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Belief in the Fed Heads South

In 1720, British legislators considered the South Sea Company's proposal to privatize the national debt. While they debated this swap of debt (in the form of annuities) for stock, a speculative mania for South Sea shares began. Edward Chancellor in Devil Take the Hindmost relates; "Exchange Alley in April 1720 resembled 'nothing so much as if all the Lunatics had escaped out of the Madhouse at once.'"

Most remarkable in this particular financial episode was the involvement of high level authorities.

The South Sea Company was established in 1711 by Lord Treasurer Robert Harley, Earl of Oxford. By 1720, Sir John Blunt, Sir Robert Chaplin, Sir Theodore Janssen, Mr. Sawbridge, and Mr. F Eyles, all members of Parliament, served as directors. No less than the King himself (King George the First) operated as the current Governor of the Company.

But that was not all. As Chancellor states: "The South Sea systemically bribed both the Court and Parliament. Part of this bribe was overt (the 7.5 million for covering the annuities) and part covert (in the form of illegal share options granted to courtiers and ministers)." Charles Mackay in his Extraordinary Popular Delusions and the Madness of Crowds lists these friends as: "the Earl of Sunderland, Duchess of Kendal, Countess of Platen, her two nieces, Secretary of the Treasury Charles Stanhope and the Chancellor of the Exchequer John Aislabie." Edward Chancellor summarizes: "all parties - annuitants, government, existing and prospective shareholders - had an interest in an inflated share price."

The British governments "support for the scheme sent out a message to speculators that South Sea shares were a sure thing." And as has happened over and over again since: when the public believes that a sure thing arrives, insiders begin taking profits. However, "Chancellor Aislabie, attempted to persuade George I to sell his stock, but the King ignored this advice..." MacKay comments: "If the King was prepared to invest in the Third Money Subscription at a price of £1000, it appeared safe for his subjects to do likewise." Chancellor concludes; "Where the King led, the nation followed."


2012 Fed Premium

Investors have a near universal belief that Fed action will support their investments. The only disagreement these days is whether stocks or bonds will benefit more from Fed policy.

If one is nervous about the stock market and is holding bonds, one most likely believes that Fed buying will keep bond prices high/rates low for an extended period. But as we explained back in January of 2009, the Fed's Operation Twist was also implemented from 1961-65. Not only did bond yields rise during those four years, when the Fed gave up, rates soared from 4% to 14%. Disastrous for bondholders.

If you are holding U.S. equities, you most likely understand that bonds are the most expensive in 300 years, so therefore stocks are a relative value. However, to be supported above their long term average valuation, you most likely believe that government support will come faster than any correction. (By the Fed's own calculations there is a 50% premium built up since 1994.) Such was the belief of South Sea investors who invested in shares alongside their Absolute Ruler. So what happened to them?


'The Surprise of the World'

As Chancellor relates: "On October 1, the Applebee's Journal reported that 'the sudden fall of our Stocks, without visible reason, is the Surprise of the world.'" Charles Mackay describes the fallout: "...it was most surprising to see the extraordinary panic which had seized upon the people. Men were running to and fro in alarm and terror, their imaginations filled with some great calamity, the form and dimensions which nobody knew:

'Black it stood as night -

Fierce as ten furies - terrible as hell.'"

In a few short months, South Sea stock was down more than 80%. Chancellor Aislabie, who was eventually sent to the Tower along with the other South Sea directors, "later claimed that events had run away from the company and the government:

'It became difficult to govern it; and let those gentlemen that opened the floodgates wonder at the deluge that ensued as much as they please - it was not in one man's power, or in the power of the whole administration to stop it, considering how the world was borne away by the torrent.'"

"The belief that the government would support the share price above its intrinsic value was not a singular occurrence. As we shall see, it recurred in Japan in the 1980s, when it was argued that the Ministry of Finance would not allow share prices to fall. 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." - Edward Chancellor. Devil Take the Hindmost. 2000.

"Where the King led, the nation followed."

San Francisco Earthquake 1906 modified accordingly.

 

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