History Repeats: 1929 versus 1999 - Part 1

One of the timeless maxims known to almost every student of human affairs is that history always repeats, and that those who do not learn from the mistakes of the past are doomed to repeat them. What fewer realize, however, is how this universal truth can be usefully applied to the various financial markets in forecasting price trends and market movements.

To the technical analyst of stock and commodity markets, this basic principle of history repeating itself underlies his analysis of financial conditions, for, after all, technical analysis is nothing more than the ability to recognize trends and patterns within financial charts that have forecasting ability based on historical reliability. A further assumption of the market technician is that a trend once begun is not soon altered but instead must continue onward until it reaches a climax—usually accompanied by frenzy and excess—and that this in turn evokes a reversal of trend in direct proportion to the formerly prevailing trend. Put simply, booms must inevitably be followed by busts.

By keeping this principle firmly in mind and by comparing past instances of market behavior similar to what we are witnessing today, we may logically arrive at a probable forecast of where our present stock market is headed one the present trend reaches "maximum resolution" (i.e., when the bubble bursts). We know of no better place to start than the extraordinary events of 1929, particularly in the United States, because the similarities are astounding. The seminal work that captures the essence of this era, at least from an economic perspective, is John Kenneth Galbraith's classic book,The Great Crash 1929.

Galbraith captures the atmosphere of the great speculative bubble that existed in the U.S. stock market in 1929 and the years leading up to it. His remarkable portrayal of the people and events of those heady days become even more intensely fascinating when viewed in the backdrop of today's market.

Galbraith begins his book by describing the hallmarks of the speculative temperament of the months preceding the Great Crash of '29. He noted that most prominent was the display of "an inordinate desire to get rich quickly with a minimum of physical effort" on the part of the masses, adding that "it is another feature of the speculative mood that, as time passes, the tendency to look beyond the simple fact of increasing values to the reasons on which it depends greatly diminishes." Already the parallels between 1929 and our time can be seen.

Contributing to the speculative mania in 1929 was the easing of the rediscount rate of the New York Federal Reserve Bank, from 4 to 3.5 percent. According to Galbraith, this sent a signal to the investing public that the Fed stood ready to provide liquidity at a moment's notice should the market ever begin to falter. The inevitable result of the Fed lowering interest rates and increasing the money supply was obvious: "The funds that the Federal Reserve made available were either invested in common stocks or (and more important) they became available to help finance the purchase of common stocks by others," wrote Galbraith. "So provided with funds, people rushed into the market…From that date, according to all the evidence, the situation got completely out of control." The same scenario was re-enacted by the Federal Reserve late last year in successively lowering interest rates and increasing the M3 supply of money in order to stimulate the stock market and steer America clear of deflationary pressures. If history is any judge, the results will be the same.

In the summer of 1928 the bull market that had raged throughout most of the 1920s was commonly thought to have ended after a bout of bearishness lasting several days. On one particular trading day, the Dow plummeted severely accompanied by high volume, a development that frightened many traders. A New York newspaper began its accounts of the day's events, "Wall Street's bull market collapsed yesterday with a detonation heard round the world." However, the leading financial titans of the day came to the rescue with words of comfort. Andrew Mellon said, "There is no cause for worry. The high tide of prosperity will continue." This is eerily similar to the mini-crash of last summer when the sentiment that the bull market had ended was commonly heard. And just as in 1928, the financial giants of our time came to the "rescue" with reassuring phrases. Commented Galbraith: "By affirming solemnly that prosperity will continue, it is believed, one can help insure that prosperity will in fact continue. Especially among businessmen the faith in the efficiency of such incantation is very great."

"As the boom developed," wrote Galbraith, referring to the financial moguls of that time, "the big men became more and more omnipotent in the popular or at least in the speculative view. In March [1929], according to this view, the big men decided to put the market up, and even some serious scholars have been inclined to think that a concerted move catalyzed this upsurge." This same exaltation of the "big men" that was seen in 1929 is evident today in the immense homage paid by the financial press to figures such as Alan Greenspan, Robert Rubin and Abbey Cohen. As to the market being "put up" by the manipulative efforts of such financial titans, similar parallels can be drawn to today, when the Dow also began rising prominently in March to previously uncharted heights and hasn't looked back since. And just like 1929, rumors of market manipulation by insiders abound.

Another hallmark of every great speculative bubble is the propensity for the participants to affix value to an intangible asset at the expense of a tangible one. "At some point in the growth of a boom," he wrote, "all aspects of property ownership become irrelevant except the prospect for an early rise in price. Income from the property, or enjoyment of its use, or even its long-run worth are now academic…What is important is that tomorrow or next week market values will rise—as they did yesterday or last week—and a profit can be realized." We see that same manner of speculative temper today as countless millions willingly trade all their worth—including money on loan—for a stock that could easily lose all value in a short time.

Note the similarities to today's speculative atmosphere in the following account: "In the days of this history the earnings [of publicly traded companies] were almost invariably less than the interest that was paid on the loan [by which the stock was paid for]. Often they were much less. Yields on securities regularly ranged from nothing to 1 or 2 percent. Interest on the loans that carried them was often 8, 10, or more percent. The speculator was willing to pay to divest himself of all the usufructs of security ownership except the chance for a capital gain." Galbraith observes: "The machinery by which Wall Street separates the opportunity to speculate from the unwanted returns and burdens of ownership is ingenious, precise, and almost beautiful." Then, as now, "people were swarming to buy stocks on margin—in other words, to have the increase in price without the costs of ownership. This cost was being assumed, in the first instance, by the New York banks, but they, in turn, were rapidly becoming the agents for lenders the country over and even the world around. There is no mystery as to why so many wished to lend so much in New York."

As the year 1929 progressed, however, a small but vocal minority in the financial press, the New York Times among them, began expressing their concern that the bull market had gone to far and that a crash was inevitable. "Among those who sensed what was happening in early 1929," wrote Galbraith, "there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy." Here Galbraith hits upon a profound point. A speculative bubble allowed to advance too far must inevitably implode, and once it does, its collapse will be particularly pronounced. Would that our financial leaders had recognized this truth before the present speculative mania got out of hand.

Galbraith also described the late 1920 as "an age of consolidation, and each new merger required, inevitably, some new capital and a new issue of securities to pay for it." Hence we see similarities between then and now with the present trend toward mergers and acquisitions among U.S. industries. "The primary motivation in all but the rarest of cases," wrote Galbarith, "was to reduce, eliminate, or regularize competition. Each of the new giants dominated an industry, and henceforth exercised measurable control over prices and production, and perhaps also over investment and the rate of technological innovation. This same trend is widely present today.

By far the most notable piece of speculative architecture of the late twenties, however, was one by which, more than any other device, the public demand for common stocks was satisfied, according to Galbraith—the investment trust, or what we call today mutual funds. The public's appetite for holding shares in an investment trust was insatiable, then as now. "Sponsorship of a trust was not without its rewards," wrote Galbraith. "The sponsoring firm normally executed a management contract with its offspring. Under the usual terms, the sponsor ran the investment trust, invested its funds, and received a fee based on a percentage of capital or earnings. Were the sponsor a stock exchange firm, it also received commissions on the purchase and sale of securities for its trust. Many of the sponsors were investment banking firms, which meant, in effect, that the firm was manufacturing securities it could then bring to market. This was an excellent way of insuring an adequate supply of business.

By late 1929 a further variable had entered the equation—leverage. By the summer of 1929, one no longer spoke of investment trusts, per se, wrote Galbraith. Instead, "one referred to high-leverage trusts, low-leverage trusts, or trusts without any leverage at all. But as investors soon discovered, leverage works both ways. Wrote Galbraith: "Not all of the securities held by investors were of a kind calculated to rise indefinitely, much less resist depression." This point will be brought out more fully in Part 2 of our installment series.