Manias and Panics – Lessons from last 400 years

 

“I can calculate the movement of stars, but not the madness of men.”

Sir Issac Newton (after losing money in the South Sea Bubble, 1720)

 

Financial bubbles and crashes have been a frequent occurrence throughout the recorded world history. Almost all have led to bankruptcies, job losses, and financial distress.  If meltdown of bubbles is so painful, why can’t we stop them? Won’t it be better if prices remain etched to the financial worth of underlying securities/ assets, and owners earned the natural yields of those assets?

We scanned over 10 episodes of bubbles and crashes of last 400 years – including Tulip Mania of 1636, the Great Depression of 1929, the Dot Com bubble of 1999, the Sub-prime crisis of 2008 etc – to try and understand the causes of bubbles and crashes. The objective was to pull out/ revise lessons that today’s enthusiastic investors can learn from and avoid similar mental and financial toil.

Initial Rational Source: In almost all the bubbles of last 400 years, one or more of the following were the initial source(s) of economic exuberance:

SN Initial Rational Sources Examples
1 Inventions/ Productivity growth o    US 1920s (railways, radio, automobiles),

o    US Tech Bubble 1990s (internet)

2 Expansion of credit, excessive leverage, easy money, low interest rates o    Japanese Real Estate 1980s,

o    US Subprime Crisis 2000s,

o    Global Venture Capital boom 2015-2022

3 Globalisation, exports, cheap currency o    Japanese Real Estate 1980s,

o    South East Asia 1990s,

o    China 2000s

4 Economic Reforms/ Liberalisation o    Mexico 1980s,

o    US abandoning the Gold Standard 1970s,

o    India Harshad Mehta episode 1990s

5 Monopolies o    South Sea Bubble 1720,

o    Mississippi Bubble 1720

 

Most of the above measures were taken in pursuit of progress and economic well-being. And most of these measures were justified reasons for imagining a brighter future. They did improve lives and general wealth.

Wealth Effect: Anticipation of higher demand and growth due to above initial events leads to rise in asset prices. Banks get comfortable lending funds against security of these inflating assets. Raising money through equities become cheaper. Easy availability of both debt and equity capital at low cost of capital encourages capital investments and job creation. This raises incomes and thereafter consumption. The wealth effect thus feeds itself. 

Greater Fool Theory: What turns initial optimism into euphoria and bubble is the over estimation of brighter future, animal spirits and emotional outburst of greed, envy and fear of missing out (FOMO). Wealth effect leads to general sense of prosperity. It triggers envy and FOMO among sideliners. Prices start to detach from underlying reality. People buy in the hope that others may buy from them at even higher price – the Greater Fool Theory.

Timing the top: Sadly, sooner or later the supply of greater fools run out. Some external event happens that makes prices to first stop rising and then start falling. Those not able to service debt or expenses are forced to liquidate falling assets. Gradually greed turns to fear and wisdom of crowds turns into stampede of folly. If we try to pick clues about being able to time the peaks, we will return disappointed. For, there is no upper range of time in months when a bubble pops. However, sooner or later, it does pop. Following have been one or more common crash triggers/ escalators of the past:

SN Crash Triggers/ Escalators Examples
1 Frauds or Swindles o    Enron/ Worldcom During US Tech Bubble 1990s,

o    Satyam, India 2008

2 Default or Bankruptcies o    US Maring Debt 1920s,

o    South East Asian Crisis 1997,

o    Lehman Brothers 2008,

o    IL&FS default 2018

3 Contraction of credit or money supply o    Japanese Real Estate 1980s,

o    US Tech Bubble 1990s

4 Geo-Politics, Terrorism, War o    Yom Kippur War and Oil Crisis 1973,

o    9/11 Attack 2001

5 Natural Calamities including Pandemics o    Spanish Flu, 1918,

o    Covid -19, 2020

 

 Saviour: Primary protection against emotional follies of envy, greed, fear of missing out and overconfidence in an overheated market is to remember what Benjamin Graham and Warren Buffett said about bubbles and human nature –

“The investor’s chief problem, and even his worst enemy, is likely to be himself”

“Be fearful when others are greedy”

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