We're Here Again 300 Years Later

The pandemic has driven many people to fill their newfound free time with day trading and speculation in the stock market. They can yield unprecedented gains and losses. This is the side of the market which more aptly resembles gambling than the classic value investing. Like gambling, for every winner crowing about gains, there are many losers who have lost their nest egg.

As a whole, this gambling activity makes share prices detach from the company's actual value. History can help guide us through this time because what may seem unprecedented events, is a phenomenon that repeats itself across centuries. The baseless speculative activities of today are similar to those in 1720 Britain where at the time the South Sea Company reigned as the stock to be traded up and down. The resemblance is uncanny to anyone who is familiar with the South Sea Bubble and our reenactment is happening almost exactly 300 years later.

Bubbles are a phenomenon where people buy into an idea of something which is overvalued; typically prices skyrocket in a short time to an inflated price. Tulips, railroads, and houses are all examples of bubbles. Opportunists looking to make money draw others in with promises of extra grant returns. Wide-eyed investors get caught up by the opportunity to increase their wealth without doing their research. At some point, people realize the overvaluation and the bubble “pops” causing the price to fall rapidly. As a result, most investors lose a lot of money while only a few profit. One notable bubble was the South Sea Company which took place in 1720 in London. The South Sea Bubble was started by greed, inflated to massive proportions by the fear of missing out, taking in a wide cross-section of society in the process, and the bubble was popped by the reality of its very limited financial value, leaving many families to beggary.

In 1711, the British government was struggling with crippling war debt. The South Sea Company joined the Bank Of England and the East India Trading Company to help with the recovery. After the war of Spanish Succession in the early 18th century, The South Sea Company took on almost 10 million pounds of government war debt in the form of annuities. Annuities are a type of insurance policy that functions similar to life insurance policies. These annuities were converted into shares of the South Sea Company. In return for taking on the debt, the government granted the South Sea Company an annual allowance and a British trade monopoly on South American trade. This trade deal was not as much of an asset as the directors of the South Sea Company first believed. The Harvard Business School describes the situation well, “The company was promised a monopoly of all trade to the Spanish colonies in South America in exchange for taking over and consolidating the national debt raised by the War of Spanish Succession (1701-1714). The value of this promise, however, was closely tied to the outcome of the war.” When the war ended in favor of the Spanish, the trade monopoly was virtually worthless. South America was almost completely ruled by Spain.

The South Sea Company would have appeared doomed by the unsuccessful trade deal, however, John Blunt, the company's chairman, saw the opportunity to make money. The circumstances provided the perfect shell to emulate another recent bubble known as the Mississippi bubble in France. The Mississippi company was started by John Law, a Scottish economist with a passion for gambling. His actions influenced the rise and the fall of the South Sea Company. By creating his own financial system, Law ended up working for both the French and Dutch governments. The financial system in Amsterdam amazed Law. He thought of ways that it could be modified to maximize returns, so he started asking questions. Jan Sytze Mosselaar writes, “If the Bank of Amsterdam was so stable, why didn’t it issue paper money to monetize on its good reputation and boost the Dutch Republic’s economy? And why didn’t the Dutch East India Company (VOC) issue more shares? Investors clearly liked them and more capital potentially led to higher profits." This got him thinking and planning his own financial system. As he planned this system, he thought about where in Europe it could be implemented. This eventually led him to France because it, like Amsterdam with the VOC, had a subsidiary trading company, the Compagnie d’Occident, or more famously known as the Mississippi Company, which was founded in, 1717.

Blunt was inspired by the scale on which Law operated. This inspiration stemmed from greed. He saw the opportunity to make money on government sponsorship and rising share prices. At Blunt’s direction, the South Sea company issued its first share subscription in January 1720. They sold 31.5 million pounds worth of shares at a price of 100 pounds per share. The shares proved to be wildly popular and started a frantic trade of the shares, most prominently in exchange alleys. In lieu of a formal trading venue, speculators utilized alleys between coffee houses. These were the precursors to the modern stock exchange.

Between February and July, the South Sea Company became a bubble. The price became overvalued almost instantly. The price jumped from 128 pounds in January to 187 pounds in February. During the second share subscription, the South Sea directors increased the number of shares sold, to 2 million pounds worth of shares and increased the price to 300 pounds per share. Mosselaar commented on the rising bubble, “Everybody seemed to profit from higher share prices: annuitants got higher market value for their new shares, the government got its annual payment, and the company’s profits rose, benefitting existing shareholders.” Buying South Sea stock was contagious and drew in all levels of society, both men and women. Those who didn’t bother with going to the alleys hosted high-class brunches and exchanged shares. Paradoxically, the more the shares rose, the stronger the belief that they would continue to rise. The fear of missing out brought in more investors. Everyone believed that the South Sea stock would keep rising, so most investors didn’t cash out. On paper, everyone was getting rich and their avarice kept them from selling. The bubble rose. As stated by the Dutch banker, Crellius by April exchange alley resembled, "nothing so much as if all the lunatics had escaped out of the madhouse at once."

John Blunt made the shares attractive with a nefarious scheme. In order to boost the share price he implemented a loan system. Investors only had to put a fraction of the full cost down in cash, Blunt offered an option to buy shares with only a 20% down payment. The remainder had to be paid in full at a later date. If the share prices went up, it would be fine. However, if the price were to drop, investors would have a problem because they would have to make up for the loss. As prices rose from February through July, this incentivized people to ignore the downside, and they continue to buy shares.

Blunt accelerated the growth of the share price by luring important officials into the scheme. He gave parliament members, priests, and other influential community members the first opportunity to get their names on share subscriptions. The parliament members were instrumental because as shareholders they were incentivized to let the illegal operations continue. Their stake acted as a bribe. By involving the priests, it opened the door for parishioners to get involved.

Despite South Sea stock ruling England, a few weren’t as enticed by its promises of returns. Edward Chancellor, a financial historian, notes, “Sir Isaac Newton, the Master of the Mint, began selling his 7,000 pound holding of South Sea shares when asked about the direction of the market he is reported to have replied, 'I can calculate the motions of heavenly bodies, but not the madness of the people.'"

South Sea Company Share Price 1719-1721

As shown in the diagram above the price rose to many times its worth and fell just as fast as it had risen. Most would see the rise as an indicator of many becoming wealthy, however more often than not investors lost money, as Jamie Catherwood writes, “Their results show that these speculative margin loan holders largely follow the herd by buying at the top, and selling out at the bottom. In addition, these loan holders were twice as likely to ‘buy new shares of overvalued companies’ at peak prices. We see similar scenarios unfold in modern times with retail investors piling into flashy but overpriced IPOs.”

In spite of a few doubters, prices kept going up. On June 15th, the 3rd South Sea share subscription took place. Jan Sytze Mosselaar commented, "With hindsight, one might wonder what the right level for the South Sea share price really was. The company’s monopoly on trade in South America was pretty much worthless, but it received an annual income from the government. In the spring of 1720, Hutcheson determined the fair value to be 150 pounds. As the stock price hovered around the 1,000-pound level.” At the insane price of 1,000 pounds per share, the shares were valued more than 3 times the price from two months prior. The idea of a company trading at 10 times its value in 6 months to a rational person would be suspect. However, most people were not rational. Their actions were driven by the fear of missing out.

There were many notable people who invested in the South Sea Company. The most notable investor was King George I. The King's investment influenced those around him to follow suit. Some of these investors included his oldest son, the Prince of Wales, and less notably dukes, marquises, earls, and barons. These people all invested in the hopes of getting in the good graces of the King, and they felt secure in the belief that if a company was safe enough for the royal fortune it was safe enough for theirs.

Other notable non-political investors included Alexander Pope, who was a poet, and has been famously quoted in reference to his investment in the South Sea company, “Ignominious not to Venture.” Jonathan Swift, author of Gulliver's Travels, invested because as he described in a poem, “I have inquired of some who have come to London, what is the religion there? They tell me it is South Sea stock; What is the policy of England? The answer is the same; What is the trade? South Sea still; And what is the business? Nothing but the South Sea.” There were a few other notable investors, for example, Daniel Defoe, the author of Robinson Crusoe, and Sir Isaac Newton.

Bubble Card with the Tree Drawing

Sir Isaac Newton also lost big. As stated by University of Minnesota professor Andrew Odlyzko, “A famous anecdote tells of Sir Isaac Newton realizing large gains in the early stages of the South Sea Bubble, but then losing all that and more by buying back in at the top.” As described in the quote, Newton did the smart thing of buying low and selling high, however, he was drawn in again as if by the Sirens from The Odyssey. This was the fate of many who got in on the “ground level” and then made a nice return and then proceeded to entrust even more money than before into the scheme which they ended up losing. They did this for fear of missing out on the wealth and by the time they realized what had happened it was too late.

The press was also influential during the South Sea Bubble. The South Sea Company compensated the newspapers for their kind words. A newspaper named The Director was put in place by the board of the South Sea Company and was led by Daniel Defoe. The newspaper spread propaganda to convince people to start or continue buying South Sea stock.

“Des waerelds doen en doolen, is maar een mallemoolen”, engraving from Het Groote Tafereel der Dwaasheid, 1720.

During the year 1720, opportunistic predators appeared to be coming from every dark corner. There were many companies that had “interesting” business plans to say the least, in most cases, scams. Some of these bubble companies are depicted by Edward Chancellor, “The Bubblers Mirror...listed several real companies together with fabulous schemes for extracting silver from lead, for the transmutation of quicksilver, for building an engine to remove SOUTH SEA HOUSE to MOORE FIELDS(ie the mental hospital was commonly known as Bedlam), and for an air pump for the brain.” Due to the rise in speculation, many imitators started popping up. These were commonly referred to as the bubble companies. Even though the economy was small, 190 bubble companies started in 1720.

Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, wrote about one of the most ludicrous schemes, "The most and absurd and preposterous of all which showed...the utter madness of the people was one started by an unknown adventurer 'a company for carrying on an undertaking of great advantage, but nobody to know what it is'... how this immense profit was to be obtained he did not condescend to inform them”

In June, the directors of the South Sea Company were worried by the newfound competition from the bubble companies and thus turned to the politicians. The politicians who were indebted to the South Sea directors readily passed the Bubble Act of 1720. This act banned businesses that offered shares unless they had a charter from the British government(as the South Sea Company did).

The act did its job of slowing the South Sea companies’ competitors; of the 190 bubble companies started in 1720 on the coattails of the South Sea Bubble, only four survived. However, the Bubble Act unintentionally also hurt the South Sea company. This Act instilled doubt in the public in all investing, which was detrimental for the South Sea company. The stock immediately began to fall. Since the scheme relied on a rising share price, the Bubble Act had backfired far more than any of the South Sea directors could have imagined.

In an attempt to squeeze the last drops of money out of the scheme whilst selfishly trying to protect their personal fortunes, the directors worked to make the stock more attractive. They did this by offering a huge dividend of thirty percent the first year that would rise to fifty percent for the next twelve years. For reference, that would be a six hundred percent return from just the dividend.

By this point, many of the directors had cashed out, knowing that the dividend promise was empty. , For reasonable thinking people, the exorbitant dividend should have been a red flag. Astonishingly though, the scheme continued to draw in more investors. This insured that the directors could make some quick cash; in other words, inside trading. Jan Sytze Mosselaar CFA explains, “They could subscribe at favorable terms, ahead of conversion, and then make a quick and easy profit. This was insider trading and Blunt himself profited most of all. However, he too was aware that the stock price was irrationally high in the summer of 1720, and by the time the last subscription took place in August, he had already secretly sold a lot of his stock and moved his money into property." The new investors who were afraid of being left behind lost out.

Meanwhile, in Paris, John Law’s Mississippi scheme started to unravel, shares dropped by seventy-three percent. Archibald Hutcheson pointed out that the South Sea scheme might suffer the same fate as the Mississippi company, Jan Sytze Mosselaar writes, "In mid-July, after the Mississippi Bubble burst in Paris, he pointed out the many similarities between Law’s System and the South Sea scheme, and just how disastrous the outcome could be." The demise of the Mississippi bubble may have instilled fear in the investors of the South Sea Bubble.

Reality begins to set in, the fourth share subscription on August 22 took the better part of the day to sell out. Unlike prior subscriptions which sold out in an hour. The Dutch and English financiers refrained from investing in the fourth share subscription and the Dutch in particular cashed out to reap their rewards to invest in the Amsterdam stock market. Professional and international bankers saw that the profitability of the scheme had gone. They left with it, leaving mainly individual investors to continue at their own peril. The crash had begun.

The company’s stock price fell faster than it had risen, Charles Mackay states "In spite of all that could be done to prevent it, the South Sea company's stock fell rapidly. Their bonds were in such discredit, that a run commenced upon the most eminent goldsmiths and bankers, some of whom, having lent out great sums upon South-Sea stock, were obliged to shut up their shops and abscond.”

By the beginning of September, the price was down from one thousand pounds to seven hundred pounds. This was a loss of three hundred pounds per share in less than two weeks. The investors, who had utilized the loan option of putting two hundred pounds down to buy a one thousand pound share, now would have to come up with one hundred pounds in cash to fill the gap. This was a rude awakening for those who were accustomed to the shares, only rising in price. After sustaining extreme losses, Charles Blunt, nephew of Sir John Blunt, committed suicide in early September.

The Sword Blade Bank attempted the impossible by trying to burn the candle at both ends, acting as both the South Sea companies banker and loaning money against its stock. When the South Sea stock crashed, borrowers couldn’t pay back their loans to the Sword Blade bank. The Sword Blade bank failed.

The reality of the ruse came crashing down and people felt a cold-blooded hatred toward the directors. This is depicted in a writing by Charles Mackay, "The directors could not appear in the streets without being insulted; dangerous riots were every moment apprehended. Despatches were sent off to the king at Hanover, praying his immediate return." By this point the scheme had unraveled and now it was time to punish the conspirators. After the crash, a bill was passed to take away the profits the directors made in 1720.

The directors were stripped of their fortunes and many were jailed. John Blunt was convicted like the other directors, removed from his post and stripped of his profits, however, he was acquitted. The country did not agree with this decision to acquit and mobs gathered in London.The South Sea company destroyed the public credit which left it for people like Archibald Hutcheson and Robert Walpole to clean up their mess. Mr. Walpole’s job was to come up with a plan to restore the public credit. The crash brought to beggary many families who bet their fortunes on the South Sea. Meanwhile, others who sold out at the height of the share price become millionaires. Very few came out on top.

The South Sea bubble rose and fell in1720. London was overrun by greed, thousands of people entrusted their fortunes to this and other baseless schemes with great winnings in mind. They were willing to look past the scheme’s shortcomings in hopes of their dreams becoming a reality. People like John Blunt took the opportunity to increase their personal fortunes by starting schemes that would draw in investors. They capitalized on human greed. They upped the ante multiple times and each time people fell into the trap blinded by their own gluttony. The South Sea Bubble was fueled to gargantuan proportions by everyone trying to get in on the action. The masses caved to social pressure from 18th century influencers like kings, politicians, priests, poets and press. The whole society, every class, men and women sought to be included. Meanwhile, there were a host of other bubble companies attempting to execute the same scheme. The South Sea bubble rose rapidly and fell even faster. It fell apart due to the realization that there was no structure or value to the investment. Many of the original conspirators like John Blunt had already cashed out and left investors with unfulfilled promises. The economy collapsed, forcing former investors to beg on the street. 

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Bibliography

Chancellor, Edward. Devil Take the Hindmost. New York, USA: Plume, 2000. (Book)

Harvard Business School. "SOUTH SEA BUBBLE SHORT HISTORY." Harvard Business School. Accessed April 14, 2020. https://www.library.hbs.edu/hc/ssb/history.html.

Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. London, UK: Ordinary to her Majesty, 1841.(Book)

Odlyzko, Andrew. "Bubble Pages." In Bubble Pages. Previously published as "An Undertaking of Great Advantage, But Nobody to Know What It Is." Bubble Pages. pdf.

———. "Isaac Newton and the Perils of the Financial South Sea." In Isaac Newton and the Perils of the Financial South Sea. Previously published in University of Minnesota, March 5, 2020. Accessed April 13, 2020. http://www.dtc.umn.edu/~odlyzko/doc/mania13c.pdf.

———. "Isaac Newton, Daniel Defoe and the Dynamics of Financial Bubbles." In Bubble Pages. Excerpt from Bubble Pages. Accessed April 16, 2020. http://www.dtc.umn.edu/~odlyzko/doc/mania13b.pdf.

"The South Sea Bubble." Yale School of Management. Accessed April 14, 2020. https://som.yale.edu/case/2009/the-south-sea-bubble.

Mosselaar, Jan Sytze. Concise Financial History of Europe. Rotterdam, Netherlands: Robeco, 2018.

Kindleberger, C. Manias, Panics and Crashes: A History of Financial Crises.

Catherwood, Jamie. Investor Amnesia

Images:

Bubble Cards

Exchange Alley