Bubbles, Manias & Fraud — Investor Amnesia

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Visualizing History 

South Sea Company Stock

Source: Global Financial Data


From the Archives

The South Sea Bubble, and The Numerous Fraudulent Projects to Which It Gave Rise in 1720 (1825)

This book was written in 1825, a year in which another extremely speculative bubble broke out across the United Kingdom as investors poured money into Latin American mining stocks. The authors of this book explicitly state in the introduction that their intent with this book was to remind investors of the bad outcomes stemming from a similarly ludicrous period of speculation a century before: The South Sea Bubble.


Sunday Reads

 

“The hurry of our stock-jobbing bubblers, especially, has been so great this week, that it has even exceeded all that ever was known before. The subscriptions are innumerable; and so eager all sorts of people have been to engage in them, how improbable or ridiculous so ever they have appeared, that there has been nothing but running about from one Coffeehouse to another, and from one Tavern to another, to subscribe and without examining what the proposals were.

The general cry has been, For God’s sake let us but subscribe to something, we do not care what it is !’ So that, in short, many have taken them at their words, and entered them adventurers in some of the grossest cheats and improbable undertakings that ever the world heard of; and yet, by all these, the projectors have got money, and have had their subscriptions full as soon as desired.”

An Exciting Announcement

Today, my good reader, is a very special day.

And why is that, you may ask? Six months ago I posted on Twitter that I was thinking of organizing an online financial history course that would feature guest lectures from a mixture of high-profile investors, bestselling financial history authors, and esteemed professors.

Well, today is a special Sunday Reads because I can finally announce that the online financial history course I’ve been working on for the past 6 months is finished, and launches tomorrow. This first course is on Bubbles, Manias & Fraud. Here’s a teaser video:

Ah what the hell, here’s another teaser:

As you can see, there is quite the stellar lineup of guest lecturers participating to teach you the ins and outs of financial history. I do not want to dwell too much on the course today because subscribers to this newsletter will receive an email tomorrow morning with a discount code and more information on how to enroll in the course. That said, if you are interested in the course, either subscribe to my newsletter today (which will get you discounted access to the course) or just check my social media accounts tomorrow for information on how to access the course.

Given that the focus of the course is on Bubbles, Manias & Fraud, it seemed only fitting that this also be the topic of today’s Sunday Reads.

The Bubble Triangle

Boom and Bust: A Global History of Financial Bubbles by Professor John Turner and William Quinn is one of the best books to be published in 2020. This in-depth and nuanced look at the history of global asset bubbles over three centuries was recently named one of the Financial Times’ books of the year, and covered in Jason Zweig’s most recent Wall Street Journal column. Well, I am very happy to say that Professor Turner is also one of the seven outside experts that gave a lecture for my online financial history course, where he dove into the Brewery Bubble of the 1890s, and Bicycle Mania.

In addition to the fascinating stories of speculative fervor and fraud detailed in their book, one of the most interesting frameworks that Turner and Quinn discuss is what they term “The Bubble Triangle”.

As Jason Zweig’s recent article so eloquently summarized:

Also Read on FinMedium:  The Next Frontier — Investor Amnesia

Boom and Bust looks closely at 300 years’ worth of market manias using the metaphor of ‘the fire triangle.’ That image has long been evoked to explain the conditions necessary for flames to erupt and persist: oxygen, fuel and heat. Remove one, and you can prevent or put out a fire.

The oxygen of investing is marketability, or the ease of buying and selling an asset. Centuries ago, that meant carving up difficult-to-transfer corporate ownership into tradable shares. Nowadays it’s carrying a stockbroker in your pocket. With a smartphone-trading app, you can buy or sell so-called fractional shares in increments anyone can afford.

The second side of the fire triangle, fuel, is manifested in financial markets by money and credit. Low interest rates make investing with borrowed money cheaper, while paltry yields on safe savings compel people to invest in riskier alternatives. Today, borrowed money fuels mega-billion-dollar private-equity firms buying entire companies—and individual investors conducting small ‘margin’ trades with as little as $2,000 in a brokerage account.

The third side of the triangle, heat, is supplied by speculation. When prices go up, more people buy, inflaming prices even more and attracting another rush of speculators.

The Boom and Bust book completes the metaphor by noting that the fire triangle has in recent years been updated with a fourth component, an ‘exothermic chain reaction.’ Marketability, credit and speculation are necessary, but not sufficient, to start and maintain a market fire. A fourth component, what the authors call a ‘spark,’ is also needed.

That can come from new technology, government intervention or both. The stock-buying binge of the late 1990s was sparked by euphoria over the potential of the internet. China’s more-recent market booms have been stoked by government policies and propaganda.”

 

As Jason goes on to point out in his post, one of the interesting insights from the book is that while we all tend to think of ‘bubbles’ as a term that’s is applicable to the stock market as a whole, history demonstrates that this is actually not the case.

“Boom and Bust shows that most bubbles tend to be confined to a few stocks or industries.

That was true in 1824-25, when Latin American mining stocks listed in London rose more than fivefold in roughly six months, while British blue-chip companies lost almost a tenth of their market value. Again in London, in the 1890s, shares in bicycle companies more than doubled in a year even as major stocks went nowhere.”

The chart below illustrating this point comes from co-author William Quinn’s article on Bicycle Mania:

Quite a stark contrast, right? One might think that ‘bubbles’ occurring in isolated sectors or groups of stocks implies some sort of insulation from a crash when the bubble inevitably pops. As Jason points out, this is not the case. Particularly, he notes, when indices utilizing market capitalization weighting enables a small group of stocks to dominate an index.

I don’t see much cause for concern about overheating in relatively small areas like newly listed stocks, alternative-energy firms and shell companies formed to do buyouts.

The bigger worry is that a fire among a few giant stocks can set the neighborhood ablaze. After the technology-heavy Nasdaq index collapsed in 2000, the broader S&P 500 also tumbled.”

If you find topic interesting, I’d highly encourage you to enroll in the course tomorrow and hear the author of Boom and Bust describe this framework in much more detail over the course of a 45-minute lecture.

The Bubble Triangle & Fraud

The other component of my new history course – and focus of today’s post – is Fraud. Now, in the course this section will be taught by none other than legendary short-seller Jim Chanos himself. In a masterclass and in-depth lecture lasting over an hour, Jim walks through what he calls ‘The Greatest Hits of US Fraud from 1983 to 2008″. Diving into 12 case studies of Jim’s greatest shorts and examples of fraud, one of the recurring themes is that fraudulent companies are able to thrive in periods of excess speculation due to investor’s willingness to suspend their sense of disbelief. In other words, when the market is roaring higher and potentially fraudulent companies or those with bad business models are roaring higher with it, investors happily ignore damning evidence that indicates trouble lies ahead.

The excerpt below from a book written in 1825 about the South Sea Bubble and other madness a century earlier in 1720 depicts this point brilliantly:

As Chanos points out in his lecture, it is only when these companies and the market as a whole start to lose money that people take a closer look at why they own a particular stock. This is when frauds are often uncovered. So to continue using the Bubble Triangle / Fire Triangle analogy, it is usually in the aftermath of the blaze (bubble crash) that we can see in the wreckage which pieces of infrastructure (companies) were flimsier and more fragile than what was previously believed.

Also Read on FinMedium:  Bankruptcy & Markets — Investor Amnesia

Now lets dive in deeper to some pieces of work by the lecturers in my new course. Remember, subscribe to this newsletter if you are not already to receive a discount and information on how to access the course tomorrow morning. Share with friends and colleagues! 

New Evidence on the First Financial Bubble

The South Sea Bubble of 1720

At first, the link between SPACs and the South Sea Bubble is not very clear. During the interview I did with Professor William Goetzmann for my upcoming financial history course, we discussed how his article on the South Sea affair reminded me of the recent boom in SPACs for two reasons.

The first is that it represents another type of financial contraption or “innovation”, as described below:

The first innovation was in government finance. Both the Mississippi Company in France and the South Sea Company in Britain – the two most famous firms in the bubble of 1720 – exchanged equity shares for government debt; in effect converting the national debt of their respective countries into corporate stock. This was clearly perceived at the time as a new financial technology. The 1720 bubbles have historically been attributed to these large scale debt-for-equity conversions.”

More specifically related to SPACs, read this excerpt and tell me that this doesn’t seem at least somewhat similar:

“The fourth innovation was the short-lived attempt by corporations in Great Britain to pursue opportunities beyond their charter. Leading up to 1720, entrepreneurs had purchased chartered firms and repurposed them by using their rights to issue stock as a means of financing new enterprises. One such entrepreneur was Case Billingsley, the co-founder of the Royal Assurance Company, who, in 1719, purchased the York Buildings Company, a poorly performing London waterworks. He recapitalized it with the issuance of shares to the public and used the proceeds to purchase confiscated Scottish estates. These properties were intended to serve as income-producing capital to underwrite life annuities and life insurance policies.

The legitimacy of these and other attempts to expand the scope of corporations was examined by the Attorney General and debated by Parliament during the course of 1720. It ultimately resulted in the Bubble Act; an anti-speculative law that stopped the London boom in IPOs and the “mission-creep” of existing firms. The fluctuations in share prices of repurposed firms, or firms without clear Parliamentary charter, as well as the many IPOs that were ultimately banned by the enforcement of the Act were, among other things, a barometer of public expectations about the future powers of the corporation vs. the state.

While it’s not a direct parallel, the concept of investors buying a company that had a royal charter with the intention of converting it into a separate line of business seemed reminiscent of investors buying SPACs with the intentions of “converting” into another business through an acquisition / merger.

Technological Revolutions and Speculative Finance: British Bicycle Mania

“Technological revolutions are often accompanied by substantial stock price reversals, but previous literature has produced competing explanations for why this is the case. This paper brings new evidence to this debate using data from the innovation-driven British Bicycle Mania of 1895-1900, in which cycle share prices rose by over 200 per cent before collapsing by more than 75 per cent. These price patterns are not fully explained by fundamentals or by changes in the nature of risk associated with cycle shares. Instead, the evidence from the Bicycle Mania supports the hypothesis of Perez (2009), who argues that new technology, high short-term profits, and loose monetary conditions increase the level of speculative investment, ‘decoupling’ share prices from fundamentals.”

The Cycle Mania

American Drivers Have Bicyclists to Thank for a Smooth Ride to ...

“The growth of the cycle industry between 1895 and 1900 had its origins in a series of technological innovations. The ‘safety’ design, diamond frame, and pneumatic tire made for a much more comfortable ride, and the use of ball bearings and new processes for producing weldless steel tubes substantially increased British productive capacity. The widespread adoption of the pneumatic tire in 1895 resulted in a rapid increase in demand for bicycles, which existing producers struggled to meet. There was thus a rapid increase in the number of registered cycle manufacturers in Britain: Harrison reports a fourfold increase between 1889 and 1897, with the majority based in the West Midlands. Rubinstein estimates that at the height of the boom in 1896, 750,000 bicycles were produced per year, and 1.5 million people cycled, at a time when the population of Britain was around 35 million.”

In April 1896 a British newspaper argued that “cycle shares promise to become as inflated as the tires”. There was ample reason for such a statement, as the table below exhibits how many new cycle companies were being floated at the time of Cycle Mania.

Again, we see the recognizable pattern of companies forming following a dramatic rise in shares of stocks related to a new technology:

Also Read on FinMedium:  Making an Impact — Investor Amnesia

Fraud and Financial Scandals: A Historical Analysis of Opportunity and Impediment

“The paper analyses the history of fraud and financial scandal and identifies some common features. To do so it develops a conceptual framework based on the long run interaction of technology and market development. These features lead respectively to problems of context specific asset valuation and value verification, which taken together define the environment of mispricing opportunities. Such opportunities do not in themselves lead to specific fraudulent transactions, but do influence the probability of their occurrence and their character. Thus, whereas particular frauds vary in terms of the specific opportunity, motivation and ex post rationalizations of the individuals involved (Cressey, 1953), historians might focus on the factors that make frauds more or less likely.

A historical approach may accordingly explain why frauds and scandals tend to cluster in certain time periods. The paper begins by developing a conceptual framework based on the dynamic interaction of opportunity and impediment. It then presents a brief history of fraud and financial scandal in the United Kingdom, in three broad periods. The first, on manias and frauds before and during industrialisation, examines the features of frauds that became common in subsequent events. The second period begins by considering Victorian frauds and the notions of reasonable business behaviour and honesty as substitutes for direct intervention in corporation’s affairs, which have survived largely unmodified through a series of twentieth century frauds. The third details the period since 1980 during which time the process of financialisation compounded earlier circumstances leading to fraud opportunity, culminating in financial crash of 2007-2008. The final section draws conclusions referring to limitations of the conceptual framework whilst noting the value of a historical approach for the purposes of identifying the long run determinants of fraud and financial scandal.”

Trading Options Before Black-Scholes: A Study of the Market in Late Seventeenth-Century London

“This article uses data from the ledgers of the financial broker Charles Blunt to explore the market in equity options that emerged in London during the stock market boom of the early 1690s. Blunt’s ledgers provide a unique opportunity to observe the workings of an early modern derivatives market. They reveal a broadly based and highly active trade in options. The market functioned well, determined value using agreed criteria, and was utilized by a diverse range of individuals to facilitate both risk-seeking and risk-averse investment strategies…

The source for this study is the hitherto unexplored ledgers of the financial broker Charles Blunt. Blunt’s ledgers provide a unique insight into the workings of London’s first derivatives market. They cover the period from January 1692 to mid-1695 and contain details of just under 1,500 transactions relating to twenty-three joint-stock companies. More than one-third of the transactions were derivatives. The article will begin by asking what Blunt’s ledgers can tell us about the structure of the options market. Section II explains how options were used during the 1690s and by whom, and section III analyses prices in order to assess the extent to which those who traded in options accounted for the factors that are now understood to influence value. Finally, it will be acknowledged that, in spite of the sophistication of the market and varied utility of the instrument, many contemporaries regarded the trade in options as disruptive and dangerous. Their fears led to an ill-conceived and ultimately ineffective attempt to restrain the market.”

The 2020s Bubble?

The Roaring Twenties

While the author admit that just because we are in the 20s that obviously does not guarantee a decade of bubbles like we experienced previously, this article is still a very entertaining and informative look at the strange phenomenon of legendary bubbles occurring in the ‘Twenties’ of multiple centuries (1720s, 1820s, 1920s,).

“Long-term data allows you to make long-term predictions. Given the performance of the stock market over the past 300 years, there appears to be a high probability that the next roaring Bull market for equities will occur in the 2020s. If you look back at the stock market over the past 350 years, you’ll find that in each Century, the Twenties have  always enjoyed bull markets in equities; this rings true for the 1720s, the 1820s and the 1920s. Unfortunately, as we’ve seen with bull markets across many asset classes, these dramatic bubbles came crashing down by the end of the decade.

Although there is no reason why events a hundred years ago should determine events one hundred years forward, similar situations can produce similar results. As the saying goes, history doesn’t repeat itself, it rhymes. What were the situations that produced the Bull Markets of the 1720s, 1820s and 1920s? Could this pattern repeat itself in the 2020s?”

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Jamie Catherwood
My name is Jamie Catherwood, and I’m a Client Portfolio Associate at O’Shaughnessy Asset Management. Get your financial history fix through reading my articles, or those that I link to in my weekly “Financial History: Sunday Reads”.
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