From the Archives
The Causes Influencing Investment & Speculation & the Fluctuations in Values (1885)
While you should peruse the entire book and find a section that sounds interesting to you, I would highly encourage you to read this section on The Speculator vs. The Investor .
Speculation. For centuries the speculator has been looked down upon by society and the purportedly more ‘respectable’ class known as ‘investors’. While many are familiar with the comparison of Investors and Speculators popularized by Benjamin Graham in The Intelligent Investor, this divide stretches hundreds of years (if not thousands). In fact, the book provided above (written in 1885) in From the Archives includes a chapter titled The Speculator vs. The Investor. However, an even earlier example of looking down upon the speculator is detailed below.
Early instances of anti-speculator sentiment can be found in the 17th century, where market participants on the Amsterdam Stock Exchange referred to the practice of speculating on assets that you did not own as windhandel (wind trading).
As Jason Zweig describes it:
‘The Dutch were also familiar with the word “bubble” (which they presumably borrowed from the English), as you can see here. It was closely related to windhandel, or “dealing in wind,” the Dutch expression for trading in securities that weren’t in the speculator’s possession, as short-sellers do today – and did back then, too. (Windhandel also referred to trading in derivatives like options and futures instead of common stock or physical commodities.) Wind trading is first recorded shortly after the Dutch East East India Company was founded in 1602…
Joseph Penso de la Vega, who in 1688 wrote what is commonly regarded as the world’s earliest book about the stock market, Confusion de Confusiones, described a stratagem used by short-sellers at the Amsterdam exchange:
“they offer for the stocks more than the price of the day (what we call ‘inflating’ the price). They influence the price this way in order to sell [short] at the higher figure and thus to gain in the end. God with one breath breathed life into Adam, whereas the bears take the life of many people by inflating the price [of the shares]…”
This image – pumping up prices by puffing them full of air – is the most logical and likely derivation of the financial term “bubble”…
After several bubbles blew up and burst almost simultaneously, windhandel acquired a more scatological meaning. An explicit Dutch engraving from 1720, “Arelquyn Actionist,” or “Harlequin the Stockbroker,” shows securities dealers selling their offerings to a speculative mob through a unique distribution system: by breaking wind. Customers snatch stock certificates from the streams of gas blasting out of the brokers’ posteriors – a fitting metaphor for investments that ended up too foul to touch.’
What Drives Speculation?
While no period in history is exactly the same, there are often identifiable themes that tend to repeat themselves.
This week we study the role of Technology, Credit, and Low Yields in fueling speculative booms.
History is riddled with evidence of technological innovations that permanently changed society, with the internet and smartphone are obvious examples in recent decades.
As discussed in the article The Telegraphic Transmission of Financial Asset Prices and Orders to Trade below, the Telegraph had a similarly profound impact:
‘Large scale manufacturers such as James Duke and Andrew Carnegie used the telegraph to coordinate the inflow of raw materials and outflow of manufactured product in a manner that increased capacity utilization rates and amortized the holding costs of this capital over a larger flow volume of output. In wholesale and retail distribution the telegraph net permitted the increase in the rate of inventory turnover that made possible the advent of mass merchandising in the form of the department store and mail order house.
Similarly, the telegraph revolutionized the distribution of fresh meat and vegetables at a relatively early time in the nation’s history. Just in time inventory control, and other advances in what is known today as supply chain management, often popularly attributed to the Japanese, were in fact pioneered by Americans in the late nineteenth century. Here were real payoffs to the investment in the telegraph. From these standpoints, one can view the device as an archetypal physical capital saving innovation of a type to which economic historians have paid relatively little attention.’
Yet like the internet and smartphone, there were repercussions from the telegraph’s invention. Regarding investor behavior and speculation, the increased flow of information and democratized access to financial markets made it easier than ever to make speculative bets.
Simply put, speculation increases when the barriers to speculating are reduced or removed by technology. For instance, the ability to place buy/sell orders through an app on our phone in just a few clicks makes it all too easy for panicked investors to overreact.
Until recently, however, there was still a financial cost to placing these trades on your phone in the form of trade commissions. As most readers will know, this changed last year with the introduction of commission-free trading on almost all major brokerage platforms. The immediate impact of this decision on investor’s behavior is abundantly clear in the chart below from a recent Wall Street Journal article:
By removing the financial barrier to over-trading, speculation exploded. Not only did this move encourage more speculative behavior for existing investors, but also provided access to financial markets for a large number of first-time investors. The WSJ article stated:
‘TD Ameritrade said last week that retail clients opened a record 608,000 new funded accounts in the quarter ended March 31, with more than two-thirds of those opened in March. E*Trade saw a net gain of 363,000 accounts in the quarter—a company record—around 90% of which were retail. Charles Schwab Corp. reported a record 609,000 new brokerage accounts in the quarter, including individuals’ self-directed accounts and those managed by financial advisers.’
That said, the articles in today’s Sunday Reads will focus on the impact of a previous revolutionary technology on financial markets, and how investor’s behavior was altered.
Credit & Low Yields
One of the most common phenomenons in financial history is ‘reaching for yield’, where investors needing a source of income are forced into higher yielding-but riskier-instruments as a result of low bond yields. A few well-known examples of this are found in the Panic of 1825 and The Panic of 1890, which both stemmed from the particularly low yield on British Consols. In both periods, British investors poured their funds into foreign debt that offered yields up to 7 or 8 times higher than British Consols.
In these low yield environments, where investors are pushed into riskier assets to obtain their desired yield, fraudulent behavior abounds as scam artists seize upon the heightened levels of speculation. The image below depicts a number of the bubbles and frauds around the Panic of 1825. To the right of the man in the blue coat’s head, there is a bubble for the infamous Poyais scam, where investors bought the ‘sovereign’ debt of a Latin American ‘paradise’ that didn’t actually exist!
A similar dynamic unfolds when access to cheap credit fuels a boom in risky new ventures and questionable business practices. For example, the 17th century IPO Bubble in London saw 70% of the publicly listed stocks operating in 1694 get wiped out by the turn of the century.
To better understand these themes, I’ve included articles below on the relationship between credit, low yields, and speculation.
Now let’s dive in!
Does Credit Affect Stock Trading? Evidence From the South Sea Bubble
‘We study the relationship between credit, stock trading and asset prices. There is a wide array of channels through which credit provision can fuel stock prices. On one extreme, cheap credit reduces the cost of capital (discount rate) and boosts prices without trading or wealth transfers. On the other extreme, extrapolators use credit to ride a bubble and lose money. We construct a novel database containing every individual stock transaction for three major British companies during 1720 South Sea Bubble. We link each trader’s stock transactions to daily margin loan positions and subscriptions of new share issues. We find that margin loan holders are more likely to buy (sell) following high (low) returns. Loan holders also sign up to buy new shares of overvalued companies and incur large trading losses as a result of the bubble.’
As a general rule: When credit is cheap, speculators are a dime a dozen.
For example, the chart below exhibits the Bank of England’s gross loan issuance in 1720, the year of the South Sea Bubble:
Looking into these loans further, the authors show that 79% of these loan holders were taking speculative positions in the popular stocks of that time: The South Sea Company, Royal African Company, and East India Company.
Knowing that there was rampant levels of speculation in 1720 London, this paper analyzes the behavior of speculators through an exciting new dataset:
‘We construct a novel database containing every individual stock transaction for three major British companies during 1720 South Sea Bubble. We link each trader’s stock transactions to daily margin loan positions and subscriptions of new share issues.’
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.
The outcome of all this is predictable: poor performance.
‘Even without taking returns on these share subscription positions into account, loan holders incur large trading losses. A margin loan holder realizes a 14 to 23 percentage point lower return than the average investor.‘
In short, margin holders buy and sell at exactly the wrong time, purchase new offerings at peak prices, and generated returns noticeably lower than the average investor. So who were these margin loan holders?
‘Less experienced individuals, investors who trade a lot and male investors are more likely to take margin loans. In the current finance literature, male investors and frequently trading investors are often associated with poor trading performance.’
The authors’ conclude the article by writing:
‘We collect every single stock transaction with buyer and seller identities for three large British companies during the classical 1720 South Sea Bubble. In May 1720, the Bank of England grants its shareholders the right to borrow cash by collateralizing their shares. Each investor can borrow up to the nominal value of the share and loans are recorded in the stock ledger books of the Bank. The meticulous documentation of the transactions allows us to link, on a daily basis, each investor’s share trading to her loan positions. Our data documents the daily equity transactions of about 50% of the British market capitalization over the course of the bubble and five years before.
We find that the marginal borrower displays speculative trading behavior. First, we document that a loan holder acts as an extrapolator by buying stocks that have experienced high returns in the recent past. Second, we find that borrowers realize lower returns than investors without a loan. Third, we find that margin loan holders are more likely to subscribe to new share offerings at peak prices. This strategy is extremely risky and we can ex-post determine that it leads to negative returns. Finally, we show that there is a positive relation between loan holder buying pressure and stock prices during the bubble.’
What Makes Uninformed Traders Tick?
This piece on ticker subscriptions and price efficiency is one of the most fascinating articles I’ve read in months because of its implications for markets today, particularly as it relates to passive investing and price discovery.
While the parallel is not immediately obvious, the period covered in this paper and recent decades both involve the rise of a new ‘technology’ with the potential to affect pricing efficiency and co-movements in prices.
For example, this quote from Michael Green in a recent article on passive investing states:
‘Each new dollar invested into passive index funds must purchase the securities in the benchmark index. These purchases exert an inexorable influence on the underlying securities. Per Sharpe’s own work, these are not passive investors – they are mindless systematic active investors with zero interest in the fundamentals of the securities they purchase.
If incremental investor dollars were increasingly flowing into market capitalization indices, we would expect to see two clear phenomena. First, we would expect to see momentum rewarded as securities that rose in price would capture an increasing fraction of each incremental investment dollar. Second, we would expect to see a rise in correlation as securities become increasingly traded as a group.‘
In that same vein, the authors of this article looks at some of these same issues in relation to the ticker:
‘How does access to information affect price efficiency? We address this question by studying the stock ticker; a device that disseminated price changes to brokerage offices with a ticker subscription. We find that an increased number of ticker subscriptions in a state strengthened the return continuation and return co-movement of firms headquartered in the state. Therefore, the increased dissemination of price changes appears to have decreased price efficiency by increasing uninformed trend chasing. Our results challenge the assumption that greater access to information improves price efficiency.‘
The article specifically looks at ‘return co-movement to determine whether uninformed trading explains return continuation.’
‘The positive β1 coefficients in Panel A of Table 7 indicate that an increased number of ticker subscriptions in a state increases the average local beta of firms in the state, which indicates greater return co-movement among local stocks… This positive coefficient indicates that greater price dissemination in a state is associated with higher return co-movement in the state.’
Their analysis also yielded an interesting insight on ‘local’ investment biases:
‘The positive state-level relation between ticker subscriptions and return co-movement also suggests that the stock ticker did not mitigate local investment bias. Instead, investors appear to have continued to focus their trading on “familiar” local firms despite gaining exposure to non-local firms via the stock ticker. Note that the ticker subscription did not confer any informational advantage that would justify the continuation of local investment bias.’
The authors conclude:
‘In summary, recall that the stock ticker disseminated price changes, not information on fundamentals. Furthermore, any decrease in trading costs associated with ticker subscriptions is predicted to increase informed trading by facilitating arbitrage activity and therefore lowering return co-movement. Overall, the positive relation between ticker subscriptions and return co-movement indicates that greater uninformed trend chasing, not greater liquidity, explains the positive impact of ticker subscriptions on return continuation.‘
There is an even more direct linkage between the Ticker and Passive Funds: Cost. Tell me this doesn’t sound familiar:
‘Ticker subscriptions had an inverse relation with the cost of transmitting data to the ticker’s location. We find that lower operating costs for a stock ticker increased ticker subscriptions and strengthened both the return continuation as well as the return co-movement of firms in the state. Intuitively, lower data transmission costs reduced price efficiency as the associated increase in investor access to price changes increased trend chasing.’
In other words, lower costs increased the prevalence of tickers, which increased uninformed trading, which decreased price discovery and increased co-movement in returns.
You can see how easy it would be for one to apply this logic to passive funds today. With access to low-cost (or even free) passive ETFs or mutual funds, assets in passive vehicles have exploded. In turn, critics argue that this has produced a ‘momentum’ effect and increased in return co-movements. Food for thought.
‘Overall, the instrumental variable procedure confirms that increasing the access of investors to price changes decreases price efficiency by increasing trend chasing.’
Definitely take the time to read this article.
The Yield of An Empire
The late 19th century is a perfect example of the speculative boom that occurs when yields are low. I wrote this article in 2018 on the boom in EM debt among London investors:
‘It was in the midst of this low-yield environment, coupled with an expanding empire, that Sir Philip Rose founded the Foreign and Colonial Government Trust (FCGT) in 1868. True to its name, the firm focused on loans to foreign governments both within, and outside her majesty’s realm.
Founded in a year when consols yielded 3.2%, the FCGT was an attractive alternative. According to their first prospectus, the portfolio’s lowest and highest yielding issues were 5.01%, and 15.43%, respectively.
Assets readily poured into the fund, and other firms were quickly founded after witnessing the FCGT’s success. By 1890, there were roughly 100 investment trusts in operation. It is not by chance that this growth in investment trusts coincided with the largest debt conversion, which lowered yields to 2.5%.’
The Telegraphic Transmission of Financial Asset Prices and Orders to Trade
‘This paper delineates how the telegraph was used in the financial services sector in the United States, and considers the implications of this use for U.S. economic growth, New York Stock Exchange trading volume, and securities market regulation. The parallel implementation of two separate dedicated telegraphic networks facilitated the emergence of a technological / institutional trading regime that endured for the better part of a century, beginning in the 1870s, and breaking down decisively only in the second half of 1968. There is little evidence that communications innovation per se made volume or asset prices either more or less volatile.
The telegraph did permit a reduction in per share transactions costs, which given the elasticity of demand for such services, resulted in an upward drift over time in the real resources consumed by the secondary exchanges, the brokerage industry, and individuals and institutions engaged in short term trading. It is unlikely that the benefits of enhanced trading in secondary markets, in relation to the costs needed to realize them, and in comparison with a posited world without the telegraph, created a social return that came close to that realized in the other major business application of the telegraph: logistical control.’
In 1913, the House Report on the Control of Money and Credit covered a ‘systematic and comprehensive analysis of the operation of modern securities markets, those resulting from the widespread adoption of telegraphic technology, in the first decades of the twentieth century.’ The report was critical of this new technology that made it easier than ever for speculators to access financial markets.
‘The most frequently voiced concern of critics of the new technological order was that the telegraph facilitated the growth of “speculation” and that “speculation” diverted capital away from “productive uses”.’
Interestingly, there were some that thought increased access to information from the telegraph would actually reduce bubbles, since prices would likely stay closer to their true value. This was not the case. Instead, bubbles were more likely because of the reduced barrier to entry for speculators and first time traders.
‘Why didn’t the “glare of publicity” made possible by the broadcast stock ticker reports act to reduce the probability of bubbles? Because these broadcast possibilities and the opportunity to trade almost instantaneously did as much to facilitate bubbles of either type as it did to eliminate them. The broadcast ticker vastly increased the audience that could be exposed to and perhaps react to activity manufactured through matched or wash sales. The telegraph ironed out regional differences in prices at moments of time; it did not attenuate the propensity of securities markets to exhibit more volatility than volatility in the underlying real income flows and interest rates warranted.’
In fact, the introduction of the Telegraph and Ticker technologies spawned an entire new industry that was founded on speculative activities:
‘It is apparent that we are seeing, by the first decades of the twentieth century, intense speculative interest in financial assets at activity levels that would have been unimaginable without the telegraph. The peculiar history of bucket shops and their suppression provides compelling evidence that the telegraph itself was a key enabler of intense periodic speculative interest in securities identified in the data above. Bucket shops provided the equivalent of “off track” betting on financial assets. Clients placed wagers on the future course of a stock price, but no orders to buy or sell securities were actually placed…
The history of the bucket shops and the mechanism whereby they were eliminated is strong circumstantial evidence linking the telegraph to purely speculative activity associated with volume booms.’
Tricentenary of the South Sea Bubble
No financial history special on speculation would be complete without covering one of the most notorious speculative booms in history: The South Sea Bubble. In honor of the bubble’s 300 year anniversary, The Wiley Online Library has compiled a series of phenomenal articles on a wide range of topics related to the South Sea episode in 1720.
The text below is financial historian William Quinn’s introduction to the series:
‘1720 fully deserves its reputation as a watershed moment in financial history: it was the year in which ongoing sovereign debt crises in France and Britain reached a spectacular resolution. But whereas the implosion of John Law’s Mississippi scheme in France led to the reinstatement of pre-1720 levels of public debt, Britain emerged having substantially reduced its debt burden without significantly increasing future borrowing costs (Quinn and Turner, 2020). The mechanism by which it did so was the South Sea Bubble: a scheme in which holders of government debt traded that debt for shares in the South Sea Company. This scheme was then accompanied by an unprecedented stock market boom. In addition to its significance for Britain’s fiscal development, the South Sea Bubble has provided scholars with valuable evidence on the nature and development of early investment and the (ir)rationality of investors – much of which has been published in the Economic History Review and is part of this Virtual Issue. There are three broad themes covered in this Virtual Issue:
How did the South Sea scheme operate, and what was its effect on Britain’s financial and political development? Kleer questions the consensus that the boom in the price of South Sea shares was driven by the self-interest of the South Sea Company’s directors, showing that said directors gained very little from the boom and experienced substantial losses as a result of being scapegoated for the subsequent crash. Hoppit shows that, contrary to previous claims, the collapse of the scheme was not accompanied by a major depression or financial crisis. Harris examines the legacy and eventual repeal of the Bubble Act of 1720, a regulatory consequence of the Bubble that affected Britain’s corporate development for over a century.
Who invested during the Bubble? Carlos and Neal, studying the identity of Bank of England shareholders between 1720 and 1725, argue that the diverse and wealthy investor base of 1720 provided the British financial system with sufficient resilience to weather the bursting of the South Sea Bubble. This paper also shows that a significant proportion of Bank of England investors were women, and women typically gained money during the Bubble while men lost money. Carlos and Neal show that investors in this era were not typically well-diversified, with 80 per cent owning stocks in only one company. The paper then argues that the most likely reason for this was that company-specific voting rules required a high level of share ownership, and investors preferred to hold shares in quantities that provided them with greater power.
Does the Bubble provide evidence of irrational investor behaviour? Dale et al. argue that inconsistencies between the prices of South Sea shares and the prices of tradeable South Sea subscription contracts prove that the episode must have contained some irrational pricing. Shea disputes this conclusion, arguing that since the subscription contracts allowed the holder to default on future capital calls, they were more akin to options than they were to shares, and thus would not be priced identically in a rational market. Dale et al. respond by arguing that the legal language used in subscription contracts gave the company the right to coerce future calls. Although this right was later not exercised, it is argued that it is nevertheless inaccurate to characterize the contracts as having built-in options.’
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