A South Sea Cruise
In a conversation with a client last week, I was asked if it was possible that the conditions we see today in the economy and the markets are somehow unique or new. The implication being that the techniques that have worked for investors – contra speculators – for decades might no longer work in this brave new world. We take a long term view of investing and use some of these well known techniques (Shiller P/E, Stock market value to GDP, Q ratio, etc.) to adjust our long term allocations. These are not tools for short term trading and have no value to the speculator concerned with the course of the market over the next few months or even the next couple of years for that matter. But they have, over a long history, provided guidance to investors concerned with their net worth a decade or two hence.
My answer was no, there is nothing new in the world when it comes to speculating, investing or concocting and enacting crackpot economic theories. It seems that every few generations, somewhere in the world, a population needs to learn once again that no, Virginia, there is no economic Santa Claus. Speculative episodes are sprinkled across the pages of history from the second century BC Roman Empire to Venice in the Middle Ages to the Netherlands Tulipmania in 1630s to the South Sea and Mississippi Bubbles in the 1700s, etc., etc.
These periods share characteristics with our recent bubbles. They often follow periods of financial “innovation”. Derivatives such as options and futures flourished during the Tulip bubble. The South Sea bubble followed what has been called the Financial Revolution in the late seventeenth century during which many of the innovations of the Dutch were imported to England. Our Dot.com and housing bubbles followed a period of deregulation and “financial innovation” so shady it spawned an industry known affectionately as the Shadow Banking system.
These periods often feature “financial innovators” who after the bust have to be punished and/or ridiculed. John Law was a monetary genius while the Mississippi Bubble was inflating but had to run for his life when it burst. Michael Milken was a Master of the Universe until junk bonds brought down the S&L industry. Alan Greenspan was the Maestro of the Great Moderation until the housing bust.
There’s nothing new in the stock market either. The terms Bull and Bear have been around since at least the early 1700s. Daniel Dafoe wrote of “buyers of Bear-skins” in 1719. Charles Johnson defined a Bull in 1715 as “one who endeavours by speculative purchases, or otherwise, to raise the price of stocks”. Momentum investing may have gotten its academic imprimatur in the 20th century but 19th century economist David Ricardo
made money by observing that people in general exaggerated the importance of events. If, therefore, dealing as he dealt in stocks, there was a reason for a small advance, he bought, because he was certain the unreasonable advance would enable him to realise; so when stocks were falling, he sold in the conviction that alarm and panic would produce a decline not warranted by circumstances.
Value investors were also around during the time. Daniel Dafoe often warned against buying shares above their “intrinsick value”. Sir Richard Steele elaborated a contrarian investment strategy in the early 1700s:
Nothing could be more useful, than to be well instructed in his Hope and Fears; to be diffident when others exalt, and with a secret Joy buy when others think it is their interest to sell.
The IPO booms of the late 90s and recently may seem unique to us but all speculative episodes feature large volumes of new issues often centered on new technologies. The Financial Revolution in England featured a frenzy of stock offerings that culminated in the so called Bubble Companies of the South Sea period. Radio and auto companies were the dot coms of the Roaring 20s. US railroads and canals were the emerging market stocks of the 19th century.
Speculative episodes run concurrently with monetary and fiscal shenanigans as well. It probably isn’t a coincidence that the Financial Revolution of the late 17th century started about the same time the Bank of England was granted a Royal Charter and a banking monopoly in 1694. Its charter was dependent on an agreement to lend the government 1.2 million pounds which it provided in the form of its own banknotes. In other words, they loaned the government some newly printed up fiat currency. Later, after the government had predictably accumulated even more debt, the South Sea company was established for the sole purpose of taking over 10 million pounds of government debt and converting it to South Sea shares. The other side of the war that generated the debt, France, granted similar favors to John Law and his Mississippi Company. In other words, these privileged companies printed up some pieces of paper to buy government debt, which sounds suspiciously like the Fed’s newfangled innovation, Quantitative Easing. Forward guidance and its effect on markets was known as well. Joseph de la Vega in 1688:
the expectation of an event creates a much deeper impression upon the exchange than the event itself
Human nature has not changed over the centuries. Remember former Citigroup CEO Chuck Prince’s description of the bank providing financing for LBOs in 2007?
As long as the music is playing, you’ve got to get up and dance. We’re still dancing.
Compare that to London banker John Martin in 1720:
when the rest of the world is mad, we must imitate them in some minor measure.
During the manias there is also a general perception that the government will come to the rescue if share prices start to fall. That was certainly true in Japan in the 1980s when it was argued repeatedly that the Ministry of Finance wouldn’t allow prices to fall. It was also true in the South Sea bubble when it was thought that having the King as a shareholder meant South Sea shares couldn’t fall. And it is true today when there is an almost religious belief that the Fed’s QE will keep prices from falling.
The response to the bursting of these bubbles is also eerily similar to what we see today. Soon after the South Sea bubble England enacted a law that outlawed short sales, futures and options. Politicians rail against the speculators who they believe have caused the crisis with “stockjobbers” pilloried in the 1690s while FDR castigated the “moneylenders” and today President Obama demonizes the rich. The periods of financial innovation and bubbles are followed by periods of regulation. In the Depression we got Glass-Steagall, in the 90s we repealed it and now we’re trying to implement Dodd-Frank.
Almost every financial bubble and crisis in the history of the world has been accompanied by some form of monetary debasement. Credit is readily available and used for speculative purposes. By the 1690s the total value of credit instruments circulating in England exceeded the currency of the kingdom and people noticed that these instruments shared many of the properties of money. Most of the initial share flotations of the South Sea company were done on credit with a portion due today and the rest over the next year. Unlike gold though, which was considered real money at the time, credit was and is subject to the whims of the market (credit is derived from the Latin credere, to believe). As economist Charles Davenant wrote of credit:
It is never to be forced and it hangs upon the opinion, it depends upon our passions for hope and fear; it comes many times unsought for, and often goes away without reason, and when once lost, is hardly to be quite recovered.
That, my friends, is what we call today liquidity and an excess of it is always present at the formation of bubbles. Today, it is produced by the mass delusion of quantitative easing and its effect is felt mostly in the prices of risky assets. Its loss, as we saw in 2008, can be devastating for an economy built on a sandy foundation of credit. The most amazing thing about the most recent episode of speculation in stocks is that we recovered the liquidity so quickly, that so many have been sucked back into the vortex of another Fed induced bubble.
It is impossible to predict when or by what means speculative episodes will break. Most bubbles burst when the credit created to sustain them is no longer available. The means by which the credit is withdrawn varies though and is entirely unpredictable. All an investor can do is observe the current conditions and using proven methods with demonstrated efficacy, altar his asset allocation accordingly. What that means to us today is that risk assets, including stocks, are trading in excess of their “intrinsick” value and should therefore be held in smaller proportions than when better values exist. Floating along on our modern day South Sea voyage requires patience, emotional control and some cash to exercise that “secret joy” of buying when everyone else feels compelled to sell.
Note: Many of the quotations above come from the excellent Edward Chancellor book, Devil Take The Hindmost, copyrighted in June 1999 and published in 2000. I’ve read many a blog post recently about how the recent talk of bubbles means we can’t be in one. Well, there were Cassandras in all the previous periods of speculative excess and this time is no different. Robert Shiller published Irrational Exuberance in early 2000 and if I had the time I’d dig out a bunch of my commentaries from that period that warned of a bubble. I certainly wasn’t the only one; there was plenty written of bubbles in 1999 and 2007. That didn’t keep them from inflating and it sure didn’t keep them from deflating.
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com or 786-249-3773. You can also book an appointment using our contact form.