Beyond The Headlines

An Apple, A Plague, and A Bubble

September 17, 2020 | Bogumil Baranowski
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An Apple, A Plague, and A Bubble

This article was inspired by comments and thoughts I have been hearing from fellow investors concerned about the fear of missing out on this ever-rising market that has defied laws of gravity.

I imagine that almost everyone has heard the story of young Isaac Newton watching an apple fall from a tree, which inspired his theory of gravity. A story he shared himself in his memoirs. I will guess that a few would know that he was home at the time, away from school due to a plague going around. And I can bet that even fewer know that the same Newton made some money, but lost a fortune in a stock bubble of his time!

I remember how my physics teacher was able to bring his stories and discoveries to life (she didn’t mention he made and lost a fortune in the South Sea Company Bubble!). When I think of physics, laws of nature, I still see him. When I see a stock melt-up quintupling in a few months, for no reason, I also think of him! For a long time, physics was one of my favorite subjects at school, and I still have a weakness for it. I liked its logic and how it explains the universe. I think that in some way, I often hoped that economics, finance, and investing would have clear laws like physics, and explain the world around us. They don’t.

You might see some parallels between Newton’s life and our 2020 pandemic, stay-at-home, work-from-home policies, and a bubbly stock market.

The time spent at home between 1655 and 1657 Isaac Newton called in his memoirs the Year of Wonders, the time he embarked on a journey of understanding how the universe works. Woolsthorpe Manor, his birthplace and the family home, was the place where Newton found refuge during the plague, and it was the place where he retreated through his life to think and write.

The bubonic “Great Plague” (the worst plague to hit the UK since the black death of 1348) sent many home, away from schools, and cities. Town-dwellers retreated to the countryside, while London alone lost 15% of its population to the plague. Newton made the best of this time, writing later: “For in those days I was in the prime of my age for invention and minded mathematics and philosophy more than at any time since.” It was then when he developed his theories on calculus, optics, and the laws of motion and gravity.

It’s been a little over six months since this year’s pandemic sent our Team home. We left our Manhattan office behind and retreated to our homes, and in my case, two different cabins in the Appalachian Mountains. I can’t say that I had a chance to reinvent the laws of physics in my time away. I have been reading, writing, and thinking more than in a while, though. I can’t help but count this peculiar period among the most productive in my life. I also took up several online courses that I have always wanted to do. Megan and I even embarked on learning Spanish together. To a great surprise of other hikers, we have been practicing rolling our “Rs” lately on our regular waterfall walk. I also completed training for various software solutions we use for work. I saw significant leaps in virtualization, digitization, streamlining of many processes that make up the work we do. It saves time, limits errors, and leaves more time to talk to our clients and look for investment ideas. We owe a big thank you to all our service providers that make our business possible.

Newton might have spent his time at-home wisely explaining the laws of physics, but it was only later that he learned more about human behavior, finance, and stock investing! He is believed to have concluded: “I can calculate the motion of heavenly bodies but not the madness of people.” If not for human emotion, one could imagine the stock market and finance follow precise laws the same as those that govern the stars and planets in the sky. For better or worse, it’s not the case. It offers buying opportunities for calm, disciplined investors, and it may cost a fortune those who give in to greed and fear—the fear of missing out being at the very top of the dangers to any investor.

Sir Isaac Newton was not immune. Apart from physics, mathematics, astronomy Newton was no stranger to money, finance, and investing. He held a position of the Master of the Royal Mint and even worked as a detective chasing money counterfeiters. He was also a shrewd investor in years before the South Sea Company Bubble. It is believed that Newton made money in the initial rise of the South Sea Company stock, sold his holdings, only to buy in again as the stock continued to rise with no end in sight. The South Sea Company bubble eventually burst, fortunes were lost, and Newton himself lost some £20,000 (or about $20 million today), according to his biographer.

That’s a story I didn’t learn in my physics class. I read it first in the commentary to the introduction of  Benjamin Graham’s (father of value investing) classic – The Intelligent Investor:

“Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people.’ Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost £20,000. For the rest of his life, he forbade anyone to speak the words’ South Sea’ in his presence.”

My Parisian grad school professor in the aftermath of the Internet Bubble burst (2000), and likely due to his own experience losing a fair amount of money, assigned to us a study of all the major past bubbles. I couldn’t be more grateful for that lesson. It definitely shaped my investment approach for the rest of my career. My professor’s quick advice was – don’t buy stocks because there are bubbles. What I heard, and what I chose to walk away with was – since there are bubbles, there might a good time to buy stocks and a good time to sell them.

Newton’s investment: the South Sea Company Bubble was at the top of our study list, as it is among the most famous bubbles in history. South Sea Company was founded in 1711 as a joint-stock company. This particular company was created to consolidate the national debt of Great Britain and reduce the cost of it. Needless to say, excess public debt seems to be a theme that repeats through history, including today, with looming record deficits all around. The company was given a monopoly on trade with South America to generate income. Since Great Britain was involved in the War of the Spanish Succession at the time, and Spain and Portugal controlled most of South America, the prospects for profits were meager. The company never realized any significant profit from its monopoly.

South Sea Company leadership wasn’t worried too much by likely business challenges. They got inspired by the financial wizardry of a Scottish financier, John Law. France, as much as Great Britain, wanted to get rid of its debt. Louis XIV’s reign almost bankrupted the French monarchy, leaving the country with a big problem. Instead of tightening the belt and paying off what’s owed, France endorsed John Law’s monetary shenanigans. He consolidated the debt and offered shares in a promising business venture in exchange. His Mississippi Company was given a monopoly on trade and mineral wealth in French colonies in North America and the West Indies. Law exaggerated the business opportunity creating excitement around the stock, which kept rising higher and higher. He also controlled the money issuing bank in France, Banque Royale. Eventually, the company and the bank merged. Money was printed to allow investors to buy more shares in the company, further inflating its price. Ultimately, the sentiment shifted; investors wanted their money back; the price collapsed. Law tried all kinds of restrictions to keep the madness going. Payment in gold and silver for paper money was suspended. Holding precious metals was made illegal.

The bubble burst, John Law, escaped, and one would hope an invaluable lesson for investors, financiers, and central bankers was carved in stone never to repeat. I highly recommend Virginia Cowles’s book – The Great Swindle: A History of the South Sea Bubble, if you want to learn more about both companies, both bubbles and their aftermath.

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Yet here we are, in the second half of 2020, public debts are at record highs. US numbers are staggering. This year’s fiscal deficit is expected to reach almost 20% of the GDP (the 50-year average is closer to 3%, and the last recession recorded about a 10% deficit). Total Federal government debt is about to reach 100% of the GDP, which is as high as during the last debt peak after WW2.

Our money is not convertible to gold or silver; we can still, though, buy and hold precious metals. The Federal Reserve (the US central bank) has been busy printing more money, lowering the cost of debt to almost zero. This new money might be digital, and it might be sitting on the balance sheets of banks, but no matter how you look at it, these are fresh new dollars created at no cost, and there are a lot of them. Pre-pandemic, the Fed already held $4 trillion in assets on the balance sheet, and now leaped to $7 trillion in a matter of months. What does it mean, though? The Fed issued new money to buy the debt of various kinds: public debt, mortgages, and, more recently, corporate debt. Now, if the Fed is buying, someone is selling and ends up with cash. That freed up cash can buy whatever is left to buy – how about stocks? I can’t help but see another parallel with John Law’s attempt to print money to help investors buy more shares in the Mississippi Company.

Where does the Federal Reserve end, where does the market begin, we can start to wonder? That’s been a moving target, but it starts to bear the resemblances of John Law’s merger of Banque Royale and his Mississippi company. Actually, the minute the Federal Reserve starts buying US equities, there won’t be much of a line left between the Fed and the market. The Fed will effectively become the market. We certainly hope we never go that far, but other central banks, including the Swiss National Bank and the Bank of Japan, have crossed that line already. Our portfolio gold holdings give us some peace of mind if that were to happen.

Lots of debt, unlimited paper money, and a bubble in a stock or many stocks… that summed it all up in 1720 Great Britain and France, and it sums it up in our 2020. If you overlay it with an economic recession – GDP dropping by 1/3, corporate profits down by 1/3 in the second quarter, with record unemployment, the disconnect between the market and the reality is even more glaring.

You would think that investors today have a wider choice than two trading companies with promised trade monopolies oceans away. Nasdaq 100, the technology index of the largest 100 tech companies, rose over 70% since March lows through the summer peak (Source: Bloomberg). At the same time, the NYSE FANG+ index doubled during the same period. The latter covers only a handful (ten) of the largest, best performing technology stocks. Investors have conveniently ignored the other few thousand publicly traded stocks and chose to chase a tiny group of ever-rising, seemingly invincible stocks. The index mentioned above generously includes ten companies, but investors’ attention has been mostly focused on 4-5 stocks, namely Facebook, Amazon, Apple, Netflix, and Google, with frequent mention of Tesla, Inc.

In a single year, the South Sea Company price went up from £100 to £1000; in our today’s tech world, we witnessed Tesla, Inc. rise seven times since March alone before early September correction. One rose on expectations of the great riches brought by a trade monopoly from distant lands, the latter on the great success of electric cars in the distant future.

Both Americas prospered over the following centuries, but it wasn’t either of the two trade companies that benefited much from it, and it was definitely not their shareholders that saw much gain from it either. During the Internet bubble (which still haunted my grad school professor), we witnessed a new technological revolution, but again very few companies lasted long enough to capture its benefits. Today is not different; we do not doubt that some of the top tech companies inflating the market might have some remarkable businesses. We also pay attention to several new multi-billion-dollar companies (many of them “profit free” but full of promise) to be listed in the coming months. The excitement will come and go. Profitable companies are likely here to stay, and if we pay reasonable prices for them, we may even benefit from their success. Chasing rising stocks, and giving in to the fear of missing out, didn’t work for our Isaac Newton three hundred years ago, and won’t likely work today.

Whenever we don’t know what the future may hold, we like to pick up yet another history book, and this might prove to be the best use of our work from home time, and Virginia Cowles – The Great Swindle: A History of the South Sea Bubble is not a bad place to start.

Happy Investing!

Bogumil Baranowski

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