Over the next few weeks, I will be writing a series of pieces on trends in the global economic landscape, and what the implications of these trends are for investors. Before we begin, however, a brief history lesson is in order…
What goes up must come down
– Sir Isaac Newton (1642-1727)
Gravity is a conceptually simple, but mathematically complex physical phenomenon where in its presence, what goes up eventually must come down. Financial markets are no different, and our world is chock full of examples of speculative frenzies. While it is never fun to be involved when asset bubbles burst, history may provide some insight as to the conditions under which asset prices bubbles can develop, grow, and disappear. What I present below is a mere sketch of selected well-known asset bubbles. For more in-depth reading on the subject, I would recommend starting with Charles Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crises.
Countless monetary systems have developed (and failed) over the past few thousand years, and have enabled man a means through which to openly speculate on the value of possessions. Among the most notable well-documented asset bubbles in modern Western history is the tulip craze of the early 17th century. In his book Famous First Bubbles: The Fundamentals of Early Manias, Peter Garber notes that at the height of the speculative craze, a futures market was created for tulips, and spot prices for the flowers commanded an average of four years’ salary for the average Dutchman. The chart below showcases the evolution of tulip prices towards the peak of the bubble in 1636-1637.
Source: Thompson, Earl (2007), “The Tulipmania: Fact or Artifact?”, Public Choice 130(1–2): 99–114; Chart courtesy of WikiPedia user JayHenry
In England in the early 18th century, speculative fever swept the country when the South Seas Trading Company was given monopoly rights by the British government over trading in Latin and South America. The announcement sent the value of the company’s stock to over £1,000 at the height of the mania, which also sparked intense interest in equities in general. “Investors” were sobered in 1720, when news of fraud at the firm caused equity prices to plummet. A forced capitulatory sell-off ensued as market participants were forced to close their positions to cover losses.
In the 1920s, American investors prospered from rampant productivity gains and began investing on a large scale in the stock market. Brokers, in an attempt to profit from the heightened interest in equities, instituted margin loans. With margin requirements as low as 20%, the stock market was now accessible to the masses, triggering additional interest and a firm rise in share prices. In addition, utility companies, the darlings of investors at the time, were able to leverage themselves several times over via the creation of holding companies (and did). Brokers, in an attempt to control the risk, slowly began raising margin requirements, which culminated in a broad-based forced selling of equities in October 1929. While the market in aggregate was not tremendously overvalued at its peak (P/E ratios for industrial stocks were about 15 at a time where corporate debt was yielding 5.1%), utility stocks were trading at over three times book value and over 35 times earnings. The withdrawal of liquidity from financial markets by the brokerage industry in the form of increased margin requirements is what ultimately likely sealed the fate of the stock market. Equities eventually tumbled over 80% before bottoming in 1932.
By now, it should be fairly clear that while markets can behave normally most of the time, the fact that markets are merely an extension of human impulses makes them vulnerable to the same distortions that human behaviour can succumb to. Next week, we’ll look into more contemporary bubbles like the rush to precious metals in the 1970s, the boom in Japan in the ‘80s, and the tech bubble in the ‘90s. Stay tuned!
Happy trading,
Jason Moschella
Consulting Editor
Tags: asset bubbles, DJIA, October 1929, South Seas Trading Company, tulip prices
