Introduction
All,
Welcome back to the second day of bubble week. Yesterday, I discussed Tulip Mania, the widespread craze in the 1600s where individuals were paying over $500,000 in today's dollars for a single Tulip bulb.
Today, I examine the South Sea Company. Before diving in, a few reminders on the key factors I previously discussed that seem to indicate a bubble (with some new additions as suggested by the community):
- They experience a dramatic, often very quick, rise in price.
- They often involve some degree of opactiy and/or market manipulation.
- They often have a few very vocal advocates.
- They are accompanied by wide-spread speculative investment, often fueled by excess capital and/or debt.
- The market price of the underlying asset differs greatly from the asset's fundamental value.
- Their collapse leads to widespread panic/systemic problems.
With this in mind, let's see what can be learned from this chapter of financial history, and an incident that caused none other than Sir Isaac Newton to remark "I can calculate the movement of the stars, but not the madness of men" (perhaps especially interesting in light of the belief of some "hot shot" hedge funds today that try and use sophisticated mathematical algorithms to gain an edge on the market).
South Sea Company
The South Sea Company was an early type of corporation given a monopoly on trade between Britain and South America. Importantly, while this monopoly sounds valuable, a skeptical investor should have realized that it was practically worthless at the time since Spain controlled much of South America and Britain was at war with Spain (not exactly conducive to trading). Actual trading activity (including the slave trade) was minimal and what little trading occured was unprofitable.
However, for a combination of reasons (government "guarantees", debt, insider trading, and good old fashioned greed), the South Sea Company began spreading rumors of large future profits. Despite all evidence showing that, what little trade took place was unprofitable, the South Sea Company became the "hot pick" that everyone wanted to own. Prices rose almost eight fold over the course of 8 months.
The Company itself was also clearly involved in this manipulation - besides spreading rumors, it cut "back room deals" with the political leaders of the day - selling them shares at a substantial discount from the market price. Such incentives also led these leaders to publicly back the fictitious claims of the South Sea Company and lent an air of "credibility" to these outlandish claims.
Ultimately, for a variety of reasons (most importantly a general lack of liquidity) sellers found nobody willing at buy at the greatly inflated price. Within a month, prices fell by 90%, systematic economic panic requiring government intervention set in, and many of those that speculatively invested on credit were financially ruined and bankrupt, some as a direct result of government sanctions on those creating the bubble.
Bubble Checklist - South Sea Company
- They experience a dramatic, often very quick, rise in price.
Yes - value increased 10x over a few months.
- They often involve some degree of opacity and/or market manipulation.
Absolutely - a major factor. When the king and queen are promoting your stock to maximize the value of their personal holdings, that is pretty clear market manipulation.
- They often have a few very vocal advocates.
Certainly a yes - the company's board of directors was largely selected for their high profile and ability to garner additional investment or lend credibility to the company.
- They are accompanied by wide-spread speculative investment, often fueled by excess capital and/or debt.
Again, yes. While not discussed in the main text, the company borrowed money to lend it out to its own shareholders to let them buy more shares on credit. In fact, the company itself was formed to move governmental debt "off the books" and thus "loose" fiscal policy definitely contributed to the rise in price.
- The market price of the underlying asset differs greatly from the asset's fundamental value.
No question - the company's theoretical niche was trade with South America. Little trade ever took place, and what did was unprofitable. In fact, not a single member of the company's board had any experience with overseas trade.
- Their collapse lead to widespread panic/systemic problems.
I would say that this is a probable yes. The exact extent of economic panic ic not clear however it is certain that some amount of government intervention occurred to help stop a panic.
Visual Aid - Standardized South Sea Company Prices
Data Source - Neal, 1990, "The Rise of Financial Capitalism: International Capital Markets in the Age of Reason", p. 62-117. As far as I can tell, this book is not generally available online to read for free; I used my University library system to request it via an Inter-Library Loan. It is certainly well worth the read.
Additionally, some readers complained yesterday that the graph I produced of Tulip Mania differs from that used elsewhere and perhaps exaggerates the scope of this bubble. I apologize to any that felt mislead - I've attempted to create orginal "price graphs" for these bubbles in a standardized form to increase comparability across bubbles. Doing so certainly makes any individual graph less accurate than what could be obtained by looking at primary sources individually (espescially when dealing with older data); my hope is that what I add in terms of comparability offsets (what I believe are farily minor) distortions in any individual graph. I will always post primary source material for those interested in analyzing my decisions and will do my best to remain as faithful to them as possible. Fact checking is so often a difficult and thankless job but one that is important to truly understand the limitations of any analysis.
A few footnotes are in order, espescially given that some readers expressed interest in a more detaied analysis.
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The formation of the South Sea Company was very closesly tied to a plan to reduce the national debt (perhaps an early example of a "bailout" where debt claims are swapped for equity - perhaps too an early example of a "spin-off" as the South Sea Company was itself a new "asset" seperated from the parent "company" (the national government). Clearly this important for understanding the formation of the bubble as well but given the complexity of the multiple debt-equity swaps that took place, I decided to omit a detailed explanation in the interest of simplicity.
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Part of the reason for the collapse is certainly other international markets having their own bubbles collapse leading to a world-wide scramble for liquidity. Perhaps the most important contemporaneous bubble is the Mississippi Company.
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In the interest of space, I did not discuss the role of The Bubble Act in, ironically, fueling the South Sea Bubble. Such legislation is certainly fascinating and historically important.
Submitted November 07, 2017 at 11:08AM by pfbubbleweek http://ift.tt/2Apcpou
