Causes and dynamics of equity market run‐ups and “bubbles”: Lessons from the boom and bust of Britain's railway mania of the 1840s

“…the business of economists is to find clever fundamental market explanations for events; and our methodology should always require that we search intensively for market fundamental explanations before clutching the “bubble” last resort. Thus, among the “reasonable” or “market fundamental” explanations I would include the perception of an increased probability of large returns. The perception might be triggered by genuine economic good news, by a convincing new economic theory about payoffs or by a fraud launched by insiders acting strategically to trick investors. It might also be triggered by uninformed market participants correctly inferring changes in the distribution of dividends by observing price movements generated by the trading of informed insiders.” –Peter Garber1 “Noise trading is trading on noise as if it were information…With a lot of noise traders in the market, it now pays for those with information to trade. It even pays for people to seek out costly information which they will then trade on. Most of the time, the noise traders as a group will lose money by trading, while the information traders as a group will make money. …The noise that noise traders put into stock prices will be cumulative, in the same sense that a drunk tends to wander farther and farther from his starting point.” –Fischer Black2 Equity market run-ups (also known by the fraught term, “bubbles”) have riveted the attention of investors, asset managers, regulators, and central bankers for centuries. Commonly defined as a departure of prices from fundamental values dominated by a self-fulfilling feedback loop between expected prices and current prices, such episodes summon the conventional view that run-ups reflect market irrationality. Some run-ups preceded spectacular crashes and spawned serious economic contractions, from which new regimes of prudential regulation and pre-emption followed. Iconic examples were the Mississippi Bubble (1720), the South Sea Bubble (1720), the “Roaring Twenties” (1924–1929), and the Housing Bubble (of 2003–2008). Yet other run-ups have produced no long-lasting effects.3 Success in distinguishing malign run-ups from their benign counterparts depends on a deep understanding of their causes and dynamics. Making use of these four propositions, we offer insights into the causes of one of the most prominent run-ups of the 19th century and then offer reflections upon their implications. Yet why does discernment about run-ups matter? Central bankers and regulators often debate whether and how to intervene in run-ups and slumps. Household investors and professional asset managers struggle to adjust portfolios to unusual market conditions. CEOs and CFOs labor to make sense of unusual changes in their share prices in an effort to sustain efficient capital allocation. As a result, the astute official, investor, or executive should: (1) look for economic shocks that might explain the run-up; (2) assess the sufficiency and quality of information about them; and (3) ascertain which investors are trading—who is at the margin? New research on Britain's “Railway Mania” of the 1840s by Atta-Darkua, Bruner, and Miller (2024) provides the foundation for this discussion. In 1844, British Prime Minister Robert Peel commenced a legislative reform of laws, regulations, and customs that constrained economic growth, restricted foreign trade, limited the ability of entrepreneurs to form new companies, checked the Bank of England's lending, challenged investors’ property rights, and constrained governance in the burgeoning railway industry. Altogether, Peel's initiative amounted to one of the most significant liberalizations in economic history.5 This programmatic onslaught coincided with a remarkable run-up in British railway equity prices from early 1844 to August 1845. Charles Mackay, a contemporary writer described the “mania” as the “greatest example in British history of the infatuation of the people for commercial gambling” ([1841], 1980, p. 88). Then in the fall of 1845, the run-up turned into an equity price slump, followed by a modest recovery, and then a long and deep deflation in both stock prices and economic activity. This process triggered serious civil unrest in Britain. Indeed, Karl Marx and Friedrich Engels (Marx & Engels, 1850) went so far as to suggest that the railway “mania” and subsequent commercial crisis were capable of setting off a communist revolution across Europe. What causes them? Run-ups have been attributed to greed, fraud, and theft, overoptimism, and other cognitive biases.6 But such explanations have in turn prompted critical responses, notably Peter Garber's (1994, 31) reply printed above. This study offers evidence that a run-up can reflect rational responses to news of economic shocks. Our research suggests that the run-up of 1844–1845 was significantly (but not exclusively) associated with a government policy “shock” in the form of Peel's economic liberalization program. Our article is the first to find an association between an equity market run-up and rapid liberalization, a shock to be added to other triggers (positive and negative) in economic history.7 The tendency of markets to over-react to shocking news (and even mundane news) has been documented8—therefore we do not dismiss behavioral causes of run-ups, but rather offer our evidence as supporting a complementary explanation. Our earlier study was the first to confirm the association of a government policy shock with the run-up of 1844–1845.10 In this article, we build upon the insights of that study to explore the inflation and deflation stages of the run-up, and to consider the why and the how of run-ups. The discussion here offers preliminary evidence about the dynamics of the run-up, on which we hope to stimulate research on run-ups and careful reflection for policymakers.11 Markus Brunnermeier (2018) summarizes a growing literature on bubbles by attributing these events to limits to arbitrage, asymmetric information,12 overconfidence,13 and cognitive biases.14 Austrian economists and monetarists argue that expansion of the money supply and availability of credit presage runups.15 However, none of these theories suggests why a run-up starts, or how it advances. A Disparate Trading Environment: Traders in the market differ in terms of experience, expertise, sophistication, information, and/or access to special information or benefits. Parliamentary debates in 1846 suggested that the railway run-up attracted investors who were novices, inexpert, uninformed, and outsiders in British society. Recognition of such divisions is not new in financial theory but has received less attention in empirical studies of run-ups.18 Also, laboratory experiments reveal that depth of information and experience significantly affect the propensity for bubble-like run-ups to form.19 Black (1986) distinguished between informed and uninformed (or “noise”) traders. The informed traders may have benefited from investing in deep due diligence analysis or from inside information from people close to the shock. Uninformed traders trade on “noise,” momentum, or the behavior of seemingly informed traders. Hong and Stein (1999) distinguished between “newswatchers” and “momentum traders”—the former respond to news (i.e., real facts), whereas the latter respond to trends in prices. As Hong and Stein wrote, “…when only newswatchers are active, prices adjust slowly to new information…momentum traders…arbitrage away any underreaction left behind by the newswatchers…the initial reaction of prices in the direction of fundamentals is indeed accelerated.”20 Joshua Schwartzstein and Adi Sunderam (2021) describe two kinds of traders in a market, “model persuaders” (or experts such as financial intermediaries “talking their book”) who aim to influence “receiver” traders (such as household investors) by “proposing models that organize past data to make predictions” (276)—models (and their persuaders) come and go as their ability to interpret data waxes and wanes. The point is that differences across segments of traders and the interactions among them offers explanations consistent with what we observe in run-ups and slumps such as the British railway mania episode. The Conservative (Tory) Party gained a parliamentary majority in the British general election of July 1841, which presaged the rise of Robert Peel as Prime Minister. He led a party sustained by the nobility, gentry, industrialists, and rising middle class. As a reform-oriented conservative, he stood apart from the more reactionary elements in his party. Peel recoiled from the social privations and civil unrest associated with the Industrial Revolution its business cycles. However, he sensed that intra-party resistance to his reform ideas would erode his political power. “Peel's convictions became firmer and his language harsher and more defiant,” wrote his biographer (Hurd, 2007, 255). By the start of the 1844 parliamentary session, Peel decided to wager his political capital on a range of laws addressing social, political, and economic problems. The diffusion of railway technology had been growing for years, beginning with the founding of the first inter-city steam-driven railway, the Liverpool and Manchester, in 1830. A smaller boom of railway expansion occurred in the mid-1830s, only to recede with depressed conditions in the late 1830s. After a recession that lasted from 1841 to 1843,22 the run-up popularly known as the “railway mania” began in earnest. Figure 1 depicts the equity market23 run-up (January 1, 1844–August 9, 1845) and slump (late August and thereafter). Cumulative returns associated with the run-up amounted to 29.7% on a broad portfolio of stocks, and 63.5% on a portfolio of railway stocks. Our analysis of the returns to shareholders yields three important insights. First, the equity market run-up was a railway sector phenomenon. We examined equities in other industrial sectors and found only modest positive cumulative returns to shareholders. Spillovers from the railway sector to other sectors seem to have been scant: returns were small and generally insignificant—but positive—for a portfolio of banks, and smaller yet among firms in the insurance, metals, and shipping sectors over the same period. Second, the run-up was significantly associated with events in Peel's liberalization program. Drawing on hand-collected data and an empirical research method not previously used in the analysis of run-ups, our study found a significant association between events in Peel's liberalizing program and returns to shareholders. From January 1, 1844 to August 9, 1845, event returns accumulated to 58.7% for railways and 46.2% for the broader diversified portfolio.25 Further analysis revealed that railways in the South and Midlands regions of England (areas with dense populations and concentrations of manufacturing and trading firms) saw significantly greater returns to railway shareholders. Finally, the largest firms (those that led a process of industry consolidation into country-wide systems) experienced significantly greater shareholder returns. Third, as Figure 1 shows, the run-up was not a monotonic advance. Two phases emerged—a slower gain on railway equities of 24% January–August 1844, and a greater gain of 32.5% January–August 1845.26 It is important to note that the two phases of high returns were contemporaneous with sessions of Parliament which typically met from January to the end of August each year. During the interim between parliamentary sessions (September–December, 1844), railway entrepreneurs and consolidators flooded Parliament with applications for charters to expand existing railway systems or to charter new railway companies. The number and nature of these applications was not announced until January. Whereas Parliament considered 66 applications in the 1844 session, Members of Parliament confronted 248 applications at the start of the 1845 session.28 The implication of this look-ahead is that the opening of Parliament's session in winter 1845 faced an explosion in applications to expand Britain's railways. The flood of charter applications would rise even higher in following years. Figure 2 indicates that railway expansion sharply accelerated in 1845, that 1846 marked the peak of railway bills enacted by Parliament, and that enactments nevertheless continued into the early 1850s. The boom in real railway expansion lasted from 1844 through 1848. The implication of this look-ahead is that the opening of Parliament's session in winter 1845 encountered a tsunami of applications to expand Britain's railways. Why the rush? First-mover winner-take-all benefits30 motivated the pre-emption of competitors. As a Member of Parliament claimed, some “railway lines [were] put forward merely for the purpose of preventing competing lines.”31 Parliament was worried about overbuilding that would to of that a railway charter would a with the of Finally, the of railway the of of of and returns on equity to a which economists with efficient and However, the two phases of the run-up The first a in railway returns of only significantly from a and a of returns of and marked this as a rather of the run-up as not about the nature of the liberalizing until the end of the parliamentary session in This policy may to explain the of this The 1845) a of and of significantly from the a the two phases reveal a significant in Figure depicts differences between the two sessions 1 and as as to the interim between the two In the of the 1845 parliamentary the higher cumulative and significantly more trading What might explain the differences in cumulative returns between the parliamentary sessions of 1844 and First, about the and terms of the initial three new laws was not until the end of the session of The laws and that late in that session the of applications to charter new railways or existing Second, the new financial and shareholder rights, which research has is associated with shareholder Third, the and of consolidation of railways a to of Finally, contemporary evidence the of a broad range of new and were less informed traders. or at small in and have and of the the of Members of Parliament the of investors at the of the run-up in The of these new investors is consistent with research on and with theories that on segments of traders to explain why run-ups can to shocks at first and then The of these contemporary the of such traders in other The run-up on August 9, 1845, followed by a that began slowly and then of in and of a in and of shareholder on news in and the Bank of England its to the would it to Then on The of printed an of the capital to the railway expansion by existing and new the was more Britain's in 1845 and more its During parliamentary debates over the railway mania in over the ability of Britain's financial markets to the with the news, share prices of railway about from August to 1845. 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