Shows Sea Bubble Study Shows News of Financial Difficulty Triggered Crash

November 20, 2011

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Many bubble studies successfully isolate the behavioral factors, policies, and preconditions of a bubble, but few focus on the triggers of the burst. Indeed, many global macro portfolio managers choose not to try to time the bust, preferring to initiate their positions, then patiently wait.

Goetzmann, Frehen, Rouwenhorst (2011) discovered a new data set from the South Sea Bubble and the contemporaneous Dutch Windhandel of 1720 and used it to find triggers and how the crash spread throughout different industries and countries

The research confirmed my own study of the triggers of the 1997 Asian Financial crises. As the contagion spread throughout each ASEAN country, the catalyst in each instance was news about trouble at a major company : a financial firm, semiconductor manufacturer, an automobile manufacturer. This triggered a crises of confidence about other, even unrelated firms, leading to a crash. This led to my conclusion for China : News of financial difficulty at a major Chinese company will trigger a panic and massive outflow of capital from the country.

  • Financial Innovation :  new instruments that enabled the expansion of debt, the sharing of risk, pooling of capital, and permitted “lottery like playoffs”contributed to the bubble
  • Technological innovation : The expansion of global trade raised investor expectations to an irrational level
  • Exponential Price Move : the timing of takeoff and the top of the market differed, but the log scale moves show a similar move (about a 7 fold move). There was a 4 day lag between London Crash and Dutch West Indie collapse.
  • News : “events about financial distress (seeking to raise capital, corporate malfeasance, losses, missed debt payments ) likely coordinated a sudden collapse in an important market sector which propagated to other sectors and internationally.”
  • Contagion : Spread within the industry (starting with the insurance sector – see York Building Society below) to related industries, then finally internationally

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HS : The talk of a debt conversion scheme through new government banks as an outgrowth of debts incurred by the war in 1718- 1720 makes one wonder if we will not see an existing or new government bank will finance another bubble soon. We’ve already heard talk of this in the form of an “infrastructure bank” in the US and new European bank to finance government deficits in Europe. There is SecondMarket, which may be indicative of a bubble in Social Media stocks. Likewise, it is not a stretch to peg Ben Bernanke as today’s John Law.

The paper mentioned how wars between countries broke out, leading to speculation. The progression of wars, from preconditions, to catalyst, will be another interesting study.

Source : SSRN

Lessons from The 1997-1998 Asian Financial Crises

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