David McEwen has long had an interest in the causes of bad investment behaviour and the great fraudsters who take advantage of this. In this article he describes two classic frauds from which we all seem to have learned precisely nothing.
Those who say human nature never changes are certainly right when it comes to investment. Somehow, the allure of easy money seems to trigger something inside of us all, leading the human race inexorably from bust to boom and back to bust again. There have been many investment manias over the years and, although the products and the people change, the same pattern emerges time and time again.In his book “A Short History of Financial Euphoria”, economist John K Galbraith, who came to fame for his penetrating studies of the US stock market boom and crash of the 1920s, identified a clear pattern that every investment mania goes through. “The more obvious features of the speculative episode are manifestly clear to anyone open to understanding. Some artefact or some development, seemingly new and desirable…captures the financial mind or perhaps, more accurately, what so passes. “Securities, land, objets d'art, and other property, when bought today, are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted; yet more buy; the increase continues. The speculation building on itself provides its own momentum.”
He also points out that observers of this speculative momentum fall into two camps. Most belong to the group that believes “some new price-enhancing circumstance is in control” and this will ensure hugely and infinitely growing returns. The others are those who know that every bubble has to burst sometime but believe they are smart enough to ride the wave and get out before it crashes.
“Built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster,” Galbraith says. “That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape. Something, it matters little what - although it will always be much debated - triggers the ultimate reversal.
“Those who had been riding the upward wave decide now is the time to get out. Those who thought the increase would be forever find their illusion destroyed abruptly and they, also, respond to the newly revealed reality by selling or trying to sell. "Thus the collapse."
His description, word for word, can be used to describe all of the booms and busts of history. Here then is the first two in our series about the most famous, and most devastating, investment manias in history and how investors of today can learn falling into the same traps.
Tulip mania, 1637
Novelty is a big contributor to investment manias. The sense of something new and exciting quickly leads into must-have trendiness. Whenever demand exceeds supply - or is likely to - entrepreneurs and investors come rushing.
The newest and most fashionable items in Holland in the early 17th Century were tulip bulbs, which had been introduced from Turkey a few decades earlier. The unusual flowers were always a big hit but the mania really began when a virus caused many plants to produce bright, unusual colours and patterns.
This stimulated particularly high levels of interest and these new, bizarre blooms soon became a status symbol. Increasing numbers of well-heeled people became enamoured with them and it soon became a must-have item for the fashionable house and garden.
Demand grew and entrepreneurs found they could make a lot of money by breeding and selling bulbs of the most colourful tulips. Over several years, more and more people became involved in growing, selling or investing in the flowers and prices began to escalate.
Merchants discovered they could make an easy profit by paying a deposit on a grower's bulbs that wouldn't be ready for months and agreeing to pay the balance on delivery (the world's first futures contracts). By the time the bulbs were ready to be sold their value tended to be much higher than the contract price.
Eventually, tulip bulbs began to be traded at newly established exchanges, the forerunners of today's stock markets, and tulip prices were listed in Dutch newspapers. In fact the word “bourse”, another term for a stock exchange that is popular in Europe, stems from the wealthy Van Bourse family, whose Amsterdam mansion was used by many people as a trading post.
Travelling salesmen spread the word of easy money to be made to rural villages and investment seminars were held in every local tavern. Prices continued to escalate. By the early 1630s, the nation had become obsessed with getting rich quickly and it seemed everyone was buying, selling or talking about tulips.
No market is complete without speculators and there were plenty of people willing to mortgage their homes or sell everything they owned to possess a single, valuable bulb. The extent of the tulip investment mania has never been repeated. Some bulbs were considered so valuable that people swapped houses, ships or farms to own just one.
At the height of the madness, the highly sought after Semper August variety traded for today's equivalent of $US1 million for a single bulb. In a development that casts a shadow over today's so-called expert financial advisers, tulip broking firms sprang up and tulip analysts wrote lengthy reports about the relative merits, values and growth prospects of differing varieties.
The Netherlands government issued warnings about the rampant speculation but virtually no one took any notice. As always during investment manias, those who dared to criticise the developing bubble were viciously criticised. The crash came in early 1637 when the government, worried about the impact of speculative fever on the economy, stated that tulips and tulip bulbs were products, not investments. That meant the bulbs had to be paid for in cash and couldn't be used as security for loans.
Banks began calling in loans issued against bulbs and investors disappeared. Prices tumbled and many people were bankrupted. So much of the nation's wealth had been tied up in speculation that productive activities had been sorely neglected. The government's tax revenue dried up and it couldn't afford to pay its armed forces. It eventually had to pull them out of its many colonies around the globe, causing the collapse of a once substantial empire.
Some commentators believe it took hundreds of years for the Netherlands to recover from the financial shock of the tulip market collapse. And those who say that what goes down must eventually go back up have been proven wrong where tulip bulbs are concerned. Not one has traded for anything like $US1 million in the past 360 years or so.
Not everyone agrees the apparent mania over the tulips was a fledged bubble. Author Peter Garber takes issue with many of the myths about tulip mania. He believes it was not solely a speculative bubble but a normal market reaction to high demand for tulips in the first place.
“In France, it became fashionable for women to array quantities of fresh tulips at the tops of their gowns. Wealthy men competed to present the most exotic flowers to eligible women, thereby driving up the demand for rare flowers.” As a result, he argues, the high prices in futures contracts for rare bulbs were a normal response.
He adds that there was less logic in the transactions relating to common bulb futures and the market crash on February 6, 1637. “These markets consisted of a collection of people without equity making ever-increasing numbers of 'million dollar bets' with one other with some knowledge that the state would not enforce the contracts. This was no more than a meaningless winter drinking game, played by a plague-ridden population that made use of the vibrant tulip market,' he concludes.
Whether a drinking game or a mania, it has been a colourful period of investment history that will never be forgotten.
The South Sea Bubble, 1720
In the 17th and 18th Centuries, exploitation of newly discovered territories around the world was carried out by private companies, themselves a new and popular moneymaking entity.
Although supposedly independent, these companies were generally established by the rich and connected to the king or queen of the day. In most respects, these companies acted like any other part of the government.
That was the case in 1711 when UK politician Robert Harley founded the South Sea Company. Established by an act of Parliament, it had monopoly rights to trade on England's behalf with Spanish colonies in South America and the West Indies.
At the time, England was at war with Spain. However, Harley knew from contacts in the palace that peace. Negotiations were looming and he believed that trading rights in Spanish territory would be conceded by the King of Spain as part of any settlement.
Like many speculative ventures, South Sea offered incredible potential and at first glance appeared to make sense. The idea was to take advantage of a lull in European tensions that would enable increased volumes of goods to be moved along global trade routes. South Sea, with a government guaranteed monopoly, was considered by investors to be such a low risk that failure was out of the question.
Harley won over the government of the day by promising the new company would help the country with its ever-growing debt burden. He suggested that holders of government debt (who realistically had little chance of being repaid in the near future) be encouraged or forced to swap their bonds for shares in the new corporation.
Ironically, the company was then able to use government guaranteed bonds it had swapped for shares as security for huge loans. As reward for what was widely believed to be a brilliant debt-relief programme, the government agreed to pay Harley's company an annual fee of six per cent of the debt taken over.
This quickly amounted to an agreement to pay 540,000 pounds on around nine million pounds of debt (huge numbers at the time). While this arrangement should have been obvious to many as a money-go-round with little merit, investors at the time couldn't see its flaws.
They flocked to buy the South Sea Company's shares in the belief that trading profits would be both huge, rapid and virtually guaranteed (all major contributing factors to any investment mania). Their hopes appeared close to realisation in 1713 when Spain and England agreed peace terms. However, Spain put its foot down over giving up control over what it saw as valuable trade flows with its territories. The South Sea Company tried to live up to its name by carrying out some trading activities while waiting for Spain to come to its senses.
It had several contracts to ship slaves to Spanish territories but it generally made a loss on these. Hopes were eventually dashed when war with Spain broke out again in 1718. Thwarted in its main aim, but with lots of capital and a get rich-quick mentality by directors, (a sentiment that was also widespread in Britain at the time and not for the last time), the company took up more and more financially speculative activities.
In 1719 the company suggested that the government relieve itself of more of its ever-mounting debt burden by converting a staggering 31 million pounds into South Sea shares. In return for this favour, South Sea would earn 7.5 million pounds in fees. South Sea's directors soon figured out that the higher the price of the company's shares, the more government debt it could acquire and therefore the higher fees it could earn. To stimulate the price, it announced that the company's cash reserves were so high that it would lend money against the security of its own shares.
For those that couldn't afford the ever more expensive shares, a simple deposit and promise to pay the balance was enough. In order to keep up momentum, the company paid out generous dividends, using cash generated by new share issues. These and other measures stimulated demand for the shares to the extent where people lost all sense - a mania had developed. In January 1720, a share in South Sea could have been purchased for 128 pounds - enough for a nobleman to live on for a year in those days. At their peak six months later, those same shares were trading for more than a thousand pounds each.
The bubble popped in September, after news seeped out that directors and their friends were dumping the hugely priced shares. Others tried to get out as well and the price began to fall. Within a few months, the shares had lost 80% of their value.
Bankruptcies began to mount, not just by individual investors but also by banks that had extended loans based on no more security than a few South Sea shares. As always occurs in the aftermath of a speculative mania, scapegoats were sought and punishment was severe.
Typically, the victims were the same people who only recently had been lauded as the stars and leaders of the greatest wealth-building ventures. The company's directors and backers, or at least those without connections to wealthy and powerful people who could protect them, were fined and imprisoned.
The aftermath, as with the tulip bubble, was economic hard times and returns to social conservatism and distaste for taking risk that lasted for decades. Hundreds of millions of pounds (worth many billions today) had been squandered on unproductive assets for no lasting gain.
South Sea was not an isolated example of the 18th Century, although an extreme version of investment manias of the time. The period was famous for its speculative culture and hundreds of companies, from the forthright to the downright fraudulent, were attracting investors' capital.
Businesses sought capital to enable them to implement such plans as develop a perpetual motion machine, change base metals into gold or establish a trade in human hair. One promoter famously raised a large sum '…for carrying on an undertaking of great advantage but nobody to know what it is.'
On the day the shares were issued, a queue of more than a thousand formed to purchase them. By the end of the day, the organiser had prudently boarded a boat bound for France with the money.
What We Can Learn From Investment Manias Part 2
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