Euphoria and ruin are inherent in markets. There’s a long history to back it up, as John Kenneth Galbraith explains in A Short History of Financial Euphoria.
All it takes is an idea — it doesn’t have to be a good one — grounded in reality, along with rising prices to get the ball rolling. But if speculative euphoria takes hold, it’s because imagination runs wild with the possibilities brought by higher prices.
In the book, Galbraith relayed three common traits in every speculative episode:
- New Innovation: every episode is driven by something new and exciting that catches the public’s imagination. The stories around it are rich in imaginative possibilities but light on realistic ones. Financial innovations are just as enticing as technological ones. But financial innovations turn out to be less innovative than first thought.
- Debt: leverage against assets scaled to excess helps keep prices aloft.
- Crash: it always ends in collapse and ruin. The designers and promoters once labeled as geniuses are condemned. Investigations follow, scrutinizing the innovation, debating new rules and regulations, and placing blame, though not on irrational speculation.
It also requires people. Financial memory loss and our ability to link money to intelligence keep the cycle alive.
There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
Ignorance grows as time passes. A new generation always comes around, confident that they’ve discovered a new thing that will bring riches.
Those that criticize or don’t play must be “too old” or “out of touch” with the new paradigm. Those that do play, get It. Whatever It is. They’ve bought in. Criticism never goes over well. Besides, the people pushing It must be smart. They’re rich or they manage a ton of money, so they’re right. Right?
There’s been a lot of It’s over the years.
One of the earliest was the Mississippi Bubble. John Law was behind the scheme that began in 1716. In exchange for setting up the Banque Royale for France, he got exclusive trading rates to the Louisiana Territory. The Banque issued notes to cover government expenses and pay off debt. And Law created the Mississippi Company, offered shares to the public, and promoted the “wealth” of Louisiana.
Of course, there was no gold in Louisiana but the public loved the story. Demand for shares soared. So Law issued more shares:
The proceeds of the sale of the stock in the Mississippi Company went not to search for the as yet undiscovered gold, but to the government for its debts. The notes that went out to pay the debt came back to buy more stock. More stock was then issues to satisfy more of the intense demand, the latter having the effectof lifting both the old and the new issues to ever more extravagant heights.
It turned out the Banque issued more outstanding notes than it had coin to cover the notes. Law’s scheme collapsed with a run on the bank.
A few years earlier the South Sea Bubble took hold in Britain that suckered Isaac Newton into gaining and losing a fortune. The South Sea Company was a joint-stock company created in 1711 with sole trading rights to the Americas.
By 1920 the public couldn’t get enough. Share prices soared from a January high of £128 to over £1,000 by late summer of the same year. But by December it was over. Prices were back to the January highs.
The side-effect of the euphoria was a proliferation of other new joint-stock companies promoting every type of product or service possible — horse insurance, perpetual motion machines, soap, hair, house repairs, orphanages, and hospitals. The new companies increased the total supply of shares and likely played a role in ending the euphoria just as quickly as it started.
The U.S. has experienced a number of bubbles throughout its history. The earliest were mostly fueled by debt — 1751, 1810, 1819, 1857, and 1907 — but two stood out for advances in transportation. Canal stocks had their heyday before busting in 1837. And the railroads had their biggest boom, busting in 1873. In both cases, much of the euphoria was fueled by British money.
Florida “beachfront” property could be bought for 10% down in the mid-1920s. Nobody seemed to care that it was marshland 10 miles from the beach because prices were doubling after several weeks. But the buyers eventually dried up. Miami banks that cleared $1 billion in 1925, only cleared $143 million by 1928. The Florida real estate boom was a practice run for what came next.
The 1929 crash finalized a speculative boom that ticked all the boxes. Investment trusts were the new financial innovation of the time. And trading corporations were launched for the sole purpose of speculating in stocks. Even the trading corporations launched their own trading corporations and repeated the process. In return, the “value” of stock prices was reflected in the creator.
Stocks could be bought with 10% down, margining the other 90%. By 1929, margin rates ran from 7% to as high as 15%. Add in trading costs and speculators had a high bar to overcome before they ever made a profit. It was practically self-fulfilling for a while. Throughout all of this, new technologies like radio fueled the craze.
When the market collapsed in October 1929, the blame was placed not on the speculative frenzy, but on the weakening economy.
It would take several decades and World War II before euphoria popped up again. The Go-Go ’60s produced euphoria in growth mutual funds, the Nifty-Fifty, franchises, and a new idea called conglomerates.
It showed up in REITs in the 1970s, junk bonds in the ’80s, southwestern U.S. commercial real estate in the ’80s (led to the S&L crisis), disk drive companies also in the 1980s, the Japanese stock market in 1990, the Dotcom boom that ended the century, the housing boom kicked off this century…and in between, frenzy took hold of smaller niche ideas and assets.
All of this suggests that people will find a reason to get excited about any asset. And if they can’t find a legitimate reason, rising prices will do.
This post was originally published on June 12, 2019.