Modern Issues, Old Solutions

Caption: “Wall Street Persians & The Washington Egyptians

At the battle of Pelusium, between Egypt and Persia, the Persians armed themselves with cats, the sacred animals of Egypt. The disconcerted Egyptians dared not shoot their arrows, for fear of hitting holy cats.”

Explanation:

“Illustration shows the battle of Pelusium with the Persians identified as having ‘Vested Interests’ (looking like Chauncey M. Depew), belonging to a ‘Wall Street Syndicate’ (looking like John D. Rockefeller), or a ‘Railroad Trust’, throwing cats labeled ‘Small Stock Holder, Small Investor, Widow, Little Stock Holder, [and] Orphan’ at the bewildered Egyptians who are outside a building labeled ‘Administration’ and flying a banner labeled ‘Federal Prosecution’.”

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Visualizing History

Source: Global Financial Data

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From the Archives

The Revival of Speculation (March 1910)

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Sunday Reads

There has rarely been a dull moment in financial markets over the last 18 months. As a historian, this period has been particularly interesting because of the seemingly endless direct parallels to previous moments in financial history. Whether it be studying the impact of past pandemics on markets, 19th century electric vehicle booms, short squeezes, etc., there has been no shortage of lessons for students of history to draw upon.

In this morning’s post we are going to narrow our focus on a few major themes surrounding markets today, and dive deeper into their historical context. That said, we’ll begin by looking at one of these themes, Technology, before getting into today’s links.

Technology & Markets

Technology has always played a critical role in the development and functioning of markets.

In 1903, Sereno Pratt stated the cornerstone of modern finance is “speed with accuracy [and] promptness in all things.” Pratt also argued “most of the tools of Wall Street are time-savers”, with the six most important tools being:

1. The stock indicator [Ticker]
2. The telegraph
3. The cable
4. The telephone
5. The news slips
6. The market reports

The tools that I want to focus on are the telegraph, cable, and ticker machine. For in addition to being a crucial innovation for improved efficiency and time-saving, the ticker machine was like the printing press in that it democratized access to information through widening its dissemination at a scale never seen before. The chart below depicts ticker “impressions” from 1890 to 1901.

The image below portrays examples of some of the earliest ticker tape readings:

Yet, of course the advent of faster and easier trading was not a uniform benefit as these developments also engendered a boom in speculation. Similar to today, a speculative boom was the inevitable outcome of democratized access to financial markets and an ability to transact quickly / easily (relatively).

Interestingly, there were some that thought increased access to information through the telegraph and ticker 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.” (Excerpt from the last article in today’s post)

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.’

In another fun example, to truly understand the significance of the ticker for transmitting market prices speedily, it is helpful to consider the systems in place pre-ticker. The excerpt below describes a carrier-pigeon system employed by market participants for transmitting information from Europe to Boston:

“Before the days of the Atlantic cable, Mr. D. H. Craig, of Boston, conceived the idea of training pigeons to act as messengers for the European news brought by foreign steamers arriving at Halifax. He would take with him a half dozen of his pigeons, board the incoming steamer, and take passage thereon for Boston.

Once on board the steamer, he would secure copies of the latest dates of the European papers, and from their pages prepare a careful digest of the significant political and commercial news, written upon fine manifolded tissue paper. At the proper moment, the pigeons were dispatched from the steamer on their homeward journey, and with fleet wings soon reached their destination, with the valuable reports, which were quickly transcribed and distributed to Mr. Craig’s subscribers in Boston, and by telegraph to other cities.

While this system seems crude and unsatisfactory, in comparison with modern methods now in use, yet, at that time, the fortunate subscribers to Craig’s “bird mail” were often rewarded in their market operations by the possession of early information.”

The parallels to today are obvious. The ticker and telegraph allowed large swathes of society to participate in financial markets for the first time as technology democratized access to markets and information. Built upon a foundation of cables that connected New York to the rest of the world, telegraph communications allowed individuals to speculate with greater ease and speed than ever before. As always, speculation ensued and entire industries (Bucket Shops) were built upon the explosion of new market entrants looking to speculate. Is this sounding familiar?

Yet, it is important to remember that for all the speculation and in some instances outright gambling occurring today, we can look to history and see that there are positive outcomes. When bucket shops were forced to close their doors in the early 20th century, many of these speculators upgraded to the real stock exchange. While this may seem insignificant, it was critical because it meant that smaller investors were participating in financial markets that had previously been out of reach. So, while their journeys may have begun with degenerate speculation in bucket shops, many of these individuals “graduated” to the stock exchange and adopted more mature investing strategies.

While there are obviously reasons to be concerned with the levels of speculation among new investors today, it is important to remember that their speculation today may be the reason they become a more serious investor in 2 years time. Broader participation in the stock market is good for society, even if an individual’s foray into markets is speculative in nature.

Now let’s dive in to some other clear historical parallels for modern markets!

The 1910 Rubber Boom & Momentum Investing

Why This is Relevant:

Yesterday the Financial Times ran an article titled “Investors see ‘gold rush on steroids’ for green battery metals”, which stated:

“Investors are betting that the world’s shift towards electric vehicles and renewable energy will create a supercycle in the price of metals essential for building batteries. Shares in the Global Lithium and Battery ETF have risen about 170 per cent over the past year, while producers of lithium, a battery metal, have raised more than $2bn from investors during the past few months. Some of the most prominent names in the mining industry, such as Mick Davis and billionaire Robert Friedland, have also launched funds to invest in the sector.

The surge in investor interest reflects the growing realization that government pledges to reach net zero emissions of greenhouse gases by the middle of this century will demand huge quantities of battery metals.“

So, what makes this interesting? This exact dynamic played out over a century ago with the birth of automobiles and ensuing “Rubber Mania”.

Coming off the back of a ‘bicycle mania’ at the end of the 19^th century, another new technological innovation requiring tires had just started rolling off the assembly lines in America: the automobile. Explaining his investment thesis, in 1910 a portfolio manager at The Rubber Plantation Investment Trust exclaimed:

“If you take two of the industries which are practically the largest users of rubber, like electricity and motor traction, I do not think that anyone can come to any other conclusion than that both these industries, large as they may be to-day, as yet are only in their infancy.”

The boom in commodities like Lithium,  a battery metal, have been fueled by the expectations of increased demand going forward as electric vehicles become more ubiquitous. As the FT pointed out, there are existing ETFs dedicated to capitalizing on this trend, but new funds are also being launched to invest in this sector as well.

In the early 1900s witnessed a very similar situation when investors became enthusiastic about the prospect of commodities like rubber due to the increased demand for tires stemming from new automobiles and recent bicycle mania. Similar to today, commodity prices soared and funds like The Rubber Plantation Investment Trust were subsequently launched to seize the moment. In short order there was a speculative mania in “rubber shares” that was described at the time as “one of the wildest booms ever experienced in the annals of finance.”

The Economist wrote:

“There are also many signs that the point has now been reached at which prudent optimism ceases and is replaced by emotional enthusiasm. Prospectuses pour out, and subscriptions pour in. The speculative public wants rubber shares-it does not care which.”

The ‘Rubber Boom’ in early 20^th century London offers a perfect case study of how strong stock returns originally justified by growing earnings can quickly morph into a speculative ‘boom’. Investors chased returns, herded into rubber companies’ shares, and ignored information that indicated a reversal was likely.

First, it is important to understand what drove the excitement for rubber shares. As it turns out, the reasoning was simple. Coming off the back of a ‘bicycle mania’ at the end of the 19^th century, another new technological innovation requiring tires had just started rolling off the assembly lines in America: the automobile. Explaining his investment thesis, one investment manager exclaimed:

“If you take two of the industries which are practically the largest users of rubber, like electricity and motor traction, I do not think that anyone can come to any other conclusion than that both these industries, large as they may be to-day, as yet are only in their infancy.”

These two new forms of transportation, particularly the automobile, led to a burgeoning demand for tires, and consequently, rubber.

“The Rubber Boom undoubtedly has solid foundation. New uses are constantly being found for rubber, and there is an increasing demand for the articles in which it is used to present…. There are ample materials here for a legitimate boom, and there can be little doubt that there are good prospects of a prosperous future for those rubber companies which have chosen their ground well, and whose flotation has been carried with wisdom and moderation.”

Visualizing History:

Rubber Plantation Investment Trust Shareholder Meeting (1910):

“What a change do we find in the conditions of the rubber share market since I had the pleasure of addressing you in June last… Now everybody has a craving for rubber shares. One of the first paragraphs in the summary of every financial paper is devoted to the rubber market and a breakfast table unadorned by at least one rubber prospectus would look very unappetizing…

Your board have not omitted to take advantage of this state of things, and they have, of course, had many opportunities of furthering your interests by acquiring blocks of shares in the best rubber companies… The public subscribed all these securities with great avidity, and they have attained to substantial premia.”

What Came Before the $10 Billion Bet on Flying Taxis

Humans have long enjoyed the thrill of exploring uncharted territories, and investors are often equally enthusiastic about the transportation facilitating that exploration. One of the most high-profile examples in recent memory is Virgin Galactic’s public debut via SPAC. Even more recent, air-taxi companies Archer Aviation Inc. and Joby aviation have announced similar SPAC deals valued at $3.8 Billion and $6.6 Billion, respectively. In the modern era there is not much left to explore on earth, but space and air travel offer an exciting new frontier that piques the interest of both adventurers and speculators alike.

This paper by one of my favorite writers and friend Jason Zweig looks at the history of previous transportation booms dating back to electric vehicles in the late 19th century.

Summary:

“The history of transportation over the past two centuries is a chronicle of astonishing advancement. (Until the 1860s, it could take more than six months to get from the East Coast to the West Coast of the U.S.) That progress, however, has been full of false starts, stalls and surprises. The funders of radical new transportation technologies have often been wiped out. Because history is written by the winners, it’s important to remember the lessons of the losers, too.

Taxi companies using radical new technologies and promising to transform transportation have arisen before. In 1897, what became known as the Electric Vehicle Co. began operating battery-powered taxicabs in New York City. In the U.K., the London Electrical Cab Co. also began service that year. In 1899, the Compagnie Française des Voitures Électromobiles got underway in Paris.

The electric taxis offered some great advantages over the horse-drawn cabs they sought to replace. They were clean and quiet and, because they were so innovative, they appealed to the wealthy and fashionable.

In New York, the electric-taxi business boomed…. In 1899, the Electric Vehicle Co. had about 45 cabs in service, averaging 27 miles of trips per day, and a financing rush was on. A rival, the General Carriage Co., sought to raise $20 million in capital (about $650 million today)…

That year, estimates of demand for electric taxis quickly ratcheted up from 1,600 to 2,000 to 12,000. To shuttle passengers to New York’s booming Metropolitan Street Railway trolley system, which covered 232 miles in Manhattan, 1,500 battery-powered taxis would be needed. The Electric Vehicle Co.’s parent ordered as many as 850 “electromobiles” from its manufacturing affiliate in Hartford, Conn.

In seven weeks that spring, the share price of the New York electric taxi company nearly tripled.

Visualizing History:

The Electric Vehicle Company Stock Price: 1899 – 1907

Notable Quote:

“Technologies and industries often take leaps forward when products and services can be put to surprising new uses, enabling customers to fulfill needs—or aspirations—they didn’t even know they had.

Radio, developed to assist navigation, became the indispensable musical accompaniment to people’s lives. The airplane, in its early decades, was used far more for delivering mail and shipping goods than for carrying passengers. The mobile phone, originally designed for people to talk with, has become the all-in-one wristwatch, camera, stereo, movie theater, road map and encyclopedia we all carry in our pockets and purses.”

Does Credit Affect Stock Trading? Evidence From the South Sea Bubble

A recent CNBC article reported:

“Half of respondents between 25 and 34 years old plan to spend 50% of their stimulus payments on stocks… Meanwhile, 18- to 24-year-old retail investors involved in the survey planned to use 40% of any stimulus checks on stocks.”

This insight is not necessarily novel in that people have been discussing the impact of stimulus checks on speculative behavior ever since the first round of checks were cut in early 2020. Coupled with historically low interest rates, the role of excess capital in fueling speculation has become a major discussion point. This article takes a look at how cheap credit fueled another speculative year ending in ’20: The South Sea Bubble of 1720.

Like the CNBC article stated that stimulus checks were being plowed into equities, this paper demonstrates that 79% of loan holders were taking speculative positions in the speculative du jour: South Sea Company, Royal African Company, and East India Company.

1. A loan holder acts as an extrapolator by buying stocks that have experienced high returns in the recent past.
2. Borrowers realize lower returns than investors without a loan.
3. Margin loan holders are more likely to subscribe to new share offerings at peak prices.
4. There is a positive relation between loan holder buying pressure and stock prices during the bubble.

“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.”

Visualizing History:

“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.”

Stocks versus Bonds: Explaining the Equity Risk Premium

Recent movements in the 10-Year Treasury yield have spooked markets and sent tech heavy indices like the NASDAQ falling. In this paper, Cliff Asness looks at the long relationship between equities and bond yields by analyzing the Equity Risk Premium since 1927.

Summary:

“From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long- run difference in volatility between stocks and bonds. This model fits 1871–1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields.

Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term.”

Visualizing History:

The Telegraphic Transmission of Financial Asset Prices and Orders to Trade

Why This is Relevant:

A major theme of the last decade, and particularly in more recent years, has been the role of technology in democratizing access to markets. As with all things, of course, this has not been without problem. The same technology that enabled democratization has also encouraged gambling and speculative behavior by making it easier than ever to buy/sell assets. The elimination trading commissions was the final spark for a boom in speculation.

This paper looks at the introduction of a different technology that had some similar effects: the telegraph and ticker.

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.’

“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.”

Visualizing History:

“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.”

 

 

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