Historical Bubbles: Explores the South Sea Bubble, Railway Mania, and Japan’s 1980s asset bubble, emphasizing recurring patterns of speculation and herd behavior.
Government Influence: Highlights how policy support, implicit guarantees, and regulatory lapses amplified speculative excess and delayed market discipline.
Leverage and Momentum: Details how margin financing and rising prices created self-reinforcing loops that unraveled rapidly once momentum stalled.
Japan Case Study: Covers deregulation, financial engineering, property collateralization, and BOJ tightening that triggered a prolonged downturn and multi-decade recovery.
Red Flags: Notes smart money exiting near peaks, proliferation of dubious promotions, and frauds exposed only after the bust.
Investor Lessons: Urges discipline, focus on fundamentals, skepticism of “this time is different,” and avoiding late-stage, leveraged speculation.
Transcript
(00:00) Probably the most important one is the belief that the market risk or the downside can be eliminated so infinite prices can be paid. Throughout the late 1980s, skeptics were told that the government would not allow share prices to fall and that the banks and brokerages were too big to fail. (00:19) When the bubble collapsed a few years later, this deception was exposed. We saw a similar theme in the South Sea bubble when British shareholders believed that the government backing would protect them from losses. Most importantly, it's critical not to let your emotions overtake your decision-making when you find yourself caught in the bubble. Before we dive into the video, if you've been enjoying the show, be sure to click the subscribe button below so you never miss an episode. It's a free and easy way to support us, and we'd really appreciate it. Thank you so much. On (00:53) today's episode, we'll be outlining three of the biggest bubbles in financial history. the 1720 South Sea bubble, the railway mania of 1845, and the Japanese stock market and property bubble of 1989. They say that history doesn't repeat itself, but it often rhymes. And that is the theme that plays right into all three of these bubbles. (01:15) Each displayed unprecedented levels of greed, speculative excess, and the belief that fundamentals did not matter for investors. I believe that studying the financial bubbles of the past is practically essential to ensuring that we ourselves don't fall prey to one during our investing lifetime. (01:33) Bubbles remind me a bit about house fires. We assume that it's something that only happens to other people. It's easy for us as investors to become complacent and assume that the good times of the past will almost certainly continue. This kind of thinking led investors in Japan, for example, to lose tremendous amounts of wealth in a matter of a few years. (01:54) As John Miner Keen said, the market can stay irrational longer than you can stay solvent. So sometimes bubbles can last much longer than we'd probably expect. In studying these three historic bubbles, I picked up Edward Chancellor's book, Devil Take the Heindmost, which was a sobering reminder that our mistakes as humans have repeated themselves time and time again throughout history. So, with that, I hope you enjoyed today's episode on history's most historic market bubbles. (02:28) Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, PlayFink. Welcome to the Investors Podcast. (02:58) I'm your host, Clayfink, and today we'll be discussing Edward Chancellor's book, Devil Take the Heinmost. This book is one of the best books ever written about speculation, bubbles, and why investors keep repeating the same mistakes across centuries. Through these historic events, Chancellor shares the key factors at play that helped fuel each bubble and how exactly investors got led astray. (03:20) What's really interesting to me about historic bubbles is that they just tend to repeat themselves and show up in these different forms. And Chancellor is a perfect person to cover such examples as he's practically a walking library. He's read practically everything on the subject and clearly understands investor psychology and what is really driving human behavior. (03:48) I think this is a really important topic to cover on the show because learning about and understanding past bubbles can be one of our best defenses against getting caught up in one ourselves. When you consider that bubbles can lead people to losing say 70 to 80% of their capital in the more extreme examples, the payoff of avoiding such bubbles can be extraordinary over the long run. (04:12) So, I hope this episode will be a useful tool for you to avoid getting caught up in the bubbles we see today or in the future. One of the things that is interesting to me about investing is that almost nothing about it is black or white. So much of investing is subjective. While it can be easy to judge somebody as a speculator, I think that all of us to some degree actually are speculators. (04:35) Let's say if you purchase the S&P 500 because you believe that markets are efficient and you want broad diversification, you're still speculating that US companies will be more profitable in the future than they are today and that investors will continue to want to pay up for the companies in that index. (04:54) If you're starting a local coffee shop in your city, you're speculating that the economy in that city will continue as usual. For an economy to thrive, you need entrepreneurs who are willing to take these risks and dare I say speculate with their own self-interest in mind. (05:13) For example, with the expansion of the internet in the 1990s, it would have been impossible for many companies to raise money if there weren't people who believed in the possibility that that new technology could bring. If the economy was full of investors who were totally riskaverse, then it would be difficult for society to progress and to build out new ways of doing things. But I think that speculation is something that lies a bit on a spectrum. (05:34) And the case studies outlined in Chancellor's book are the most extreme examples of speculation. So the goal is to recognize what extreme speculation looks like and learn to largely avoid such activities. The term speculation first developed economic meaning in the late 18th century. (05:54) Scottish moral philosopher and economist Adam Smith, he defined a speculator by his readiness to pursue short-term opportunities for profit. His investments are fluid whereas those of the conventional businessman are more or less fixed. (06:13) This train of thought was reiterated by John Miner Keynes who described the term enterprise as the activity of forecasting the perspective yield of assets over their whole life. In contrast to speculation which he called the activity of forecasting the psychology of the market. Speculation is conventionally defined as an attempt to profit from changes in the market price. Now this reminds me a bit of the idea in value investing of just thinking like an owner. (06:44) When my grandfather, for example, purchased farmland here in Nebraska in the 1970s, he purchased the land as if he was going to own it forever and pass that land down to his children, which is really exactly what he did. Whereas, if you're a speculator, you might purchase the land this year with the hopes that someone else is going to buy it for more next year. So, it's this active versus passive approach. (07:03) If you truly think like an owner, you really shouldn't care all that much about what the share price does over the next year or two. Turning back to the idea of my grandfather purchasing land, if I had asked him how he would react if the value of the land he purchased fell by 50%. (07:23) He probably wouldn't care that much because he purchased the land for the crops and the income that it would produce for the years ahead. the quoted price of the land actually made no difference to him. But I think for a lot of people when they see a stock that they own decline by 50%, many would consider selling that position because they were interested in eventually selling that stock for a gain. (07:47) Fred Schwed stated, "Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort which should be successful to prevent a lot of money becoming a little end quote. According to modern market theory which states that markets are efficient, share prices would reflect their underlying intrinsic values. (08:09) In this theoretical world, the amount of speculation would be very little. In the world of efficient markets, there are no animal spirits, no crowd instincts, no emotions of greed or fear, no trend following speculators, and no irrational speculative bubbles. (08:28) The case studies outlined in the book are anything of this sort, as they are history's most pronounced examples of vast speculation among the crowds. What's sort of funny about this is that when many everyday people hear about the stock market or really any financial concept for that matter, they just don't find it to be that interesting. (08:49) But I personally find some of these topics to be incredibly fascinating, including the study of bubbles. The reason is that bubbles aren't really about numbers or spreadsheets. They're about human behavior, storytelling, and how people react when their emotions are playing a pivotal role in their decision-making. When you study bubbles, you're really studying how otherwise rational people can trick themselves into becoming delusional. (09:16) So, let's transition here to discuss the first case study we'll outline today, which is the South Sea bubble. In the year 1711 in London, England, the South Sea Company was established to take over 10 million pounds of government debt, which it guaranteed to convert into its own shares. In a sense, the British national debt was being privatized. In exchange, the South Sea Company received an annual interest payment from the government and the monopoly of trade with the Spanish colonies in South America. (09:45) Although the monopoly of trade seemed promising, the South Sea Company acted more like a financial institution as the trading activities always showed a loss. In 1719, it took over a further 1.7 million pounds of government debt in the form of annuities, which it then converted into South Seas stock. By absorbing this debt, the company gained a guaranteed stream of interest payments from the government, which was far more reliable than the uncertain trade profits. (10:14) Now, the issue the South Sea company had was that there were all of these holders of government debt who were receiving a safe and reliable income stream. You can imagine that if you purchased government bonds that paid say 5% interest, you would only be willing to part ways with that consistent income if what you were getting in exchange was much better or more enticing. (10:39) The company made this trade attractive by pushing up its share price. So, the shares the debt holders received were worth more on the market than the safe debt that they parted ways with. In simple terms, people traded a guaranteed but boring income for shares that looked immediately more valuable and easy to sell for a profit. (10:59) Chancellor referred to this as the South Sea scheme, as all parties had an interest in continuing to inflate the South Sea share price. The company benefited because a higher share price meant that it could issue fewer shares to take over the same amount of government debt, leaving extra cash as profit. (11:19) The government benefited because the scheme reduced its interest payments and worked best politically if people eagerly accepted it. And the debt holders and other investors benefited because a higher share price made the shares they received or already owned look more valuable and easier to sell for a gain. In 1720, the price of shares swiftly began to rise from 128 at the start of the year to 187 in February to over 300 not too long after. (11:48) Meanwhile, several members of the government were secretly handed shares of the company by its directors. The shares were issued at a premium to the market price and no deposit was required. Upon receiving the shares, several government officials now had an interest in keeping the share price rising regardless of the cost to the nation. (12:07) The conundrum with this scheme, which sort of made my head spin when I was reading through it because it just defies all logic, it's that it appeared that all of the parties benefited from the continuing rise in share price. And this made it difficult for anyone to determine a rational estimate of what the shares were worth. (12:28) So, some argued that as the share prices rose higher, the more they were actually worth. Those who were more financially savvy and were able to keep their emotions under control, they understood that this just defied all economic logic. Usually, if something sounds too good to be true, it probably is. One economist explained that people who bought surplus South Sea stock at its elevated price must be deprived of all common sense and understanding since they would be giving their money away to the original stockholders and annuitants. The economist clearly saw that the scheme was dependent on convincing the annuitants into (13:04) converting their securities into shares and for more investors to purchase those shares. The government only committed to 5% interest payments and the trading prospects of the company were not good. So the potential for loss for investors was substantial given the prices that investors were paying. The South company was led by a man named John Blunt. (13:26) In running the company, Blunt had one primary goal and that was to keep the stock price rising. In Chancellor's words, he looked for a thousand ways to attain this end. Blunt built up public enthusiasm for the stock and offered the chance for the public to invest on multiple occasions. (13:47) For example, in April of 1720, 2 million pounds of South Sea stock was offered to the public at 300 a share and the subscription sold out in less than an hour. This price was three times the notional value. This would be like buying a ticket to a concert for $150 where the ticket price's face value was $50. And given the public's enthusiasm around the concert and the scarcity of the tickets, you expected to eventually sell your ticket for more than you purchased it. (14:20) The catch is that instead of this ticket gaining you entry to go see the Beatles is to see an artist that played on Tuesday nights at your local pub. But this still doesn't tell the whole story here. Blunt was also intentional about not being fully transparent with investors. With the issuing of new shares, the conversion of annuities hadn't taken place yet, which made it impossible for anyone to confidently determine the value of the company. (14:45) In Blunt's view, the more confusion, the better. One of the ways that Blunt made the share offers more attractive to the public was by allowing them to purchase shares on leverage. Only a 20% deposit was required and the remainder would be paid over the following 16 months. So in essence, the company was providing loans to investors. (15:08) This of course helped increase the stock price as speculators were able to purchase more shares than they otherwise could and the supply of shares available for sale was reduced as many shares were held by the company on margin. Once the debt holders were able to convert their debt instrument to Southeast shares, the vast majority of them did so. (15:29) Holders of government debt who rushed blindly into shares included some of the highest profile firms including the Bank of England and Million Bank. Even King George was in on the action and went against others advice of selling shares during the mania and instead wanted to purchase more shares in the new subscriptions issuance. In the end, 31 million pounds of debt was converted with a nominal value of just 30% of that amount. (15:54) As the bubble was inflating, several smart investors took notice that it just couldn't last forever. So, they started selling their shares. English mathematician and physicist Sir Isaac Newton started selling his shares and economist Richard Canelon sold his shares as well with the anticipation of a collapse. (16:15) While it's impossible to precisely predict when a bubble will end, the departure of more experienced investors can be a signal that the peak is nearing. Adam Anderson, a former cashier of the Sousy Company, later claimed that many purchasers of shares bought them knowing that their long-term prospects were hopeless, and they aimed to get rid of them in a crowded alley to others more credulous than themselves. (16:40) The rise of South Seas shares led to a number of other examples of investor irrationality, such as bubble companies. In the months following the South Seas scheme, new stock promotions were advertised in the newspaper to lure in investors and benefit from the speculative market environment. (17:00) Only four of the 190 bubble companies ended up being legitimate enterprises with a real underlying business underneath. The rest just wanted to prey on investors greed. But these bubble companies didn't necessarily take away the continued speculation in the South Sea company as a new issue went for 1,000 a share and it was sold out in a few hours. (17:25) The orchestrators of the scheme had become infatuated with their own success, increasing the amount they wanted to raise, increasing the share price they would issue at, and lowering the deposit required to purchase shares on leverage. And this is a common theme I see amongst many bubbles that end up crashing. Whether it's the South Sea company, Enron, Long-Term Capital Management, or Bernie Maidoff, the people orchestrating the scheme get in over their heads and have too much arrogance, overestimating their ability to keep the party going. Blunt enjoyed the success that came from the South Seas scheme. When the shares (17:56) were at their height, he sold out and started to buy land with his profits. He even sold more shares than he owned, securing the knowledge that the time would soon come when he could buy them back at a cheaper price. If the scheme had been reasonably executed from the start with a fixed value for the conversion of annuities into shares, and if Blunt had been content with a fairly priced stock, then the conversion would have proven to be useful to all parties. (18:23) But Blunt's reckless ambition destroyed any chance of success it might have had. Now, when you hear that the Sousi company took over 30 million pounds of debt, you might not think that's a big amount, but to put this into perspective, the amount of debt they took over equated to about 80% of the country's GDP at the time. So, this was just an enormous scheme relative to the size of the economy. (18:48) The level of speculation had tangible impacts on the economy as some would quit work to focus on speculating, spend their time chasing quick riches, and on the other side see their wealth evaporate rather quickly. Bubbles of this size usually send ripple effects throughout the entire economy. (19:07) Many who made fortunes go out and flaunt their newfound wealth, buying houses, furniture, and gold watches. By August of 1720, the frenzy had reached its peak. The South Sea Company launched its fourth and final subscription and once again demand was overwhelming. Huge crowds of speculators packed into the narrow streets around the South Sea House, pressing forward with cash and promises in hand. (19:35) In a matter of hours, the entire issue, which was 10,000 shares priced at £1,000 each, was completely sold out. By this point, shares had increased more than eight times in under 6 months. However, directors of the South Sea Company were fearful that competition from the bubble companies would spoil the party. New bubble companies were appearing almost daily, which would inevitably steal some of their firepower. (20:02) As a result, they attempted to monopolize the speculative enthusiasm by making the establishment of such companies illegal without government permission. Ironically, the government crackdown on bubble companies led to their share prices collapsing, which led to margin calls for investors who own shares of the South Sea company. I think this is a big lesson that leverage cuts both ways. (20:26) The South Sea company had exhausted all means of sustaining upward momentum in the share price and without that momentum, the decline was inevitable. Within a couple of weeks, the share price fell below 600. And already by that time, the company's directors gave up hope on further inflating the bubble and started selling their mortgage shares. (20:47) Swordblade Bank, which acted as the banker to the South Sea Company and had made extensive loans against the stock, they ended up failing. By the end of September, the share price was below 200, representing a 75% decline in just 4 weeks. The violence of the collapse took most people by surprise, even if many speculators knew that the high share price was not sustainable over the long run. (21:12) They assumed that they would be able to carry on the scheme for longer. One speculator reflected and shared how many had this dream about the newfound wealth they were creating only to quickly be found with nothing in their hands. With the collapse of the Southeast Seas stock and the surrounding bubbles, it put a dent in consumer confidence, which impacted practically everybody. The oil to juice the economy is confidence and trust. (21:37) And without that confidence and trust, things really start to break down. So with the collapse of the South Sea Company, the British Parliament took action to confiscate the profits that the South Sea Company directors had made. They brought in around £2 million, which of course at that time was a ton of money. (21:57) Many speculators lost tremendous amounts of money. The director of the Bank of England went bankrupt for £347,000 and Sir Isaac Newton would end up losing £20,000 after initially exiting for a profit, but reentering the company due to FOMO. He then came up with the famous line, "I can calculate the motions of the heavenly bodies, but not the madness of the people. (22:21) " In hindsight, the role the government played in fueling the South Sea bubble cannot be overlooked. Government officials were bribed in helping facilitate the scheme and they would get shares handed to them. So, they were financially incentivized to fuel the bubble as much as possible and not put these guard rails in place that would protect the everyday investor. (22:42) Are you looking to connect with highquality people in the value investing world? Beyond hosting this podcast, I also help run our tip mastermind community, a private group designed for serious investors. Inside, you'll meet vetted members who are entrepreneurs, private investors, and asset managers, people who understand your journey and can help you grow. Each week, we host live calls where members share insights, strategies, and experiences. (23:08) Our members are often surprised to learn that our community is not just about finding the next dog pick, but also sharing lessons on how to live a good life. We certainly do not have all the answers, but many members have likely faced similar challenges to yours. And our community does not just live online. (23:27) Each year, we gather in Omaha and New York City, giving you the chance to build deeper, more meaningful relationships in person. One member told me that being a part of this group has helped him not just as an investor, but as a person looking for a thoughtful approach to balancing wealth and happiness. (23:47) We're capping the group at 150 members, and we're looking to fill just five spots this month. So, if this sounds interesting to you, you can learn more and sign up for the weight list at thevestorpodcast.com/mastermind. That's thespodcast.com/mastermind. or feel free to email me directly at claytheinvespodcast.com. If you enjoy excellent breakdowns on individual stocks, then you need to check out the intrinsic value podcast hosted by Shaun Ali and Daniel Mona. (24:21) Each week, Shawn and Daniel do in-depth analysis on a company's business model and competitive advantages. And in real time, they build out the intrinsic value portfolio for you to follow along as they search for value in the market. So far, they've done analysis on great businesses like John Deere, Ulta Beauty, Autozone, and Airbnb. (24:40) And I recommend starting with the episode on Nintendo, the global powerhouse in gaming. It's rare to find a show that consistently publishes highquality, comprehensive deep dives that cover all of the aspects of a business from an investment perspective. Go follow the Intrinsic Value Podcast on your favorite podcasting app and discover the next stock to add to your portfolio or watch list. (25:04) They even sent out a message to speculators that an investment in the company would be a sure thing as the king was prepared to invest at a,000 a share. Chancellor explains that the government's failure to protect the nation from the pitfalls of speculation was the single most important lesson to come out of the calamitous events of the South Sea episode. (25:28) Chancellor also points out that investors who were buying shares at a,000 a share, they just were not behaving rationally as there was enough publicly available information that would suggest that the shares were severely overvalued. Some investors put a fair value for the shares closer to 150 based on the expected payments to come from the government. (25:54) By entering the bubble in the later stages, the investor then faced a poor riskreward trade-off, therefore chasing a small potential gain and risking a larger and more certain loss. Furthermore, we can then conclude that investors who purchase shares at such high levels were hoping for a greater fool to pay an even higher price in the near future rather than purchasing based on the underlying fundamentals. (26:17) The problem with this approach is that when the bubble pops, there is rarely going to be ready buyers as the market is overwhelmed with sell orders by the speculators trying to get out before it's too late. Many people think that they are smart enough to get out before the crash, but few have the foresight to make such accurate predictions, leaving many investors left with painful losses. (26:45) Let's transition here to discuss the second case study we'll be covering today, and that is the railway mania of 1845. At the start of this chapter, Chancellor gives further distinction between an investor and a speculator. In his view, an investor is much more interested in established business models that produce steady returns in the current state of affairs. In other words, an investor is much more interested in preserving the capital they already have in generating income off of that investment. (27:12) On the other hand, speculators are much more interested in capturing a capital gain and whether they realize it or not are less interested in capital preservation and generating income today. Inventions and novelties have always excited speculators. In the 1690s, it was the diving machine, fire engine, and burglar alarm companies. (27:36) In the 1720s, it was the financial alchemy generated by companies like South Sea. It wasn't until the industrial revolution did we start to come across technologies that weren't nearly as limited in their application. Starting in the late 18th century, a number of innovations in the field of communications had very significant impacts on society. (27:57) First, it was the canals followed in succession by railways, motorcars, radio, aircraft, computers, and more recently the internet. Each of these technologies also attracted fervent attention from speculators who ironically also contributed greatly to their successful establishment. The canal age in Britain started with the completion of the Duke Bridgewater Canal in 1767 which ran around 30 mi long and over the following two decades more than a,000 m of canals were constructed. The first canals produced tremendous returns on capital, paid large dividends, and enjoyed (28:34) soaring share prices. Furthermore, canals were beneficial to society as a whole due to lower transportation costs. In the early 1790s, speculation started to creep into this industry, and the government passed 50 acts for new canals to be built, and speculation would hit its peak around 1793. The canal media would come to an abrupt end with the recession in 1793 brought on by the outbreak of the French Revolutionary War. (29:06) Canal share prices collapsed and the investment returns on the new canals turned out to be abysmal in comparison to their predecessors. By the turn of the century, the overall return on capital invested in canals went from a premania level of 50% to around 5% as the gravity force of capitalism took hold. But canals actually were not new as the Romans had built aqueducts centuries prior. (29:31) The canal simply extended the benefits of water transportation to areas which had not previously enjoyed it. As Chancellor explains, the advent of railways on the other hand represented a far more significant change in the life of mankind. When the steam engines first appeared in the 1820s, they were greeted with a mixture of skepticism and trepidation. (29:55) It was anticipated that locomotives would prevent cows from grazing and hens from laying eggs, that their poisonous fumes would kill birds and blacken the fleces of sheep, and that their speeds of up to 15 mph would blow passengers to atoms. Railways also faced criticism and opposition from canal owners and land owners who feared losing the value of their assets. (30:17) When the Great Western Railway was proposed to connect London to Western England, both the University of Oxford and Eaton College initially refused a connection. But as they say, you cannot stop an idea whose time has come. (30:36) The first wave of railway excitement began with the opening of the Stockton and Darlington, but it faded quickly as an economic downturn cooled speculation. A few years later, the success of the Liverpool and Manchester Railway proved that steam locomotives were the future, reigniting public enthusiasm and setting off a second, far more powerful railway fever. But it took several years for the public at large to truly embrace railways. (30:59) In the summer of 1842, the young Queen Victoria was persuaded to make her first railway trip, which she reported to be pleasantly free from dust, heat, and crowds. and landlords realized that land lying adjacent to railway lines tended to rise in value. Then journalists suddenly started to proclaim that railways were a revolutionary advancement in the history of mankind. (31:24) One man understood best how to direct the public's enthusiasm for railways to his own ends. George Hudson, who was the chairman of the York and North Midland Railway, was an energetic and abrasive Yorkshshire man. By 1844, he controlled over 1,000 mi of railway, more than a third of the total track in operation at the time, which might be why he was coined the railway king. (31:51) Hudson closely associated himself with the advancement of railways and deliberately staged opening ceremonies to increase the public's interest as much as possible. Hudson was the chairman of several railway companies and he managed these companies really in an unusual manner. (32:11) company's accounts and records were kept to himself and he would update the accounting methods to his own liking and acted as if many business rules just didn't apply to him. While he showcased personal extravagance in display on several occasions, he also cut quarters when it came to running his own operations. For example, there was a fatal accident on the York and North Midland line. (32:35) And it turned out that he had employed an elderly train driver with defective eyesight in order to save on wages. Because of his lower cost structure, he was able to pay higher prices to acquire other railways and distribute greater dividends to shareholders. By late 1844, the economy was really starting to heat up. Interest rates were at their lowest point in almost a century. And after a series of excellent harvests, corn was cheap and plentiful. (33:00) Railway construction costs had also fallen and railway revenues were rapidly rising. and the three largest railway companies were paying dividends of 10%, four times that of the prevailing interest rate. As a result, the public's interest in the railway revolution was growing. Meanwhile, the number of railway companies skyrocketed as the newspapers were flooded with advertisements for railway perspectuses. (33:19) The playbook by many of these firms was to retain the majority of these shares with insiders, promote a small number of the shares to the public, creating a scarcity of the shares to allow them to get bid up to high prices. If the promotion was successful, prices would get bit up high, demand for shares would be oversubscribed, and this would allow insiders to eventually offload their shares to the public to lock in substantial profits. (33:45) Many of the promoters of new railways appeared to only be interested in profiting for themselves. One of the things that was unique about the railway mania was that it extended outside of the metro areas. And similar to the South Sea story, part of what helped fuel the mania and speculation was the ability to use leverage as banks provided loans against the collateral of railway shares. (34:08) In several cities, new stock exchanges were established for the trade of shares, and it was estimated that half a million transactions were processed daily by around 3,000 stock brokers. One news article explained how the amount of business being done had never been seen before. (34:26) A government report published in June 1845 revealed the identity of 20,000 speculators who had each subscribed for more than 2,000 worth of railway shares. And naturally, many who were on the list had contracted obligations that were well beyond their means. Some didn't even have the intention of meeting the subsequent calls on the railway shares, simply hoping to sell the option to buy shares at a premium to someone else later down the line, and others expected to flip their shares on the open market in early trading. These speculators were known as the railway stags. Although both the (35:03) Times and the Economists accepted railway advertisements, they did warn the public about the corruption of the mania and the inevitability of a crash. In particular, the newspapers attempted to draw the public's attention to the insupportable amount of capital that was required to finance the reckless extension of the railway system. (35:28) By June of 1845, there were more than 8,000 m of new railway under construction by the Board of Trade, which was four times the size of the existing railway system. A pamphlet published in Manchester during the summer warned of an impending crisis as workers were more interested in getting involved in the speculation rather than working on real things in the economy. (35:51) Once again, the old cry was raised that speculation was distracting people from lawful occupations. There was concern that this speculation would be felt for years as the industry was consuming the nation's capital resources for construction of railways. One paper wrote, "To think or dream that the present mania will subsist without a crisis the most severe ever experienced in this country would be to shutter eyes to all past experience." George Hudson or the railway king. (36:16) He really enjoyed his success. As long as the mania continued, Hudson remained a hero to the people as he had literally gone from rags to riches and was a symbol of the get-richquick mentality that enthralled the nation. He celebrated his success in August by purchasing a 12,000 acre estate for nearly half a million. (36:36) That amount of money, adjusted for inflation, would be worth something like a hund00 million today. By the late summer of 1845, speculation was nearing its peak. Foreign railways were projected all around the globe and over 100 railways were planned for Ireland. (36:56) In September, over 450 new schemes were registered in a single issue of the Railway Times contained over 80 pages of prospectus advertisements. Even after the excitement of the mania cooled, the damage was already done because enormous amounts of capital had been committed and could not easily be reversed. Railway projects kept demanding cash through share calls, forcing investors to keep paying even as share prices collapsed, which drained money from the broader economy. Shortly after, the Bank of England decided to raise interest rates by half a percent. Although the (37:28) race was small, it really signaled the end of the railway fiesta. As economic conditions worsened in 1846 and 47, businesses failed, banks collapsed, and panic spread throughout Britain's financial system. Investors who had speculated during the boom suddenly found themselves legally obligated to fund projects that they no longer believed in, leading to bankruptcies, lawsuits, and personal ruin. (37:59) The middle class was especially hit hard with families losing savings, homes, and livelihoods as railway shares imploded. By late 1847, the situation became so severe that the Bank of England was forced to suspend its own rules to prevent a complete financial collapse. Now that the bubble had popped, the railway king started to get more scrutiny. It was discovered by investors that he had been propping up dividends by using investor capital and not the profits of the underlying business. (38:25) So in essence, shareholders were sending him money and he was sending part of it right back as a dividend. This alongside other illusions helped keep share prices inflated for longer than they would have otherwise. As railway revenues declined and dividends were cut, Hudson's empire unraveled quickly. (38:46) There were accusations of false accounting, insider trading, self-deing, and political bribery, exposing the significant conflicts of interest at play. It was estimated that Hudson embezzled around 70 million inflationadjusted dollars. Share prices of York and North Midland had fallen by 2/3 from its 1845 peak and was trading at a discount to its paid up capital. (39:11) Railways had really lost their appeal and the railway king had been dethroned. But Hudson, of course, was not the only bad actor. He was just an output of a broken system. While other regions took necessary measures to prevent such manas, private enterprises were left unchecked in Great Britain. The uncontrolled expansion of the railway system in the hands of semi-criminal entrepreneurs producing economic catastrophe. (39:36) By January 1850, railway shares had declined from their peak by an average of 85% and the total value of all railway shares were less than half the capital expended on them. Railway dividends averaged less than 2% of capital expended and in the years that followed, many companies could not even afford to pay a dividend. (39:55) Several railroads built in the 1840s produced very poor returns and were eventually bankrupted by the arrival of the automobile. However, the results of the mania were not entirely negative. With over 8,000 m of track in 1855, this helped bring great benefits to society in the form of faster and cheaper transportation for passengers, raw materials, and finished goods. (40:19) And it helped bring many jobs in the industry for the years ahead. Now, this book by Chancellor was published back in the year 1999. And I think he makes an accurate comparison when he compared the railway mania to the tech bubble in the 1990s. (40:37) The railway mania is one of history's first examples of how a new technology does not necessarily bring good returns for the investor base at large. If anything, it suggests that we should avoid investing in new technologies, especially when there's a lot of hype surrounding it and high levels of capital investment is pouring into the industry. (40:55) One of the big differences between the internet bubble and the railway mania was that the internet bubble didn't necessarily require a lot of capital to finance. Many companies could just hire a few programmers, spin up a website, and start promoting their ideas or paying for clicks to that website. (41:15) This helped enable a wave of internet startups with the hope of hitting the public markets in a blockbuster IPO. Chancellor loops in this quote at the end of the chapter from none other than Bill Gates. He said, "Gold rushes tend to encourage impetuous investments. A few will pay off, but when the frenzy is behind us, we will look back incredulously at the wreckage of failed ventures and wonder who funded those companies. What was going on in their minds? Was it just mania at work?" End quote. (41:42) To close out the episode, let's cover one more case study. So, in chapter 9, Chancellor covers the Japanese bubble economy of the 1980s. Chancellor opens up this chapter by discussing this concept of nonjaron. So this term roughly translates to the theory of the Japanese. (42:03) This concept ties into this idea that Japan is unique and perceived differences between Japan and the west were sometimes invoked by the Japanese authorities in order to hinder the import of foreign goods. For instance, it was said that Japanese stomachs digested food differently than the West. So therefore they were unsuited to foreign beef and foreign rice. (42:24) It was even claimed that American skis were useless in Japan because the snow was different. As you read about the history of the US and other countries, one common theme that I come across is that the west tends to be more individualistic than other countries. This idea comes from how western societies historically organized their economies, politics, and social values around individual rights and personal autonomy. (42:51) In practice, this led to political systems that prioritize individual rights and economic systems that reward personal initiative and entrepreneurship. By contrast, many non-western societies, including Japan, evolved around collective structures where social harmony and group obligations often take precedence over individual choice. In Chancellor's words, Japanese capitalism is in many respects the antithesis of the Western model. (43:22) Until the middle of the 19th century, Japan remained a feudal economy, closed to the outside world with no tradition of legal rights for the individual. In the years that followed, they borrowed selectively from the west. But the hierarchy of the feudal system, it still remained in place. The peasant who had formally bowed to the feudal lord now served a corporate master. Individuals felt a deep sense of belonging with the companies they worked for. (43:45) And in exchange for their devotion and sacrifice, explorers were rewarded by their companies with lifetime employment and promotion according to their seniority. Now, as someone who's lived in the US my whole life, reading about the Japanese economy is certainly interesting. Some companies in Japan enjoy a privileged position as they receive protection from foreign competition. (44:08) The Ministry of Finance guarded the financial sector and ensured that cheap loans were available to firms that were cash hungry and highly leveraged and the capital would be raised from Japan's thrifty savers. as interest rates were kept artificially low by these arrangements and companies generally paid out small dividends. So returns for Japanese investors were rather poor. (44:27) Furthermore, the domestic consumer was similarly exploited by the Japanese system as imports were restricted and the cost of everyday items were therefore higher. The Japanese prided themselves on the belief that their system was less selfish and more stable than their Western counterparts. (44:47) They boasted that they thought long term and that the West pursued only short-term gains. Speculation is antithetical to a state-directed economic system. And after the stock market crash and bank collapses during the Great Depression, Japanese authorities were determined to never again tolerate such failures. Nevertheless, speculation still came to Japan in the 1980s. (45:11) And as Chancellor puts it here, it burrowed so deep inside the Japanese system that when it departed after a mere 5 years, the system was in ruins. End quote. For much of the 20th century, the US was the dominant empire globally from an economic standpoint. But by the middle of the 1980s, its position was threatened by the growing might of Japan. (45:35) Japan's industrial companies were deeply intertwined with new technologies and consumer electronics and a number of other fields and its banks were the largest in the world when measured by assets and market value. Japan was running a trade surplus and the US was running a trade deficit and this was partially funded by Japan's continued purchase of US Treasury bills. (45:56) As we know, in 1971, we entered a new monetary system as the US broke the gold standard and the dollar was free floating. During this time period, President Nixon criticized Japan for chronically undervaluing their currency in order to make their exports cheaper. In 1980, Japan started to loosen their control of their currency with the hope of making Japan a financial center of the world alongside London and New York. (46:23) In light of the deregulation happening, banks were able to offer what was referred to as token accounts that allowed customers to deposit cash and earn a competitive interest rate. So, Japanese companies started to supplement the regular income from their operations with interest earned on these accounts. In 1985, 9 trillion yen was invested in such accounts, and that amount would triple 4 years later. (46:49) Chancellor refers to the financial engineering that Japanese companies used during this time period as Zitec. Zitec created a circular feedback loop. As share prices rose, the ability to perform financial engineering increased, which helped fuel share prices to rise even higher. And this helped companies perform even more financial engineering and so on and so forth until the entire thing unravels. More than half of the reported profits of the largest players were derived from financial engineering. (47:16) Companies were raising tremendous amounts of capital at low interest rates to increase these endeavors. Another important piece of the Japanese bubble was property values. Land holds a special place in the minds of Japanese people. (47:36) Its ownership continued to convey status in a society not long released from feudal servitude and development of land was relatively scarce when compared to a country like the US. There were also high capital gains taxes for short-term property gains which encouraged owners to hold for the long term. Ironically, by discouraging the sale of land and creating an illlquid property market, the system actually encouraged land speculation. (48:04) Between 1956 and 1986, land prices increased by 5,000% while consumer prices only doubled. To help further fuel the bubble, banks acted on the belief that land prices would never fall again. So, they provided loans against the collateral of the land rather than cash flows. Additionally, the banks knew that should things ever go badly, the government would likely be on the lookout to try and prevent a catastrophe from taking place. (48:28) In the mid1 1980s, the US and Japan had opposing economic policies. The US had relatively higher interest rates to keep inflation at bay, and Japan had a looser monetary policy. This led to a stronger dollar and weaker yen, which helped Japanese companies ship more products overseas. (48:48) But in September 1985, the Plaza Accord was signed to correct the large trade imbalances globally. This led to a sharp appreciation of the Japanese yen. And now all of a sudden, Japanese goods in the international market were twice as expensive. Economic conditions in Japan then worsened, which led to the Bank of Japan lowering interest rates to help stimulate the economy. (49:07) And then it just didn't take long for the market to just start roaring higher as the NIK index reached 18,000 in the fall of 1986. Against the backdrop of a rising market, the government launched a long- aaited flotation of NT, the National Telephone Company, offering 200,000 shares to the Japanese public. (49:28) Within just 2 months, nearly 10 million people applied for shares. Even though the government had yet to announce the issue price, demand was so strong that the shares had to be distributed by a special lottery. The shares went live in February 1987 and within weeks the share price had nearly tripled, valuing the company at over $200 times earnings. (49:53) The market cap was around $375 billion, which in inflationadjusted terms would make it over a trillion dollar company. One of the reasons that the stock traded at such elevated levels was because the government was behind the public offering and it was widely believed that the government just wouldn't allow the share price to fall. In the public's eyes, betting on NT was akin to betting on Japan itself. (50:16) So, the public embraced it without hesitation. Underneath the surface, Japanese politicians also had a vested interest in keeping the market going higher. Reaching the heights of the political sphere was expensive as one needed to pay for favors and buy votes. (50:37) It was estimated that the annual expense to maintain a major political position was around $3 million. This was partially funded for a lot of politicians by the stock market's gains. So instead of politicians helping keep speculation in check, they helped enable it. During the late 1980s, Japanese share prices would increase three times faster than corporate earnings, and the earnings themselves were inflated due to financial engineering. (51:00) The Tokyo stock market flaunted some of the most overvalued shares in history. The textile sector traded at 103 times earnings. Services companies traded at 112 times earnings, and fishery and forestry firms traded at 319 times earnings. Western investors believed that such values were not justified and had reduced their stakes from the mid 1980s onwards. There were several explanations as to why such valuations were maybe justified. (51:29) Some argued that accounting practices understated real earnings and cross shareholdings inflated reported PE measures. What also helped lift share prices was that interest rates were artificially low and the rising yen discouraged investors from taking their money abroad. (51:48) So they didn't have many alternatives which led to a scarcity of sellers of Japanese stocks. It seemed that nothing could stop share prices from rising. When the emperor died in 1989, the market went up. When a small earthquake hit Tokyo 6 months later, prices continued to rise. Alongside the stock market, Japanese property prices climbed on an everinccreasing supply of credit. (52:11) And as they climbed, many workers were being priced out of being able to buy a home, even a small apartment. Home buyers were then forced to take out multi-generational 100-year mortgages. By 1990, the total Japanese property market was valued at over 2,000 trillion yen. This was over four times the real estate value of the entire United States. (52:35) The grounds of the Imperial Palace in Tokyo was estimated to be worth more than the entire real estate value of California. Property values were simply beyond levels that would be considered unprecedented. Turning back to the government's role in helping fuel the bubble. (52:53) The Ministry of Finance met with the four top brokers in the country and they ordered them to make a market for NT shares and keep the NIK average above 21,000. The hope was that the broker's biggest clients would feel comfort knowing that share prices would not fall substantially, hopefully encouraging them to invest more. (53:13) During the second half of the 1980s, 8 million new investors entered the market, taking the total number of Japanese investors to 22 million. New investors were encouraged by brokers to speculate in the market and were practically never handed a sell recommendation. Brokers took advantage of the Japanese population because they knew they tended to behave in herds and tend to not do what's unconventional and they're prone to shifting mood swings which can lead them to making emotional investing decisions. The four brokers which accounted for more than half of the overall trading volume worked together (53:44) to determine which stocks should be pushed to customers. And for the major clients that needed tended to or even needed losses recovered in short order, the brokers would be sure to make up for those at the expense of those who weren't insiders. (54:03) The booming equity and property markets helped bring about a booming economy as well. Chancellor referred to it as the new golden age. People felt rich, so consumer spending was strong. The strong end helped stimulate demand for imports. Low income taxes gave consumers more disposable income. Loans were refinanced at low interest rates and consumer debt was hitting new highs. (54:28) Since I've been getting more into golf lately in my personal life, not to say that I'm really any good, it was fun to read about the golf club membership craze of all things that was happening in Japan during this period. Golf was played by nearly a third of all salary men. So, it was really an important feature of the Japanese culture. (54:46) The different ranks accorded to clubhouses allowed members to display their hierarchic status while businessmen, politicians, and bureaucrats used their time at the club to expand their network, which played an integral part of their social and professional life. Since golf clubs were owned by their members, when land prices soared in the 1980s, the property rights of a membership became increasingly attractive. (55:11) In early 1982, the NIK Golf Membership Index was launched and it was based on the average membership price at different clubs. Given how illquid the property market was, the index served as a good indicator of the state of the market. From a base of 100, the index reached 160 at the end of 1985, and by the spring of 1990, it would reach over 1,000. The cost of joining Tokyo's leading country club was around $2. (55:36) 7 million. And over 20 clubs cost over $1 million to join. So, not only was a golf club membership something to use for networking and showcasing your social status, but it in itself was also a speculative vehicle. Banks even provided margin loans of up to 90% against the collateral of a membership certificate, which was of course used to invest more in the stock market. (56:02) As the Japanese bubble was nearing its peak, it was starting to cause concern within some circles of society. One growing concern was the growing wealth inequality. The fortunes of the richest fifth of the population quadrupled and the bottom fifth of society's wealth actually declined. (56:21) The bubble was seen as eroding the work ethic by severing the connection between labor and reward. As 1989 drew to a close, the NIK index was approaching 40,000, up 27% on the year. The PE ratio of the NIK was 80 times trailing earnings. The market yielded just 38% in dividends and sold for six times book value. But in 1990, the governor of the Bank of Japan was replaced by a career central banker who boasted in public that he never owned a share in the market. (56:51) He made it his personal mission to prick the bubble. He ordered for a raise in interest rates as the NIK reached its peak and from there the market started its descent. And the Bank of Japan went on to raise interest rates five more times to 6% to try and bring down property prices. (57:13) With a yield on long-term bonds of 7% and a dividend yield well under 1% for the stock market, there was just nothing left to keep valuations so high. Authorities did their best still to try and manage the decline. Margin requirements were lowered. Authorities ordered brokers to purchase stocks when the NIK fell below 20,000 and then margin requirements were lowered again. (57:38) In the midst of the decline, frauds were uncovered and overly leveraged institutions went under as one domino after another fell. For example, one golf club was raided by police after having sold 60,000 memberships instead of the 2,000 they were authorized to sell. The dream that Tokyo would emerge as a global financial capital declined along with share prices and the Japanese economy headed towards a recession. (58:04) Enormous capex during the good times saddled the country with excess productive capacity and falling asset values led to declining consumer confidence and spending. By late 1992, property prices had fallen by 60% from their peak. Interest rates were then cut to try and undo the tremendous damage and would hit an all-time low of. (58:25) 5% in 1995 and 0.25% in 1998. But low interest rates failed to bring the market back to life. In 1989, the market peaked out around 39,000 and it wouldn't reach that level again until 2024. That's 35 years later. As Keynes observed during the Great Depression, deflationary conditions, monetary policy was no more effective than pushing on a string. (58:51) Falling property values led to a banking crisis as values of collateral fell and customers were in a hurry to pull their remaining cash out of banks. The environment in Japan rhymed of that with the Great Depression. 9 years into the collapse of the bubble, Japan teetered on the brink of systemic collapse as its banking system was weighed down with bad debts. (59:17) The story of the Japanese bubble along with the other bubbles outlined in the book delivers several lessons that all of us could take away. Probably the most important one is the belief that the market risk or the downside can be eliminated so infinite prices can be paid. Throughout the late 1980s, skeptics were told that the government would not allow share prices to fall and that the banks and brokerages were too big to fail. When the bubble collapsed a few years later, this deception was exposed. (59:44) We saw a similar theme in the South Sea bubble when British shareholders believed that the government backing would protect them from losses. Most importantly, it's critical not to let your emotions overtake your decision-making when you find yourself caught in the bubble. When it feels like share prices can go nowhere but up, the market can feel more stable and durable than it actually is because we're anchored in the recent past. (1:00:11) The Japanese bubble showcase that markets can detach from fundamentals for several years, and we shouldn't trick ourselves into thinking that this can continue forever. Another takeaway from studying bubbles from the past is the fraud and deception that takes place beneath the surface. Promoters often have financial incentives to further inflate the bubble and make things really look better than they are. (1:00:29) It isn't until after the bubble is burst do you tend to see the fraud and deception exposed. And by then, it's too late to get out because the insiders realized before you did when it was the best time to do so. The final takeaway is that the bigger the bubble, the longer it can take for things to normalize. (1:00:51) The Japanese bubble is a good example of how destructive a bubble can be if things get way too far out of hand. With many stocks trading at north of 100 times earnings, it creates a huge level of capital misallocation and leverage that took several years to clean up. While each bubble has its own story, each are driven by many of the same human traits such as greed, fear, overconfidence, and the belief that this time is different. (1:01:20) Studying episodes like the South Sea bubble, the railway mania, and Japan's 1989 collapse helps us recognize when speculation crosses the line, so we can protect our hard-earned capital by staying grounded in fundamentals and disciplined when enthusiasm is at its loudest. So, with that, thank you for tuning in to today's episode on Devil Take the Heindost by Edward Chancellor. (1:01:40) I really hope you enjoyed it, and I hope to see you again next week. Thanks for listening to TIP. Follow We Study Billionaires on your favorite podcast app and visit the investorspodcast.com for show notes and educational resources. (1:02:00) This podcast is forformational and entertainment purposes only and does not provide financial, investment, tax, or legal advice. The content is impersonal and does not consider your objectives, financial situation, or needs. Investing involves risk, including possible loss of principle and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions. (1:02:18) Nothing on this show is a recommendation or solicitation to buy or sell any security or other financial product. Hosts, guests, and the investors podcast network may hold positions in securities discussed and may change those positions at any time without notice. References to any third party products, services, or advertisers do not constitute endorsements, and the Investors Podcast Network is not responsible for any claims made by them. Copyright by the Investors Podcast Network. All rights reserved. (1:02:42) High current profitability often leads to overconfidence among managers who confuse benign industry conditions with their own skill. Both investors and managers are engaged in making demand projections which have a wide margin of error and are prone to systemic biases. (1:03:01) In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic. High profitability loosens capital discipline, and when returns are high, companies are inclined to boost capital spending. Competitors follow suit, perhaps because they're equally hubistic, or maybe they just don't want to lose market share. (1:03:19) And remember that most CEOs are incentivized to grow their business.
History's Biggest Market Bubbles w/ Clay Finck (TIP784)
Summary
Transcript
(00:00) Probably the most important one is the belief that the market risk or the downside can be eliminated so infinite prices can be paid. Throughout the late 1980s, skeptics were told that the government would not allow share prices to fall and that the banks and brokerages were too big to fail. (00:19) When the bubble collapsed a few years later, this deception was exposed. We saw a similar theme in the South Sea bubble when British shareholders believed that the government backing would protect them from losses. Most importantly, it's critical not to let your emotions overtake your decision-making when you find yourself caught in the bubble. Before we dive into the video, if you've been enjoying the show, be sure to click the subscribe button below so you never miss an episode. It's a free and easy way to support us, and we'd really appreciate it. Thank you so much. On (00:53) today's episode, we'll be outlining three of the biggest bubbles in financial history. the 1720 South Sea bubble, the railway mania of 1845, and the Japanese stock market and property bubble of 1989. They say that history doesn't repeat itself, but it often rhymes. And that is the theme that plays right into all three of these bubbles. (01:15) Each displayed unprecedented levels of greed, speculative excess, and the belief that fundamentals did not matter for investors. I believe that studying the financial bubbles of the past is practically essential to ensuring that we ourselves don't fall prey to one during our investing lifetime. (01:33) Bubbles remind me a bit about house fires. We assume that it's something that only happens to other people. It's easy for us as investors to become complacent and assume that the good times of the past will almost certainly continue. This kind of thinking led investors in Japan, for example, to lose tremendous amounts of wealth in a matter of a few years. (01:54) As John Miner Keen said, the market can stay irrational longer than you can stay solvent. So sometimes bubbles can last much longer than we'd probably expect. In studying these three historic bubbles, I picked up Edward Chancellor's book, Devil Take the Heindmost, which was a sobering reminder that our mistakes as humans have repeated themselves time and time again throughout history. So, with that, I hope you enjoyed today's episode on history's most historic market bubbles. (02:28) Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, PlayFink. Welcome to the Investors Podcast. (02:58) I'm your host, Clayfink, and today we'll be discussing Edward Chancellor's book, Devil Take the Heinmost. This book is one of the best books ever written about speculation, bubbles, and why investors keep repeating the same mistakes across centuries. Through these historic events, Chancellor shares the key factors at play that helped fuel each bubble and how exactly investors got led astray. (03:20) What's really interesting to me about historic bubbles is that they just tend to repeat themselves and show up in these different forms. And Chancellor is a perfect person to cover such examples as he's practically a walking library. He's read practically everything on the subject and clearly understands investor psychology and what is really driving human behavior. (03:48) I think this is a really important topic to cover on the show because learning about and understanding past bubbles can be one of our best defenses against getting caught up in one ourselves. When you consider that bubbles can lead people to losing say 70 to 80% of their capital in the more extreme examples, the payoff of avoiding such bubbles can be extraordinary over the long run. (04:12) So, I hope this episode will be a useful tool for you to avoid getting caught up in the bubbles we see today or in the future. One of the things that is interesting to me about investing is that almost nothing about it is black or white. So much of investing is subjective. While it can be easy to judge somebody as a speculator, I think that all of us to some degree actually are speculators. (04:35) Let's say if you purchase the S&P 500 because you believe that markets are efficient and you want broad diversification, you're still speculating that US companies will be more profitable in the future than they are today and that investors will continue to want to pay up for the companies in that index. (04:54) If you're starting a local coffee shop in your city, you're speculating that the economy in that city will continue as usual. For an economy to thrive, you need entrepreneurs who are willing to take these risks and dare I say speculate with their own self-interest in mind. (05:13) For example, with the expansion of the internet in the 1990s, it would have been impossible for many companies to raise money if there weren't people who believed in the possibility that that new technology could bring. If the economy was full of investors who were totally riskaverse, then it would be difficult for society to progress and to build out new ways of doing things. But I think that speculation is something that lies a bit on a spectrum. (05:34) And the case studies outlined in Chancellor's book are the most extreme examples of speculation. So the goal is to recognize what extreme speculation looks like and learn to largely avoid such activities. The term speculation first developed economic meaning in the late 18th century. (05:54) Scottish moral philosopher and economist Adam Smith, he defined a speculator by his readiness to pursue short-term opportunities for profit. His investments are fluid whereas those of the conventional businessman are more or less fixed. (06:13) This train of thought was reiterated by John Miner Keynes who described the term enterprise as the activity of forecasting the perspective yield of assets over their whole life. In contrast to speculation which he called the activity of forecasting the psychology of the market. Speculation is conventionally defined as an attempt to profit from changes in the market price. Now this reminds me a bit of the idea in value investing of just thinking like an owner. (06:44) When my grandfather, for example, purchased farmland here in Nebraska in the 1970s, he purchased the land as if he was going to own it forever and pass that land down to his children, which is really exactly what he did. Whereas, if you're a speculator, you might purchase the land this year with the hopes that someone else is going to buy it for more next year. So, it's this active versus passive approach. (07:03) If you truly think like an owner, you really shouldn't care all that much about what the share price does over the next year or two. Turning back to the idea of my grandfather purchasing land, if I had asked him how he would react if the value of the land he purchased fell by 50%. (07:23) He probably wouldn't care that much because he purchased the land for the crops and the income that it would produce for the years ahead. the quoted price of the land actually made no difference to him. But I think for a lot of people when they see a stock that they own decline by 50%, many would consider selling that position because they were interested in eventually selling that stock for a gain. (07:47) Fred Schwed stated, "Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort which should be successful to prevent a lot of money becoming a little end quote. According to modern market theory which states that markets are efficient, share prices would reflect their underlying intrinsic values. (08:09) In this theoretical world, the amount of speculation would be very little. In the world of efficient markets, there are no animal spirits, no crowd instincts, no emotions of greed or fear, no trend following speculators, and no irrational speculative bubbles. (08:28) The case studies outlined in the book are anything of this sort, as they are history's most pronounced examples of vast speculation among the crowds. What's sort of funny about this is that when many everyday people hear about the stock market or really any financial concept for that matter, they just don't find it to be that interesting. (08:49) But I personally find some of these topics to be incredibly fascinating, including the study of bubbles. The reason is that bubbles aren't really about numbers or spreadsheets. They're about human behavior, storytelling, and how people react when their emotions are playing a pivotal role in their decision-making. When you study bubbles, you're really studying how otherwise rational people can trick themselves into becoming delusional. (09:16) So, let's transition here to discuss the first case study we'll outline today, which is the South Sea bubble. In the year 1711 in London, England, the South Sea Company was established to take over 10 million pounds of government debt, which it guaranteed to convert into its own shares. In a sense, the British national debt was being privatized. In exchange, the South Sea Company received an annual interest payment from the government and the monopoly of trade with the Spanish colonies in South America. (09:45) Although the monopoly of trade seemed promising, the South Sea Company acted more like a financial institution as the trading activities always showed a loss. In 1719, it took over a further 1.7 million pounds of government debt in the form of annuities, which it then converted into South Seas stock. By absorbing this debt, the company gained a guaranteed stream of interest payments from the government, which was far more reliable than the uncertain trade profits. (10:14) Now, the issue the South Sea company had was that there were all of these holders of government debt who were receiving a safe and reliable income stream. You can imagine that if you purchased government bonds that paid say 5% interest, you would only be willing to part ways with that consistent income if what you were getting in exchange was much better or more enticing. (10:39) The company made this trade attractive by pushing up its share price. So, the shares the debt holders received were worth more on the market than the safe debt that they parted ways with. In simple terms, people traded a guaranteed but boring income for shares that looked immediately more valuable and easy to sell for a profit. (10:59) Chancellor referred to this as the South Sea scheme, as all parties had an interest in continuing to inflate the South Sea share price. The company benefited because a higher share price meant that it could issue fewer shares to take over the same amount of government debt, leaving extra cash as profit. (11:19) The government benefited because the scheme reduced its interest payments and worked best politically if people eagerly accepted it. And the debt holders and other investors benefited because a higher share price made the shares they received or already owned look more valuable and easier to sell for a gain. In 1720, the price of shares swiftly began to rise from 128 at the start of the year to 187 in February to over 300 not too long after. (11:48) Meanwhile, several members of the government were secretly handed shares of the company by its directors. The shares were issued at a premium to the market price and no deposit was required. Upon receiving the shares, several government officials now had an interest in keeping the share price rising regardless of the cost to the nation. (12:07) The conundrum with this scheme, which sort of made my head spin when I was reading through it because it just defies all logic, it's that it appeared that all of the parties benefited from the continuing rise in share price. And this made it difficult for anyone to determine a rational estimate of what the shares were worth. (12:28) So, some argued that as the share prices rose higher, the more they were actually worth. Those who were more financially savvy and were able to keep their emotions under control, they understood that this just defied all economic logic. Usually, if something sounds too good to be true, it probably is. One economist explained that people who bought surplus South Sea stock at its elevated price must be deprived of all common sense and understanding since they would be giving their money away to the original stockholders and annuitants. The economist clearly saw that the scheme was dependent on convincing the annuitants into (13:04) converting their securities into shares and for more investors to purchase those shares. The government only committed to 5% interest payments and the trading prospects of the company were not good. So the potential for loss for investors was substantial given the prices that investors were paying. The South company was led by a man named John Blunt. (13:26) In running the company, Blunt had one primary goal and that was to keep the stock price rising. In Chancellor's words, he looked for a thousand ways to attain this end. Blunt built up public enthusiasm for the stock and offered the chance for the public to invest on multiple occasions. (13:47) For example, in April of 1720, 2 million pounds of South Sea stock was offered to the public at 300 a share and the subscription sold out in less than an hour. This price was three times the notional value. This would be like buying a ticket to a concert for $150 where the ticket price's face value was $50. And given the public's enthusiasm around the concert and the scarcity of the tickets, you expected to eventually sell your ticket for more than you purchased it. (14:20) The catch is that instead of this ticket gaining you entry to go see the Beatles is to see an artist that played on Tuesday nights at your local pub. But this still doesn't tell the whole story here. Blunt was also intentional about not being fully transparent with investors. With the issuing of new shares, the conversion of annuities hadn't taken place yet, which made it impossible for anyone to confidently determine the value of the company. (14:45) In Blunt's view, the more confusion, the better. One of the ways that Blunt made the share offers more attractive to the public was by allowing them to purchase shares on leverage. Only a 20% deposit was required and the remainder would be paid over the following 16 months. So in essence, the company was providing loans to investors. (15:08) This of course helped increase the stock price as speculators were able to purchase more shares than they otherwise could and the supply of shares available for sale was reduced as many shares were held by the company on margin. Once the debt holders were able to convert their debt instrument to Southeast shares, the vast majority of them did so. (15:29) Holders of government debt who rushed blindly into shares included some of the highest profile firms including the Bank of England and Million Bank. Even King George was in on the action and went against others advice of selling shares during the mania and instead wanted to purchase more shares in the new subscriptions issuance. In the end, 31 million pounds of debt was converted with a nominal value of just 30% of that amount. (15:54) As the bubble was inflating, several smart investors took notice that it just couldn't last forever. So, they started selling their shares. English mathematician and physicist Sir Isaac Newton started selling his shares and economist Richard Canelon sold his shares as well with the anticipation of a collapse. (16:15) While it's impossible to precisely predict when a bubble will end, the departure of more experienced investors can be a signal that the peak is nearing. Adam Anderson, a former cashier of the Sousy Company, later claimed that many purchasers of shares bought them knowing that their long-term prospects were hopeless, and they aimed to get rid of them in a crowded alley to others more credulous than themselves. (16:40) The rise of South Seas shares led to a number of other examples of investor irrationality, such as bubble companies. In the months following the South Seas scheme, new stock promotions were advertised in the newspaper to lure in investors and benefit from the speculative market environment. (17:00) Only four of the 190 bubble companies ended up being legitimate enterprises with a real underlying business underneath. The rest just wanted to prey on investors greed. But these bubble companies didn't necessarily take away the continued speculation in the South Sea company as a new issue went for 1,000 a share and it was sold out in a few hours. (17:25) The orchestrators of the scheme had become infatuated with their own success, increasing the amount they wanted to raise, increasing the share price they would issue at, and lowering the deposit required to purchase shares on leverage. And this is a common theme I see amongst many bubbles that end up crashing. Whether it's the South Sea company, Enron, Long-Term Capital Management, or Bernie Maidoff, the people orchestrating the scheme get in over their heads and have too much arrogance, overestimating their ability to keep the party going. Blunt enjoyed the success that came from the South Seas scheme. When the shares (17:56) were at their height, he sold out and started to buy land with his profits. He even sold more shares than he owned, securing the knowledge that the time would soon come when he could buy them back at a cheaper price. If the scheme had been reasonably executed from the start with a fixed value for the conversion of annuities into shares, and if Blunt had been content with a fairly priced stock, then the conversion would have proven to be useful to all parties. (18:23) But Blunt's reckless ambition destroyed any chance of success it might have had. Now, when you hear that the Sousi company took over 30 million pounds of debt, you might not think that's a big amount, but to put this into perspective, the amount of debt they took over equated to about 80% of the country's GDP at the time. So, this was just an enormous scheme relative to the size of the economy. (18:48) The level of speculation had tangible impacts on the economy as some would quit work to focus on speculating, spend their time chasing quick riches, and on the other side see their wealth evaporate rather quickly. Bubbles of this size usually send ripple effects throughout the entire economy. (19:07) Many who made fortunes go out and flaunt their newfound wealth, buying houses, furniture, and gold watches. By August of 1720, the frenzy had reached its peak. The South Sea Company launched its fourth and final subscription and once again demand was overwhelming. Huge crowds of speculators packed into the narrow streets around the South Sea House, pressing forward with cash and promises in hand. (19:35) In a matter of hours, the entire issue, which was 10,000 shares priced at £1,000 each, was completely sold out. By this point, shares had increased more than eight times in under 6 months. However, directors of the South Sea Company were fearful that competition from the bubble companies would spoil the party. New bubble companies were appearing almost daily, which would inevitably steal some of their firepower. (20:02) As a result, they attempted to monopolize the speculative enthusiasm by making the establishment of such companies illegal without government permission. Ironically, the government crackdown on bubble companies led to their share prices collapsing, which led to margin calls for investors who own shares of the South Sea company. I think this is a big lesson that leverage cuts both ways. (20:26) The South Sea company had exhausted all means of sustaining upward momentum in the share price and without that momentum, the decline was inevitable. Within a couple of weeks, the share price fell below 600. And already by that time, the company's directors gave up hope on further inflating the bubble and started selling their mortgage shares. (20:47) Swordblade Bank, which acted as the banker to the South Sea Company and had made extensive loans against the stock, they ended up failing. By the end of September, the share price was below 200, representing a 75% decline in just 4 weeks. The violence of the collapse took most people by surprise, even if many speculators knew that the high share price was not sustainable over the long run. (21:12) They assumed that they would be able to carry on the scheme for longer. One speculator reflected and shared how many had this dream about the newfound wealth they were creating only to quickly be found with nothing in their hands. With the collapse of the Southeast Seas stock and the surrounding bubbles, it put a dent in consumer confidence, which impacted practically everybody. The oil to juice the economy is confidence and trust. (21:37) And without that confidence and trust, things really start to break down. So with the collapse of the South Sea Company, the British Parliament took action to confiscate the profits that the South Sea Company directors had made. They brought in around £2 million, which of course at that time was a ton of money. (21:57) Many speculators lost tremendous amounts of money. The director of the Bank of England went bankrupt for £347,000 and Sir Isaac Newton would end up losing £20,000 after initially exiting for a profit, but reentering the company due to FOMO. He then came up with the famous line, "I can calculate the motions of the heavenly bodies, but not the madness of the people. (22:21) " In hindsight, the role the government played in fueling the South Sea bubble cannot be overlooked. Government officials were bribed in helping facilitate the scheme and they would get shares handed to them. So, they were financially incentivized to fuel the bubble as much as possible and not put these guard rails in place that would protect the everyday investor. (22:42) Are you looking to connect with highquality people in the value investing world? Beyond hosting this podcast, I also help run our tip mastermind community, a private group designed for serious investors. Inside, you'll meet vetted members who are entrepreneurs, private investors, and asset managers, people who understand your journey and can help you grow. Each week, we host live calls where members share insights, strategies, and experiences. (23:08) Our members are often surprised to learn that our community is not just about finding the next dog pick, but also sharing lessons on how to live a good life. We certainly do not have all the answers, but many members have likely faced similar challenges to yours. And our community does not just live online. (23:27) Each year, we gather in Omaha and New York City, giving you the chance to build deeper, more meaningful relationships in person. One member told me that being a part of this group has helped him not just as an investor, but as a person looking for a thoughtful approach to balancing wealth and happiness. (23:47) We're capping the group at 150 members, and we're looking to fill just five spots this month. So, if this sounds interesting to you, you can learn more and sign up for the weight list at thevestorpodcast.com/mastermind. That's thespodcast.com/mastermind. or feel free to email me directly at claytheinvespodcast.com. If you enjoy excellent breakdowns on individual stocks, then you need to check out the intrinsic value podcast hosted by Shaun Ali and Daniel Mona. (24:21) Each week, Shawn and Daniel do in-depth analysis on a company's business model and competitive advantages. And in real time, they build out the intrinsic value portfolio for you to follow along as they search for value in the market. So far, they've done analysis on great businesses like John Deere, Ulta Beauty, Autozone, and Airbnb. (24:40) And I recommend starting with the episode on Nintendo, the global powerhouse in gaming. It's rare to find a show that consistently publishes highquality, comprehensive deep dives that cover all of the aspects of a business from an investment perspective. Go follow the Intrinsic Value Podcast on your favorite podcasting app and discover the next stock to add to your portfolio or watch list. (25:04) They even sent out a message to speculators that an investment in the company would be a sure thing as the king was prepared to invest at a,000 a share. Chancellor explains that the government's failure to protect the nation from the pitfalls of speculation was the single most important lesson to come out of the calamitous events of the South Sea episode. (25:28) Chancellor also points out that investors who were buying shares at a,000 a share, they just were not behaving rationally as there was enough publicly available information that would suggest that the shares were severely overvalued. Some investors put a fair value for the shares closer to 150 based on the expected payments to come from the government. (25:54) By entering the bubble in the later stages, the investor then faced a poor riskreward trade-off, therefore chasing a small potential gain and risking a larger and more certain loss. Furthermore, we can then conclude that investors who purchase shares at such high levels were hoping for a greater fool to pay an even higher price in the near future rather than purchasing based on the underlying fundamentals. (26:17) The problem with this approach is that when the bubble pops, there is rarely going to be ready buyers as the market is overwhelmed with sell orders by the speculators trying to get out before it's too late. Many people think that they are smart enough to get out before the crash, but few have the foresight to make such accurate predictions, leaving many investors left with painful losses. (26:45) Let's transition here to discuss the second case study we'll be covering today, and that is the railway mania of 1845. At the start of this chapter, Chancellor gives further distinction between an investor and a speculator. In his view, an investor is much more interested in established business models that produce steady returns in the current state of affairs. In other words, an investor is much more interested in preserving the capital they already have in generating income off of that investment. (27:12) On the other hand, speculators are much more interested in capturing a capital gain and whether they realize it or not are less interested in capital preservation and generating income today. Inventions and novelties have always excited speculators. In the 1690s, it was the diving machine, fire engine, and burglar alarm companies. (27:36) In the 1720s, it was the financial alchemy generated by companies like South Sea. It wasn't until the industrial revolution did we start to come across technologies that weren't nearly as limited in their application. Starting in the late 18th century, a number of innovations in the field of communications had very significant impacts on society. (27:57) First, it was the canals followed in succession by railways, motorcars, radio, aircraft, computers, and more recently the internet. Each of these technologies also attracted fervent attention from speculators who ironically also contributed greatly to their successful establishment. The canal age in Britain started with the completion of the Duke Bridgewater Canal in 1767 which ran around 30 mi long and over the following two decades more than a,000 m of canals were constructed. The first canals produced tremendous returns on capital, paid large dividends, and enjoyed (28:34) soaring share prices. Furthermore, canals were beneficial to society as a whole due to lower transportation costs. In the early 1790s, speculation started to creep into this industry, and the government passed 50 acts for new canals to be built, and speculation would hit its peak around 1793. The canal media would come to an abrupt end with the recession in 1793 brought on by the outbreak of the French Revolutionary War. (29:06) Canal share prices collapsed and the investment returns on the new canals turned out to be abysmal in comparison to their predecessors. By the turn of the century, the overall return on capital invested in canals went from a premania level of 50% to around 5% as the gravity force of capitalism took hold. But canals actually were not new as the Romans had built aqueducts centuries prior. (29:31) The canal simply extended the benefits of water transportation to areas which had not previously enjoyed it. As Chancellor explains, the advent of railways on the other hand represented a far more significant change in the life of mankind. When the steam engines first appeared in the 1820s, they were greeted with a mixture of skepticism and trepidation. (29:55) It was anticipated that locomotives would prevent cows from grazing and hens from laying eggs, that their poisonous fumes would kill birds and blacken the fleces of sheep, and that their speeds of up to 15 mph would blow passengers to atoms. Railways also faced criticism and opposition from canal owners and land owners who feared losing the value of their assets. (30:17) When the Great Western Railway was proposed to connect London to Western England, both the University of Oxford and Eaton College initially refused a connection. But as they say, you cannot stop an idea whose time has come. (30:36) The first wave of railway excitement began with the opening of the Stockton and Darlington, but it faded quickly as an economic downturn cooled speculation. A few years later, the success of the Liverpool and Manchester Railway proved that steam locomotives were the future, reigniting public enthusiasm and setting off a second, far more powerful railway fever. But it took several years for the public at large to truly embrace railways. (30:59) In the summer of 1842, the young Queen Victoria was persuaded to make her first railway trip, which she reported to be pleasantly free from dust, heat, and crowds. and landlords realized that land lying adjacent to railway lines tended to rise in value. Then journalists suddenly started to proclaim that railways were a revolutionary advancement in the history of mankind. (31:24) One man understood best how to direct the public's enthusiasm for railways to his own ends. George Hudson, who was the chairman of the York and North Midland Railway, was an energetic and abrasive Yorkshshire man. By 1844, he controlled over 1,000 mi of railway, more than a third of the total track in operation at the time, which might be why he was coined the railway king. (31:51) Hudson closely associated himself with the advancement of railways and deliberately staged opening ceremonies to increase the public's interest as much as possible. Hudson was the chairman of several railway companies and he managed these companies really in an unusual manner. (32:11) company's accounts and records were kept to himself and he would update the accounting methods to his own liking and acted as if many business rules just didn't apply to him. While he showcased personal extravagance in display on several occasions, he also cut quarters when it came to running his own operations. For example, there was a fatal accident on the York and North Midland line. (32:35) And it turned out that he had employed an elderly train driver with defective eyesight in order to save on wages. Because of his lower cost structure, he was able to pay higher prices to acquire other railways and distribute greater dividends to shareholders. By late 1844, the economy was really starting to heat up. Interest rates were at their lowest point in almost a century. And after a series of excellent harvests, corn was cheap and plentiful. (33:00) Railway construction costs had also fallen and railway revenues were rapidly rising. and the three largest railway companies were paying dividends of 10%, four times that of the prevailing interest rate. As a result, the public's interest in the railway revolution was growing. Meanwhile, the number of railway companies skyrocketed as the newspapers were flooded with advertisements for railway perspectuses. (33:19) The playbook by many of these firms was to retain the majority of these shares with insiders, promote a small number of the shares to the public, creating a scarcity of the shares to allow them to get bid up to high prices. If the promotion was successful, prices would get bit up high, demand for shares would be oversubscribed, and this would allow insiders to eventually offload their shares to the public to lock in substantial profits. (33:45) Many of the promoters of new railways appeared to only be interested in profiting for themselves. One of the things that was unique about the railway mania was that it extended outside of the metro areas. And similar to the South Sea story, part of what helped fuel the mania and speculation was the ability to use leverage as banks provided loans against the collateral of railway shares. (34:08) In several cities, new stock exchanges were established for the trade of shares, and it was estimated that half a million transactions were processed daily by around 3,000 stock brokers. One news article explained how the amount of business being done had never been seen before. (34:26) A government report published in June 1845 revealed the identity of 20,000 speculators who had each subscribed for more than 2,000 worth of railway shares. And naturally, many who were on the list had contracted obligations that were well beyond their means. Some didn't even have the intention of meeting the subsequent calls on the railway shares, simply hoping to sell the option to buy shares at a premium to someone else later down the line, and others expected to flip their shares on the open market in early trading. These speculators were known as the railway stags. Although both the (35:03) Times and the Economists accepted railway advertisements, they did warn the public about the corruption of the mania and the inevitability of a crash. In particular, the newspapers attempted to draw the public's attention to the insupportable amount of capital that was required to finance the reckless extension of the railway system. (35:28) By June of 1845, there were more than 8,000 m of new railway under construction by the Board of Trade, which was four times the size of the existing railway system. A pamphlet published in Manchester during the summer warned of an impending crisis as workers were more interested in getting involved in the speculation rather than working on real things in the economy. (35:51) Once again, the old cry was raised that speculation was distracting people from lawful occupations. There was concern that this speculation would be felt for years as the industry was consuming the nation's capital resources for construction of railways. One paper wrote, "To think or dream that the present mania will subsist without a crisis the most severe ever experienced in this country would be to shutter eyes to all past experience." George Hudson or the railway king. (36:16) He really enjoyed his success. As long as the mania continued, Hudson remained a hero to the people as he had literally gone from rags to riches and was a symbol of the get-richquick mentality that enthralled the nation. He celebrated his success in August by purchasing a 12,000 acre estate for nearly half a million. (36:36) That amount of money, adjusted for inflation, would be worth something like a hund00 million today. By the late summer of 1845, speculation was nearing its peak. Foreign railways were projected all around the globe and over 100 railways were planned for Ireland. (36:56) In September, over 450 new schemes were registered in a single issue of the Railway Times contained over 80 pages of prospectus advertisements. Even after the excitement of the mania cooled, the damage was already done because enormous amounts of capital had been committed and could not easily be reversed. Railway projects kept demanding cash through share calls, forcing investors to keep paying even as share prices collapsed, which drained money from the broader economy. Shortly after, the Bank of England decided to raise interest rates by half a percent. Although the (37:28) race was small, it really signaled the end of the railway fiesta. As economic conditions worsened in 1846 and 47, businesses failed, banks collapsed, and panic spread throughout Britain's financial system. Investors who had speculated during the boom suddenly found themselves legally obligated to fund projects that they no longer believed in, leading to bankruptcies, lawsuits, and personal ruin. (37:59) The middle class was especially hit hard with families losing savings, homes, and livelihoods as railway shares imploded. By late 1847, the situation became so severe that the Bank of England was forced to suspend its own rules to prevent a complete financial collapse. Now that the bubble had popped, the railway king started to get more scrutiny. It was discovered by investors that he had been propping up dividends by using investor capital and not the profits of the underlying business. (38:25) So in essence, shareholders were sending him money and he was sending part of it right back as a dividend. This alongside other illusions helped keep share prices inflated for longer than they would have otherwise. As railway revenues declined and dividends were cut, Hudson's empire unraveled quickly. (38:46) There were accusations of false accounting, insider trading, self-deing, and political bribery, exposing the significant conflicts of interest at play. It was estimated that Hudson embezzled around 70 million inflationadjusted dollars. Share prices of York and North Midland had fallen by 2/3 from its 1845 peak and was trading at a discount to its paid up capital. (39:11) Railways had really lost their appeal and the railway king had been dethroned. But Hudson, of course, was not the only bad actor. He was just an output of a broken system. While other regions took necessary measures to prevent such manas, private enterprises were left unchecked in Great Britain. The uncontrolled expansion of the railway system in the hands of semi-criminal entrepreneurs producing economic catastrophe. (39:36) By January 1850, railway shares had declined from their peak by an average of 85% and the total value of all railway shares were less than half the capital expended on them. Railway dividends averaged less than 2% of capital expended and in the years that followed, many companies could not even afford to pay a dividend. (39:55) Several railroads built in the 1840s produced very poor returns and were eventually bankrupted by the arrival of the automobile. However, the results of the mania were not entirely negative. With over 8,000 m of track in 1855, this helped bring great benefits to society in the form of faster and cheaper transportation for passengers, raw materials, and finished goods. (40:19) And it helped bring many jobs in the industry for the years ahead. Now, this book by Chancellor was published back in the year 1999. And I think he makes an accurate comparison when he compared the railway mania to the tech bubble in the 1990s. (40:37) The railway mania is one of history's first examples of how a new technology does not necessarily bring good returns for the investor base at large. If anything, it suggests that we should avoid investing in new technologies, especially when there's a lot of hype surrounding it and high levels of capital investment is pouring into the industry. (40:55) One of the big differences between the internet bubble and the railway mania was that the internet bubble didn't necessarily require a lot of capital to finance. Many companies could just hire a few programmers, spin up a website, and start promoting their ideas or paying for clicks to that website. (41:15) This helped enable a wave of internet startups with the hope of hitting the public markets in a blockbuster IPO. Chancellor loops in this quote at the end of the chapter from none other than Bill Gates. He said, "Gold rushes tend to encourage impetuous investments. A few will pay off, but when the frenzy is behind us, we will look back incredulously at the wreckage of failed ventures and wonder who funded those companies. What was going on in their minds? Was it just mania at work?" End quote. (41:42) To close out the episode, let's cover one more case study. So, in chapter 9, Chancellor covers the Japanese bubble economy of the 1980s. Chancellor opens up this chapter by discussing this concept of nonjaron. So this term roughly translates to the theory of the Japanese. (42:03) This concept ties into this idea that Japan is unique and perceived differences between Japan and the west were sometimes invoked by the Japanese authorities in order to hinder the import of foreign goods. For instance, it was said that Japanese stomachs digested food differently than the West. So therefore they were unsuited to foreign beef and foreign rice. (42:24) It was even claimed that American skis were useless in Japan because the snow was different. As you read about the history of the US and other countries, one common theme that I come across is that the west tends to be more individualistic than other countries. This idea comes from how western societies historically organized their economies, politics, and social values around individual rights and personal autonomy. (42:51) In practice, this led to political systems that prioritize individual rights and economic systems that reward personal initiative and entrepreneurship. By contrast, many non-western societies, including Japan, evolved around collective structures where social harmony and group obligations often take precedence over individual choice. In Chancellor's words, Japanese capitalism is in many respects the antithesis of the Western model. (43:22) Until the middle of the 19th century, Japan remained a feudal economy, closed to the outside world with no tradition of legal rights for the individual. In the years that followed, they borrowed selectively from the west. But the hierarchy of the feudal system, it still remained in place. The peasant who had formally bowed to the feudal lord now served a corporate master. Individuals felt a deep sense of belonging with the companies they worked for. (43:45) And in exchange for their devotion and sacrifice, explorers were rewarded by their companies with lifetime employment and promotion according to their seniority. Now, as someone who's lived in the US my whole life, reading about the Japanese economy is certainly interesting. Some companies in Japan enjoy a privileged position as they receive protection from foreign competition. (44:08) The Ministry of Finance guarded the financial sector and ensured that cheap loans were available to firms that were cash hungry and highly leveraged and the capital would be raised from Japan's thrifty savers. as interest rates were kept artificially low by these arrangements and companies generally paid out small dividends. So returns for Japanese investors were rather poor. (44:27) Furthermore, the domestic consumer was similarly exploited by the Japanese system as imports were restricted and the cost of everyday items were therefore higher. The Japanese prided themselves on the belief that their system was less selfish and more stable than their Western counterparts. (44:47) They boasted that they thought long term and that the West pursued only short-term gains. Speculation is antithetical to a state-directed economic system. And after the stock market crash and bank collapses during the Great Depression, Japanese authorities were determined to never again tolerate such failures. Nevertheless, speculation still came to Japan in the 1980s. (45:11) And as Chancellor puts it here, it burrowed so deep inside the Japanese system that when it departed after a mere 5 years, the system was in ruins. End quote. For much of the 20th century, the US was the dominant empire globally from an economic standpoint. But by the middle of the 1980s, its position was threatened by the growing might of Japan. (45:35) Japan's industrial companies were deeply intertwined with new technologies and consumer electronics and a number of other fields and its banks were the largest in the world when measured by assets and market value. Japan was running a trade surplus and the US was running a trade deficit and this was partially funded by Japan's continued purchase of US Treasury bills. (45:56) As we know, in 1971, we entered a new monetary system as the US broke the gold standard and the dollar was free floating. During this time period, President Nixon criticized Japan for chronically undervaluing their currency in order to make their exports cheaper. In 1980, Japan started to loosen their control of their currency with the hope of making Japan a financial center of the world alongside London and New York. (46:23) In light of the deregulation happening, banks were able to offer what was referred to as token accounts that allowed customers to deposit cash and earn a competitive interest rate. So, Japanese companies started to supplement the regular income from their operations with interest earned on these accounts. In 1985, 9 trillion yen was invested in such accounts, and that amount would triple 4 years later. (46:49) Chancellor refers to the financial engineering that Japanese companies used during this time period as Zitec. Zitec created a circular feedback loop. As share prices rose, the ability to perform financial engineering increased, which helped fuel share prices to rise even higher. And this helped companies perform even more financial engineering and so on and so forth until the entire thing unravels. More than half of the reported profits of the largest players were derived from financial engineering. (47:16) Companies were raising tremendous amounts of capital at low interest rates to increase these endeavors. Another important piece of the Japanese bubble was property values. Land holds a special place in the minds of Japanese people. (47:36) Its ownership continued to convey status in a society not long released from feudal servitude and development of land was relatively scarce when compared to a country like the US. There were also high capital gains taxes for short-term property gains which encouraged owners to hold for the long term. Ironically, by discouraging the sale of land and creating an illlquid property market, the system actually encouraged land speculation. (48:04) Between 1956 and 1986, land prices increased by 5,000% while consumer prices only doubled. To help further fuel the bubble, banks acted on the belief that land prices would never fall again. So, they provided loans against the collateral of the land rather than cash flows. Additionally, the banks knew that should things ever go badly, the government would likely be on the lookout to try and prevent a catastrophe from taking place. (48:28) In the mid1 1980s, the US and Japan had opposing economic policies. The US had relatively higher interest rates to keep inflation at bay, and Japan had a looser monetary policy. This led to a stronger dollar and weaker yen, which helped Japanese companies ship more products overseas. (48:48) But in September 1985, the Plaza Accord was signed to correct the large trade imbalances globally. This led to a sharp appreciation of the Japanese yen. And now all of a sudden, Japanese goods in the international market were twice as expensive. Economic conditions in Japan then worsened, which led to the Bank of Japan lowering interest rates to help stimulate the economy. (49:07) And then it just didn't take long for the market to just start roaring higher as the NIK index reached 18,000 in the fall of 1986. Against the backdrop of a rising market, the government launched a long- aaited flotation of NT, the National Telephone Company, offering 200,000 shares to the Japanese public. (49:28) Within just 2 months, nearly 10 million people applied for shares. Even though the government had yet to announce the issue price, demand was so strong that the shares had to be distributed by a special lottery. The shares went live in February 1987 and within weeks the share price had nearly tripled, valuing the company at over $200 times earnings. (49:53) The market cap was around $375 billion, which in inflationadjusted terms would make it over a trillion dollar company. One of the reasons that the stock traded at such elevated levels was because the government was behind the public offering and it was widely believed that the government just wouldn't allow the share price to fall. In the public's eyes, betting on NT was akin to betting on Japan itself. (50:16) So, the public embraced it without hesitation. Underneath the surface, Japanese politicians also had a vested interest in keeping the market going higher. Reaching the heights of the political sphere was expensive as one needed to pay for favors and buy votes. (50:37) It was estimated that the annual expense to maintain a major political position was around $3 million. This was partially funded for a lot of politicians by the stock market's gains. So instead of politicians helping keep speculation in check, they helped enable it. During the late 1980s, Japanese share prices would increase three times faster than corporate earnings, and the earnings themselves were inflated due to financial engineering. (51:00) The Tokyo stock market flaunted some of the most overvalued shares in history. The textile sector traded at 103 times earnings. Services companies traded at 112 times earnings, and fishery and forestry firms traded at 319 times earnings. Western investors believed that such values were not justified and had reduced their stakes from the mid 1980s onwards. There were several explanations as to why such valuations were maybe justified. (51:29) Some argued that accounting practices understated real earnings and cross shareholdings inflated reported PE measures. What also helped lift share prices was that interest rates were artificially low and the rising yen discouraged investors from taking their money abroad. (51:48) So they didn't have many alternatives which led to a scarcity of sellers of Japanese stocks. It seemed that nothing could stop share prices from rising. When the emperor died in 1989, the market went up. When a small earthquake hit Tokyo 6 months later, prices continued to rise. Alongside the stock market, Japanese property prices climbed on an everinccreasing supply of credit. (52:11) And as they climbed, many workers were being priced out of being able to buy a home, even a small apartment. Home buyers were then forced to take out multi-generational 100-year mortgages. By 1990, the total Japanese property market was valued at over 2,000 trillion yen. This was over four times the real estate value of the entire United States. (52:35) The grounds of the Imperial Palace in Tokyo was estimated to be worth more than the entire real estate value of California. Property values were simply beyond levels that would be considered unprecedented. Turning back to the government's role in helping fuel the bubble. (52:53) The Ministry of Finance met with the four top brokers in the country and they ordered them to make a market for NT shares and keep the NIK average above 21,000. The hope was that the broker's biggest clients would feel comfort knowing that share prices would not fall substantially, hopefully encouraging them to invest more. (53:13) During the second half of the 1980s, 8 million new investors entered the market, taking the total number of Japanese investors to 22 million. New investors were encouraged by brokers to speculate in the market and were practically never handed a sell recommendation. Brokers took advantage of the Japanese population because they knew they tended to behave in herds and tend to not do what's unconventional and they're prone to shifting mood swings which can lead them to making emotional investing decisions. The four brokers which accounted for more than half of the overall trading volume worked together (53:44) to determine which stocks should be pushed to customers. And for the major clients that needed tended to or even needed losses recovered in short order, the brokers would be sure to make up for those at the expense of those who weren't insiders. (54:03) The booming equity and property markets helped bring about a booming economy as well. Chancellor referred to it as the new golden age. People felt rich, so consumer spending was strong. The strong end helped stimulate demand for imports. Low income taxes gave consumers more disposable income. Loans were refinanced at low interest rates and consumer debt was hitting new highs. (54:28) Since I've been getting more into golf lately in my personal life, not to say that I'm really any good, it was fun to read about the golf club membership craze of all things that was happening in Japan during this period. Golf was played by nearly a third of all salary men. So, it was really an important feature of the Japanese culture. (54:46) The different ranks accorded to clubhouses allowed members to display their hierarchic status while businessmen, politicians, and bureaucrats used their time at the club to expand their network, which played an integral part of their social and professional life. Since golf clubs were owned by their members, when land prices soared in the 1980s, the property rights of a membership became increasingly attractive. (55:11) In early 1982, the NIK Golf Membership Index was launched and it was based on the average membership price at different clubs. Given how illquid the property market was, the index served as a good indicator of the state of the market. From a base of 100, the index reached 160 at the end of 1985, and by the spring of 1990, it would reach over 1,000. The cost of joining Tokyo's leading country club was around $2. (55:36) 7 million. And over 20 clubs cost over $1 million to join. So, not only was a golf club membership something to use for networking and showcasing your social status, but it in itself was also a speculative vehicle. Banks even provided margin loans of up to 90% against the collateral of a membership certificate, which was of course used to invest more in the stock market. (56:02) As the Japanese bubble was nearing its peak, it was starting to cause concern within some circles of society. One growing concern was the growing wealth inequality. The fortunes of the richest fifth of the population quadrupled and the bottom fifth of society's wealth actually declined. (56:21) The bubble was seen as eroding the work ethic by severing the connection between labor and reward. As 1989 drew to a close, the NIK index was approaching 40,000, up 27% on the year. The PE ratio of the NIK was 80 times trailing earnings. The market yielded just 38% in dividends and sold for six times book value. But in 1990, the governor of the Bank of Japan was replaced by a career central banker who boasted in public that he never owned a share in the market. (56:51) He made it his personal mission to prick the bubble. He ordered for a raise in interest rates as the NIK reached its peak and from there the market started its descent. And the Bank of Japan went on to raise interest rates five more times to 6% to try and bring down property prices. (57:13) With a yield on long-term bonds of 7% and a dividend yield well under 1% for the stock market, there was just nothing left to keep valuations so high. Authorities did their best still to try and manage the decline. Margin requirements were lowered. Authorities ordered brokers to purchase stocks when the NIK fell below 20,000 and then margin requirements were lowered again. (57:38) In the midst of the decline, frauds were uncovered and overly leveraged institutions went under as one domino after another fell. For example, one golf club was raided by police after having sold 60,000 memberships instead of the 2,000 they were authorized to sell. The dream that Tokyo would emerge as a global financial capital declined along with share prices and the Japanese economy headed towards a recession. (58:04) Enormous capex during the good times saddled the country with excess productive capacity and falling asset values led to declining consumer confidence and spending. By late 1992, property prices had fallen by 60% from their peak. Interest rates were then cut to try and undo the tremendous damage and would hit an all-time low of. (58:25) 5% in 1995 and 0.25% in 1998. But low interest rates failed to bring the market back to life. In 1989, the market peaked out around 39,000 and it wouldn't reach that level again until 2024. That's 35 years later. As Keynes observed during the Great Depression, deflationary conditions, monetary policy was no more effective than pushing on a string. (58:51) Falling property values led to a banking crisis as values of collateral fell and customers were in a hurry to pull their remaining cash out of banks. The environment in Japan rhymed of that with the Great Depression. 9 years into the collapse of the bubble, Japan teetered on the brink of systemic collapse as its banking system was weighed down with bad debts. (59:17) The story of the Japanese bubble along with the other bubbles outlined in the book delivers several lessons that all of us could take away. Probably the most important one is the belief that the market risk or the downside can be eliminated so infinite prices can be paid. Throughout the late 1980s, skeptics were told that the government would not allow share prices to fall and that the banks and brokerages were too big to fail. When the bubble collapsed a few years later, this deception was exposed. (59:44) We saw a similar theme in the South Sea bubble when British shareholders believed that the government backing would protect them from losses. Most importantly, it's critical not to let your emotions overtake your decision-making when you find yourself caught in the bubble. When it feels like share prices can go nowhere but up, the market can feel more stable and durable than it actually is because we're anchored in the recent past. (1:00:11) The Japanese bubble showcase that markets can detach from fundamentals for several years, and we shouldn't trick ourselves into thinking that this can continue forever. Another takeaway from studying bubbles from the past is the fraud and deception that takes place beneath the surface. Promoters often have financial incentives to further inflate the bubble and make things really look better than they are. (1:00:29) It isn't until after the bubble is burst do you tend to see the fraud and deception exposed. And by then, it's too late to get out because the insiders realized before you did when it was the best time to do so. The final takeaway is that the bigger the bubble, the longer it can take for things to normalize. (1:00:51) The Japanese bubble is a good example of how destructive a bubble can be if things get way too far out of hand. With many stocks trading at north of 100 times earnings, it creates a huge level of capital misallocation and leverage that took several years to clean up. While each bubble has its own story, each are driven by many of the same human traits such as greed, fear, overconfidence, and the belief that this time is different. (1:01:20) Studying episodes like the South Sea bubble, the railway mania, and Japan's 1989 collapse helps us recognize when speculation crosses the line, so we can protect our hard-earned capital by staying grounded in fundamentals and disciplined when enthusiasm is at its loudest. So, with that, thank you for tuning in to today's episode on Devil Take the Heindost by Edward Chancellor. (1:01:40) I really hope you enjoyed it, and I hope to see you again next week. Thanks for listening to TIP. Follow We Study Billionaires on your favorite podcast app and visit the investorspodcast.com for show notes and educational resources. (1:02:00) This podcast is forformational and entertainment purposes only and does not provide financial, investment, tax, or legal advice. The content is impersonal and does not consider your objectives, financial situation, or needs. Investing involves risk, including possible loss of principle and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions. (1:02:18) Nothing on this show is a recommendation or solicitation to buy or sell any security or other financial product. Hosts, guests, and the investors podcast network may hold positions in securities discussed and may change those positions at any time without notice. References to any third party products, services, or advertisers do not constitute endorsements, and the Investors Podcast Network is not responsible for any claims made by them. Copyright by the Investors Podcast Network. All rights reserved. (1:02:42) High current profitability often leads to overconfidence among managers who confuse benign industry conditions with their own skill. Both investors and managers are engaged in making demand projections which have a wide margin of error and are prone to systemic biases. (1:03:01) In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic. High profitability loosens capital discipline, and when returns are high, companies are inclined to boost capital spending. Competitors follow suit, perhaps because they're equally hubistic, or maybe they just don't want to lose market share. (1:03:19) And remember that most CEOs are incentivized to grow their business.