinhart and Rogoff attempt to make the study of financial crises into a true discipline. Their key finding is that financial crises have many similarities, and that it would be good if market participants understood them better.

The institutions charged with educating analysts and investors include the MBA and CFA programs. While it has been a few years since I completed both of these programs, a little research shows that neither pays much attention to financial history or the study of financial crises. There is plenty of material on derivatives, options, efficient markets, statistics and optimal capital structure. The journals of the business schools are full of articles with equations and theories. None of this research was of much use apparently in predicting the financial crisis. Could it be that a profession educated in the common ways in which such crises develop would have done a better job? It is impossible to say, but it certainly couldn’t have done much worse.

As to the second question (when the next one is and what will it be?), here are a few possibilities. The issues listed below are potential crises in the making. While not everyone is a classic bubble, they are all situations where there is an unsustainable process which could end in a crisis. Most will probably be handled before that happens.

Sovereign debt defaults. The United States is charting new territory in terms of its fiscal deficit and so are many countries in Europe. The PIGS (Portugal, Ireland, Greece and Spain) are of particular concern along with the UK. Some people believe even the U. S. could face a financial crisis in the next 10 years.

Quantitative easing exit strategy. Printing money worked well on the way in, and helped prevent a meltdown of the global economy. Getting out of this strategy will be more difficult.

The Euro mechanism breaks apart. There is no particular timetable on this possibility, but as economic performance continues to be more disparate within countries in the Euro, its underpinnings could be threatened.

Chinese Financial System has little transparency. Lots of bad loans were likely made after the crisis to keep its economy growing. A slowdown in China could expose where the problems lie.

Double Dip Recession could happen. The real risk here is that we used virtually every tool last time which could make dealing with a new recession more difficult.

An Inflationary Surge. There are no signs of this right now, but it wouldn’t be a surprise given the amount of liquidity created in the past 18 months.

After a financial crisis like the past one, it would be good to see some positive reforms. After the 1930’s crisis several important laws were passed which resulted in relative financial stability for nearly 80 years. In fact, it was only when many of these were repealed that a similar crisis followed.

Many have commented that the current crisis was impossible to predict, and certainly the timing and scope of it could not be predicted with any accuracy. But the type of crisis which occurred in 2008 has happened many times throughout history, as shown by Reinhart and Rogoff. Modern market participants such as Warren Buffet, James Grant and George Soros have warned about the potential for such events for years. The crisis was caused by some combination of human nature and a poor understanding of financial markets by policy makers and market participants. While human nature isn’t going to change anytime soon, an increased understanding of how and when markets fail by those entrusted with regulating and playing leading roles in the industry would be a good first step in avoiding such problems at least for another generation.

William Andersen, CFA, Principal of Andersen Capital Management and Portfolio Manager, Wanger Income and Growth Strategy