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Tulipmania: Lessons from past

Oct 7, 2008

The recent meltdown of equity markets world over once again highlights the gullibility of crowds and the dangers of financial speculation. Speculation in equity markets is merely a modern version of gambling instinct of humans, which can be traced back to probably the first bubble in mid 17th century -Tulipmania. The History
'Tulipmania' saw the price of single Tulip bulb rise to the value of a luxury house in 17th century Amstradam. Around 1624, the price of one bulb reached 3,000 guilders, which roughly equaled the annual income of a wealthy merchant.

At the time of the tulip speculation, the Netherlands and in particular the city of Amsterdam had become the center of international commerce and had superseded the Italian cities of Genoa, Venice, and Naples. The Bank of Amsterdam was established in 1609. It had what amounted to a stock exchange. Even today there exists a list of price quotations from as early as 1585. Commerce had become the lifeblood of the merchant class. There were independent handicraft workers, small farmers, an infant bourgeois class in the cities (the burghers) and commodity production was in full swing. Holland at the time of the middle of the 17th century was, in the words of Karl Marx, "on a level of economic development which Britain attained in the 18th century.

Tulip mania reached its peak during late 1637. Tulip bulbs started changing hands more than ten times in a day and the mania reached its pinnacle in early that winter after which tulip prices crashed. It began in Haarlem, at a routine bulb auction when, for the first time, a buyer refused to show up and pay. Within days, the panic had spread across the country. Despite the efforts of traders to prop up demand, the market for tulips evaporated. Flowers that had commanded 5,000 guilders a few weeks before were selling at one-hundredth that amount.

'Tulipmania' teaches us that speculation is merely the symptom of a much deeper malady, which has accompanied every stage of the evolution of capitalism.

The collapse of the tulip market was the result of capitalist overproduction. The overproduction was not because of extremely favorable weather conditions or other natural phenomena. It was the result of production for a capitalist market. It was production for profit and not for immediate consumption. The relatively new and powerful class of merchant capitalists harnessed the trade and directed the profit into the channels of world commerce.

We can draw a parallel between the tulipmania crash and the current stock markets crash. Current crisis is also result of speculation of mortgage products.

Any form of transitory noise can create opportunities for beating the market. In general, when the stock price rises, there is a chance that it rose because of the transitory noise and will therefore fall in the near future. Variations in price, no matter how extraordinary, explain only the fluctuations. They do not touch the fundamental causes. Thus it is of paramount importance that an investor looks at the fundamental of the stock and values a stock on the basis of its fundamentals not on the basis of its price.

The investor who focuses on business fundamentals is able to perform emotional arbitrage, selling when the market is irrationally exuberant and buying when the market is irrationally pessimistic. As Benjamin Graham says, "Common stocks have one important investment characteristic and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble".

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