Transcript
Host of TIP (0:00)
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Clay Fink (0:03)
On today's episode, we'll be outlining three of the biggest bubbles in financial the 1720 South Sea Bubble, the Railway Mania of 1845, and the Japanese Stock Market and Property Bubble of 1989. They say that history doesn't repeat itself, but it often rhymes. And that is the theme that plays right into all three of these bubbles. Each displayed unprecedented levels of greed, speculative excess, and the belief that fundamentals did not matter. For investors. I believe that studying the financial bubbles of the past is practically essential to ensuring that we ourselves don't fall prey to one during our investing lifetime. Bubbles remind me a bit about house fires. We assume that it's something that only happens to other people. It's easy for us as investors to become complacent and assume that the good times of the past will almost certainly continue. This kind of thinking led investors in Japan, for example, to lose tremendous amounts of wealth in a matter of a few years. As John Maynard Kean said, the market can stay irrational longer than you can stay solvent. So sometimes bubbles can last much longer than we'd probably expect. In studying these three historic bubbles, I picked up Edward Chancellor's book Devil Take the Hindmost, which was a sobering reminder that our mistakes as humans have repeated themselves time and time again throughout history. So with that, I hope you enjoyed today's episode on history's most historic market bubbles.
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Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Think.
Clay Fink (2:02)
Welcome to the Investors Podcast. I'm your host Clay Fink and today we'll be discussing Edward Chancellor's book Devil Take the Hindmost. This book is one of the best books ever written about speculation bubbles and why investors keep repeating the same mistakes across centuries. Through these historic events, Chancellor shares the key factors at play that helped fuel each bubble and how exactly investors got led astray. What's really interesting to me about historic bubbles is that they just tend to repeat themselves and show up in these different forms. And Chancellor is a perfect person to cover such examples as he's practically a walking library. He's read practically everything on the subject and clearly understands investor psychology and what is really driving human behavior. I think this is a really important topic to cover on the show because learning about and understanding past bubbles can be one of our best defenses against getting caught up in one ourselves. When you consider that bubbles can lead people to losing, say, 70 to 80% of their capital. In the more extreme examples, the payoff of avoiding such bubbles can be extraordinary over the long run. So I hope this episode will be a useful tool for you to avoid getting caught up in the bubbles we see today or in the future. One of the things that is interesting to me about investing is that almost nothing about it is black or white. So much of investing is subjective. While it can be easy to judge somebody as a speculator, I think that all of us to some degree actually are speculators. Let's say if you purchase the S&P 500 because you believe that markets are efficient and you want broad diversification, you're still speculating that US companies will be more profitable in the future than they are today, and that investors will continue to want to pay up for the companies in that index. If you're starting a local coffee shop in your city, you're speculating that the economy in that city will continue as usual. For an economy to thrive, you need entrepreneurs who are willing to take these risks and dare I say, speculate with their own self interest in mind. For example, with the expansion of the Internet in the 1990s, it would have been impossible for many companies to raise money if there weren't people who believed in the possibility that that new technology could bring. If the economy was full of investors who were totally risk averse, then it would be difficult for society to progress and to build out new ways of doing things. But I think that speculation is something that lies a bit on a spectrum. In the case studies outlined in Chancellor's book are the most extreme examples of speculation. So the goal is to recognize what extreme speculation looks like and learn to largely avoid such activities. The term speculation first developed economic meaning in the late 18th century Scottish moral philosopher and economist Adam Smith. He defined a speculator by his readiness to pursue short term opportunities for profit. His investments are fluid, whereas those of the conventional businessman are more or less fixed. This train of thought was reiterated by John Muhner Keynes, who described the term enterprise as the activity of forecasting the prospective yield of assets over their whole life. In contrast to speculation, which he called the activity of forecasting the psychology of the market. Speculation is conventionally defined as an attempt to profit from changes in the market price. Now this reminds me a bit of the idea in value investing of just thinking like an owner. When my grandfather, for example, purchased farmland here in Nebraska in the 1970s, he purchased the land as if he was going to own it forever and pass that land down to his children, which is really exactly what he did. Whereas if you're a speculator, you might purchase the land this year with the hopes that someone else is going to buy it for more next year. So it's this active versus passive approach. If you truly think like an owner, you really shouldn't care all that much about what the share price does over the next year or two. Turning back to the idea of my grandfather purchasing land, if I had asked him how he would react if the value of the land he purchased fell by 50%, he probably wouldn't care that much because he purchased the land for the crops and the income that it would produce for the years ahead. The quoted price of the land actually made no difference to him. But I think for a lot of people, when they see a stock that they own decline by 50%, many would consider selling that position because they were interested in eventually selling that stock for a gain. Fred Schwed stated, speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort which should be successful to prevent a lot of money becoming a little. According to modern market theory, which states that markets are efficient, share prices would reflect their underlying intrinsic values. In this theoretical world, the amount of speculation would be very little. In the world of efficient markets, there are no animal spirits, no crowd instincts, no emotions of greed or fear, no trend following speculators, and no irrational speculative bubbles. The case studies outlined in the book are anything of this sort, as they are history's most pronounced examples of vast speculation among the crowds. What's sort of funny about this is that when many everyday people hear about the stock market, or really any financial concept for that matter, they just don't find it to be that interesting. But I personally find some of these topics to be incredibly fascinating, including the study of bubbles. The reason is that bubbles aren't really about numbers or spreadsheets. They're about human behavior, storytelling, and how people react when their emotions are playing a pivotal role in in their decision making. When you study bubbles, you're really studying how otherwise irrational people can trick themselves into becoming delusional. So let's transition here to discuss the first case study we'll outline today, which is the South Sea Bubble. In the year 1711 in London, England, the South Sea Company was established to take over £10 million of government debt, which it guaranteed to convert into its own shares. In a sense, the British national debt was being privatized. In exchange, the South Sea Company received an annual interest payment from the government and the monopoly of trade with the Spanish colonies in South America. Although the monopoly of trade seemed promising, the South Sea Company acted more like a financial institution, as the trading activities always showed a loss. In 1719, it took over a further £1.7 million of government debt in the form of annuities, which it then converted into South Sea stock. By absorbing this debt, the company gained a guaranteed stream of interest payments from the government, which was far more reliable than the uncertain trade profits. Now, the issue the South Sea Company had was that there were all of these holders of government debt who were receiving a safe and reliable income stream. You can imagine that if you purchased government bonds that paid, say, 5% interest, you would only be willing to part ways with that consistent income if what you were getting in exchange was much better or more enticing. The company made this trade attractive by pushing up its share price. So the shares the debt holders received were worth more on the market than the safe debt that they parted ways with. In simple terms, people traded a guaranteed but boring income for shares that looked immediately more valuable and easy to sell for a profit. Chancellor referred to this as the South Sea scheme, as all parties had an interest in continuing to inflate the South Sea share price. The company benefited because a higher share price meant that it could issue fewer shares to take over the same amount of government debt, leaving extra cash as profit. The government benefited because the scheme reduced its interest payments and worked best politically if people eagerly accepted it. And the debt holders and other investors benefited because a higher share price made the shares they received or already owned look more valuable and easier to sell for a gain. In 1720, the price of shares swiftly began to rise, from 128 at the start of the year to 187 in February to over 300 not too long after. Meanwhile, several members of the government were secretly handed shares of the company by its directors. The shares were issued at a premium to the market price and no deposit was required upon receiving the shares. Several government officials now had an interest in keeping the share price rising regardless of the cost to the nation. The conundrum with this scheme, which sort of made my head spin when I was reading through it, because it just defies all logic, it's that it appeared that all of the parties benefited from the continuing rise in share price, and this made it difficult for anyone to determine a rational estimate of what the shares were worth. So some argued that as the share prices rose higher, the more they were actually worth. Those who were more financially savvy and were able to keep Their emotions under control, they understood that this just defied all economic logic. Usually, if something sounds too good to be true, it probably is. One economist explained that people who bought surplus South Sea stock at its elevated price must be deprived of all common sense and understanding, since they would be giving their money away to the original stockholders and annuitants. The economists clearly saw that the scheme was dependent on convincing the annuitants into converting their securities into shares and for more investors to purchase those shares. The government only committed to 5% interest payments and the trading prospects of the company were not good. So the potential for loss for investors was substantial, given the prices that investors were paying. The South Sea Company was led by a man named John Blunt. In running the company, Blunt had one primary goal and that was to keep the stock price rising. In Chancellor's words, he looked for a thousand ways to attain this end. Blunt built up public enthusiasm for the stock and offered the chance for the public to invest on multiple occasions. For example, in April of 1722 million pounds of South Sea stock was offered to the public at 300 a share and the subscription sold out in less than an hour. This price was three times the notional value. This would be like buying a ticket to a concert for $150 where the ticket price's face value was $50. And given the public's enthusiasm around the concert and the scarcity of the tickets, you expected to eventually sell your ticket for more than you purchased it. The catch is that instead of this ticket gaining you entry to go see the Beatles is to see an artist that played on Tuesday nights at your local pub. But this still doesn't tell the whole story here. Blunt was also intentional about not being fully transparent with investors. With the issuing of new shares, the conversion of annuities hadn't taken place yet, which made it impossible for anyone to confidently determine the value of the company. In Blunt's view, the more confusion the better. One of the ways that Blunt made the share offers more attractive to the public is was by allowing them to purchase shares on leverage. Only a 20% deposit was required and the remainder would be paid over the following 16 months. So, in essence, the company was providing loans to investors. This, of course, helped increase the stock price as speculators were able to purchase more shares than they otherwise could and the supply of shares available for sale was reduced, as many shares were held by the company on margin. Once the debt holders were able to convert their debt instrument to South Sea shares, the vast majority of them did so. Holders of government Debt who rushed blindly into shares included some of the highest profile firms including the bank of England and Million Bank. Even King George was in on the action and went against others advice of selling shares during the mania and instead wanted to purchase more shares in the new subscriptions issuance. In the end, £31 million of debt was converted with a nominal value of just 30% of that amount. As the bubble was inflating, several smart investors took notice that it just couldn't last forever. So they started selling their shares. English mathematician and physicist Sir Isaac Newton started selling his shares and economist Richard Cantelon sold his shares as well with the anticipation of a collapse. While it's impossible to precisely predict when a bubble will end, the departure of more experienced investors can be a signal that the peak is nearing. Adam Anderson, a former cashier of the South Sea Company later claimed that many purchasers of shares bought them knowing that their long term prospects were hopeless and they aimed to get rid of them in a crowded alley to others more credulous than themselves. The rise of South Sea shares led to a number of other examples of investor irrationality such as bubble companies. In the months following the South Sea scheme, new stock promotions were advertised in the newspaper to lure in investors and benefit from the speculative market environment. Only four of the 190 bubble companies ended up being legitimate enterprises with a real underlying business underneath. The rest just wanted to prey on investors greed. But these bubble companies didn't necessarily take away the continued speculation in the South Sea Company. As a new issue went for £1,000 a share and it was sold out in a few hours. The orchestrators of the scheme had become infatuated with their own success. Increasing the amount they wanted to raise, increasing the share price they would issue at and lowering the deposit required to purchase shares on leverage. And this is a common theme I see amongst many bubbles that end up crashing. Whether it's the South Sea Company, Enron, Long Term Capital Management or Bernie Madoff, the people orchestrating the scheme get in over their heads and have too much arrogance overestimating their ability to keep the party going. Blunt enjoyed the success that came from the South Seas scheme. When the shares were at their height, he sold out and started to buy land with his profits. He even sold more shares than he owned, secure in the knowledge that the time would soon come when he could buy them back at a cheaper price. If the scheme had been reasonably executed from the start with a fixed value for the conversion of annuities into shares, and if Blunt had been content with a fairly priced stock, then the conversion would have proven to be useful to all parties. But Blunt's reckless ambition destroyed any chance of success it might have had. Now, when you hear that the South Sea company took over 30 million pounds of debt, you might not think that's a big amount. But to put this into perspective, the amount of debt they took over equated to about 80% of the country's GDP at the time. So this was just an enormous scheme relative to the size of the economy. The level of speculation had tangible impacts on the economy, as some would quit work to focus on speculating, spend their time chasing quick riches, and on the other side, see their wealth evaporate rather quickly. Bubbles of this size usually send ripple effects throughout the entire economy. Many who made fortunes go out and flaunt their newfound wealth, buying houses, furniture and gold watches. By August of 1720, the frenzy had reached its peak. The South Sea Company launched its fourth and final subscription, and once again, demand was overwhelming. Huge crowds of speculators packed into the narrow streets around the South Seahouse, pressing forward with cash and promises in hand. In a matter of hours, the entire issue, which was 10,000 shares priced at £1,000 each, was completely sold out. By this point, shares had increased more than eight times in under six months. However, directors of the South Sea Company were fearful that competition from the bubble companies would spoil the party. New bubble companies were appearing almost daily, which would inevitably steal some of their firepower. As a result, they attempted to monopolize the speculative enthusiasm by making the establishment of such companies illegal without government permission. Ironically, the government crackdown on bubble companies led to their share prices collapsing, which led to margin calls for investors who who own shares of the South Sea Company. And I think this is a big lesson that leverage cuts both ways. Let's take a quick break and hear from today's sponsors.