Friday, February 11, 2011

Grantham on Bubbles

Here's an excerpt from Grantham's most recent quarterly letter:

"...asset bubbles don't spring out of the ground entirely randomly. They usually get started based on something real – something new and exciting or impressive, like unusually strong sales, GDP, or profits, which allow the imagination to take flight. Then, when the market is off and running, momentum and double counting (among other factors) allow for an upward spiral far above that justified by the fundamentals. There is only one other requirement for a bubble to form, and that is a generous supply of money."

Grantham later adds...

"Any value manager worth his salt can measure when there is a large bubble. To avoid exploiting bubbles is intellectual laziness or pure chickenry and is a common failing, in my opinion, in otherwise sensible and suitably brave Graham and Doddites.

I unabashedly worship bubbles. One of the very early ones – the famous South Sea Bubble – is shown in Exhibit 4. It's beautiful, isn't it? The shape is perfect."

Exhibit 4 in the letter is a chart that shows:

- Newton invests a small amount prior to the bubble
- Newton exits happy in the early stages before the bubble really gets going having made some money
- Newton sees his friends getting rich as the bubble does really get going
- So Newton re-enters near the peak of the bubble with a lot of money

Then, of course...

- Newton exits with the investment essentially a complete bust after the stock then falls roughly back to where he had initially invested just a small amount of money
The world has progressed in all kinds of ways over the past three hundred years or so. Yet human nature, the behavioral tendencies that move prices in the short-to-intermediate term, hasn't changed much if at all.

Sir Isaac apparently lost what would be roughly $ 4 million to $ 5 million in current terms or practically all (if not quite all) of his stake in the South Sea Company. While the losses he suffered from the South Sea Company was enormous compared to his total wealth, he apparently still did not end up poor by any means. So the investment in South Sea Company itself was, give or take, basically wiped out (something like roughly 90% of his stake) but it did not destroy Newton's entire fortune.

More on Isaac Newton in a follow up post.


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