Saturday, December 29, 2018

Longread: "The Five Eras of Financial Markets"

An overview of equity market history by some folks who are good at sweating the details. Unlike the intro to the University of Chicago's ProMarket piece  "How Politicians Intensify Financial Cycles: 300 Years of Pro-Cyclical Regulation" I don't have to get all pedantic and point out problems in the introduction:
Be careful with this piece. I didn't have time to check all the details the writer musters to his argument but am pretty sure there are a couple errors in this bit:... 
I hate doing that, really try not to, but after the egregious misstatements ProMarket did a good job so, as the man said "Whaddya gonna do?"

From Global Financial Data:
Global Financial Data has produced indices that cover global markets from 1601 until 2018.  In organizing this data, we have discovered that the history of the stock market over the past 400 years can be broken up into four distinct eras when economic and political factors affected the size and organization of the stock market in different ways.  Politics and economics define the limits of financial markets by determining whether companies can exist in the private or the public sector, by controlling the flow of capital in financial markets, and by determining the level of regulation that companies face in maximizing their profits.

The first era covers the period from 1600 until 1815 when financial markets funded government bonds and a handful of government monopolies. The British East India Company was established in 1600.  For the next 200 years, financial markets traded a very limited number of securities.  After the bubbles of 1719-1720, shares traded more like bonds than equities. Investors were more interested in getting a secure return on their money than investing for capital gains.

The second period from 1815 until 1914 was one of expanding equity markets, globalization of financial markets, and a reduction in the importance of government bonds relative to equities. This changed in the 1790s when first canals, and later railroads changed the nature of financial markets forever. Investors discovered that transportation stocks could provide reliable dividends as well as capital gains.  For the next hundred years, investors had the opportunity to invest in thousands of companies that could generate capital gains as well as dividends. Financial markets became globalized and the transportation revolution enabled the global economy to grow.  By 1914, capital flowed freely throughout Europe and the rest of the world, enabling investors to optimize returns globally.
The era of globalized financial markets came to an end on July 31, 1914 when the world’s stock markets closed down when World War I began. During the war, capital was directed toward paying for the war. Attempts to restore globalized financial markets after the war failed. Financial markets operated on a national level, not on an international level.  Before World War I, markets provided similar returns because they were integrated.  After the war, national equity market returns diverged because capital was unable to flow to the countries with the highest rates of return. After World War II, Europe nationalized many of its main industries and the United States regulated industries.  
It wasn’t until the 1980s that equity markets became globalized once again when deregulation and privatization swept over the world’s stock markets. The poor performance of markets and the economy in response to the OPEC Oil Crisis of the 1970s brought the role of government in regulating the economy into question.  Privatization swept over the capitalist economies, and the former Communist countries opened stock markets and began to integrate with the world’s financial markets. The global market capitalization/GDP ratio increased dramatically.  There is no definitive date when this transition occurred, so the bottom of the bear market in bond and equities in 1981 is used as the starting point of this new era.

How long the fourth era will last before we move into a fifth era will depend upon technology. The fifth financial era will begin when financial markets reach singularity, where the national markets in financial assets merge into one market and financial markets are not just global, but singular.  All financial assets will trade 24 hours a day over computer networks that are connected to every corner of the globe. Markets have almost reached that point in the foreign exchange market, and it is only a matter of time before the market for financial assets reaches that point as well.

The First Era: Monopolies and Funds
A Financial Revolution occurred in 1600 when the Dutch East India Company and the English East India Companies were established.  The Dutch East India Company was founded in 1601 and continued to operate until 1799.  The English East India Company was established in 1600 and reorganized three times before the fourth East India Company was established in 1657. That company lasted until 1874.  
Before 1600, merchants had created “shares” in voyages that ships made to the far east.  By investing in several ships, merchants could reduce their risk. The innovation of the Dutch East India Company was to vest ownership in the company, and not in individual voyages.  This provided economies of scale and by creating perpetual life for the corporation, allowed capital from one voyage to be reinvested in other voyages. What is important about the Financial Revolution of 1600 was that it established the principal of founding corporations that could issue shares which did not expire. Shareholders could buy and sell their shares to others, and receive dividends if the company was profitable.
Nevertheless, the Dutch East India Company made several mistakes which future companies learned from. The Dutch East India company allocated its shares by municipality, which limited trading in its shares. The company did not raise additional equity capital by issuing new shares, but borrowed money which increased its debt-to-equity ratio and eventually ended up bankrupting the Dutch East India Company.  Moreover, dividends were often paid in kind.  Instead of receiving cash dividends, shareholders would receive cloves brought back from the West Indies.  Merchants were happy to receive payment in kind and sell the cloves, but investors preferred cash payments.

A second wave of incorporations occurred in the 1690s following the Glorious Revolution of 1688, during which English parliamentarians overthrew King James II and established a constitutional monarchy in England. This not only brought a Dutch ruler to London, but also brought Dutch capital and Dutch financial knowledge. 
In 1688, Amsterdam financial markets were more sophisticated than London’s. Joseph de la Vega’s Confusion de Confusiones was published in 1688 to show the Jewish community of Amsterdam the inner workings of stock markets.  When the William Phipps treasure-seeking expedition of 1687-1688 paid a 10,000% dividend to shareholders, it encouraged other corporations to be established for investors to profit from. 
In 1694, John Houghton began writing articles on share trading and in January 1698, the Course of the Exchange began its regular bi-weekly publication, publishing trade prices collected from London coffee houses. A similar publication for Amsterdam was the Amsterdamsche Courant which published share prices fortnightly beginning in 1723. Les Affiches de Paris began publishing the price of shares traded in Paris in 1745. By the middle of the 18th century, the growth of the financial press reflected the growing interest in financial markets. Between these three publications and others, GFD has been able to put together data on share prices from 1601 until 1815.
The 1600s and 1700s were a period of continual war in Europe and the debt of the English, Dutch and French rose as a result. Governments in the Netherlands and Great Britain began issuing debt that had longer maturities, in some cases creating annuities that provided annual payments as long as someone was alive.  These debt instruments eventually were converted into perpetuities which never matured just as shares of stock in the East India Company or the Bank of England never matured.  Given the choice of obtaining a perpetuity that paid a fixed yield from a government and variable dividends from a corporation, most investors chose to invest in the government security. 
The key event for financial markets was the bubbles of 1719-1720. The market cap of British equities steadily rose from 1688 until 1720 as is illustrated above. The Dutch, French and British governments all issued large amounts of debt to fight the War of the Spanish Succession between 1701 and 1713.  John Law offered the French government a way of converting their debt into equity in the French East India Company.  In Britain, investors were allowed to convert their debt into shares in the South Sea Company. Enthusiasm for the shares drove prices of the stocks to unsustainable levels, but after the crash in 1720, companies were restricted from raising additional capital and few companies issued new shares for the rest of the 1700s.

Investors wanted a reliable cash flow, and after the bubbles of 1719-1720, only the largest monopolies backed by the government were seen as reliable enough to warrant investment.  Most financial capital went into government bonds. Even the few companies that survived the bubble behaved more like bonds than equities, changing little in price. Between 1688 and 1789, British government debt grew from £1 million in 1688 to £244 million in 1789 and to £745 million in 1815. During that same period of time the market capitalization of British shares grew from £1 million in 1688 to £30 million in 1789 and £60 million by 1815.  The market cap of shares, which was equal to outstanding government debt in 1688 shrank to less than 10% of government debt by 1815. Because of its reliability in payment, Britain was able to increase its debt to levels twice GDP by 1815, while the yield on the debt declined, falling from 8% in 1701 to 3% in 1729 when the annuities were introduced.

The Second Era: Globalization
The process of globalization began in the 1780s and continued to grow until 1914. The Bank of Ireland and the Grand Canal went public in 1783-1784, and government debt from the major European powers traded on the Amsterdam stock exchange in the 1780s. However, the Napoleonic Wars bankrupted most of Europe. During the Napoleonic Wars, the Dutch West India Company and Dutch East India Company as well as the French East India Company were all driven into bankruptcy while the Netherlands, France, Austria, Russia, Spain, Sweden and the United States all defaulted on their debt. Britain was the only country that didn’t default.  French and Dutch debt was reissued at a loss to bondholders, but British debt continued to pay on time attracting more investors to British government debt.

It cannot be understated how much equity markets were transformed between the late 1700s and the early 1800s. Before 1815, British financial markets were primarily geared toward issuing bonds, or “the Funds” as they were called, to investors who wanted consistent, reliable dividend and interest income from their investments.

In the 1790s, things started to change.  The first canal bubble occurred in the 1790s as dozens of canals in the midlands of England issued shares to raise capital to build canals across Britain.  In 1789, Alexander Hamilton reorganized the finances of the United States and the Bank of the United States was founded in 1791, issuing $10 million in capital to investors. The Bank of the United States was followed by the incorporation of dozens of other banks and insurance companies that raised capital in the United States. The Federal government and state governments all issued new debt....