The Great Boom and Panic

[Note: The following is part 1 of a multi-part installment covering what is probably the most insightful book ever written about the stock market panic of 1929, "The Great Boom and Panic," by Robert T. Patterson.]

The book "The Great Boom and Panic" is the most incisive and probing analysis we have ever come across in attempting to discover what exactly "caused," and resulted, from the runaway bull market of the 1920s and its subsequent collapse. While many expositions have been written on this subject, we believe Patterson's to be the most suitable explanation and it is our purpose in this article, and in the installments to follow, to expound Patterson's excellent observations, for there are numerous parallels between 1929 and the present.

We have chosen to skip over Patterson's first chapter, entitled "Various Aspects of the Boom," which would is nothing more than a repetition of what we already know about the investing climate of the 1920s compared to today. Instead, we will begin with Chapter 4, "The Last Year of the Boom."

Just prior to the crisis that would develop later in 1929, the Federal Reserve Board adopted a stance toward a loose credit policy, lowering interest rates and increasing the money supply in order to stimulate commerce and, inadvertently, stock market speculation. Observed Patterson, "Through liberal lending and open market operations, and by reducing the rediscount rate, the Board encouraged a further expansion of bank credit for speculative purposes."

Another common characteristic that the financial climate of 1929 shared with our own today was the widespread aversion to commodities. Commodities of all types, and especially gold, were largely ignored and dismissed as "out of fashion" by the investing public. Ironically, it was this very antipathy toward tangible assets that would later prove to be their downfall. Patterson makes an intriguing observation on this note when he writes, "Through September 1928, stock prices remained high, but buyers were reluctant to bid aggressively. In October the upward trend was resumed, despite seasonal pressure upon the loan markets for funds to harvest and move the crops and stock goods for the heavy retail buying of the holiday season. The rates for call money and for thirty-to-ninety-day loans ranged around 7 percent. Seasoned followers of the securities and commodities market knew that a credit strain in the autumn sometimes had led to panic." [Emphasis added]

From this passage two pertinent observations can be made: 1.) The 7 percent short-term securitized debt that Patterson refers to led to what is known as an "inverted yield curve" at that time. This occurs when the yield on shorter-maturity bonds exceeds that of longer-term yields. Typically, this presages a downturn in the economy. Earlier this year, we witnessed a similar inverted yield curve in the Treasury market. 2.) Patterson cogently discovers the reason, perhaps without realizing it, why financial panics so frequently happen in the autumn. They are, in part, the products of a pressured commodities sector, for when farmers must harvest their crops in the Fall, it requires great sums of capital that must be pulled out of banks, and by extension, equities markets. If it so happens that there is already a pre-existing strain on credit markets at that time—not to mention a precarious aspect to the stock market—it is easy to envision what all too often ensues: a financial panic. What is even more ironic is that in cases such as these, bureaucratic policy, which always strives to stimulate a brisk financial climate in equities at the expense of commodities, "shoots itself in the foot" by pursuing such strategies. Because federal policy encourages growers to overproduce and plant more than they should (thus guaranteeing a huge surplus and corresponding deflation of commodities prices, thereby stimulating the equities markets), it eventually leads to exactly the conditions they seek to avoid.

Can there be any denying that our present economic case parallels almost precisely that of 1929? Even now, an agricultural and general commodities surplus of monstrous proportions has kept this sector in the doldrums of deflation for several years. And now, with credit and equities markets at vertiginous heights, commodities are starting to show signs of life and threaten to knock down the inverted pyramid that is the U.S. financial structure.

Speaking of "pyramid," Patterson provides us another example of one in 1929 similar to one that exists today. Writes Patterson: "Many who were long in stocks had followed them up with stop-loss orders. (Such an order could be placed below the current market price of a stock, and it would become a "sell-at-the-market" order if and when the designated price was reached. A similar order to buy could be entered above the prevailing price). As the decline set off these selling orders they added to the pressure upon the market from the forced liquidation of margin accounts and from the persistent short selling of the bears. Thousands of thinly margined accounts, some of whose paper profits had been used to 'pyramid' holdings, were sold out by the brokers to protect themselves from loss." The widely-used "stop-loss" (which, in its proper place is not necessarily a bad thing) was in fact one of the contributing factors to the vicious aspect of the stock market crash in 1929, as waves of selling were triggered automatically from pre-existing selling orders. Today, traders and investors are being taught to never enter a buy order without a stop-loss order to accompany it. We got a foretaste of things to come in the summer of 1998 when similar waves of stop-loss orders were set off in waterfall fashion, contributing the 22% Dow correction. Based on our research, the use of stop-losses far exceeds that of 1998 or any other time, for that matter. This will undoubtedly be one of the many catalysts that will set of the Wall Street collapse later this Fall.

Yet another mirror between pre-Crash 1929 and pre-Crash 2000 exists in the way of public temperament. Besides the widespread gambling spirit that was, and is, present in both cases, there was (to employ a psychological term), a "learned response" on the part of the speculating public to ignore declines and view each setback in the market as a buying opportunity. "The recovery from [market corrections]," writes Patterson, "had convinced many people that they should ignore the reversals and hold on to their stocks. They had learned how difficult it was to get out of the market and back in again to any advantage, and that in selling out they risked losing for good their bull market positions." We have seen this same tendency on the part of the public time after time, including during the mini-crashes of 1997, 1998 and 1999. It will be no different in the not-so-mini-crash of 2000.

A great fallacy of the late 1920s that is also presently in vogue is the mistaken belief that consumer spending was the basis of the great economic and stock market boom. Patterson notes this when he writes that "the exceptionally large volume of pre-Christmas shopping was taken to be a very favorable sign by those who thought of consumer demand as the basic support of the great prosperity." Then, as now, the "consumer" (really, an Orwellian word designed as much to invoke a certain response on the part of the public as to describe the public) was spending money with gusto, certain that the magnificent prosperity could do nothing but continue ever and anon into the far-off future. What they learned too later, however, is that consumer spending is merely a by-product—not a cause—of a booming economy. Take away the undergirding strength of the economy, namely, the soundness of business, and consumer spending immediately dries up. We, too, will learn the same lesson…the hard way.

Another aspect of pre-Crash 1929 that concerns us is the state of the credit market at that time. Observes Patterson: "One important change that had come about in the financial scene was the high 'price' of money. Borrowable funds were no longer abundant and cheap, as they had been from the 1920-21 deflation through 1927. Interest rates had risen markedly along with the enormous increase in borrowing by brokers to finance their customers who bought and held stocks on margin [yet another disaster waiting to happen]. Loans to brokers had increased by $2 billion during 1928 and by $3.2 billion since the beginning of 1927. At the end of 1928, the total amount of Federal Reserve bank credit outstanding was 'at the highest level in seven years.'" Until October 1998, our own interest rates were low and conducive to broad speculation and borrowing of funds. Since then, the Fed Funds interest rate has slowly risen when, earlier this year, it reached a seven-year high and began to choke off speculation to some extent and made borrowing money for all types of purposes more difficult. It is also interesting to note that then, as now, "whether or not the rediscount rate would be increased was the subject of substantial betting each week in the New York and out-of-town financial districts." And just as in 1928-1929, consumer credit outstanding remains at all-time highs.

But fear not, our benevolent bankers are just as concerned today as they were then for our financial safety. In a move reminiscent to recent Alan Greenspan overtures, the Federal Reserve in 1928 "issued a forthright statement to the effect that too much of the country's bank credit was being absorbed by speculation. Its purpose [so they would have us to believe] was to discourage the commercial banks from borrowing at the Federal Reserve banks while making loans that supported stock speculation. Although the Board took no direct action to tighten credit, the possibility that it would do so was implied." Of course, taking action and merely taking the semblance of action are two different things entirely.

As an aside, another parallel to the late '20s and today occurred with a redesign of federal bank notes. Paper money was converted in 1928 from the old "horseblanket"-sized bills to the much smaller-sized denominations we use today. In the past couple of years, our own currency has been overhauled to reflect an entirely new design on all of the larger denominations, as well as the insertion of a readable strip on the face of each bill of nearly all denominations. The explanation for this may lie in the belief that a "New Era" (then as now) is worthy of a new currency.

Finally, we make some observations about the volume of trading in 1928-29 compared to today. Patterson notes that late in the boom and just prior to the crash that trading was heavy, prices were erratic, and market leadership shifted from stock to stock and from sector to sector. This is the exact same phenomenon we are witnessing now which can only be described as a "split tape." Patterson notes that "the tape frequently recorded large blocks of high-priced stock changing ownership at advancing prices. Some pool operators, to their amazement, discovered that they could liquidate all of their holdings of a stock with little effect on its price. One pool was reported to have sold 60,000 shares of a leading stock within an hour, and within a price range of little more than two points. Again, it was the 'rich men's' stocks—the respectable, high-priced 'blue chips'—in which a great deal of speculative excitement centered."

"Large blocks of high-priced stocks changing ownership at advancing prices" is the hallmark of every distribution campaign, and we are starting to witness a similar phenomenon in the current market, particularly in stalwart "blue chips." Indeed, a vigorous, fast-moving bull market which enjoys broad public participation is ideal of distributing massive quantities of stock onto unsuspecting investors since it is very difficult to interpret this selling on the tape under such conditions. These are precisely the conditions we find ourselves in today.

It will suffice to end our exposition of Chapter 4 of "The Great Boom and Panic" as Patterson did, with a note of warning: "the credulity and the delusion, the 'willing suspension of disbelief' on the part not only of the less seasoned public but even of the smart, long-time professionals, were at just as high a level as the stock prices recorded on the exchanges."

[Note: Next week we will continue our exposition of Patterson with a look at Chapter 5, "The Developing Crisis".]