Commentary: Manias, Panics and Crashes
Fear of missing out is the most dangerous emotion in investing. But if history is any guide, and usually it is, this time is never different, and eventually the valuation chickens come home to roost.
“Stock prices have reached what looks like a permanently high plateau," - Irving Fisher, NY Times, Oct. 16, 1929
"A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: speculation is most dangerous when it looks easiest." - Warren Buffett
“I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.” - Stanley Druckenmiller
Fear of missing out is the most dangerous emotion in investing. We see our neighbors and our brothers-in-law striking it rich, seemingly easily, and wonder if we should maybe throw caution to the wind and finally buy that Tesla stock at 1,400x earnings, on its way to 2,800x. After all, “that Elon Musk is a genius, and sometimes maybe trees really do grow to the clouds. Tesla just got added to the S&P 500, so surely it will rise even further.” But if history is any guide, and usually it is, this time is never different, and eventually the valuation chickens come home to roost.
Speculative manias are an interesting phenomenon that have been with us almost since it became possible to split the earnings power of a business apart from the ability to buy and sell a claim on that future income. It seems that evaluating a business as a tradable piece of paper takes away our drive to ensure that we are getting a good deal for our money. Many speculators judge the attractiveness of a claim on future income based on their perceived ability to turn that claim back into more cash over the next few months. It is this type of operation that begins to untether security prices from reality, and establish the criteria needed to create big losses in tradable ownership claims. It has been called the “greater fool game”, in which a market participant relies on finding a greater fool to relieve her of ownership at a greater price than she originally paid. It is when the market runs out of fools that prices crash back to reality.
So why do we avoid participating in this frenzy to sell our investments at higher and higher prices, unloading onto the masses of fools as our investments soar to the sun like Icarus? Unfortunately, just like there is no flashing light that says, “This is the bottom!” during a crash, there is no notification at the top during a mania. And while many individuals are sure that they are deft enough to maneuver in and out at tops and bottoms, it is impossible for everyone to fit through the exit doors at the same time; history is littered with the careers of investors who found out too late that the laws of market modesty apply to them the same as everyone else. And in the words of Lord John Maynard Keynes: “The market can remain irrational far longer than you can remain solvent”.
This is not a treatise about how we are in the midst of a great bubble that will soon make fools of all who dare ignore the market’s peril; we are much humbler than that. It is a reminder that bubbles have been a recurring phenomenon since at least 1637, when the price of tulips in Holland climbed to the sky, and a single Semper Augustus bulb could command enough cash to buy a new house. One distinguishing characteristic of every one of these manic episodes is that very few people saw the culmination over the horizon, and the few who did were castigated and humiliated because of their far-sightedness. The unfortunate fact of the matter is that the market makes a fool of almost everyone on occasion. We get to choose whether to look like a fool before a crash, or after. If we choose to play the fool before a decline, we must deal with underperformance. If we choose after, we are lucky to get away with half of our money.
The reason that manias, panics, crashes, and bubbles are so hard to see in advance is that they are caused by many different factors. Sometimes they are liquidity driven, and money floods the system from outside, settling to the lowest point on the risk curve and slowly dragging future returns down to zero in all but the riskiest investments. Sometimes they are credit driven, and businesses are unable to fund daily operations, and a great deal of companies lie on the precipice of bankruptcy, causing both good and bad companies to be indiscriminately sold for scrap. Sometimes they are demand driven, and the price of an individual investment commands more value in money terms than is rightly justified by its future income, or inherent value. It could even be a combination of these factors at once. In addition, the dislocation from reality could be in some stocks, or all stocks, or art, or gold, or something esoteric like interest rates, or even volatility of prices that has reached the realm of insanity. This is why we are so careful about always being able to justify the price we pay for any investment in terms of future income, or clearly lay out a case for why a non-income bearing security or commodity is dependable as a hedge against some quantifiable risk.
Our focus on financial planning and determining how much return you need to meet your goals is the antidote for the indiscriminate buying of whatever the financial wizards are trying to unload. Our goal is not to maximize returns regardless of risk. It is to make sure your money lasts as long as you need it, and to maintain your purchasing power over time. This is a slow, arduous, and mostly boring process characterized by “decades where nothing happens, and weeks where decades happen”. We focus on avoiding “errors of commission”, where we invest in something that vaporizes, and embrace “errors of omission” wherein the unlikely occurs and the price of a barely profitable electric car manufacturer trades for more than all the other car companies combined. While it always seems like in hindsight some people “knew” this would happen, when a low probability event occurs it is likely if you were able to repeat the experiment 1,000 times, 998 would be catastrophic failures. Unfortunately, there are no do-overs for reality.
Businesses probably first began trading hands in the Western World as pieces of paper around the 14th Century in Vienna. There are no well documented cases of extreme mania during this time because the markets for these slips of paper representing ownership were small and mostly populated by sober men in the merchant class looking to store wealth in liquid form with high returns. It is fitting that the first incredible bubble was blown in the most sober of lands, and in a simple object that produced no income to provide a yardstick for determining valuation.
Tulipa, or tulips in English, are a genus of flowering herbaceous bulb that grow wild in countries east of the Mediterranean. It is said that their name comes from the Turkish word for Turban, due to the configuration of their soft petals. Tulips are in the Lily family, and there are over 160 different species. A man named Conrad Gesner claimed credit for creating the buzz around tulips, and he first saw them in 1559 at the Augsburg garden of Counsellor Herwart, a man known for cultivation of exotic plants. In 1562 a shipload of bulbs arrived in Antwerp from Constantinople. By the 1570’s upper class people were clamoring to collect the most beautiful and exotic bulbs, having them imported directly from Constantinople at great cost.
For decades the prestige of tulips increased exponentially, until a family was considered low class if they did not have a wide variety of the exotic perennials in their garden. This excitement began to filter down to the shopkeeper class, who were in pursuit of increasing their status. Certain innate characteristics of the tulip most likely contributed to this fad. The tulip is said to not be as beautiful as a rose, nor smell as sweet, and they are very difficult to care for. Although the wild variety is usually a single color, cultivated bulbs take on more variegations than almost any other flower, and they are weakened by cultivation, making them very difficult to transplant and keep alive. This allowed a sense of pride to develop around creating the most beautiful variety and having the ability to keep them thriving.
We find that injecting a sense of skill into speculation is typically a necessary, but not sufficient condition for creating a wild mania. Those who feel they are especially adept at something tend to suspend belief about how valuable that skill is. Whether this is in cultivating tulips, selecting and appreciating art, or picking pieces of paper representing the ownership of a future stream of income. It is this mass hubris that leads to prices untethering from reality; the belief that making money is ordained by one’s creator by gift of a special skill.
By 1634 tulips had become such a valuable commodity that the normal commerce of necessities began to be neglected nationally in Holland. The entire population of Holland was focused on the cultivation of this herbaceous bulb, neglecting things like growing and processing food and making shoes. Even the lowest dregs of society were in line to get a piece of the tulip market, now a completely democratic institution that offered great wealth to all.
This is another hallmark we will find in great detachments from reality. An entire people unified in a common cause that doesn’t add any value to society. Masses of day traders plucking up nickels in front of steam rollers and shoeshine boys finding that giving stock tips is more profitable than a day’s work. As I hear more and more about how easy it is for the neighbor’s kid to make a fortune trading stocks on Robinhood, I hear the echo of stable boys trading tulip fragments in the hope of getting a sprout. “But that boy is a genius, and Margorie sure is proud!”
A humorous and tragic story is told about a Dutch sailor who had been away during the formation of the mania, and blissfully unaware of the trade in bulbs. Having delivered a package containing a Semper Augustus bulb to a merchant at great trouble, the sailor was rewarded with a fine breakfast of pickled herring. Spying an onion lying on a counter he slipped it in his pocket to cut up and pair with his meal. As he sat chewing the last bite of his fish and onion breakfast, the frantic merchant ran upon him demanding the whereabouts of his lost tulip bulb. Blissfully unaware, the fully satisfied sailor confessed he had no idea where the Semper Augustus bulb was, or even what it was, “but that onion certainly was delicious”. Needless to say, a sailor eating a commodity worth the price of a new home was a great scandal, he even spent several months in prison as punishment for his felonious theft.
Demand had increased so much by 1636 that bulbs began trading on the stock exchange in Amsterdam. In addition, trading markets existed in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn and several other towns. This was the point where gamblers took over and that all reason regarding how much value a commodity should command was completely separated from reality. Price fluctuations increased as traders bought on dips and sold on rises completely without regard to any sort of underlying fundamentals. At this point, mass psychology ruled the system, and common sense was fully eradicated. If one is ever lucky enough to spot this type of volatility, greatly reducing exposure is highly recommended.
At this crescendo, the wealthy stopped planting bulbs as they had no practical value. The wise began to step away from the market because it was clear that this trend could not continue. In 1637 the prices began to drop, and contracts began to be dishonored. One merchant had agreed to buy 10 Semper Augustus bulbs for 4,000 florins each (about the cost of a house), and the price had dropped to 300 florins. The courts were filled with cases attempting to force merchants to honor contracts, but the courts demurred, insisting that they do not enforce gambling debts. In all, over 90% of the value was lost and most of society was impacted. Stable boys returned to stables, and some formerly wealthy individuals vied for jobs as stable boys. The entire economy was stagnated for years (in no small part also to do with a recent outbreak of plague), and it took time for production in neglected industries to resume. But to this day, the Dutch are known for their beautiful tulip fields, and per capita, they still pay more for bulbs than any other nation.
A tall handsome man named John Law fled his native Scotland after killing Edward "Beau" Wilson, in Bloomsbury Square, London in a duel with swords over the affection of Elizabeth Villiers on April 9, 1694. Law was convicted of murder and sentenced to execution, which was eventually reduced to a fine, but he left the country for a fresh start anyway. He was a charming gambler, impeccably dressed, and at home among the aristocracy of France. He was even invited into the court of the young King Louis XV. His father had been a goldsmith, a vaunted profession equivalent to modern bankers, and had died and left Law a fortune at age 14.
John Law introduced a couple of concepts that are familiar to us. He encouraged the formation of the first Central Bank to control the supply of money, he advocated for paper money instead of gold and silver currency, he proposed that fractional reserve banking become widespread at the national level, and he advocated for the ownership of stock companies, because they paid growing dividends instead of interest. In addition, through his manipulations, he implemented purposeful and systematic debasement of currency on a very wide scale.
In order to help France dispose of the large national debt accumulated by the long reign and wars of Louis XIV, John Law convinced his successor (friend and confidant Duke d’Orléans) to assign the debt to Banque Royale, the new central bank. In exchange for certain privileges, the bank would pay the debt from income derived from opening the Mississippi River Basin. The Mississippi Company was formed and one of the most incredible speculative bubbles in history was the result. Law controlled French tobacco and slave trades, collection of taxes, and minting of money. In total, he controlled both the foreign and domestic finances of France.
Soon the share price of The Mississippi Company rose from 500 livres to 18,000 livres in anticipation of future profits. In issuing 625,000 shares, law planned to retire the country’s debt by unloading shares onto the public. The company continued to enjoy its government mandated monopolies, an important lesson in today’s environment of carefully lobbied barriers to entry put in place by our leaders. Since Law was both a government official and a stock operator, he continued to give the Mississippi company government mandated benefits in order to monetize them.
After a spectacular gain Law began to realize that fundamentals were separated from reality based on the value of the company in relation to the goods and prices they commanded. He implemented a systematic reduction in price in order to cool the temperature of the stock. Unfortunately, shareholders wanted gold and silver instead of Law’s paper money upon sale. In order to protect the supply of precious metals Law implemented a rule change forcing shares to be exchanged for his plentiful paper currency, which he had also debased. This combination of debased currency and lower share prices caused a panicked selling frenzy that Law soon lost control of.
The entire bubble burst by 1720, and John Law returned to London after being fully pardoned for his 1694 murder. He died several years later broke. The important development was the new ability of the Central Bank to print currency. The currency was loosely backed by the vast lands owned by the aristocracy, and this trend continued into the late 18th Century, when France found itself completely broke, and looking for ways to raise funds. Around this time, and thanks in no small part to the policies of John Law, the people revolted, seized control of the government, guillotined Louis XVI, Queen Marie Antoinette, and countless other politicians. Several years later they elevated Napoleon Bonaparte to Emperor, terrorized the rest of Europe, and sold the stomping grounds of the Mississippi company, the Louisiana Territory to the United States for $15,000,000. An interesting example of unintended consequences when it comes to printing massive amounts of money. Keep in mind that this entire series of events unfolded over more than 100 years, illustrating the powerful effects of “thinking long-term”.
So, to summarize, Law established government mandated barriers to entry to create sanctioned monopolies, monetized government functions in publicly owned and traded securities, forced payments to be made in unlimited printed paper currency (removal of gold and silver standard), prohibited conversion of paper money into precious metal (adopted full fiat currency), debased the value of the paper currency (inflation), and printed unlimited amounts of it to settle government debts and pay off continuously higher share prices. Seems like an impossible scenario today, no?
The most important factor involved in both examples is that smart individuals suspended propriety in the hopes of getting rich and neglected to remember that what the wise man does in the beginning, the fool does in the end. We must avoid the fear that our neighbor will get richer than us by chasing opportunities that seem too good to be true. If getting fabulously wealthy were easy, we all would have done it already. The only two things that almost ensure wealth are good decisions and time. We work very hard to provide the former, the latter is out of our control.
Stock and bond prices are as high as they have ever been. This does not mean that they will not continue to get more expensive, but it does mean that at some point either the income they produce will have to increase, or the price they command will have to decrease. Ask yourself very humbly which is more likely. Adding to the current danger is the modern belief that bonds are conservative under all circumstances, even at negative yields, even in the face of possible inflation.
We are in an age where millions of Americans have handed over control of their investment accounts to index sponsors, not paying any attention to what they hold. In fact, they see playing poker without looking at their cards as an advantage. I’ll take that bet, given sufficient time. Jeremy Grantham has said that markets are reasonably and fairly valued 75% of the time. There is no question we are in the 25% wherein this is not true. That doesn’t mean we haphazardly flee to cash; it means that we exercise as much care and caution as possible, because we could be weeks, months, or years from a full resolution of the pricing dislocation.
Our job is to make sure you have sufficient assets to last the rest of your life no matter how severe the follies of our peers. It is just as risky to have all cash during a period of inflation as it is to have all stock during a period of market mania. We will continue to diversify your holdings so that we are prepared to weather any possible storm. We will split your accounts between cash, fixed income, equities and alternative investments to minimize the chances of permanent loss of capital in both nominal and real terms, and to earn a fair return for the risks that we accept.
It is incredibly difficult to make good decisions in the now for rewards that pay off in some unknown future. The siren’s song is strong to just suspend discipline and run headlong into the unknown. We continue to be diligent and patient and wait for our reward because we know that although the future is not promised, it always comes faster than we imagined. Being careful now ensures us and those we love a better tomorrow when we are lucky enough to see it.
As always, please do not hesitate to contact your wealth advisor, or me personally with questions. If you think there is an error in our thinking, I would love to hear it and correct it. We are humble enough to know that we do not have all the answers, but confident enough that none of this is new and we have thousands of years of history as our guide.
W. Allen Wallace, CFA, CPA/PFS, CFP®
Chief Investment Officer
Mackay, C. (1974). Extraordinary popular delusions: And the madness of crowds. New York: Noonday.
Kindleberger, C. P., & Aliber, R. Z. (2015). Manias, panics and crashes: A history of financial crises. Basingstoke, Hampshire: Palgrave MacMillan.
Galbraith, J. K. (1994). A Short History of Financial Euphoria. Penguin Books.
Thiers, A. (n.d.). The Mississippi bubble. Newton Page Classics.
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.