A Short History of Financial Euphoria - lessons for a value investor

Those who learn the lessons of history are saved the doom of repeating its mistakes; for history repeats itself. And as John Kenneth Galbraith lays out in entertaining detail in his magnificent book, financial history is no different. The one constant which can be taken for granted in the free-enterprise economy is that speculative insanity and its associated financial devastation will reliably recur. From the Dutch Tulipomania and John Law’s infamous Banque Royale scheme of the 15^th century, to the Great Crash of 1929 and the dot com bubble of late the 19^th century, to the more recent devastation heaped by the subprime mortgage crisis and the resulting credit crunch, and the numerous episodes of financial insanity in between, financial history has repeated itself time and again in reliable fashion. But the value of John Kenneth Galbraith’s book comes not from its fascinating description of all the major episodes of insanity, from the Tulipomania to the October 1980 stock market crash, and the entertaining stories from each episode. The value of his work comes from his analysis of the features common to these episodes and the things that signal their certain return. Knowing this has great practical value for an investor – firstly, in terms of being able to preserve ones wealth, and secondly, in terms of being able to profit from the insanity of the markets. I must note here that this is by no means easy and almost everyone is prone to disillusion and insanity.

The common features of financial euphoria (and the ones which ensure their recurrence in the future)

1.      Some artefact or development, new and desirable, captures the financial mind. For examples: Tulips in Holland (Tulipomania of the 1630s), Gold in Louisiana (John Law and Banque Royale in 1700s), the untold riches of Americas which The South Sea Company was all set to exploit in the 1700s, the stock market which was always set to raise in the late 1920s, the enormous economic lift to be provided by the Regan administration in the 1980s, the great dotcom companies which signalled the arrival of the new digital economy of the late 1990s, and the amazing power of securitisation to make risk disappear in the mid-2000s. By the way, Trumponomics could be the new and desirable development in today’s market.

2.       The price of the object of speculation goes up; this increase in price and prospect attracts new buyers and ensures a further increase in price; more are attracted and the increase continues. This process is only clearly evident after the fact – i.e., after the doom.

3.       The basic attributes of the participants in such episodes of financial insanity take two forms:

a.       Those who wholeheartedly believe in the new artefact or development and its price-enhancing characteristics; and,

b.       Those who believe that they have the ability to perceive the speculative mood of the times and profit from it by riding the momentum and somehow magically get out just before the crash.

4.       Both the price and the participants are sustained by their vested interests. They are experiencing an increase in wealth and no one wishes to believe that this is undeserved; they all wish to think that it is the result of their own superior insight or intuition. To directly quote John K Galbraith – “Speculation buys up, in a very practical way, the intelligence of those involved.” This is particularly true of the first group of participants discussed above.

5.       The other common feature is the condemnation heaped on doubters and dissenters. There is a general tendency in such times to ignore the sceptics and suspend disbelief.

6.       The financial world also suffers from brevity of memory, a feature which ensures that it cannot learn the lessons of history. Again, I must quote John K Galbraith on this – “Let it be emphasized once more, and specially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”

7.      The public and the market believes that intelligence and wisdom are closely associated with possession of wealth and/or control of money. In consequence, possession or control of wealth creates a lack of self-scrutiny and the general belief in one’s superiority. Again to quote John K Galbraith’s rule – “Financial genius is before the fall.”

8.     Almost all episodes of financial insanity have involved debt in some fashion; debt that became dangerously out of scale in relation to the underlying means of payment. Again, there is a tendency by participants to view each episode as being unique, a new normal, where debt take a form which is considered perfectly reasonable if not innovative and genius. As John K Galbraith notes – “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets”. And in episodes of financial insanity, the scale of this debt goes awry.

9.      Built into each episode of financial euphoria is its eventual fall. It doesn’t matter what triggers this fall – however much the cause of the fall gets debated – what matters is that it always comes and comes with a bang. At some point in the cycle, the participants who had been riding the upward wave decide to sell; and those who had up until then believed that the increase was forever get their confidence shaken and also decide to sell. When everyone decides to sell, a collapse ensues. As John K Galbraith notes – “The rule, supported by experience of centuries: the speculative episode always ends not with a whimper but with a bang.”

10.   After every collapse, anger and recrimination ensues. This always focuses on individuals who were previously admired for their financial ingenuity. Some end up in jail and others in financial obscurity. New regulations are brought in to tackle the financial excesses of the times. But what is always forgotten is the speculation itself or the insane optimism behind it. To quote John K Galbraith – “Those who are involved never wish to attribute stupidity to themselves”.

To avoid being caught up in an episode of financial insanity is no easy task. The crowd’s force is a strong pull and it is by no means easy to sit on the side watching the masses get rich. At the height of financial euphoria it is easy to buy into the euphoric belief, especially when it seems to be supported by superior financial opinion at all fronts. The only remedy, as John K Galbraith states, is an enhanced skepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.

Strong adherence to the philosophy of value investing comes to the rescue. A true value investor must never be caught up in episodes of financial euphoria. At its core, value investing requires a contrarian mindset and a long term investment horizon; the first quality inspires skepticism and the second quality inspires respect for the lessons of history. By always being disciplined; carefully measuring intrinsic value; constantly challenging and updating ones measure; and only buying at a discount to ones measure of intrinsic value, a value investor can not only preserve his wealth but also look to profit from episodes of financial euphoria.