Editor’s Note: There are times when humans collectively start believing in notions about asset prices that are later proved to have been driven by herd behaviour rather than rationality. In financial market terms, they are called bubbles. In our new Market Mania series, we take a look at some of the greatest bubbles that existed in human history – the causes, the experience of living through them, the aftermath when the bubbles burst and the learnings one can draw.
Among the many popular investment anecdotes, there is this one about how renowned scientist Isaac Newton lost a packet in the so-called "South Sea bubble" of 1720. To add insult to injury, Newton had initially made a profit on that stock by cashing out in time, before greed got the better of him.
In an updated version of Benjamin Graham’s 1949 classic, "The Intelligent Investor’, Wall Street Journal’s Jason Zweig wrote that Newton made a profit of £7,000—twice of what he had invested--when he sold all his South Sea shares.
A mad scramble for the shares by the public had Newton famously remarking that he 'could calculate the motions of the heavenly bodies, but not the madness of the people’.
However, a few months later when the share price continued to soar, Newton couldn’t resist the temptation for some more profit and brought shares at a much higher price. This time around, he wasn’t as lucky. He lost £20,000 (or more than $3 million, based on the money value in 2002-03), according to Zweig.
This anecdote has been disputed by many and some like economist John Maynard Keynes said that Newton managed to make a profit in his second attempt as well.
One can’t say if Newton made money or lost it, but the recent rally in some stocks is causing a section of market watchers to draw parallels with the South Sea bubble of 1720.
The South Sea bubble eventually resulted in one of the biggest financial crashes in London at that time. Though the real reasons behind the bubble are complex, it’s among the earliest major manipulations of financial markets. Prices on the London Stock Exchange rose to unsustainable heights before crashing in the autumn of 1720. The boom was associated with a company called South Sea Company, which was formed by one Robert Harley in 1711 to trade--mainly in slaves--with Spanish America. He sought out allies for peace negotiations to end the War of the Spanish Succession, assuming that once the war ended, a treaty permitting such trade would be in place. The British government gave him a monopoly on trade with the islands of the South Seas (present-day South America). The monopoly was based on the expectation of securing huge trading concessions from Spain in the peace treaty.
The bubble, or hoax, was centred on the fortunes of the company. Many investors expected South Sea Company to replicate the success of the East India Company, which provided England a flourishing trade with India. So, they snapped up South Sea Company shares. Holders of £9 million worth of government bonds were allowed to exchange their bonds for stock (with 6 percent interest) in South Sea Company.
Share value skyrockets
Between January and August 1920, shares of the company surged over eight-fold, from £128 to £1050. Around the same time, the company also proposed to take over the responsibility for the entire national debt. The directors suggested that they would gradually pay off the national debt, which had rocketed as a result of the War of the Spanish Succession, in return for a guaranteed profit. Again, the company offered its shares, this time in exchange for government bonds. Through this transaction, the company expected to make huge gains.
As the government accepted the proposal, the value of the company’s shares skyrocketed. Many tales were also circulated by the directors of the company, about unimaginable riches in the South Seas. All these spawned a series of similar speculative ventures.
The directors also indulged in a lot of artifice, probably because even they were not sure that if company would ever make enough profit to cover its commitment to the government. There even ran a carefully-orchestrated marketing campaign — spreading rumours of Spain allowing Britain a form of free trade with its American colonies, issuing heavily discounted shares to public figures, including politicians and royal mistresses.
The bubble bursts
Finally, around September 1720, shares of the company collapsed dramatically, as there were no longer buyers at inflated prices. By December, the value of shares fell to around £124, causing a severe economic crisis, and dragging many other stocks with them.
An inquiry ordered by the House of Commons revealed that at least three ministers had accepted bribes and speculated in South Sea shares. After the bubble burst, Prime Minister Robert Walpole announced a series of measures to restore the credit of the company and reorganise it. He had been against the South Sea Company right from the beginning. Vowing to punish all those responsible for the scandal, Walpole divided the national debt between the Bank of England, Treasury and Sinking Fund. The Sinking Fund was made up using a part of the country’s income, which was put aside every year. Eventually, stability returned.
South Sea Company survived till 1853, having sold most of its rights to the Spanish government in 1750. Right from the beginning, the company had a shaky commercial basis, with most trade concessions from Spain barely materialising. The peace treaty, the Treaty of Utrecht made with Spain in 1713, was less favourable than had been hoped. According to the treaty, an annual tax on imported slaves was imposed and the company was allowed to send only one ship each year for general trade.
South Sea Bubble was the first financial crisis precipitated by easy availability of credit. The company’s shares were overvalued and backed by unrealistic guarantees. The bubble had effects beyond the London market, as financial centres of Europe were interlinked. Many plays, satirical and political writings were inspired by the crash. To cash in on the frenzy surrounding the scam, many artworks, too, were created along South Sea themes.
(Edited by : Jomy)