The Four Horsemen of the Market
GFD has collected historical data on long-run returns to stocks, bonds and bills for over fifty developing and emerging markets. Our analysis has not only separated out returns by country, but by time periods as well. We have broken up historical financial markets into eight periods since 1792 and found that returns in those periods have differed because of war, inflation, socialism and autarky. The presence of any or all of those have significantly reduced returns to stocks, bonds and bills, while their absence has provided an environment in which high returns are possible. A brief explanation can show why each of these has a negative impact on returns.
War directs economic activity away from production. War creates massive destruction which reduces the supply of resources to the market. Governments often take over production during the war and redirects industries toward the war effort. Consumer goods become short in supply and the government limits the profitability of corporations. Countries directly involved in a war suffer while countries supplying materiel to the belligerent countries, but are not involved in the war, may benefit. Countries often default on government bonds during wars and inflate the economy since they find it difficult to pay for the war. After the war there is dislocation in the economy and recovery may be slow. Once the war and its subsequent dislocations are over, the economy can recover quickly as it returns to normal, but during the war, returns to stocks, bonds and bills falter.
Inflation is one of the worst enemies of bonds and bills. If you purchased a bond in a low-inflation environment and expected to receive a 3% return for the next ten years, but then inflation goes up to 10%, 100% or hyperinflation occurs, your returns will be quickly wiped out. Stocks can provide a protection against inflation, but mainly in relative terms. The equity-risk premium increases during inflationary periods, more because of the low return to bonds and bills than an increase in the return to stocks. After adjusting for inflation, some countries have seen real losses of over 90% to investors as inflation accelerates and shares fail to keep up. After the inflation has stopped, shares recover to their real values, but the destruction of value in bonds and bills remains. Fixed income investors have no way of recovering their losses.
Asset bubbles drive up prices as large amounts of money and credit chase assets that are limited in supply. The bubble can affect shares, real estate or any other financial assets. People begin buying financial assets because they are certain that they can sell them in the future at a profit. This process can continue for several years before reality crashes the market. Prices often return to their level before the bubble as investors flee crashing assets which can remain low for years to come as people avoid investing in shares, real estate or any other asset whose value got artificially bid up, fearing that they will get burned again.
Socialism refers to the government ownership and control of industry. This can come either in the form of government regulation of an industry, government nationalization of an industry, government restrictions on operating in an industry or any other form of restriction on the market. The mere threat of socialist intervention in the market can hold back returns for decades out of fear that either the government may pay too low of a price for the assets they nationalize or that they may seize assets without compensation. When the Communists took over in Russia, China and Eastern Europe, investors were not compensated for the loss of their assets. Some investors lost everything.
Autarky refers to trying to produce goods without pursuing international trade. Barriers to trade may help companies within their own domestic market, but limits their ability to sell their goods and services to other countries. Exchange rates can also be manipulated to limit trade between countries. Trade restrictions were used between 1914 and 1981 to limit trade between countries causing a reduction in returns to stocks. The most successful economies, such as the Anglo countries and East Asian countries, are ones that promote trade. Countries that have relied on import substitution, such as South American countries, have suffered from those policies.
Although there are other factors that influence long-term returns, these are the four main factors that provide the best explanation of differences in returns over time and between countries.
Before the Revolution
Few people realize how active the Paris stock market was during the 1700s. The Paris stock exchange was founded on September 24, 1724, though shares in the French East India Co. (Compagnie des Indes) had traded in Paris since 1718. GFD has data on over 70 securities that traded on the Paris bourse in the 1700s. This includes 15 common stocks in 7 different companies, one corporate bond, 50 different government bonds and 6 issues of scrip, all faithfully recorded from issues of the Gazette de France. Parisian investors were also able to invest in stocks and bonds in London and in Amsterdam during the 1700s and did so frequently. The prices of Dutch and English stocks were regularly published in Paris during the 1700s to aid investors.
It is interesting to note that French East India Co. stock suffered more volatility during the 1700s than shares in either London or Amsterdam. Compagnie des Indes shares rose over 4000% during the bubble in 1718 and 1719, only to lose 99% of their value during the crash that followed. There were five bull markets in which shares rose by over 90% in Paris in the 1700s and three bear markets in which shares fell by over 50%. The Paris stock exchange was not for the feint of heart. The rise and fall of Compagnie des Indes shares are illustrated in Figure 1.
Figure 1. Compagnie des Indes Share Price 1725 to 1793
Most people know the basic story of the French Revolution. France’s aid to the United States and other wars with England indebted France leading to new taxes that fed a revolt against the king and the aristocracy. The Estates General was convened in May 1789, and on July 14, 1789, the Bastille was stormed marking the beginning of the French Revolution. The Declaration of the Rights of Man was passed and feudalism was abolished in August 1789. France became a republic in September 1792 and in January 1793, King Louis XVI was executed. A dictatorship gained power in 1793 under Robespierre and the Committee of Public Safety, which introduced the Reign of Terror. In 1795, the Directory assumed control over France, suspended elections and repudiated debts. The Directory remained in power until 1799 when Napoleon Bonaparte overthrew the Directory in a coup and became the leader of France.
The Paris stock exchange was formally closed on June 27, 1793 and all joint-stock companies were banned on August 24, 1793. But once the joint-stock companies were shut down, who would dispose of the assets of the companies? French East India Co. managers bribed government officials so the company, rather than the government, could oversee its own liquidation, but once these bribes were uncovered, several of the company officials involved were arrested and later executed. The liquidation of the company produced only three ships which were liquidated in July 1795, and as a result, shareholders in the Compagnie des Indes lost virtually everything.
Bondholders met a similar fate. France defaulted on its pre-revolutionary debt in 1796. Napoleon reorganized French debt in 1799, giving shareholders 1/3 the value of their old bonds in new 5% consolidated bonds which didn’t pay any interest until 1802. A similar loss occurred to Dutch shareholders, who also lost 2/3 of the value of their bonds.
The Assignats, which were currency issued during the revolution, became almost worthless during the inflation that ravaged France. After inflation, 100 Francs in Assignats in 1789 were worth less than 5 centimes by 1796. More people were put to death for counterfeiting the eventually worthless Assignats than for any other crime committed during the French Revolution.
Just as the ancien regime collapsed during the French Revolution, so did the country’s finances. Investors were unable to sell their shares and bonds and fled to England where, at least, they wouldn’t lose their lives. As the Napoleonic Wars dragged on, other countries defaulted on their debts. The Swedes, Dutch, Portuguese, Spanish and Russians all suspended interest payments at some point during the Napoleonic Wars. Only English finances survived the Napoleonic wars intact.
Figure 2. Yield on French Government Bonds, 1746 to 2018
After Napoleon gained power during a coup on November 9, 1799, he worked to rehabilitate France’s finances. Napoleon replaced the Livre Tournois with the French Franc. The 5% Consolidated Bonds were issued to replace outstanding French debt. Initially, the price of the bonds sank to 9.25 at the end of 1798, but once the government started paying interest, the price of the bonds recovered and the yield on the bonds fell as is illustrated in Figure 2. Napoleon established the Banque de France in 1801 to provide France with a central bank similar to the one that England had. The company’s shares became the largest joint-stock company on the bourse and traded in Paris until the bank was nationalized in 1946.
The re-establishment of France’s finances was a success. Between 1800 and 1914, Paris was the center of finance in continental Europe providing shareholders and bondholders during the 100 years before 1914 with one of the highest returns of any European country.
The Periods of French Finance
We can break down the history of French financial markets into eight periods: the Age of Louis XIV (1719-1793), the French Revolution and Napoleonic Wars (1793-1815), Restoration of the Monarchy (1815-1848), the Second Republic and Empire (1848-1871), the Belle Epoque (1871-1914), World War I and II (1914-1945), the Fourth and Fifth Republic (1945-1981), France and the EEC (1981-2022).
Figure 3. GFD French Stock Index, 1718 to 2022
After Napoleon became the ruler of France, he both reorganized French government finances, allowing investors to receive one-third of the newly issued 5% government bonds and created the Banque de France to regulate the French economy. Until the rise of the railroads, the Banque de France was the largest company in France. In part, because of the problems created by the Napoleonic Wars, Banque de France stock traded in a range until 1814 when the stock collapsed in price.
After the Napoleonic Wars were over, the economy recovered and Banque de France stock tripled in price by 1840. The first French railroads appeared in 1836 and contributed to the growth of the stock market in the 1840s along with stock markets in England, Germany, Austria and other countries. Between 1836 and 1845, the capitalization of the French stock market tripled in size. However, with the revolution of 1848, the stock market collapsed in price losing half of its value.
The Second Republic came into existence in 1848 and the Second Monarchy in 1851 with Louis Napoleon becoming the leader of France. Railroads continued to dominate the French Bourse, but the stock market began to branch out into other areas, including foreign stocks, bank stocks, gas stocks, mining stocks, coal stocks and other sectors. Although the French stock market quadrupled in its capitalization between 1852 and 1871, stock prices made little progress. France lost the Franco-German war and the French Commune took over Paris in 1871 causing the stock market prices to collapse.