Sunday, February 15

A short history of irrational exuberance

“We need policies that can be effective on the assumption that private financial systems are periodically prone to irrational exuberance" – Reserve Bank of Australia governor Glenn Stevens (pictured), speaking at a conference of central bankers in Kuala Lumpur last week.

Irrational exuberance is nothing new. No doubt one could peer back into ancient civilisations to find examples.

“Mania”, “bubble” or “boom” are well known. In 1996, top US central banker Alan Greenspan added to the lexicon when he said:

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Of one thing we may be sure. Despite the lessons of the current Global Financial Crisis, there will be more manias, bubbles and periods of irrational exuberance in financial markets. Over-optimistic speculation is part of human nature, along with a belief that if you don't jump on the waggon you'll miss out. Investors get hurt, but sooner or later – usually well within a decade, in our fast-moving world – there'll be another wave throwing their money at over-valued assets.

It's been like that since tulip mania swept Holland. When tulips arrived from the Ottoman Empire late in the 15th Century, the Dutch took to the exotic blooms with passion. And when natural variations produced flowers with magnificent colouring, speculators bid insane prices for the bulbs.

One grower rejected a bid of 3000 guilders, roughly the annual income of a wealthy merchant, for a single bulb; in 1633 a farmhouse changed hands for three rare bulbs.

The bubble burst in 1637, amid widespread panic, when bulb prices dropped to one-hundredth of their peak.

Almost a century later, British investors – led by royalty and the aristocracy – showed they could be even more gullible with one of the wildest speculations in history when the South Sea Company set out to raise millions of pounds to exploit largely illusory trading rights with Spanish colonies in South America. That bubble burst in 1720.

British investors were again to lose heavily in the railway mania of the 1840s.

Boom and bust moved in cycles through the decades, and Australia had its share – including some grandiose land settlement and railway development proposals.

In the 1930s, of course, Australia could not avoid the Great Depression which swept the world.

After World War II, Australia experienced its own moments of irrational exuberance with uranium projects, a flurry in oil stocks after Ampol's Rough Range find followed by the development of the Bass Strait oil and gas fields, and the mapping of mountains of iron ore in the Pilbara.

But for sheer irrationality, there was little to beat the Poseidon nickel boom of the late 1960s. Even the language of the reports, with terms like “massive sulphides”, excited investors. The hint of drilling at a “good address” would send shares through the roof.

That boom had to collapse, and then the 1970s oil shock overtook the world, bringing the new phenomenon of “stagflation” for which Keynesian theory had no answer. In Australia, the Whitlam government's problems added to the impact.

Ah! But the 1980s! That's when the world discovered the financial skills of the “entrepreneurs”. No one seemed to worry how they did it, but they sure got results. Everyone rushed to put their money on the new corporate engineers like Alan Bond, John Spalvins, Robert Holmes a Court, Christopher Skase, Laurie Connell, and a whole brigade of lesser entities and white shoe brigade property developers.

It's now clear many of them took high risks in “leveraging” – ie, borrowing heavily – to amass their corporate conglomerates. Prudent directors unwilling to take similar risks could not withstand raids by entrepreneurs with buckets of borrowed money. But it all began to unravel from 1987.

On top of that, few analysts could penetrate the thickets of interlocking company accounts.
One of the shrewdest investors of the time, Sir Ron Brierley (pictured), published “the definitive analysis” of John Spalvins's Adelaide Steamship group in September 1990, but his report was anything but definitive. He was unable to unravel the accounts.
The Adsteam group consisted of five publicly listed companies, all regarded as blue chip – Adsteam, David Jones, Tooth & Co, National Consolidated and Petersville Sleigh (the group also held Woolworths, Penfolds Wines, and stakes in many other quality companies). It's worth noting, too, that Spalvins was not in the same mould as the flamboyant “entrepreneurs”.

In 1990, Brierley said: “The major outstanding issue is the rationalisation of the convoluted and incestuous group structure.” His advice went unheeded. In 1991 the Adsteam group collapsed into receivership.

The moral may well be: If you can't understand an investment, no matter how well it appears to be going, walk away. Advice which might have benefited Babcock & Brown investors in 2008.

The next great thing to lure unwary investors was the “Japan Inc” miracle and the wider Asian economic boom – followed by a retreat which has been re-started by the Global Economic Crisis.
If a share spruiker or a finance journalist starts to rabbit on about a “new paradigm”, zip up your wallet. Such was the stuff of the dotcom boom from about 1999, when people began to throw money at digital technology and internet companies – many of them possessing no assets other than the promoters' dreams. Every bright idea was going to create another Microsoft.

Advisers would assure investors the digital age was a new paradigm, just as the railway boom had transformed economies 130 years ago. No one reminded them that most 19th Century railway projects failed, often leaving rich promotors and bankrupt shareholders.

Perhaps a little more awareness of history would have avoided the worst of the current Global Financial Crisis which – more than the booms and busts described above – resembles the Great Depression of the 1930s.
Your Grumpy Old Journo spent much of his career as a finance journalist, generally managing to avoid irrational exuberance and hopefully damping it in his readers.

Glenn Stevens's "remarks" are here, and are worth reading as he explains the problems confronting central bankers in the 21st Century.

Wikipedia has good entries on tulip mania, the South Sea bubble, the dotcom boom, Sir Ron Brierley and Greenspan's irrational exuberance remark. Investopedia also describes booms and busts, with this page offering further links at the bottom.

The tulip mania is well described in a book by Mike Dash, reviewed here.

The Poseidon nickel affair and the rest of the crazy Australian mining boom of the late 1960s and early 70s are well described by legendary finance journalist Trevor Sykes in The Money Miners – the Great Australian Mining Boom (1978).

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