Investors and their Behavior during the South Sea Bubble

Contents

1 Introduction

2 Historical Background to the South Sea Company

3 Subscription shares

4 Investments and Investor Behaviour in the Bubble Crash

5 Conclusion

6 Literaturverzeichnis

1 Introduction

In this essay I will examine the investor behavior during the South Sea Bubble around 1720 and the involved South Sea Company. Nearly 300 years ago at the London Stock Exchange formed an enormous speculative bubble. In the eighteenth century the trade brought exotic products, such as commodities and slaves with exorbitant profits. This benefited appropriate commercial companies like the trading company South Sea Company. Its share price exploded from 120 to 950 pounds. Trigger of the former stock market crash: The South Sea Company did not have enough cash to pay overdue dividends. Therefore, I will try to reflect the investor behaviour at that time to maintain more information about why they act like they act. Additionally, I want to give a small outlook on equity valuation the time of the South Sea Bubble. My intent is not to de- liver a detailed calculation of shares, rather to investigate the valuation at that time and thus to represent the theory of the pricing relationship. Second it should demonstrate the purpose of the subscription finance and its implementation. In 1720 and the later eighteenth century subscription finance was one of the great legal and political debates. Therefore, for this article it’s important to give information about subscription shares and the historical background, before investigate the legal and political history of the South Sea Company and to give a context to the eighteen-century for subscription fi- nance and the South Sea Company. Deducted from this information, the paper will thus investigate what kind of investor behaviour was common and it will try to answer the question if this behaviour was rational or irrational. What different investor strate- gies can be found in this period and during the bubble, regarding the question which explanations can be found to explain the phenomenon when market prices deviate from fundamental values. Additionally, why investors act how they act settled in an over- loaded stock market. Therefore, the paper focuses on one of the most famous bubbles, that associated with the rise and fall of the South Sea Company during 1720. The causes of this bubble have attracted considerable academic debate, since it formed an important part of the first major speculative boom and bust in European stock markets. Its aftermath has had a considerable impact on financial markets. Much of the earlier literature characterizes this bubble as an episode of irrational speculative activity. With the help of the examined and investigated facts, I will close this essay with a proper conclusion.

2 Historical Background to the South Sea Company

To name the history of the South Sea Company has an enormous importance for this essay. Therefore, a few key aspects need to be accentuated here. The Company was founded in 1711 and with the official purpose to trade with Spanish America. (Harris, 1994) Fulfilling their purpose by the occasional slave ship and consignment of textiles that sailed under the company´s flag. The trading activity was always remained lim- ited. Right from its establishment, the company was more involved in dealing govern- ment debt than following foreign trade. In the early eighteenth century the debts of the English government had been issued in a variety of forms. That means, the government in England was exploring means of managing its outstanding debt. In parallel with the South Sea Bubble developed the crash of the Mississippi Company. This company was undercapitalized as well. Equity came largely from devalued government bonds. The rally ended simultaneously with the South Sea Bubble in a crash. This brought up a bidding process between the Bank of England and the South Sea Company. This pro- cess was won by the latter, following the right to buy in all outstanding government long annuities, short annuities, and redeemable debts (~£31.5 m) in exchange for its own stock. (Dale, R., Johnson, J., & Tang, L, 2005, S. 234-235) The English govern- ment agreed to this deal and thus credit the Company with an increase of £31.5 m in its nominal share capital, if all subscribeable debts were exchanged. Additionally, to pay interest on the debt partly at 4 percent and partly at 5 percent until 1727, when a single rate of 4 percent would be paid. On the other side, the South Sea company agreed to pay the government a sum of £7.6 m, accepeted full conversion of the gov- ernment debt, in exchange for these privileges. (Dale, R., Johnson, J., & Tang, L, 2005, S. 234-235) This led the company to its first big venture the debt conversion in 1719. This first hilarious success inspired the company to a much grander plan. In the end the propose of the South Sea Company was it, to exchange nearly all of the remaining national debt for its own shares. In exchange, the firm preserved the right to issue new shares with which the conversion was to be financed. The interesting result of the bid- ding process with the Bank of England was, the South Sea Company could offer more proper terms to the English government as it proposed at first. (Dale, R., Johnson, J., & Tang, L, 2005) Along this background and to bring now the South Sea Bubble in context to this was the fact that the conversion price was not fixed which resonated to the bubble growth. Focusing and explaining more on the importance of share prices to this context, the higher its share price, as more cheaply the Company could obtain the government debt from its former owners. So the Company was holding more cash for other purposes. Remembering the bidding process with the Bank of England were the share price rose remarkable. The South Sea Company paid bountiful bribes at this time and it granted “incentives” similar to stock options. (Harris, 1994, S. 610-627) Due to that issued the company fresh equity in four subscription steps, at higher and higher prices. Therefore, their proceeding was to announce the terms under which it would convert government debt, exchanging annuities. Furthermore, redeemable bonds for cash, bonds and stock. As the market price of the Company went up, they could buy out debtholders for even smaller amounts of stock. Another proceeding step was it, to increase its stock price by bidding and commissioning against its own shares. Plus not to supply the increasing demand at the same time. With this intention succeeded the company to force the English government to outlaw all stock companies that had no royal charter. From April 1720, the boarder market started to increase parallel with the South Sea stock. Many smaller businesses and firms were sold to other investors. These plans, known as “bubbles”, are gaining finance based on little more than some vague ideas. As well as healthy business companies such as insurance companies were offering parallel with simple frauds at this time, such as a classic scheme of high ben- efit. This increasing volume of trades put enormous impact on the settlement of all stock trade. (Harris, 1994, S. 610-627) To catch up with an ever-growing backlog of trades that had not been settled the company had to close its books in July and August 1720. Even to prepare for the fourth money subscription. By the middle of August 1720, the company initiated the parliament to close out unwelcome competition for investors funds. In addition, the company was short in cash, as it needed money to pay the debtholders who it had converted in May. Doing this in hope to settle the staging stock price, the company´s promise were dividends of 50 percent of stock´s face value. Unfortunately, in the sector was touched by a developing credit slump. Subscribers strove to make their payments for the upcoming forth money subscription. (P. Temin, H Voth, 2004, S. 1656) To explain more to the structure of the South Sea Company, it was assembled into many smaller ventures. One of this smaller companies, was the Sword Blade Company. This company was installed as the financial part of the South Sea Company. This Company went insolvent in September 1720. After this announce- ment, the price of South Sea stock declined rapidly. Trigger of the bubble crash: The South Sea Company did not have enough cash to pay overdue dividends. Due to that investors had to pay £1,000 per £100 in stock, the South Sea Company shaded plans to be taken over by its rival, the Bank of England. At the end, the year ended in scandal with a committee of the House of Commons investigating the Company’s cashier flee- ing the country. (P. Temin, H Voth, 2004, S. 1656) To reflect the immersive profit margin of all South Sea Company shares, which had already advanced from £130 in February 1720 to over £300 in early April, rose further to £400 (20 May), then to £500 (28 May) before touching £600 on 31 May. This vertical ascent continued into the following month, the share price breaching £700 on 1 June and £800 on 4 June. On 23 June the Company closed its books for two months in order to process the midsummer dividend, so that quoted prices during this period are in fact forward prices ‘for the opening of the books’. The highest (forward) price was £1,050, recorded on 25 June, but when the books were reopened the spot price had fallen to £820 (cum dividend). Thereafter South Sea stock weakened dramatically— to £520 in mid-September, £290 at the beginning of October and a low of £170 on 14 October 1720. (Dale, R., Johnson, J., & Tang, L, 2005, S. 235-236)

TABLE 1 - TRADING ACTIVITY ON HOARE’S OWN ACCOUNT IN 1720, BY SECURITY (P. Temin, H Voth, 2004, S. 1657)

Abbildung in dieser Leseprobe nicht enthalten

What kind of definition and explanation does the rise and fall of stock prices during the South Sea bubble do? To summarize are three key companies involved, for which daily data are available: The Bank of England, the East India Company and the South Sea Company. (P. Temin, H Voth, 2004, S. 1656-1658) To answer this question de- tailed, another examination and investigation would be mandatory here but will not be focused in this essay.

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