Bull Markets and their Consequences

A Short History of Financial Euphoria by John Kenneth Galbraith

Introduction to an Investing Classic:

John Kenneth Galbraith is an intellectual celebrity. As an economist, Harvard faculty member, and public servant in government, Galbraith’s legacy is held in the prolific number of books he published. For those unfamiliar with him, we suggest a review of the expansive Wikipedia page dedicated to him.

Those who own the book will find our brief notes wildly inferior to the actual book. Certainly, we agree. Fortunately, our goal is modest. If our message helps on investor avoid speculative buying, we will consider this a success.

For any new or current subscribers, we would happily provide a complimentary copy of Galbraith’s book.

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Stock Market Bubbles and their Consequences:

This book is barely over 100 pages long. Yet, despite its brevity, the work articulates the recurring market crashes that have beset financial markets from the 1400s through the 1980s with vivid prose. For those in equity markets today, we believe few books impart so much critical knowledge in such a brief package.

The bottom line is that investment decisions made by misplaced investor confidence lead to herding, speculative excess, and then a financial crisis. The path into these manic peaks and the ensuing collapses are painfully simple to see. Despite this, humanity’s lack of any long-term financial memory is an unfortunate and unavoidable fact.

While this may sound dark, we believe the book’s purpose is illuminating and essential reading for any investor. After reading it, we felt the focus on stock prices, interest rates, and other items currently debated by Wall Street to be somewhat misplaced. Examining our behavior and that of the individuals in the market is, in our view, a better measure of speculative excess than the level of a given market index.

Some Quick Lessons from A History of Financial Euphoria: Bear v Bull Markets

Foreword:

Quote: Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system. –page viii

• Financial euphoria is an inevitable part of capitalist systems
• These manias rest on mass delusions that the lessons of history no longer apply
• Excessive amounts of borrowing during euphoric times can bring down the most stalwart firms

Chapter 1: The Speculative Episode

Quote: And thus the rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang. –page 4

• People who publish warnings about speculative bubbles face ridicule and personal attacks
• During euphoric periods, price rises become self-reinforcing as ever-larger groups of people convince themselves the “old rules” no longer apply, and there is a path to wealth without work
• People riding the speculative assets higher attribute their gains to some newfound inner brilliance and aggressively condemn those who express doubts about the speculation underway

Chapter 2: The Common Denominators

Quote: There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. –page 13

• Bubbles emerge as overconfident individuals experience early success and then hail the object of speculation (and this can be anything from stocks to junk bonds to art) as a new wonder
• Human beings mistakenly associate quick riches with intelligence and are more willing to discard common sense and follow suddenly wealthy individuals who often tread outside the law
• When the bubble bursts, the exact people who were hailed as brilliant are shown to be anything but intelligent, and subsequently face the fury of the masses

Chapter 3: The Classic Cases Part 1, The Tulipomania; John Law and the Banque Royale

Quote: Fernand Braudel, the French economic historian and ultimate authority on these matters, has noted that there were active securities markets in Genoa, Florence, and Venice as early as the 14^th century, and long before then there was active trading in coinage and commodities, with, almost certainly, purchase and sale based not on present but on imagined prospective value. –page 27

• The tulip mania that broke out in the 1630s is considered one of the first great modern-day bubbles as it ascribed values to a plant with no intrinsic value or cash flows
• When the euphoria ended, fortunes were lost, litigation broke out attacking the system as being little more than gambling, yet no remedy for the losses could be made
• The book moves into the story of John Law, whose scheme to eliminate France’s huge debts is considered one of the greatest manias and mass-delusions ever
• John Law managed to become the “central bank” of France and began issuing currency backed by the future cash flows from the Mississippi Company and the Company of the Indies
• Both of those companies claimed to have rights to mine the yet-to-be-discovered gold in Louisiana
• Speculators began buying stock in the companies at a furious rate sending the worthless shares higher
• John Law was hailed as a genius during the mania, but when it imploded he became a reviled fugitive
• The shift from perceived brilliance to criminal is a common feature of bear market v bull market psychology

Chapter 4: The Classic Cases Part 2: The Bubble

Quote: Individuals were dangerously captured by belief in their own financial acumen and intelligence and conveyed this error to others. –page 51

• This chapter covers the legendary South Sea Bubble in Britain
• Despite existing for over 100 years, this bubble hailed the joint-stock company as a wonder of the world
• Similar to France, this one began as a means of extinguishing the large debts of the British government
• The South Sea Company was given the trading rights to America and other geographies
• Speculators ascribed ever greater value to the future prospects of the South Sea Company sending the stock soaring
• At the height of the mania, joint-stock companies were being formed and raising capital for indeterminate use at a later time for “carrying on an undertaking of great advantage, but nobody to know what it is.”^[1],[2]
• As the supply of stock in the South Sea Company and other nonsensical endeavors overwhelmed demand, the original insiders began cashing out, triggering a collapse in prices
• The end brought fury, and those associated with the South Sea Company were exiled, jailed, or stripped of their assets

Chapter 5: The American Tradition

Quote: Whatever the London excesses, there can, however be no trace of chauvinism in saying that in the last century the speculative imagination was at work in its most ardent form in the United States. This was because of a special American commitment to the seeming magic of money creation and its presumptively wondrous economic effects. –page 54

• In this chapter, Galbraith explains the remarkable commitment to wealth destruction by the issuance of paper money that has characterized America since its founding
• Benjamin Franklin endorsed paper money as he was a printer of it, but in 1751 the British Parliament forbade America’s use of paper money, triggering anger in the colonies who enjoyed the easy credit
• The Revolutionary war was primarily paid for by “Continental” notes which, due to negligible tax receipts, resulted in plummeting value for the currency which had been handed out to soldiers in large amounts
• Having suffered the pain of watching an average set of clothing’s cost soar to $1,000,000, the Constitution forbade the issuance of paper money unless it was backed by gold and silver
• To finance the War of 1812, America would forego this discipline, with individual states and towns issuing currencies of all kinds
• Post the war, this surplus of printed money led to rising prices of land and property
• These price increase in property became the first of what has now been many speculative bubbles driven by the overuse of paper money in America^[3]
• That property bubble would implode in 1819, after which the US became momentarily conservative with money, only to allow banks to print currency with abandon again, which led to another speculative bubble and crash in 1837
• The fall-out from the bubble of 1837 would lead the American states to cancel all their outstanding debts, which set a precedent for the country to simply walk away from its obligations
• Galbraith then walks through a staggering number of periods where the U.S. became disciplined only to then resume the use of paper money
• He quickly walks readers through the many fiscal calamities this caused through the Civil War and the many that followed; he stops the chapter in the 1920s

Chapter 6: 1929

Quote: Optimism built on optimism to drive prices up. Then came the crash and the eventual discovery of the severe mental and moral deficiencies of those once thought endowed with genius and their consignment, at best, to oblivion, but, more grimly, to public obloquy, jail, or suicide. 1929 and for years thereafter, all this was larger than life. –page 71

• Written before the dot.com bubble, which would eclipse the mania ending in 1929, Galbraith dedicates an entire chapter to the excessive valuations that caused the 1929 bubble
• Ranging from a bubble in Florida real-estate to the still remembered Charles Ponzi, the bubble that peaked in 1929 would be endorsed by legions of economics professors and affluent and admired bankers
• 1920 – 1929 saw the rampant use of leverage, a love of financial innovation in myriad forms, and a ruthless condemnation of those who dared criticize the frenetic mania
• So severe was the crash it became a crisis for capitalism as a system and led to the creation of the SEC
• Galbraith notes that the severity of the Great Depression was so severe that it would be an atypically long, if still surprisingly short, period of time until the next great mania in America

Chapter 7: October Redux

Quote: …for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. –page 87

• Galbraith uses this chapter to walk readers through the crashes of 1954, the Nifty-Fifty bubble in 1969 and the crash of 1987, which all experienced peaks of some form in the month of October
• The chapter flags the tendency of individuals who suddenly become wealthy to attribute their unexpected success to their innate brilliance as a primary cause of all these bubbles
• He reiterates that once people see these suddenly rich people, the population assumes they have some superior intelligence and begin to follow their behavior
• Galbraith takes a very dim view of the scapegoating that goes on after bubbles, believing instead that each person who partakes in the mob-like behavior is responsible for their own misfortune
• One of his principal teachings is that it is the human affinity for wealth without work that leads individuals to lose sight of simple facts and that such behavior cannot be regulated away

Chapter 8: Reprise

Quote: …The circumstances that induce the recurrent lapses into financial dementia have not changed in any truly operative fashion since the Tulipomania of 1636. –page 106

• Galbraith uses this chapter to reiterate the remarkably obvious traits of any mania in this chapter
• First comes wealth to a few who attribute their good luck to their intelligence
• Then the public comes to believe these individuals or institutions are of superior intelligence
• The public slowly then quickly all pile into the same grievous asset believing they can get rich quick
• Disastrous losses, anger and recriminations then follow
• The book closes with the perspective that there really is nothing that can be done to eradicate the horrendous cycle of euphoria to disaster systematically

Notes About Bull and Bear Markets:

The media today is filled with stories of people achieving great wealth without working. Day trading is back just as it was in 1999. Inexperienced retail investors are being lured into markets with valuations well above the levels seen in 2000.

Lacking any ordered process, they often follow fads, like cleantech stocks, on various internet websites. The market price in periods like today often turns out to be “far too high” of a price. Where there is euphoria, we urge caution.

Our research documents the unfortunate similarities between today and 2000. There are some charts that we believe will go down as infamous. Examples include:

• Chart of tech valuations
• Chart of the rise of recklessly priced firms
• The staggering market caps ascribed to money-losing firms
• The extraordinary valuation ascribed to firms that actually are charging investors to own shares

Today’s bubble is in full force, and the financial and social costs are already soaring. Individuals have seen their life savings wiped out, and others have committed suicide. The losses due to the collision of inexperience and treacherous stock promotion schemes are tragic. We hope this post brings prudence and safety to someone.

For investors interested in compounding capital using a disciplined process we may be able to help. For those of you unfamiliar with Kailash, we believe our organization provides some of the most time-tested and thought-driven investment processes and tools. Learn more about us here.

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