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The South Sea Bubble

04/07/04 02:45:22 PM PST
by Margaret Austin

You didn't think the Internet stocks bubble was the first one, did you? Manic speculation has been around a long time.

Like the popular children's amusement of blowing soap bubbles, stock prices can rise to the sky with seemingly infinite potential — and investors' elation helps to bolster the ascent. However, when the bubble inevitably bursts, you don't want to be the one with nothing to show for your investment. Educate yourself about prior fiascoes and avoid the pitfalls of manic speculation.

Introduction

In what has come to be known as the South Sea Bubble, a combination of poor judgment, outright fraud, executive and political corruption, and unbridled greed led to a major economic collapse and financial ruin for thousands. Sound like Wall Street? Is the South Sea Bubble a Martha Stewart craft idea? Not quite, but the parallels are disturbing because the South Sea Bubble — one of the worst market crashes in history (and one of the first) — occurred in the early 18th century in England. Apparently, those who do not learn from the past are condemned to repeat its mistakes. Here's your chance to avoid that fate.

A cautionary tale

Like so many other schemes, it all began with a great idea: Purchase England's massive war debts for a fixed rate of interest, then turn the debt into equity by selling shares in a company with a government-granted monopoly on trade. In 1711 a group of merchants, led by Robert Harley, the first earl of Oxford, convinced the British government to grant their South Sea Company the exclusive right to trade with the Spanish colonies in South America. In exchange for the benefit, Harley was prepared to assume nearly nine million pounds of the country's massive war debts, which he would cover by selling shares in his company. The government also agreed to pay the company 6% interest annually.

At the time, the kingdom of Great Britain (formed when England and Scotland united in 1707) was embroiled in the War of Spanish Succession, which engulfed most of western Europe. Despite this ongoing conflict with Spain, Harley sold his idea not on the basis of current revenue potential but on the great prospects of the future after a peace settlement. Harley and his vision were products of the times. It was an era of great exploration and fantastic imagination about the exotic lands of the New World. As far as the investors in the South Sea Co. were concerned, the ventures could not help but succeed. Crafty stock salesmen (known as jobbers) found eager buyers whose minds were filled with heady images of gold, silver, and jewels spilling forth from the mysterious peoples of South America in exchange for British wool. In their view, the wealth was ripe for the plucking — and they were going to get in on it.

As the South Sea Co.'s publicity grew, not only did it attract numerous investors; it also spawned imitators. All kinds of joint-stock company copycats were formed and offered for public sale. Investors snatched them up, eager for a share in the proverbial pot of gold. Many of these imitators were unabashedly fraudulent; others simply had no feasible business plan or they lacked competent management. Buying out of a near-hysterical desire to get in on the goods, investors ignored all common sense. Most of the projects were big on promise but vague on details. Some of the preposterous business propositions for instant wealth included trading in hair, a wheel for perpetual motion, and the transmutation of quicksilver into a malleable fine metal. Other prospectuses were even more blatantly dubious, such as this all-time classic: "Carrying on an undertaking of great advantage; but nobody to know what it is."

Eventually, the sheer volume of bogus imitators began to erode investor confidence in the South Sea Co. With its political clout, the company pressured the British Parliament to pass what became known as the Bubble Act, which required all joint-stock companies to have a royal charter. This measure temporarily bolstered public confidence and inflated South Sea Co. stock.

So did the company's assumption of even more of the government's debt. For the first half of 1720, the bubble rose and waves of fevered speculation carried prices of the South Sea Co. (and many of its imitators) up and up. In February 1720, South Sea shares traded at 175 pounds; by June they peaked at over 1,000 pounds. However, as the promised payoff continually failed to materialize, the bubble burst. When the selling began and the rumors spread, more and more investors sold until a full-scale collapse arrived by September, when prices plummeted to 135 pounds.

What went wrong?

Many factors converged to burst the South Sea Bubble. The business ventures of the South Sea Co. were plagued with bad luck and poor management. In 1713 the Peace of Utrecht was reached, putting an end to the war with Spain but giving Great Britain only limited trade concessions. The number of ships allowed into Spanish ports was limited by the peace treaty; the slave trade was not as profitable as anticipated; cargo trade was handled ineptly; and Spanish officials extorted a percentage. Further, by 1718 Great Britain and Spain were back at war. For the especially speculative junior companies that actually attempted to engage in stated business goals, incompetence destroyed most efforts. Then there were the purely fraudulent concerns that simply duped the stock buyers and made off with the money.

Corruption and greed also played a substantial role in the escalation and decline of fortunes. With its commercial enterprises stymied by a lack of profitable trade, the South Sea Co. turned to pure financial speculation. By bribing numerous officials with fictitious stock and assuming Britain's entire debt in 1720, the company created an upward spiral of stock price that was not matched by the company value. Ultimately, an attitude correction occurred. One observer saw the situation clearly and noted:

The additional rise of this stock above the true capital will only be imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently all the fictitious value must be a loss to some persons or other, first or last.

His advice to avoid being the one experiencing a loss: Sell out first and "let the Devil take the hindmost."

Lessons for today's investor

Analysts call the phenomenon of intense price escalation and dramatic decline that occurred for the South Sea Company and its copycats a "bubble" because buyers' mania fueled both the ascension and the plunge. This same motivation — to take a risk on the future with the hope of profit — is what drives all stock speculation and provides opportunity for wealth enhancement. However, taken to extremes and without proper foundations, this motivation becomes mania and investing becomes gambling.

The first precaution for the wise investor is: gain as much knowledge as you can. Learn about the ventures in which you choose to invest. What does the company do? How well does it do it? Is the management team honest, experienced, and competent? Do their proposed future activities make sense to you — or do they strain the limits of common sense? Keep in mind the maxim that credit is not wealth unless it rests on a wealth-producing asset. This need not mean investors become stodgy — taking risks is essential to some payoff. But calculated risk is a far cry from manic speculation.

In an atmosphere of political bribery like that which existed during the South Sea period, or of "cooked books" such as the Enron scandal, it may be hard to feel sufficiently educated. But investors today do have access to vast stores of information. Use this to your advantage. Read books, go to seminars, or hire professionals. Don't be afraid to tap into intuition as well. If it seems too good to be true, it probably is.

Another lesson from the past is to keep your expectations realistic. Don't let promises of "sure-win" situations and "instant wealth" lure you from a consistent and disciplined investment strategy. Diversify your investments and keep an eye on your holdings. Have a financial "checkup" twice a year.

Finally, if you do get duped, it might console you to recall that Sir Isaac Newton (yep, the Isaac Newton, that guy who figured out why apples fall down) lost big in the South Sea Bubble. "I can calculate the motions of the heavenly bodies," he lamented, "but not the madness of people."

Margaret Austin works at home as a full-time mom and a part-time writer.

Suggested reading

Mackay, Charles [1995]. Memoirs Of Extraordinary Popular Delusions And The Madness Of Crowds, reprint edition, Three Rivers Press.
Reed, Christopher [1999]. "The Damn'd South Sea," Harvard: May­June.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.



Margaret Austin




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