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A History of Bubbles

What if you want to repair the mobility elevator at least for yourself? In this case, financial markets offer a very powerful but also dangerous tool, a sort of nuclear lift: asset bubbles.

Piketty, as we have seen before, states very clearly that workers are getting poorer and enjoy no mobility due to r > g: return on capital goes from 4 to 5% whereas GDP growth is stuck between 0 and 1%.

What if you do not want to wait for the Government to do something about it? What if you want to repair the mobility elevator at least for yourself? In this case, financial markets offer a very powerful but also dangerous tool, a sort of nuclear lift: asset bubbles.

Riding a bubble, your small capital can increase a hundredfold in a short time. But you could also lose everything.

The usual narrative about bubbles is that bubbles are evil and they must be recognized to be avoided: they are like the Big Bad Wolf for the Little Red Riding Hood investor. That is often true of course, but tells only a part of the story. Bubbles, as any investment, represent a risk and an opportunity at the same time, require much knowledge and preparation to be managed, technical skills but also psychological ones; financial competences are not enough, a thorough knowledge of the business/product/industry in question must be acquired. 

Let us learn something about bubbles analysing a few of the most famous ones in history.


The Dutch Tulip Mania

GETTY IMAGES

Historical accounts are still under discussions for this very first and iconic bubble (1). We can underline a few facts: 

  • Tulips were a new asset class and as an asset class they did not last long.
  • Being a new asset class, a lack of historical data gave way to large swings in prices.
  • In a way, tulip bulbs were prototypes of something new and unknown, and as a technological breakthrough they inspired hopes that could not be limited by experience.
  • Only a small group of merchants was involved in the market, the effects on the overall economy of the boom and bust were negligible.
  • As a flower they proved really extraordinary: the Netherlands are still famous for their tulips!

The South Sea Bubble

The “night singer of shares” sold stock on the streets during the South Sea Bubble (Amsterdam, 1720)

At the very origin of the word ‘bubble’ (2), the South Sea crash gives us plenty of good lessons:

  • Business was not particularly new or innovative: only the financial formula changed.
  • A crucial active role was played by legislators, that were hired as testimonials and guarantors, and even passed a law to block any other competing ‘bubble’ (i.e. corporation).
  • A financial innovation swiftly mutated into a fraud.
  • The affluent classes were widely involved.
  • An economic crisis followed the crash.

There is a special story in the story: documents revealed for certain that even the great Isaac Newton incurred in heavy losses during the market frenzy (3):

“at the beginning of 1720, Newton had around 40% of his considerable wealth (comparable, based on average earnings, to around $30 million today) in South Sea stock, which can be thought of as a book-entry equivalent of shares. This stake had been acquired over some years, mostly at considerably lower prices.

But then, as the bubble was inflating, in April and May 1720, he sold most of that, at prices that were three to four times his cost. This liquidation appears to have stretched roughly over the period shown in the price chart. However, a few weeks after the last of those sales, in mid-June 1720, he appears to have jumped back into the market, at prices about double those at which he had sold. He then continued making further investments for himself until the end of August, just before the collapse of the bubble.

There had to be vigorous debates among all the executors and Hall about the prospects of the South Sea venture, with Hall likely the most fervent enthusiast. Those debates, together with the rapidly rising market price, apparently led Newton to change his mind.

It should be noted that Newton did become a truly ardent believer in the bubble, more ardent that other people in his circle, even though he started out as a sceptic and was slow to change his views. The Hall estate made some purchases of South Sea stock as late as the middle of September, when prices were in a free-fall and about half their peak level. However, this estate did keep a substantial fraction of its assets in a more stable investment, that of the Bank of England. On the other hand, Newton appears to have put all of his assets into South Sea stock.”

Newton in 1702 by Godfrey Kneller

Even one the greatest scientists in history and for sure a very rational man, under the pressure of continuous discussions, news, and an astonishing price rise, lost his principal. We then learn that a plan is necessary from the beginning. Probably if Newton did not liquidate completely his first very lucky investment, he would not have entered later.

In the same period, the great writer Daniel Defoe ran The Commentator, a newspaper that was likely subsidized by the government. He attacked the similar bubble plan designed by John Law in France and was vociferous in his condemnation of the various visionary London schemes, such as a company “For extracting Silver from Lead.” He called them various names, such as a “lunacy” caused by the “bubble infection.” (3)


The Railway Mania

‘Can you tell me how to make £10,000 HONESTLY in Railways?

The first high tech bubble, Railway Mania was really close to modern day disruptive technologies markets (4)(5)(6), but still the similarities with the South Sea were even more striking:

  • Strong role of the legislators: railroads were not centrally planned in Britain as in the rest of the world. Companies were required to submit a Bill to Parliament for approval of new railroad lines, there were no limits on the number of railroad companies and nearly anyone could form a railroad company and submit a Bill to Parliament. Financial viability of railroad lines was not a requirement for Parliament’s approval and most Bills were approved due to the fact that many Members of Parliament were heavily invested in railroad companies.
  • A technological innovation swiftly mutated into a fraud, with many impossible railway projects, that just worked in enriching their initiators.
  • Low interest rates, abundant liquidity in the system, was a key factor.
  • A rising pressure on the middleclass through newspapers news, discussions among peers and a constant rise of price: as railroad company shares continued to rise, investors became increasingly wrapped up in the speculative fervour and many middleclass families invested all of their savings into them. Many famous figures became involved in railroad stock speculation including Charles Darwin, Charles Babbage, John Stuart Mill, the Brontë sisters and Benjamin Disraeli.
  • An economic crisis followed the crash.
  • In the long run. railroad companies became lucrative in the strong hands of the big investors that bought them after they went bust.

As is noted on Wikipedia: 

“Unlike some stock market bubbles, there was a net tangible result from all the investment: a vast expansion of the British railway system, though perhaps at an inflated cost. Amongst the high number of impractical, overambitious and downright fraudulent schemes promoted during the mania were a good number of practical trunk routes (most notably the initial part of the Great Northern Railway and the trans-Pennine Woodhead route) and important freight lines (such as large parts of what would become the North Eastern Railway). These projects all required vast amounts of capital all of which had to be raised from private enterprise. The speculative frenzy of the mania made people much more willing to invest the large sums required for railway construction than they had been previously or would be in later years. Even many of the routes that failed when the mania collapsed became viable (if not lucrative) when each was in the hands of the larger company that had purchased it. A total of 6,220 miles (10,010 km) of railway line were built as a result of projects authorised between 1844 and 1846—by comparison, the total route mileage of the modern UK railway network is around 11,000 miles (18,000 km).”

The money lost by many small investors became, in a way, an unearned income for the next generations. And the technology did not die, it prospered and we still use it today.


Lessons learned

Bubbles are usually lucrative for a few and disastrous for many. The key elements that we have learned from history to assess new market trends are:

  • Retail involvement: is everyone already in?
  • Legislator role: is the price rise influenced positively or even caused by laws?
  • Liquidity and leverage: how much money is in the system? Is it sustainable? Do people invest their own money or borrowed capitals?
  • Asset class: is it totally new? If not, what do historical data tell?
  • News: how much hype is around?
  • Product: is there a technological and/or financial innovation? How will it impact people’s lives? Is there still room for improvement/adoption?
  • Investing plan: do people invest following a plan and/or generic prudency or are they under psychological pressure? And you, do you have a plan?

ReLLANPI is our swiss knife to analyse (and build plans for) today’s bubbles.


(1) https://en.wikipedia.org/wiki/Tulip_mania

(2) https://en.wikipedia.org/wiki/South_Sea_Company

(3) http://www.dtc.umn.edu/~odlyzko/doc/mania13b.pdf

(4) https://en.wikipedia.org/wiki/Railway_Mania

(5) http://www.makingthemodernworld.org.uk/stories/the_age_of_the_engineer/01.ST.04/?scene=11

(6) http://www.dtc.umn.edu/~odlyzko/doc/hallucinations.pdf

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