Anatomy of Market Bubbles

The stock market is a place where people with experience meet people with money. And after a while, the people with experience have the money and the people with money have the experience!

We seem to be stumbling from one frenzy to another; from cryptos to NFTs (Non-Fungible Tokens) to SPACs (Special Purpose Acquisition Companies) to IPOs. Quite recently, Christopher Torres sold his creation, the NFT of a Nyan cat meme showing a flying cat with pop tart at its torso, leaving a rainbow in its trail for $600000! When an economy is gripped by trading frenzy and markets keep roaring with furious financial innovation further prompting the markets to ignore all adverse developments, “investors” begin to perceive value in NFTs or abstract art, vintage wine or even a bulb of Tulip! But markets eventually in their own uncanny way jolt market players with a reality check whenever the trading excesses breach for long, the carrying capacity of the underlying real economy. Since the early 17^th century, there have been many such excesses and market bubbles have rattled mighty economies. The important ones are:

1. Tulip Mania 1634-37
2. The Great Crash 1929
3. Japanese Asset Bubble 1989-90
4. The Dotcom Mania 1999-2000
5. The Subprime Crisis 2007-08

All of these bubbles offer some useful insights which should, hopefully, help us avoid the mistakes of the past. But arguably the first and the last of the above bubbles, provide some telling details of how easily humans, driven by greed can be deluded to take leave of reason.

Tulip Mania: Businessmen in Netherlands, in the 16^th and 17^th century had come to enjoy fruits of risky but rewarding maritime trading. Soon the Dutch adopted a model strikingly similar to today’s equity markets. Shares in joint-stock companies, were bought and sold at the Bourse, named for the courtyard of the Amsterdam Beurs, one of the first stock exchanges in history. Banking, in the meantime, had multiplied money in circulation by putting the same to work at multiple points. This gave birth to large proto-corporations which grew from aggregation of many small risks; large rewards, if and when they happened which then were shared broadly across the burgher (middle class). At the low end of the risk spectrum, Dutch investors of the early 1600s could put their money in publicly regulated banks and insurance companies, or they could invest in trade through the Baltic Sea, effectively a Dutch monopoly. Such investment instruments of the day were Treasury Notes and corporate bonds. The two “Indias” – Dutch East and Dutch West trading companies, offered promise of much higher return. But that had to be set against the higher risk inherent in the distant and perilous travel and the great time lag between investment and payout. “Day-trading” in voyages that could take years to complete was neither prudent nor viable in that age. But the Dutch were not to be outdone by this challenge, given their propensity to trade and a tolerance for risk of an expanding, thriving business class. In early 17^th century, the Dutch Bourse started offering, what were in effect, stock options and futures. Although edicts were issued as early as 1610, proscribing the practice of ‘windhandel’ meaning “trading in the wind”, or dealing in shares not in possession of the seller, they were largely ignored.

Cultivation of tulips flourished in Netherlands since 1562, when shipload of tulip bulbs arrived in Antwerp (then a part of Netherlands) from Constantinople. As the burgeoning middle class became interested in attaining wealth and growing it rapidly, they turned to the high risk model of the Bourse, both in Amsterdam and its regional locations throughout the country. And they were looking for avenues which, at least, to begin with, offered more affordable “investment” avenues than the banks, insurance companies or the Baltic trade and the two “Indias”. It was then that the get-rich-quick greed coupled with one of nature’s beautiful creations, ushered in a frenzy that in hindsight seems so utterly illogical. But it happened and humbled a mighty economy of the times!

Tulips came to be treated not as flowers but as assets; that is, their extrinsic value became divorced from their intrinsic value and worth. As more and more people were happy and eager to trade in them demand for all manner of Tulips, particularly the mosaics (bulbs attacked by the mosaic virus!) vastly outstripped supplies increasing their price manifold. By the 1620s the best banks in Amsterdam were boasting of tulip vaults. Bulbs could be used to secure loans and rarer the bulb, greater the surety offered. There were even rumblings of going off the gold standard and on to a tulip one. Tulip analysts and consultants made good income in parsing stem quality and pigmentation. There were manipulators who would invest heavily in bulbs from an area, then have cattle stampede those field to create shortage. There is the story of a farmer, bankrupted when a cow ate its way through his tulip patch, who tried to recoup his fortune by creating a market in “tulip-milk” futures.

Futures trading assumes a rational market, but by the summer of 1636, any last vestige of rationality had fled the Dutch tulip market. Instead of betting on the eventual price of tulips, investors had come to bet on the Greater Fool Theory – that is, that there would always be someone further down the road willing to pay even more than you had paid for a product, the price of which had become completely disconnected from any intrinsic worth. Sometime in the first week of February 1637, four years after the Tulip Mania began in earnest, the Greatest Fool was finally found as the tulip traders cut the losses and ran in droves. An analyst of the time estimates that once coveted varieties like White Croonen, Switsers and Admiral Liefkens had crashed by over 99% from peaks of over 2900 guilders to less than a guilder! 

For Netherlands, the collapse was devastating. A people who had risen to the crest of prosperity by sharing the opportunity to amass wealth and by aggregating and spreading risk had lost their bearings in the face of a simple flower. Ordinary men and women who had gone to bed on the night of February 5, thinking they were rich woke up penniless, forced into workhouses to pay off their debts, and those ordinary people collectively formed a substantial part of the adult population. Well, Tulip mania – Tulpenwoede – was not the last of the bubbles. Human greed and fear have ensured that they devastated the markets with unfailing regularity despite the lessons of history. Coming editions of Points to Ponder will revisit some more of them, if only to remind us of the one lasting principle: caveat emptor