The copper market is one of only a handful of commodities to show a positive performance over the course of 2020. Since the corona virus nadir in April, copper prices have rebounded by almost 40% to $6,400 per tonne. Disruptions to copper mine output due to covid and expectations of higher infrastructure investment have supported the surge.
Over the next few years the market may consolidate as the final incremental mine supply comes to market following the 2011 boom. However, investment in 5G and electric vehicle infrastructure capacity will be a major boost to copper demand, coming just as the copper capital cycle is turning. That means higher copper prices.
Copper mine disruptions
Peru, the second largest copper miner, is taking longer than expected to ramp up mines after a two-month lockdown due to the spread of the coronavirus. Meanwhile, workers at two mines in Chile (the largest producer) voted to strike over wages.
The spread of the coronavirus in South America has resulted in copper mine operators in the two countries shutting down over 600,000 tonnes of production in order to contain the spread among workers and local communities (around 3-4% of global copper supply). Add in another 150-200,000 tonnes for other reasons and the prospect of further strike action in Chile and copper mine disruptions are on track to hit record levels in 2020.*
*Gold is a byproduct of many copper mines, and so the disruption to copper mines also increases the stock-to-flow of gold.
Chinese copper smelting activitysignals strong demand
China accounts for 50% of global copper consumption – higher Chinese copper production can often be a good indicator that demand growth is strong.
While conventional economic data is too slow to capture recent trends, and survey data is too distorted by a sudden change to the baseline, satellite data can provide a much more timely indicator of real time production.
The Savant Global Copper Smelting Index measures capacity-weighted activity levels observed at around 90% of the worlds smelter sites using satellites. A reading of 50 indicates that current activity levels are at average levels. Readings above or below 50 indicate greater or lesser activity levels than average.
Activity monitored by satellites over China indicate that copper smelting activity has continued to expand since the beginning of May. While a number of smaller Chinese copper smelters appear to have closed down or mothballed their plants (possibly due to a recent squeeze on margins), the loss has been more than offset by higher output from larger facilities.
Chart: China activity dispersion index since July 2019 (weekly average)
The sharp decline in Chinese copper social stocks to a 5 year also indicates that there is strong demand.
I have written several posts about the potential for copper to benefit from higher infrastructure spending post COVID. One of the widely discussed topics has been the ‘New Infrastructure’ scheme that Chinese authorities put forward earlier this year. Although the scheme includes a big focus on 5G, AI and electric charging infrastructure, it also focuses on more conventional infrastructure like the power grid and high speed rail. In China as with elsewhere it will be the speed that ‘shovel ready’ projects can actually start that will be key to how quickly copper demand will see a boost.
Unprecedented monetary stimulus and the easing of the dollar
The relationship between the US dollar and the copper price is far from stable. But over time at least a lower dollar tends to mean higher copper prices. The drop in the dollar since the end of May has been a strong tail wind for copper.
But we’re probably now at a make or break point. While many of the technical indicators and very long-term trends point to a much lower dollar over the course of the next decade there is a risk that at least in the near term the dollar soars higher.
Copper prices are also heavily influenced by Chinese monetary conditions. China’s credit impulse – a measure of the changing growth rate of credit relative to the size of the economy – tends to lead copper prices by around 18 months. This time though copper prices appear to have moved much faster, perhaps indicating that there is less upside potential.
All the extra monetary and fiscal stimulus combined with supply-side restrictions has many people concerned that significantly higher levels of inflation will start to appear. It’s worth noting that gold and other precious metals are not the only game in town. Indeed during the period 1992 to 2016 copper prices rose 3 times more than gold when US inflation started to rise.
Trend resistance a barrier to further gains
The price of copper has bounced off this long-term trend line from 2011 yet again. For now at least the copper price has been driven higher by covid related disruptions to mine supply and expectations of a boost to copper demand from infrastructure spending. The market is going to want to see that narrative reinforced before it moves higher through that trend line resistance.
I would fade this move in #copper as it approaches 3.00 and look for a meaningful pullback to at least 2.88. Coming into horizontal resistance, long term falling trend line resistance, and RSI is at 84. Needs to cool off. $HGpic.twitter.com/6dkNsipEja
Hedge fund net-long positioning in copper reached a 13 month high due to concerns that supplies in South America would be curtailed by virus and strike related shutdowns. That being said positioning is no where near as stretched as we saw in late 2016 and into 2017.
The longer term capital cycle
Much of what I’ve covered so far includes the short-term and typically focuses on the demand side of copper market. While less visible it is typically much easier to predict, but only really has power for long-term investors with the patience to take advantage of it.
Research examining centuries of commodity price data has tended to sketch a pattern of 15–20 year super-cycles (a period of rising prices), followed by a slide in prices over the following 10–15 years when excess investment leads to a flood of supply. On this basis investments in new mine supply as a result of high copper prices in the period 2006-2013 are still boosting copper mine supply growth.
However, copper mine supply growth has been erratic. While some countries have been strong performers, others have disappointed. According to BMO, Peru has been the single largest driver of growth on both a five and fifteen year view, followed by the Democratic Republic of Congo. Notably, Chilean output has been essentially flat between 2004 and 2019.
Part of the reason for this is the higher degree of capital intensity required to bring these mines to market. This means that the incremental projects are on average of a lower grade, higher in infrastructure requirement and more challenging from an environmental and jurisdictional risk perspective than existing copper mines.
Meanwhile, many of the long-life copper mines are operating below their capacity and are coming to the end of their useful productive abilities. Roughly ten mines per annum are coming to the end of life through the middle of the 2020’s, which combined account for almost half of current supply volumes.
Capital Returns: Investing Through The Capital Cycle was published in 2015 and outlines the capital cycle approach to investing used by Marathon Asset Management. Introduced and edited by financial historian and investment strategist Edward Chancellor the book includes a number of Marathon client essays published between 2002 and 2015. As pointed out by Chancellor, the essays are unashamedly a cherry picked list of client notes chosen with a big dose of hindsight bias. That being said they offer a useful way of illustrating the points made in the introductory chapters and so many of them are also worth a read.
While I initially read this book for its insights into the commodity industry the approach outlined in the book can be applied to almost any sector. The key message in the book for investors in commodities and resource equities is that while attention is typically transfixed by the prospects for demand, the real returns come from paying attention to the supply side. Ignore it at your peril.
The key to the “capital cycle” approach is to analyse how the competitive position of a company is affected by changes in the industry’s supply side. Professor Michael Porter described the “five forces” which impact on a firm’s competitive advantage: the bargaining power of suppliers and of buyers, the threat of substitution, the degree of rivalry among existing firms and the threat of new entrants. Capital cycle analysis is really about how competitive advantage changes over time but viewed from the perspective of an investor.
High current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill – a mistake encouraged by the media, which is constantly looking for corporate heroes and villains. Both investors and managers are engaged in making demand projections. Such forecasts have a wide margin of error and are prone to systematic biases. In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic.
High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share. Besides, CEO pay is often set in relation to a company’s earnings or market capitalization, thus incentivizing managers to grow their firm’s assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum!
Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sexy sectors (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker nor the brokerage analysts have much interest in long-term out-comes. As the investment bankers’ incentives are skewed to short-term pay-offs (bonuses), it’s inevitable that their time horizon should also be myopic. It’s not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly.
The delay between investment and new production means that supply changes are lumpy (i.e., the supply curve is not smooth, as portrayed in the economics textbooks) and prone to overshooting. In fact, the market instability created by lags between changes in supply and production has long been recognized by economists (it is known as the “cobweb effect”).
The capital cycle turns down as excess capacity becomes apparent and past demand forecasts are shown to have been overly optimistic. As profits collapse, management teams are changed, capital expenditure is slashed, and the industry starts to consolidate. The reduction in investment and contraction in industry supply paves the way for a recovery of profits. For an investor who understands the capital cycle this is the moment when a beaten down stock becomes potentially interesting. However, brokerage analysts and many investors operating with short time horizons generally fail to spot the turn in the cycle but obsess instead about near-term uncertainty.
There have been a litany of classic capital cycles in action since 2000: the technology bubble of the early 2000’s brought fantastic projections of future bandwidth capacity requirements, the shipbuilding industry (where it takes 3 years for a new ship to be built and delivered) into 2007-08, and then the petrochemical sector after 2011-14 in which operators thought the disconnect between oil and natural gas prices would be permanent. Each bore the hallmarks of a classic capital cycle: high prices boosting profitability, followed by rising investment and the arrival of new entrants, encouraged by overly optimistic demand forecasts; and the cycle turning once supply has increased and demand has disappointed.
But what explains the market inefficiency (Chancellor describes it the ‘capital cycle anomaly’) observed by these examples? Chancellor outlines four key factors that drive the anomaly: competition neglect, base rate neglect, narrow framing and extrapolation.
Competition neglect: When market participants respond to perceived increases in demand by increasing capacity in an industry, they fail to consider the impact of increasing supply on future returns. Competition neglect is particularly strong when firms receive delayed feedback about the consequences of their own decisions. This of course is most likely to occur when there is a significant time lag between the decision to increase supply and it actually occurring – several years if not decades in the case of a complex mine.
Base rate neglect: People tend not to take into account all available information when making a decision. Investors “focus on current (and projected) future profitability but ignore changes in the industry’s asset base from which returns are generated.” Managers make the mistake of assuming all actions stem from the her and now, when in actual fact we may be still experiencing the delayed impact of decisions made many years ago.
Narrow framing: It can be very tempting for the analyst or the manager to focus on all the cherished company, sector or country specific information that he or she has gathered to support the investment decision (known as the inside view). It can be difficult if not impossible for someone wedded to this approach to consider looking for examples elsewhere (the outside view):
An inside view considers a problem by focusing on the specific task and the information at hand, and predicts based on that unique set of inputs. This is the approach analysts most often use in their modeling, and indeed is common for all forms of planning. In contrast, an outside view considers the problem as an instance in a broader reference class. Rather than seeing the problem as unique, the outside view asks if there are similar situations that can provide useful calibration for modeling.
Extrapolation: As behavioural economists Kahneman and Tversky demonstrated we have a tendency to focus on the information placed in front of us (anchoring bias), and then mainly consider the immediate trend up to this point (recency bias):
Another common heuristic is the tendency to draw strong inferences from small samples. These weaknesses reinforce the propensity of investors to make linear forecasts, despite the fact that most economic activity is cyclical – there are trade cycles, credit cycles, liquidity cycles, real estate cycles, profit cycles, commodity cycles, venture capital cycles and, of course, industry capital cycles. Our inclination to extrapolate must be hard-wired.
Even if the canny investor has read this book and can see that high asset growth companies tend to underperform there may be a limit to what they can do to profit from it. The ‘limits to arbitrage’ as its known is described by Chancellor:
“fast-growing companies often have volatile share prices and going short volatility can be very expensive – as short-sellers of Internet and technology stocks discovered to their cost in the late 1990s. Furthermore, companies with strong asset growth often have large market capitalizations – as was the case with many of the telecoms companies in the 1990s and more recently with the global mining stocks. Investors who avoid buying high asset grow the stocks may be forced to take large bets against the benchmark.”
The tenets of capital cycle analysis
Most analysts and investors only spend their time considering the demand outlook for particular industries: whats the outlook for oil demand next year, when will commuters switch to electric cars? No one knows the answer to these questions. In contrast the outlook for the supply side is often flagged well in advance and from history the supply-side analyst will know with a reasonable degree of certainty what the lead time will be. According to Chancellor there are 8 tenets of capital cycle analysis:
Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply.
Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side.
The value/growth dichotomy is false. Companies in industries with a supportive supply side can justify high valuations.
Management’s capital allocation skills are paramount, and meet-ings with management often provide valuable insights.
Investment bankers drive the capital cycle, largely to the detriment of investors.
When policymakers interfere with the capital cycle, the market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle.
Generalists are better able to adopt the “outside view” necessary for capital cycle analysis.
Long-term investors are better suited to applying the capital cycle approach.
The ideal capital cycle opportunity
According to Chancellor the greatest opportunities for investment growth can occur is where conditions for cooperative behaviour can exist or may evolve, while avoiding those industries where this is unlikely to happen:
The ideal capital cycle opportunity for us has often been one in which a small number of large players evolve from a situation of excess competition and exert what is euphemistically called “pricing discipline.” Having a small number of players is important, since retaliation (say a price cut) is likely to be a more powerful weapon in the hands of a dominant price setter, although barriers to entry are also required to deter opportunistic entrants from taking advantage of any price umbrella.
Certain industries having evolved oligopolistic industry structures, have a potentially favourable capital cycle, and yet persist in generating poor returns. Partly, this is because “tit for tat” is only likely to work where the strategy can be properly discerned. In the auto industry, for example, there is too much noise in the everyday competitive battle. Carmakers have to decide not just on price, but also on specification, customer financing terms, new model launches, service and warranty terms etc., leading to the paradoxical conclusion that product differentiation can be an impediment to achieving supernormal returns. Contrast this with the steel or paper producer, whose product is relatively undifferentiated.
What are the characteristics to look out for in which companies can engage in cooperative behaviour? The perfect setting is a basic industry with few players, rational management, barriers to entry, a lack of exit barriers and non-complex rules of engagement (i.e. a low level of transaction frequency and product differentiation). According to Chancellor “the really juicy investment returns are to be found in industries which are evolving to this state.”
Why the long game works in investing
Competition for short term information is ferocious and tends to focus on the outlook for commodity demand or company earnings next quarter.
Long-term investors therefore seek answers with shelf life. What is relevant today may need to be relevant in ten years’ time if the investor is to continue owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period. These principally relate to capital allocation, which can be gleaned from examining the company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions and so forth.
There are a range of psychological forces stacked up against the long-term investor. In particular, there is strong social pressure from peers, colleagues and clients to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by. J.K. Galbraith observed that: “nothing is so admirable in politics as a short-term memory.” Why should politics have a monopoly on sloppy thinking? Which makes us think that long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information.
Chancellor is especially scathing of the research pumped out by investment banks and other institutions. However, as he notes since it tends to accelerate short term trends it can still be worth following as it can push asset prices to attractive levels for the long term investor focused on the capital cycle:
Following this research can be to the advantage of long term investors if it pushes prices to a level where its advantageous to buy (if prices have been pushed too low in the short term), or sell (if investors are too optimistic in the short term).
Overall I’d recommend Capital Returns: Investing Through The Capital Cycle to any investor who wants to get an edge on the competition. As always if you can think about things in a different way to everyone else (more supply focused, less demand), and lean towards time periods where there is less competition (the long term) then there is much greater potential for profits.
2020 marks the 300-year anniversary of England’s most notorious speculative mania, and the first of many economic and financial crisis.
During the first half of 1720, the price of South Sea Company stock rose eight-fold reaching a peak in early July. Restrictions on the supply of shares, coupled with surging credit availability fueled the share buying bonanza. The fear of missing out on riches drove the share price even higher.
At its peak, the Company’s market worth was around twice the total value of all the land in England. Those charged with running the Company and connected to it in government knew they had a problem: they had to keep fueling the boom or fear that it would fall around their ears and potentially crash the economy.
But that confidence act could only last so long. Eventually it began to crumble, and with it the share price. As the bubble collapsed during late summer and into September 1720 financial distress rippled out through the financial centres of Europe — from England through Holland and onto northern Italy.
The South Sea bubble follows the same distinct patterns shown in the bubble profile illustrated below. As the subsequent 300 years demonstrated: markets may change, but people do not. They forget the lessons of the past and shout “This time is different”. It never is.
The South Sea Bubble of 1720 had the same essential ingredients that make investing so challenging today: geopolitical turmoil, rapid globalisation, novel financial products, innovative business models, new communication technologies, misinformation and an abundance of tricksters ready to prey on the unwary and gullible.
As so often happens with notorious stories of financial ruin there is much more to the story. This article outlines the history of the South Sea Bubble, much of which you might know already but there will also be some of the hidden stories that will be much less familiar. But first, in order to understand the crisis that was to unfold you first need to picture the preceding decade.
The Stealth Phase
The South Sea Company exploits the shift in global trade
The South Sea Company was a British joint-stock company founded in 1711. Daniel Defoe, the author of Robinson Crusoe was a director of the Company and had persuaded the British government to setup a company to trade with the South Seas (now referred to as the islands of the south Pacific Ocean) and South America.
In return for taking on a proportion of the British national debt (effectively converting debt to equity in the Company), the government granted the South Sea Company the monopoly on all trade with the South Seas. Unknown at the time it was the beginning of the path that was to lead to a major crisis less than a decade later.
At the time the Company was created, most of South America was controlled by the Spanish and the Portuguese, and so there was little prospect of the British capturing much of that trade. However, after the end of the War of the Spanish Succession, as part of the provisions of the Treaty of Utrecht (1713), the Spanish granted the monopoly contract (the Asiento) to the South Sea Company.
The slave trade
Under the terms of the agreement the South Sea Company was contracted to import 4,800 piezas de Indias annually. A pieza was the value of a healthy male or female slave between 15 and 25 years of age. Slaves between 25 and 35, and between 8 and 15 years were valued at 2/3 peça. Slaves outside this age range and those infirm attracted a lower value. However, the terms and conditions offered an exclusion to account for the risk that shipwrecks and mortality during the crossing would affect the supply of slaves.
As well as the South Sea Company the French Mississippi Company was also set up to exploit trade with the Americas. The Mississippi Company owned the rights to develop the Louisiana territory. As with the French, the British also sought to challenge the dominant, but weakening control that Spain wielded over the Atlantic trade.
The slave trade was seen as a key route by which the British could capture some of that burgeoning trade. Often overlooked amid the mania that was to follow, the actual business of the Company involved transporting African slaves to work. The incumbent Spanish and Portuguese colonialists were suffering from a shortage of labour to mine gold, silver and other commodities— slaves were a must have.
The South Sea Company is estimated to have transported around 34,000 African slaves during the period when it was in existence. Tragically, many of the slaves transported either died during the crossing or after they were put to work. Around 15% of slaves are estimated to have died during the voyage across the Atlantic ocean — some 5,000 men, women and children. This was comparable to the mortality losses incurred by other slave operators and shows that, at least in the gruesome business metrics of the day, the Company did have some expertise in the area.
The smart money
Starting in the late 1670’s bookseller Thomas Guy began purchasing sea-man pay tickets at a large discount (when sailors returned from abroad they couldn’t always get hold of their salary and so many sailors sold that right onto others in return for some quick cash). In 1711 these tickets became part of the short-term floating national debt and were converted into shares of the South Sea Company. Guy had effectively been picking up lottery tickets for decades, and so through luck he had effectively become a major shareholder in the Company.
The Awareness Phase
A risky business
The maritime trade involved substantial risks: the voyage could be intercepted by pirates eager to capture the precious metals, ships could be shipwrecked in storms and traders faced the prospect of losing hundreds of their slaves to disease.
Maritime insurance was an essential institution for risk sharing. Prior to 1720 maritime trade was insured by matching voyages with individual insurers or syndicates. In 1720 England allowed the first joint-stock insurance companies to raise capital by issuing shares. In turn this enabled a much larger capital base to be made available for underwriting.
Financial innovation became the roots of the mania
The early 18th Century was a period of dramatic innovation in government finance. One of the most innovative financial thinkers of his time, Scottish economist, John Law wanted to boost economic growth by introducing a national paper currency not backed by gold.
Trudging around the capitals of Europe he was initially unsuccessful in persuading heads of crown to see the merits of his plan. Eventually, in the spring of 1717 he finally persuaded the French Regent, Philippe Duke of Orleans to allow him to start implementing his plans in France.
Law built up a huge conglomerate fully backed by the state. It was known as the Compagnie des Indes, but known to posterity as the Mississippi Company. As well as holding the royal patent to colonise the territory of Louisiana it also controlled most of the French currency via the Banque Royale. A succession of funding rounds accompanied by a surge in paper currency resulted in an explosive boom surging into life across the French economy.
By 1719 the directors of the South Sea Company looked eagerly across the Channel and wished to imitate the system that John Law had established in France with the Mississippi Company. Not because they were eager to help the British economy. No, they were rubbing their hands at the potential for massive wealth.
Whereas John Law was trying to create an open credit pump that would energise the French economy, John Blunt of the South Sea Company was deliberately trying to create a closed circuit that would only support the price of South Sea stock.
In 1719 the Company directors made a proposal to the British government for it to take on the entire national debt. On 12th April, 1720 the offer was accepted. As so often happens in the world of financial engineering, an innovative idea was taken to the extreme.
But why would the French and British governments be so eager to adopt such new fanged financial engineering anyway? The roots of the financial innovation was a direct result of the massive debts incurred by wars between France and England culminating in the War of the Spanish Succession (1701–14). Both countries economies were spluttering under the weight of all of that debt.
The institutional investor
Richard Cantillon was an Irish-French economist who was an early investor in the Mississippi Company. As we’ll see later he spotted the flaws in the model and cashed out too early, albeit with a massive fortune. Cantillon sold his investment in the Mississippi Company at 2500 even though it would quadruple before finally peaking four months later.
Banished from France by John Law he spotted the opportunity to make even more money by investing in the South Sea Company. Again, he profited handsomely from it but as with his earlier adventures in France sold out too early. One can only imagine the pain he would have felt from his clients as he urged them to sell out, only to see the price of South Sea stock triple a few weeks later.
The Mania Phase
The directors immediately tried to inflate the price of Company stock by any means possible, but more often through the circulation of stories about the fantastical wealth that awaited investors.
The book Robinson Crusoe tells the tale of a young and impulsive Englishman who leaves his hometown, defying his parents wishes in order to seek excitement and adventure on the high seas. Written by Daniel Defoe it was published on 25th April 1719 and helped feed the mania as people speculated on the potential for riches from the South Seas. Daniel Defoe was a director of the South Sea Company and had helped persuade the British government to setup a company to trade with the region in 1711.
But in early 1720 England was again at war with Spain and so the Company’s trading monopoly was basically worthless. The Company’s entire income derived from the fixed interest payments it was receiving from holding government debt.
When the British government agreed the terms of the monopoly agreement with the South Sea Company directors they failed to see how it could be a vehicle for fraud. First, the agreement failed to place any statutory limit on the level to which the share price would be allowed to rise, while also making no provision for profit share withe state. Second, it failed to define the precise terms to be offered to annuitants for the conversion of their holdings into South Sea stock. These two fundamental oversights — whether intentional or not — provided the ideal cover for the directors to boost the share price for their own ends.
The directors fueled the share buying boom by deliberately whetting investors appetite (tales of vast riches in the South Sea’s) but also through restricting the supply of shares. They did this by issuing further rounds of share issues but then re-channeling this money back to shareholders in the form of loans. in order to buy even more shares. The loans restricted the supply of shares and increased the velocity at which they changed hands, in turn driving the share price higher and higher.
The share price of South Sea Company stock stood at £128.50 in January 1720, proceeding to climb to £350 in March. It then went into overdrive. The stock price quickly rose to £550 in May and then to £890 in June.
A number of other British companies also saw their share prices explode higher during the early part of 1720. The Royal African Company (RAC) which, like the South Sea Company, was engaged in the Atlantic slave trade rose by a similar multiple.
The two marine insurance companies, Royal Exchange Assurance and London Assurance rose to much higher multiples. By contrast, the two banks, Bank of England and Million Bank appreciated by much less.
Nearly 200 “bubble companies” were launched at the time, hoping to cash in on the speculative mania that was gripping the South Sea Company. Some of these ventures actually involved tapping investors for money for apparently worthy business ideas — improving the Greenland fishery or importing walnut trees from Virginia.
Most however were shady ventures looking to extract as much money from gullible investors in the shortest time possible. The most famous of which had this remarkable line in its prospectus, “a company for carrying out an undertaking of great advantage, but nobody to know what it is.” Another was formed with the purpose of building a “wheel of perpetual motion”.
These scams were bad for business. The directors of the South Sea Company were wary that these dodgy schemes would detract from the speculative mania that was fueling the price of South Sea stock. They also didn’t want money going anywhere else than into the Company.
The public are drawn in by the media revolution
The media was undergoing a revolution. Hundreds of publications appeared serving every possible niche. It was in the coffee houses of London where the merits of the stories were debated and financial deals were done.
Many of the famous literary figures from that period, such as Daniel Defoe, Jonathan Swift, Richard Steele and Alexander Pope, were involved in the South Sea Bubble, either as investors or as we saw earlier with Defoe, as propagandists writing for the slew of publications that caught coffee house drinkers attention.
Defoe was a prolific writer and an able propagandist. From the beginning of 1720 he ran a newspaper called The Commentator. He is reported to have compared the South Sea Company to John Law’s Mississippi Company as like “a real Beauty and a panted Whore”, while also condemning the unworthy imitators.
A passion for gambling meant the public quickly got taken in by the potential for huge gains. The desire to invest in any project, no matter how extreme, or even whether it was genuine or bogus reached manic proportions. The Commentator newspaper (run by Daniel Defoe) described it as:
“Tis plain, the Novelty of things at this time has its beginnings in the new fashioned frenzy of men’s minds, I mean in their hunting after money which is done with such rage in their avarice that suffers no restraint and that knows no bounds.”
The Blow off Phase
The bubble’s final act
Over on the other side of The Channel, the price of Mississippi Company shares rose by a factor of 10 in 1719 and into early 1720 before eventually bursting later in the spring. In contrast to England where there had been countless copycat schemes, the monolithic Mississippi Company left little in the way of space for other schemes. For investors exposed to South Sea Company stock the collapse of the Mississippi stock should have been a warning sign of things to come.
Under pressure from the directors, the British government passed the so-called “Bubble Act” on the 11th June 1720. This required all joint-stock companies to hold a royal charter — in one strike eliminating much of the competition. The price of South Sea stock surged higher — reaching a peak of £1,050 in early July.
As prices spiraled higher this drew in even more speculators, including some that missed out on earlier increases. There was a real fear of missing out as one banker commented:
“Though I believe you had been in town you would scarce have had the courage to have ventured, but when the rest of the world are mad we must imitate them in some measure.”
While the price of RAC stock peaked around the same date as South Sea, the stock price of the banks and maritime insurance companies marched on higher through the summer reaching a peak in late August. For the canny investor who managed to cash out at the top of the market, an investment in London Assurance at the start of 1720 would have delivered a 13 X return.
After a period of relative calm for South Sea stock during the summer, things began to unwind, slowly at first and then quicker and quicker. The final death nail for the South Sea bubble was the writ, issued by John Blunt on the 18th August in which he accused four companies of misusing their charters. Rather than restoring faith in the upward trajectory of South Sea shares it undermined confidence in all shares trading in London. South Sea shares fell by 60% to £400 by mid-September and then to £124 by December, the same price they had been at the start of that fateful year.
The Dutch Windhandel (literally wind trade)
Amsterdam was a burgeoning financial centre in the early 18th Century. With attention focused on the South Sea and Mississippi bubble people forget that the Netherlands also had its own bubble.
The Netherlands also incurred significant debts as a result of the War of the Spanish Succession. Unlike France or England it didn’t import and introduce the same degree of financial innovation. The price of West Indies Company shares rose dramatically in 1720 before slumping to a fraction of their peak value by the end of October.
In addition to multiple share offerings of West Indies Company shares there was also an attempt to launch an insurance firm (Stad Rotterdam) to compete with the British maritime insurance companies.
Within weeks of Stad Rotterdam’s flotation at least 30 other Dutch companies floated fearing that if they delayed they would miss the wave of speculative fervor. Like their counterparts in England these businesses had multiple lines of business activities, as well as maritime insurance. Accounts from the time described the sudden burst of speculation as “Windhandel” — trade in wind.
What goes up
Sir Isaac Newton is the name most famously associated with the South Sea crisis. When asked about South Sea stock in the spring of 1720, Newton famously declared that he “could calculate the motions of the heavenly stars, but not the madness of people”. Newton of course is known as the physicist responsible for discovering gravity.
Less well known is that Newton was also the warden of the Royal Mint. Newton should have been in a privileged position to preempt movements in the market. Unfortunately for him he lost a great deal of money in the bubble — possibly as much as $20 million in current terms — having sold his South Sea stock in the spring of 1720, later re-entering the market and investing his entire fortune in the Company just before the bubble peaked.
Thomas Guy eventually sold his entire South Sea holding (thought to be about 5 times larger than Newton’s) around the time the acclaimed physicist was buying back into the market. Unfortunately, Guy also sold some call options betting that the market would now fall. He was a month too early. The price of South Sea Company stock more than doubled during June resulting in significant losses, but still dwarfed by the profits from his long side bet. Guy later used his enormous profits to establish the London hospital that still bears his name.
The Cantillon effect
Richard Cantillon the Irish-French economist who invested in the Mississippi, the South Sea Company and the Windhandel. He was also the biggest critic of the System John Law introduced in France and later copied in England, closing his positions too early but still amassing a fortune. But what were his concerns? First, Cantillon questioned Law’s basic economic premise. Money printing brought no lasting benefits, in his view:
“An abundance of fictitious and imaginary money causes the same disadvantage as an increase of real money in circulation, by raising the price of land and labour, or by making works and manufactures more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first sign of discredit and precipitates disorder.”
Secondly, Cantillon argued that although Law’s monetary experiment might temporarily reduce interest rates and incite speculation, the newly printed notes didn’t actually enter into the real economy but instead would just encourage corruption and inefficiency:
“The excess banknotes, made and used on these occasions, do not upset the circulation, because they are used for the buying and selling of stock they do not serve for household expenses and are not changed for silver.”
Finally, Cantillon observed that the real danger arises when an excess issuance of bank notes led to a loss of confidence in money:
“If some panic or unforeseen crisis drove the holders to demand silver from the Bank the bomb would burst and it would be seen that these are dangerous operations,”
Above all, the financial crisis resulting from the collapse of the Mississippi and South Sea Company shows that when central banks inflate bubbles there is no painless “exit” — Law’s Banque Royale had to continue printing money to sustain the bubble.
Cantillon’s general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect”. In the 18th century the closer you were to the King and the wealthy, the more you benefited — from being able to purchase financial assets at low prices and then see those prices inflate. Only later would the effects appear elsewhere, and the further away you were, the more you were harmed — perhaps through higher food prices or lower relative wages. Money, in other words, is not neutral.
The collapse of the South Sea bubble is widely believed to have produced a severe economic downturn in England. Yet records show only a small increase in bankruptcies and a slight decline in overseas trade. France was to suffer a much graver economic fallout. The deep seated distrust of banks after the crisis meant it would be impossible to formalise French governement borrowing for the rest of the 18th Century.
Despite the bust the South Sea Company continued to trade in slaves after the collapse. Indeed, some of the largest slave cargoes actually occurred after the bubble burst. Apart from a stoppage due to renewed fighting between England and Spain in 1726 the company continued to operate unaffected until 1731. After that the trade continued on a minor scale until the Asiento expired in 1750.
By the end of 1720 stock prices in three major European countries (England, France and the Netherlands) had risen seven-fold and then collapsed almost as rapidly. The widespread use of new equity issues to fund enterprise disappeared from Western Europe for several decades and didn’t return until the same levels until the 19th Century. The fact that London Assurance, Royal Exchange Assurance and Stad Rotterdam survived until the modern era proved the long-term viability of incorporated insurance companies.
Ultimately the South Sea bubble offers remains a valuable history lesson for investors 300 years later: the power of credit to pump prime a speculative bubble, the fear of missing out on riches and looking stupid by not dancing while the music is still playing, the swindlers eager to lure the unsuspecting and the emergence of fraud as the bubble cracks.
The signs were there for anyone that cared to look.