The biggest question modern investors have when the stock market is overextended is "are we in a stock market bubble". This is the answer that everyone wants an answer to in order to adjust their stock exposure. To get a clue, we need to look back at historical stock market bubbles to extract the commonalities across all of these stories. In this article, we take a look at two past stock market manias. First, there is the South Sea Scheme of 1720, which led to a huge boom and bust in the economy of England, as well as to the railway mania that happened in England in 1845. First, we'll start with the South Sea Bubble. I think this bubble was the most interesting of all the bubbles I read about that didn't even make it into the article, because it has the same characteristics as most bubbles that have popped up in the past, and it happened in just nine months.
Other bubbles have taken several years, some more than a decade, to form and finally collapse. Prior to the South Sea Bubble in 1720, England and France had just ended a long war. In the peaceful post-war years, the British economy performed very well, rates were at historically low levels, and the King of England was very positive about the future economic prospects of the country. The South Sea Company was formed in 1711 as a trading company. They converted the public debt into shares in the company. The company was not profitable, but because they took on the public debt, they managed to become a financial institution. They made further attempts to purchase all of the public debt and turn it into company stock. This is what led to the South Seas scheme, and these are conditions that need to be carefully understood as they led to a nine month boom and bust.
First, the government of England had an outstanding debt of thirty million pounds. They were going to allow the conversion of the debt into shares of the South Sea Company, and the company would take coupon payments from the debt and pay them out as dividends to shareholders. Although coupon payments were planned to be reduced after conversion. These conditions were beneficial to the British government. In addition, the company had to pay a sum of money for the privilege of owning the debt. It was some form of bribe to allow the economy to purchase debt. This was the first red flag of the scheme. The second red flag was the most important because it led to massive booms and busts in the English economy. Because it required a lot of money.
to collect the debt, the company had to sell shares at a higher premium than they had paid to make up for the bribe paid.
This meant that the South Sea Company would be able to raise a lot of capital from the shares. As the money came in, the share price rose and they were able to sell more shares. This has increased the value of the company and many sectors of the economy have increased their influence over the South Sea Company. This created a cyclical element in the pricing of South Seas stocks as the shares began to lose value, causing the British bubble to burst. The railway mania took place in 1845 and ended with the economic collapse of Great Britain in 1847. Railways were first established in Britain in 1825, but they have faced scrutiny from the public for being responsible for a large amount of pollution that has killed livestock and blackened the land. They later realized that this was not the case and attitudes changed in 1842 when Queen Victoria made her first train journey.
At the time, George Hudson owned most of the rail lines and was a central figure in the railroad business. He was known as a man who knew how to cut the cost of building railroads, he was very interested in himself and was ready to do everything possible to line his pockets. A railroad law was passed that made it easier for people to get into the railroad business, and it was this law that led to railroad mania. For a person to enter the railway business, he did not need to invest the entire amount, but only a part of the total, this led to increased speculation in the railway industry and unsustainable credit creation. The British government saw this as a problem. George Hudson used his influence to dismiss those who considered this deal unprofitable for the English economy. The mania began in 1845. Prior to this, the economy was booming and the future was promising.
When loan debtors failed to meet payment terms, this led to a credit crunch in the late 1920s. Investors were heavily attracted to railroad stocks. There was also a lot of corruption because many members of the committee were issuing a lot of small amounts of shares in the market to scare off short sellers, and as soon as demand increased and the price of the shares started to rise, the public got excited and bought more shares. A member of the committee would dump all of his shares in order to make huge profits from a suspicious public. As a result, they got rich and threw a bunch of worthless stocks to the public. As soon as parliamentarians were caught taking bribes from some railway companies. This led to a big panic in the market and many people sold their railroad shares. Although some people could not sell, because there were no people willing to buy.
This crisis led to turmoil in the economy as a whole because most of the money in the economy was in railroad stocks. We have a lot in common in these stories that we can learn and apply in today's markets. The first common thread is that there have been some new innovations that have caused a paradigm shift, and usually these are innovations that delight the public. In the South Sea bubble, this innovation was largely financial engineering, where the company took on public debt and essentially created a cyclical pattern in the price of its shares. In 1845, the new innovation was apparently the railroad, which was supposed to increase the productive capacity of the economy and the speed of information transfer. The amazing thing is that in all the storms that the markets have fallen victim to, they always bounce back. As bad as it is for the economy, some people are buying more stocks at the lowest prices.