THE FINANCIAL BUBBLES

There are no new forms of financial frauds; in the last hundred years there have only been small variations of a few classic designs.
John Kenneth Galbraith.
All people are most credulous when they are most happy.
Walter Bagehot.
“History repeats itself” is a well known saying and there are plenty of historical evidences to prove this. It’s exactly true in the stock markets throughout the world.‘Bubbles on water are not true’, a saying in Kannada language. It’s a universal truth and applies exactly to the stock market. We cannot say when they will burst. Just now, we have seen the Water Bubbles, the very next moment they will be no where. It’s a sheer illusion. It’s a fact that they are not permanent. The surprising thing is after some time again Bubbles will be formed and waiting to burst.These kinds of Bubbles often pictured in financial world. A financial bubble is caused by widespread mania and speculations followed by a brutal collapse in asset values. The difference is water bubbles are harmless but financial bubbles are very very dangerous. You will be wiped out from these financial bubbles. Without any discrimination, they will spoil related and unrelated persons.History repeats itself’ has lots of historical evidences. This applies exactly to the stock market. History always repeats itself in the financial world. Stock market fluctuations are like waves. They always fluctuate. It is because stock market is directly connected to the behaviour of investors. Investors are irrational human beings. Due to their irrational behaviour, the stock market also behaves irrationally.Why we should study these financial bubbles? What is the relevance of these manias? As an investor, you must study these financial bubbles and what were the reasons for such a foolish behaviour from the part of investors. It is pertinent to remind that “Those who cannot remember the past are condemned to repeat it”. We can learn some lessons from studying these bubbles so that we cannot make such kinds of mistakes in our investment process. Now let us discuss major financial bubbles of the world.
1. TULIP MANIA
The first and officially identified financial bubble in the world is Tulip Mania. It is quite interesting story of human folly. In 1559, Courad Guestner brought the first Tulip bulb flower from Turkey to Holland and Germany. Tulip bulb was a kind of beautiful flower. People of Holland and Germany instantly fell in love with the Tulip bulb flower. Soon Tulip bulbs became a status symbol for the wealthy. The reasons behind this are these flowers are beautiful and hard to get.Later everybody irrespective of their financial status started buying tulips with craze. And at this point of time, speculators enter into the stage and created trading activities to earn easy money. Small businessmen, professionals, housewives and formers everybody entered into trading tulips. Finally tulips were placed in the local stock exchange like stocks of the companies. Due to all these things prices of tulips sky rocketed to the dizzy heights. There was a severe competition among traders. Trading volume increased enormously thanks to speculative activities. By 1634, even middle class people craving for owning tulips. By 1635, this mania reached boom stage and prices moves to ridiculous heights.At the height of tulip mania in 1635, a single tulip bulb was sold for the following items;
1. four tons of wheat. 2. eight tons of rice. 3. one bed. 4. four oxen. 5. eight. 6. 12 sheep. 7. one suit of cloth. 8. two casks of wine. 9. four tons of beer. 10. two tons of butter. 11. 1000 pounds of cheese. 12. one silver drinking cup.
Is this surprising you! Yes this kind of mania surprises everybody. But this is the way crowd behaves. There were plenty of evidences in the human history to this kind of illusions. We read crowd’s behaviour in Shaksepeare’s dramas. That is exactly the reflection of reality. In today’s terms people of Holland bought single tulip bulb for $ 76000. What you can call it, madness of people !. People from all walks of life sold their homes and real estate at incredibly low prices in order to speculate in tulip bulbs. Everybody wants to make a quick fortune. The majority of buyers had no intention of even planting these bulbs.Rationally speaking, tulips had no practical value as such. In the dizzy height of this tulip mania all common sense and logic was thrown to the wind.Suddenly the journey of tulip took a ‘U’ turn. Some smart investors smell the over valuation and sold their position at peak prices. These are the informed speculators and made huge profit by selling their holding at the boom. Prices of tulip bulbs began to fall swiftly. Suddenly, the market began with a widespread panic when every body started realizing that tulips were not worth the prices they paid for. In a matter of 4 weeks, tulip prices crashed by over 90%. Fortune were lost like a water vapor. Wealthy people became paupers. Bankruptcies were everywhere.Investors who bought tulips at the peak were not in a position to honour their own contract with sellers because of market crash. Dutch Government nullified all the contracts purchased at the height of the mania. The Supreme Judges of Amsterdam declared all tulips speculations to be gambling, and refused to honour these contracts. As a result of this, payments were not enforced by any of Holland’s courts. This further fueled the market crash.This financial bubble spoiled the Dutch commerce for decades. The price of tulips at the height of the mania was $ 76000 (in today’s terms), 4 weeks later they were valued at less than one dollar. Just imagine magnitude of the crash, what was the fate of the investors bought tulips at the peak.Lessons; As an investor, you should not part of the crowd. You should think independently. At any cost, you should not buy stocks in times of boom. Contrarian approach to the investing is always better.
2. SOUTH SEA BUBBLE
The story of South Sea Bubble is also quite interesting and has some lessons for us. South Sea Bubble started in 1711 in England. After a war which left Britain in debt by 10 million pounds. Britain proposed a deal to a financial institution, the South Sea Company, where debt would be financed in return for 6% interest. The Government offered exclusive trading rights in the South Seas, The company smelt a good deal and instantly agreed because of proximity to wealthy South American colonies. Over the years, the company developed monopoly in the slave trade and trade the commodities such as gold and wool with British.The South Sea Company issued stocks to the public to finance its operations. Investors quickly noticed the monopoly position of the company and snatched shares up from the start. The company, seeing the success of the first issue of shares. Quickly issued even more. The stocks were accumulated by the investors with great appetite. Truly speaking, the management of t he company was inexperienced. All they knew was issuing additional shares and create hype in the market place. The company established lavish corporate office and the foolish investors were impressed by these gestures. This planted an image of success and wealth in the eyes of shareholders. It became extremely fashionable to own south sea company shares.The management team itself manipulated stock prices to create interest among investors. Speculation became rampant as the share price kept sky rocketing. There was a belief in the market that this company “could never fall”. Further the management developed sum ours that the South Sea Company had been granted full use of Latin American Ports, by Spain. But the truth was that Spain only allowed three ships per year. Investors expectations were too high.Directors of the company were involved in widespread corruption. In this boom, other companies made huge profits by issuing their IPO’s These new companies proclaimed everything from building floating mansions to distilling sunshine from vegetables. The new shares of these companies were snapped up by the speculative investors. Everybody became stock market experts.In 1718 Britain and Spain went to war again, stopping all chances for trade. Investors from other European countries started frantically scrambling for South Sea shares. Truly speaking the South Sea Company was not generating any profit from its operations. More emphasis was placed on making money from issuing more shares to investors than from actual commerce. It was at this point of time that management realized that the shares were incredibly over valued relative to the fundamentals of the company. They decided to sell their holdings while other investors were still unaware that the company was profitless.The news broke out that the management has sold its shares completely. There was a panic selling in the market in the next moment, but it was too late. Everybody was selling but no buyers. Not a single investor was ready to buy. South Sea Shares become worthless piece of papers. Fortune mere lost overnight stocks belongs to other companies were also fell to the ground across the market. Scientist Isaac Newton lost over 20,000 pounds of lies fortune and made a famous statement that, “I can calculate the motions of heavenly bodies, but not the madness of people”. Jonathan Swift also inspired to write “Gulliver’s Travel”. The British government some avoided a banking crisis as it was the financial powerhouse of the world. The government reformed financial sector and issuing of shares was barred until 1825. In spite of these efforts, the economy didn’t fully recover until next century.
3. THE MISSISSIPPI BUBBLE.
The Mississippi Bubble is similar to The South Sea Bubble. In 1720, at the same time as England’s South Sea Bubble, France experienced the financial crisis known as The Mississippi Bubble. This has a striking similarity to the South Sea Bubble.In 1715, France was bankrupt from war. Due to the war France defaulted on its debt as well as interest on the debt. The economy was also in a bad shape. At this circumference the king Louis XV turned to his trusty adbisor, the Duke of Orleans for advice. In turn, the Duke of Orleans turned to his friend John Law, a Scottish financier.John Law was born in 1671 to a gold smith who was also a money lender. John Law was well versed on the principles of banking. Unfortunately, Law involved in a duel, killing his opponent and convicted of murder. Law eventually managed to escape prison and Quickly left England. Law earned much of his income from speculation activities. John frequented destinations such as Amsterdam, Venice and Genoa. It was these financial centers that John Law renewed his fascination for high finance. In 1705, John Law advocated a monetary theory that argued against the eye of metallic money and favoured paper money would stimulate economic activities.When the Duke of Orleans sought his help, Law devised a strategy to stabilize the French economy. In 1716 John Law established the Bank general. This Bank general took deposits of gold and Sliver and issued paper money in return. Bank general gained equity through the conventional selling of shares as well as converting government debt. To John Law’s credit, the economy had begun to stabilize and this helped to increase his rapport and influence within the French government.In 1717, John Law acquired the ailing Mississippi company and merged it with Bank General. France had granted the Mississippi Company a trading monopoly with the French colonies known as “French Louisiana”. The trading monopoly carried a high value as speculation arose over the prospect of the beaver skin t rade and of finding precious metals, with Indian slaves to mine.The Mississippi company raised huge capital by selling shares to investors. The company expanded to monopolize as French Trade outside Europe. In 1719, the company got the right to mind new coinage. The company also got the right to collect all French indirect taxes and subsequently it got the right to collect direct taxes.The Company’s stock prices were sky rocketing. Shares started trading at 500 livres (French currency of the time) in January 1719. The public investors gained an insatiable desire for Mississippi company shares and price hit 10000 livres by December 1719. People belongs to all social classes became investors and many became millionaires just from t heir holidays of company shares. Interestingly, the French word millionaire originated as a result of the Mississippi bubble.The Mississippi company gained 80,500,000 livres in revenue from interest paid by the king on loans and profit from tobacco, the mint and trading further enhance investors’ confidence.The amount of back notes in calculation had increased 186% in one year, due to the rampant issuance of notes to fund share purchase. As a result hyperinflation ensued with the prices of goods doubling between July 1719 and December 1720. The majority of Bank General notes were not backed by precious metals and became worthless.A scandal struck in May 1720 when John Law decided that company stock prices were exorbitantly high and he started devaluing the shares. Additionally, Bank General notes were devalued by 50%. Intense protest resulted in compromise in which the bank notes’ value was restored but payment in precious metals was stopped. It was because bank notes’ were not backed by precious metals while issuing. Then the public was outraged against the company and the near worthless paper money.Under intense selling pressure and Law’s devaluation, shares had collapsed from 10,000 livres to 1000 livres by December 1720. At the same time John Law’s enemies confiscated two thirds of shares and took over the company. Share prices further deflated to 500 livres in 1721. Investors were financially devastated and many millionaires lost their entire fortunes.The collapse of the Mississippi company plunged France and Europe into a severe economic depression, laying the ground work for the upcoming French Revolution. John Law was considered as scam artist and was exiled from France. Law returned to his gambling roots and died in poverty. A fall from the grace.If we looked into purely, it in purely economic sense, it was a failure of monetary policy which caused excessive growth in money supply and inflation.
4. THE GREAT CRASH OF 1929.
The great crash of 1929 is an excellent lesson in economics. Wall Street crash subsequently spread widely throughout the world. And it clearly shows that capitalism is not a perfect system and it has its own drawbacks.First we should understand the back ground of this crash. It’s also a fact that every boom has the element of crash in its own womb and every crash has the element of boom in its own womb.1920’s were a time of great prosperity. After world war I, the “Roaring Twenties” was fueled by increased industrialization and new technologies such as ratio and automobile. Air flight was also becoming widespread. There was rapid economic progress in all sectors of the American economy.From 1921 to 1929 American stock exchange ‘Wall street’ rose towards sky. Wall street index ‘Dow Jones’ moved from 60 [pomts tp 400 points investors were greedily invests in the wall street. Some of them sold their homes and other valuables and invest the proceedings into stocks. They all believed there is no end for this boom. Investors snapped up every stocks with great appetite. Millionaires were created instantly. Soon Wall street became America’s favourite pastime spot as investors jockeyed to make quick bucks. Some retired persons invested their life time savings into stocks. Totally stock market was boiling.Then suddenly can tsunami into stock market in the form of fed rate. By 1929, the fed raised interest rates several times to cool the overheated stock market. On 24th of October 1929, stock market crashed due to panic selling by all investors. By November of 1929, the Dow Jones average sank from 400 to 145 points. In three days, the New York stock exchange crazed over $ 5 billion worth of share value. By the end of 1929, 16 billion dollars had been shaved market capitalization.BLACK MONDAYOctober 28, 1929 was recorded as black Monday in the financial history. This black Monday was the second terrible day in the history of wall street. (58 years later another market crash happened on 19th October 1987. It was also referred as black Monday). Black Monday was a terrible day in the market. Market crashed over 13% on this day. Investors were bankrupt. Around 16.4 million stocks were exchanged in the hands of confused investors and the ticker tape fell seriously behind two hours forcing people to sell their holdings blindlyTo make matter worse, banks had invested their deposits in the stock market at the time of boom. With the crash of stock market, banks’ investment in stocks was wiped out. The banks lost their depositors money. Depositors rushed to banks to withdrawn their deposits. But banks were not in a position to give money. Banks and brokerage houses became insolvent. The financial system was in stumbles. Many investors and speculators became bankrupt and commit suicide by jumping out of buildings. More or less 140 billion dollars of depositors money disappeared and 10000 banks were bankrupt.The market downfall continued from 1929 to 1932 and wall street index fell from peak 400 points in 1929 to 41.32 points in 1932. A terrible fall of 91%. The situation was really aggravated by serious policy mistakes of the Federal Reserve Board i.e., rise in Fed rate which led to a fall in money supply and depressed the economy. Again Dow Jones reached 400 points in 1955, after 26 years.The great depression of 1929-33 was the most severe economic crises of modern times. Millions of people lost their jobs and many of them bankrupted and unemployment increased everywhere. Due to this depression, America’s manufacturing output had fallen to 54% of its 1929 level, and unemployment had risen to between 30% of the work force. Roger Bobson wrote that “Factories will shut down…. Men will be thrown out of work ….. the vicious circle will get in full swing and the result will be a serious business depression”.The great depression began in the United States but quickly spread worldwide. Only communist countries escaped from this financial debacle.Lesson: As investors, we can learn some important and basic lessons from this 1929 market crash. Of course, trees grow bur never grown to sky. They have their own limitation. If they try to grow beyond their limitation, definitely t hey will be break down. Similarly stock market cannot grow to the sky. Rise and fall are the natural things in stock market. There need not be over optimism about boom and at the same time there need not be over pessimism about depression. And don’t invest your hard earned money at the time of boom.
5. THE STOCK MARKET CRASH OF 1987.
The stock market crash of 1987 in America was the largest one day stock market crash in the history finance. It also has some lessons. The wall street index Dow Jones lost 22.6% of its value or $ 500 billion dollars on October 19th 1987. That day was called as black Monday. It was a terrible day in the financial history of the world.We need to study causes to understand the crash. Prior to this crash the stock market had an extremely powerful bull market that started in 1982. This bull market had been fueled by hostile takeovers, leveraged buyouts and merger mania. The philosophy of the time was that companies would grow exponentially simply by constantly purchasing other companies. To fund these kinds of frenzy acquisitions, companies raised capital by selling junk bonds to the public. Every other companies started issuing IPO’s. Microcomputers’ were also a top growth industry. People started to view the personal computer as a revolutionary machines that will change the way of life and creates wonderful profit for companies. Everybody become investors. Investors aggressively buying every shares available in the market. This euphoria made people believe that the market would always go up.In early 1987, SEC (Security Exchange Commission – American Regulator) conducted numerous investigations of illegal insider trading inflationary pressures also built up in the economy. The Fed rapidly raised short term interest rates to control inflation. Unfortunately this step had a negative impact on stock prices. The panic stricken investors trying to sell their shares. Due to this mad rush, the stock prices across the market crashed like a aeroplane. Common investors rushed to market to sell their stocks simultaneously. The market couldn’t handle so many orders at once and most people couldn’t sell because there were not any buyers.In a single day Dow crashed by 22.6% and $ 500 dollars of investors money evaporated in the madness of the crowd. Investors couldn’t contact their brokers as brokers were engaged by thousands of other panic stricken investors. Many people lost their fortune instantly. Some unstable investors, who had lost fortune, went to their broker’s office and started shooting. Several brokers were killed despise they had nothing to do with the market crash. The majority of the investors simply selling their shares because others are selling. There was no reason and logic for selling. This irrational mentality caused the extreme market crash.Suddenly, the fed intervened by lowering short term interest rate to increase money supply. Fed’s intention was to prevent further depression and a banking crisis. Remarkably, the market recovered quickly from the worst one day stock market crash. Unlike the 1929’s market crash, the market quickly started on a bull run companies started buying back their own undervalued stocks. This crash helped market to reform further by introducing circuit breakers system which electronically stops stocks from trading if they plummet too quickly.Once again market witnessed the remarkable similarity between all of the market crashes.
6. THE NICKKEI BUBBLE.
Study of Japan and its economic progress is quite interesting. Japan’s history is the best example of human creativity. The Nikkei Bubble has some lessons for investors.After second world war, Japan was devastated. It’s major cities were destroyed by bombing and its economy was virtually non existent. Due to much effort and hard work, the Japanese economy slowly began to recover. In this process of recovery, American helped Japan in many ways. U.S. Provides capital and military assistance.Devastated factories were quickly built and excess labour force moved from agriculture sector to industry. Japanese were, basically, hard workers and very loyal to their employers. Savings rate was very high and it leads to massive investment in the industrial segment .Many companies merged together to become large industrial and banking conglomerates called zaibatsu. The zaibatsu gained their competitive edge by copying and improving western products and selling them for cheaper prices. These qualitative and cheaper products won western customers and started to compete U.S. companies. American market helped these Zaibatsu to had tremendous economic growth and turned into even larger business alliances called Keiretsu. These Keiretsu are based on the philosophy of mutual cooperation where all facts of business and government worked hand in hand. Due to these developments, Japanese stock market Nikkei wored like anything . as the market wored there Keiretsu purchased each other’s share.Due to 1970’s oil crisis and inflation, American car industry was suffering. Most of the American cars had V8 engines which consumed lot of petrol. Japanese car makers, such as Honda, quickly smelt American needs and produced small fuel efficient cars. Moreover these cars cost a fraction of the price of American cars. Even in the 1960’s, Japanese cars were being assembled with robots, making human error almost non existent. American automobile industry declined and Japan gained the market share. This boom helped Nickkei to further soaring.By the 1980’s, Japan started manufacturing electronic goods. Japanese Keiretsu corporations such as Hitachi and Sony, copied and produced quality electronics hardware needed by the growing computer industry. Japan trounced American companies thanks to its ability to compete on prices, aided by robots and cheep labour. Except microprocessors, Japan dominated the market for all chips, circuit boards and other components. In the 1980’s, it was widely believed that Sony and Hitachi would eventually acquire Intel and IBM.Japan entered into developed economy status. Throughout the world, every country viewed Japan as a model society. Japanese had highest of life and longest life expectancy. In addition, Japan was the world’s largest creditor and had the highest GDP per capital. As the economy booming and the stock market soaring, Japanese corporations built many sky scrapers in Tokyo and Osaka. This caused real estate prices climbed to the sky. Between 1986 and 1982, the price of commercial land in greater Tokyo doubled. Peal estate. Prices soared so much that Tokyo alone was worth more than the United States. Between 1955 and 1990, land prices in Japan appreciated by 70 times and stock increased 100 times over. An average home near Tokyo, cost above $ 2 million in 1989. Investors worldwide frenzily buying Japanese shares.All these factors together influenced Nickkei to move towards sky. The Nickkei moved from 7000 in 1965 to 40000 in 1990.Eventually all things, good or bad, come to an end. Unfortunately, the longest bull phase of Nickkei came to a sad end by March 1990. To cool the inflated and boiling economy, the Japanese Government raised rates. The next month the Nickkei crashed by over 30000 points. Nickkei crashed from 40000 to 10000 points. Japanese housing prices plummeted 14 straight years. The Nickkei further sank until its low of 8000 in 2003. Even today the Japanese economy is in doldrums