For centuries, financial bubbles have risen across different industries, and they are mostly known for the terrible social consequences they have when they burst. Surprisingly, some economists deny the phenomenon of bubbles but most agree that they are only visible after they “pop”. Often, this happens because companies’ net assets are devaluated after more critical inspection reveals that they no longer reflect their previously expected value. One of the first examples of this was The South Sea Bubble that took place in 1720. Though it’s an old example, the South Sea Bubble has much in common with the climate surrounding the current app-economy.
The 1700s was a period where the British government was seriously in debt, and different schemes were thought up to reduce the liability (such as lotteries) but none were as ingenious as the one thought up by the South Sea Company (SSC). Incepted by Harley, Earl of Oxford, but mostly managed by John Blunt, the director of an unofficial bank “Hollow Sword Blades Company”, the company agreed to accept government debt by offering the public to swap them against their joint-stock of the South Sea Company.
Closing the deal included the government granting a monopoly of the trading ports of South and Central America to the SSC. John Blunt’s ambition was to use this monopoly to replicate the spectacular success of East Indian company founded in 1600.
In part due to the initial demand for SSC stock, many joint-stock companies appeared across the country. This led to the Bubble Act of 1720, which forbade ventures not granted by a Royal charter and thus led to a decrease in competition which in hand further accelerated the demand for the SSC.
The specular success of the SSC was mostly associated with John Blunt as he was a master crowed psychologist and could contrive fanciful stories. Add bribery of parliament officials and important political figures to the mix (including at one point the King himself, George II) to key positions within the SSC. After reaching a high of GBP 890 however, the SSC stock started to fall and even John Blunt with all his trickery couldn’t stop the burst. To avoid further loss, a deal was made with the Bank of England to prevent panic which lead to the final buyout of the SSC by a reluctant Bank of England and the East India Company. A witch hunt ensured and retroactive laws were enacted. Several member of the SSC board were accused and convicted to restore the strict value of their estate.
Today, there exist somewhere around 170 unicorns (companies valued at more than USD 1 billion) globally with a combined value of more than USD 600 billion from 39 with a combined worth of USD 100 billion in 2013. Among the most famous Unicorns are Snap Inc. is start-up company created by three students from Stanford University. Snapchat, the app known for its ephemeral messaging and appeal towards the younger generation, has been praised for its innovative outlook on communication and product design, and it is currently valued at USD 28 billion while only generating USD 300 million in yearly sales.
The South Sea Bubble and Snapchat – Commonalities and differences
There are some commonalities that could be inferred by observing these two cases. For instance, Snapchat appeared after the spectacular success of Facebook. This is to some extent similar to SSC which came after East Indian Company.
The South Sea Company managed to thrive due to the marketing of John Blunt thus hiding the elusiveness of their business model. It is similar to Snap Inc. Even today, we are still eluded on how they justify an USD 28 billion valuation. Interestingly enough, the SSC eventually failed because they never held any extensive rights over the trading ports of South/Central America. Similarly, Snapchat yields a promise some sort of monopoly thus justifying to investors its valuation.
Will we see a similar burst of the value of apps such as Snapchat? Historical comparisons of this sort are naturally always highly speculative. And to be fair, Facebook struggled with their valuation before introducing their mobile business model. Often, experts who value tech companies such as WhatsApp, Facebook, Instagram base their value on user base which can be viewed as ‘monopolies’. But as with the SSC, the promise of monopoly cannot by itself justify the high valuation. Monetization of that position is key.
Psychology and the future
So what else could justify such a high price? One explanation comes from Social Psychology.
Herd behavior from behavioral finance explains how the market trend affects the behavior of investors, leading to an increase/decrease of risk-taking. Seen in the SSC and with some early signs at Snap Inc., shows that they do not escape this behavior as they increased by USD 9 billion of market capitalization within their first day of trade (!) (2).
Greater fool theory: Investors understand that their stock might be over-valued but they believe that there is another fool down the line who will buy it from them. The SSC was victim of it: at a high GBP 500/100 equity, investors still bought the equity until the collapse of SSC.
Extrapolation: a classical bias where people believe past performance will lead to future performance in order to justify their investment. Equally observable from the SSC.
But what can this tell us about the future?
New mobile technologies and the possibility to trade with ease from our phones have made “trading barriers” much less problematic enabling even the pauper to invest. Decades ago, one would need a broker and call him to access a trade then digital advances enabled the internet to a more democratic brokerage.
Today, thanks to the technology found in our smartphones, it is conspicuous that trading apps have furthermore democratized financial transactions. The argument I wish to state is that the social psychological phenomena I described above can only be amplified by the removal of barriers and increase of the crowed effects first seen in the 18th century.
 As of 05.03.2017