In today’s issue:

  • The first legendary trader
  • Don’t do drugs in economics either
  • Don’t believe your own dodgy narratives

Very few investors manage to profit from both the boom and the bust of an asset bubble. They are either captured by the irrational exuberance of the boom… and go on to lose their fortune in the bust. Or they are a cynic all along… and miss out on the gains before their gloomy predictions eventually come true in the crash.

Many people predicted the 2008 financial crisis. Indeed, one warned back in 2002 how things would unfold. He explained how US central bank and government policy would inflate a housing bubble that would eventually burst. And he was a politician!

Some hedge fund managers made an absolute fortune speculating on the bust. The Big Short film is about just one of them.

And we all know about the scandalous amounts of money made by those speculating on the dodgy housing boom in the first place. The skyline of Manhattan was littered with golden parachutes in 2008 and 2009.

But can you think of anyone who famously played the boom and the bust of the housing bubble? Who got famous speculating on house prices up to 2006, before pivoting to a “big short” type of position in 2008?

I can’t think of anyone famous for both. Let me know if I have it wrong. [email protected].

The same goes for other asset bubbles too, of course. Were there any techno-optimists who turned bearish on the Nasdaq in 2000? (I know of one poor fellow who was sceptical about tech stocks for many years, before turning bullish just before they plunged…)

Are there any Japanese billionaires who sold everything and shorted the Nikkei in 1990?

Do you know any Australians who rode the commodity bull market until 2011, before betting on their former portfolio’s demise?

Did anyone predict both negative bond yields in 2020 and 4.6% in 2024? I know of plenty of deflationistas. And those who warn about bond yields blowing out due to inflation. But did anyone do both?

As far as I can tell, the last investor to both play a boom and speculate on its bust successfully did so 300 years ago. And he managed to pull it off twice in the space of a few years…

The legendary trader who knew how to play a bubble from start to finish

The Irish banker Richard Cantillon got absurdly rich from the boom and bust cycles of the Mississippi Bubble and South Sea Bubble. But it was only on paper, in the end. His creditors refused to pay out his winnings. His savant-like trading abilities led them to suspect foul play. They sued him and pursued him for what they owed him.

It is rumoured he had to fake his own death in a house fire to escape their clutches.

Before his suspected escape, he conveniently wrote the book some say founded the field of modern economics. And that book does a great deal to explain how Cantillon predicted the booms and their inevitable busts which made him rich.

It’s all to do with governments printing too much money.

Don’t do drugs in economics either

The theory that gave Cantillon his investing edge is familiar. Indeed, it’s the same one teenagers’ parents use every Friday. If you do drugs to induce an artificial high, prepare for a subsequent low.

It’s the same in economics. If you goose economic activity to an artificial high using monetary policy, you will have to eventually have to pay the price. In this case, literally, in the form of inflation. Cutting interest rates and quantitative easing (QE) may feel good initially. But it is also the source of our subsequent economic ills.

The more advanced understanding of this theory explains why this is the case. The economy initially can’t tell the difference between printed money and saved money. It thinks savings have suddenly risen without consumption falling – an impossible but thoroughly pleasant experience.

True savings signal an eventual increase in future consumption and fund the investments of businesses to meet that future consumption. Thus, when central banks print money, the economy is misled into investing in production capacity in the hope of future profit.

We still call these effects “Cantillon effects” today. But we don’t call what happens next the “Cantillon crash”.

You see, once the savings turn out to be nothing more than printed money, the future consumption never arrives. Instead, prices just rise. And so there’s a bust as investments fail to pay off.

Applied theory of economics to investing

Using his theory, Cantillon predicted the economic and financial boom and bust cycle that would result from John Law’s currency reform in 18th century France. The Scot came up with the innovative idea of printing lots of money. As a result, the French economy went on a truly bizarre journey of exuberance followed by crisis. This most prominently played out in the share price for Mississippi Company shares. They soared and crashed.

It’s obviousIt’s much safer to look for sound investment opportunities based on careful analysis. how to invest in a boom. You buy the relevant stocks. But what about the bust? How do you make a fortune from a crash? Without running a hedge fund that has access to derivatives, I mean.

The method Cantillon used to profit from the bust is still available to investors today: options. There are two kinds. But “put options” are the ones that can provide vast profits during a stock market crash.

But let’s move on to another one of Cantillon’s lessons.

Don’t believe your own narratives

Cantillon also teaches us that one should be agnostic about the merits of a bubble in order to profit from it. Despite foreseeing the disastrous consequences of two bubbles, Cantillon speculated on both the manias and then the crashes they created.

Indeed, John Law reportedly asked Cantillon to help him re-engineer France’s monetary system. But Cantillon saw through the inflationary policies and understood what their eventual consequences would be. So he refused.

But that didn’t stop him from playing the market in Mississippi Company shares.

The final lesson is to pay attention to counterparty risk. I know people who speculated that the 2008 financial crisis would happen using options. Unfortunately, it turned out their counterparty was owned by Lehman Brothers. And so they only got paid back pennies on the pound in the end.

Similarly, Cantillon never collected on his winnings from betting the South Sea Bubble would crash. He made so much money that a good chunk of the nobility decided to turn on him instead.

So, whatever you do, don’t get too rich speculating on bubbles…

Like this one.

Until next time,

Nick Hubble
Editor, Fortune & Freedom