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Visualizing History


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Sunday Reads

Well, that was a crazy week.

The S&P 500 recorded its longest weekly losing streak since 2011 after posting losses for the fifth consecutive week. There were plenty of poor returns to go around, though, as the NASDAQ shed -1.2% and the Russell 2000 fell -1.3%. Year-to-date performance is similarly depressing:

  • NASDAQ: -22.15%
  • S&P 500: -13.37%
  • Russell 2000: -17.76%

There are plenty of reasons for why the market has suffered in 2022 (war in Ukraine, COVID-19, inflation), but the key driver in recent weeks has been Fed policy / interest rates. After the Fed announced a 50 bps rate hike on Wednesday instead of the widely feared 75 bps rate hike, stocks skyrocketed as if Jerome Powell had cured COVID and inflation in one Fed meeting. The S&P 500 posted its largest one-day gain since May 2020, and the NASDAQ rose 3.2%.

Unfortunately, markets plunged the next day, with the NASDAQ posting a particularly poor -5% return. However, the financial turmoil has not been limited to public markets.

The hammering of technology stocks in particular this year has spawned knock-on effects in the world of venture capital. Many startups and technology companies have announced layoffs (or even full closures) in recent weeks, with almost every instance being attributed to a shifting market conditions (a.k.a. investors care about profits now).

TechCrunch wrote:

“we’ve witnessed an alarming amount of layoffs across the startup ecosystem, from buzzy, big names like Cameo, On Deck and Robinhood, to B2B platforms like Workrise and Thrasio. The common thread between most of these layoffs, according to founders, is that there’s been a shift in the market and a serious pivot in business is required…

Now feels like an inflection point, in which tech unicorns are realizing that they may have overpromised a growth trajectory, over-hired or overestimated their ability to raise that next round. They aren’t alluding to the market changing, they’re blaming it.”

This “reckoning”, as some have labeled it, highlights how companies have relied on narratives over profits to justify their valuations. This largely resulted from the era of historically low interest rates, which pushed investors into riskier assets like venture capital in search of returns as the yields on traditional assets like fixed income were unattractive. With sizable amounts of capital available for venture capitalists to deploy, startups were able to command rich valuations.

However, the reality of rising interest rates has quickly undone this goldilocks environment for startups. Legendary venture capitalist Bill Gurley tweeted:

A Diet of Cheap Money & Shifting Narratives

While each example is different, this scenario in which speculative periods built upon excess and narrative are undone by the reality of rising interest rates is nothing new. I know that I’ve shared this article many times before, but it is worth re-sharing. The excerpts below are from an 1896 Spectator article titled “Panic in the City”, which reports how those in London’s financial district reacted to the Bank of England raising interest rates 0.50%.

At this time, the official interest rate in Britain was 2%, the lowest rate on record (until 2008). As always, this period of cheap money and low interest rates fueled speculative bubbles in things like bicycle stocks and breweries – which we’ll cover in a moment. However, when the BoE raised rates 50 bps, investors panicked.

“The nerves of the City were rudely upset last week by the Directors of the Bank of England, who exploded a veritable bomb-shell by suddenly raising the official minimum rate of discount. The advance in the rate was small enough, from 2% to 2.5%, and in former days when the course of the Money Market was more or less regular, would have been accepted as part of the established order of things

Nevertheless, so ready are even the keen-witted men who work the great machine of our credit system to accept an artificial state of things as normal if it only lasts long enough, and to forget in a couple of years the mental habits of a lifetime, that an upward movement in the Bank-rate came upon them like a thunderbolt, altogether disorganising the discount market for several days, and causing a very severe fall in prices on the Stock Exchange.”

As the author points out, the Bank of England had routinely raised interest rates by a full 1.0% in the past and markets accepted this as par for the course. However, following an era of “cheap money” (low rates), investors forgot “in a couple of years the mental habits of a lifetime… [and] an upward movement in the bank-rate came upon them like a thunderbolt”.

The Spectator article continued its criticism:

“It is to be hoped that the lessons of the panic will be taken to heart by the bankers, who, by the freedom with which they lent money on securities at low rates, encouraged the growth of an artificial and dangerous state of things. The effects on markets of a trifling rise in the Bank-rate were severe enough to make one tremble at the thought of what might happen if the Stock Exchange, in the inflated and flabby condition caused by a diet of cheap money, were called upon to face a really dangerous crisis.

There are plenty of materials about for a genuine explosion, and it is evident that our credit system owes hearty thanks to the Bank of England for clearing away a great deal of very awkward- top-hamper in preparation for any real gales that may be brewing.”

I love the description of London’s stock exchange as “inflated and flabby” from a “diet of cheap money”.

The Brewery Bubble & Rising Interest Rates

In my first online financial history course covering “Bubbles, Manias & Fraud”, Professor John Turner delivered an excellent lecture on London’s Brewery Stock Bubble in the 1890s. Importantly, this coincided with the interest rate environment covered in the Spectator article above. In the clip below, Turner discusses the role that interest rates and credit played in fueling this boom:

Turner highlights the stark contrast in returns for brewery stocks in the speculative “happy hour” phase of the bull market, and inevitable “hangover” as interest rates rose and the market waned.

A few years ago it was almost unimaginable to consider tech / growth stocks losing their dominance, but here we are. Of course, it was inevitable that interest rates would eventually rise, but this inevitability did little to mentally prepare investors, as the reaction today has been quite similar to those described by the author of that 1896 article.

That said, today we will look at a few examples of narrative driven markets, and how quickly things can change.

 

Happy Hour Followed by Hangover: Financing the UK Brewery Industry (1880-1913)

Why This is Relevant:

A more detailed look at the 1890s brewery bubble covered in the introduction.

Summary:

“In the last 15 years of the nineteenth century c.300 British brewers incorporated and floated securities on the stock market. Subsequently, in the 1900s, the industry suffered a long-lived hangover. In this paper, we establish the stylized facts of this transformation and estimate the gains enjoyed by brewery investors during the boom as well as the losses suffered by investors during the bust of the 1900s. However, not all brewery equity shares suffered alike. We find that post-1900 performance correlates positively with capital-market discipline and good corporate governance and negatively with family control, but does not correlate with indebtedness.”

Visualizing History:

 

Stock Market Swings and the Value of Innovation (1908-1929)

Why This is Relevant:

This paper looks at how investors perceived the value of innovations and intangibles in the 1920s stock market boom, and how these perceptions impacted prices.

Summary:

“A recurrent theme in the modern literature on the economics of financial markets is the extent to which stock market swings reflect changes in the present discounted value of expected future earnings or the ‘animal spirits’ of investors. For example, the rapid acceleration in stock prices during the 1990s can be explained both by changes in expected investor payoffs in response to the accumulation of intangible capital by firms, and by behavioral phenomenon that caused a speculative bubble. Whether swings in the stock market are driven by the diffusion of new technologies or by periods of irrational exuberance is an important question in the economics of innovation and finance…

it is also important to a fuller understanding of another major event in the American stock market – the run-up in equity prices during the 1920s and the Great Crash of 1929. While Irving Fisher famously reported on the eve of the Crash that stock prices would remain permanently higher than in past years due to the arrival of new technologies and advances in managerial organization that created positive expectations about future profits and dividend growth, retrospective analysis has indicated the presence of a ‘bubble’. The speculative bubble hypothesis has become orthodox in the literature given that the S&P Composite Index fell by more than 80 percent from its September 1929 peak to its level in June 1932. The Great Crash is the canonical example in American financial history of market prices diverging significantly from fundamentals.”

Visualizing History:

 

Credit Booms Forecast Sub-Par Performance of Equities

Why This is Relevant:

This paper analyzes the impact of credit booms on returns, finding that credit booms hurt equity returns in particular relative to bonds.

Summary:

“Rapid growth in credit, which has been linked to slower economic growth and even economic downturns, is also a predictor of below-average equity returns. In The Leverage Factor: Credit Cycles and Asset Returns (NBER Working Paper 26435) , Josh Davis and Alan M. Taylor study returns in 14 advanced economies over the period 1870 to 2015. They conclude that credit booms are followed, on average, by unusually low returns to equities, both in absolute terms and relative to bonds.”

Visualizing History:

 

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

Why This is Relevant:

Looking at how the availability of credit impacts trading behavior.

Summary:

“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.”

Visualizing History:

 

 

 

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