History Repeats: 1929 versus 1999 - Part 2

[Note: The following is the second installment of a four-part series based on the John Kenneth Galbraith classic, The Great Crash 1929, and the parallel events of today's stock market.]

"To a few alarmed observers it seemed as though Wall Street were by way of devouring all the money of the entire world," wrote Galbraith. Indeed, Wall Street was awash in an extraordinary wave of liquidity, the likes of which had never been seen. Money from all over the world came pouring into the U.S. stock market in hopes of finding a quick return. Everywhere, it seemed, people were talking of the great bull market in U.S. stocks and everyone wanted to participate in it and enjoy its fruits. The parallel to this phenomenon in our time can be easily seen. Just as in 1929, money today from around the world flows unabated into the U.S. equities market in hopes of finding an immense return in a short time. This is the great foundational hope that our present bull market is predicated upon.

Another hallmark of the speculative excess that characterized the months leading up to the Great Crash of 1929 was the tremendous amount of speculative activity done on margin, using leverage. Reports Galbraith, "Each Friday [the Federal Reserve outstanding loan report] showed a large increase in loans; each Friday it was firmly stated that it didn't mean a thing, and anyone who suggested otherwise was administered a stern rebuke. It seems probable that only a minority of the people in the market related the volume of the brokers' loans to the volume of purchases on margin and thence to the amount of speculation."

Herein lies the great linchpin of any bull market—quality of trading volume. Any market analyst worth his salt knows that just as important as price movement is the volume that propels that movement. A stock or market that moves higher on low volume is destined to fail. Conversely, a market that moves lower on low volume is destined to reverse higher. The overriding principle is that volume is to the market what gasoline is to a car: without volume the stock market would cease to work properly; furthermore, prices can only advance or decline in proportion to the amount of volume propelling them. So when it comes to interpreting action in the stock market one must have a good idea where volume of trade is going. A healthy bull market will always be characterized by a steady increase in upside volume, for this is what enables prices to rise higher and higher without fear of falling. But when that volume of trade is based on excessive leverage; that is, money that has been borrowed without the commensurate funds to back the loan up, there is the acute danger that, should the market fail, the entire base on which the market has been built will quickly fall to pieces without any hope that it can be reconstructed. Quality of volume is just as important as volume itself.

It is generally accepted that the Great Crash of 1929 was precipitated by a widespread panic among investors who suddenly found themselves on the receiving end of a broker's margin call. When an investor who has loaded his portfolio with great sums of stock paid for with borrowed money receives such a call, it tends to produce panic since the investor has no way of paying for the needed margin. After all, his "investment" was paid for with nothing more substantial than the promise to repay what he has borrowed. When countless thousands (or millions) of investors all receive calls for more margin simultaneously it doesn't take a genuis to figure out what the consequence will be—panic-induced selling. And so it was in 1929.

The great danger in our present bull market is that so much of the volume of trade transacted each day is done on borrowed money, money that in many (perhaps most) cases can never hope to be paid back were the lender to demand payment in full. It has been estimated that the dollar amount of derivatives worldwide numbers in the trillions. Simply put, ours is a most precarious market and one that could most easily unwind at the punch of a button, a telephone button that is.

Galbraith noted that another distinguishing feature of the late 1920's bull market was the "sharp criticism of the prophets of doom." He wrote, "Scholars also reacted against those who, deliberately or otherwise, were sabotaging prosperity with their unguarded pessimism." Herein lies another outstanding feature of every speculative bubble—the endorsement of stock market participation by the academic establishment. It was the great Professor Irving Fischer of Yale who in 1929, just weeks before the Great Crash, made his immortal estimate: "Stock prices have reached what looks like a permanently high plateau." Parallels to this widespread academic enthusiasm for stock ownership that existed in the late'20s can be seen today in the great number of books and periodicals in which noted college professors and scholars, who have no real basis on which to speak of matters relating to financial speculation, give their effervescent endorsement of "investing for the long run." Perhaps the most glaring example of this occurred last fall when in the pages of the Wall Street Journal a distinguished professor of economics at the Massachusetts Institute of Technology, Rudi Dornbusch, wrote a heralded editorial extolling the virtues of the bull market. The article was entitled, "Growth Forever," and in it the author argued that non-stop linear growth was not only possible but was well on its way toward being achieved. The business cycle, he asserted, has been conquered, and we can now expect to live in a perpetual fantasy world of non-stop growth.

Here lies one of the foundational myths of any bull market. The great French sociologist Jacques Ellul noted in his seminal work on propaganda (entitled Propaganda: The Formation of Men's Attitudes) that one of the three great myths on which every civilized society is based, and without which no propaganda can be successful, is the "myth of progress." It is this myth which burns brightly in the bosom of modern man and imbues him with the comforting (if mistaken) belief that progress always continues in a straight line and that every endeavor undertaken by man in the collective—be it widespread participation in a bull market or anything else—will always tend toward progress and success. Without a widespread embracement of this myth a speculative bubble is impossible. The events of 1929—and of our day—attest to that.

Another trait that must be widely present before a speculative bubble can begin (and end) is the virtue of "innocence," that is, a widespread ignorance of all things financial. "Perhaps the failure to visualize the extent of one's innocence was especially true of women investors, who by now were entering the market in increasing numbers," wrote Galbraith. Itt may seem sexist to suggest this, but it has been widely noted that the end to every runaway bull market has always been marked by a surge of interest in investing among women. Women, it seems, being the more naturally conservative and cautious when it comes to financial affairs, are loathe to take risks with hard-earned money. But when a speculative bubble becomes so pronounced that it begins to entice even the more stable-minded of investors, the end is near. This point was brought out by author Donald Christensen in his best-selling book, Surviving the Coming Mutual Fund Crisis. In it he writes, "It should be noted that historically one the final groups of people to be targeted as a special separate group are women. That doesn't mean that women haven't been involved from the beginning…Rather, the promoters of the financial idea try to get all women to join in. The sales pitch here is to admonish women that by not taking an active role in their own financial destiny they are forsaking their own independent right to personal wealth achievement." He notes that when general-circulation "women's interest" magazines such as Women's Day or Family Circle begin circulating articles extolling the benefits of trading or investing there's not much life left in this financial idea. Such articles—and even entire books—have become increasingly common over the past two years.

Continues Galbraith, "Between the end of 1928 and the end of July of 1929, a period when the popular folklore has Americans rushing like lemmings to participate in the market, the number of margin accounts on all of the exchanges of the country increased by only slightly more than fifty thousand. The striking thing about the stock market speculation of 1929 was not the massiveness of the participation. Rather it was the way it became central to the culture."

It is here that we see perhaps the most striking of parallels between 1929 and 1999. No one can possibly deny the great extent to which the stock market has become our central culture—our collective common ground as a nation of many cultures, races, religions and interests. The stock market has come to replace baseball as the national pastime and has become the national obsession, replacing every other common area of collective interest. The stock market has become our passion, the altar on which we place our hopes and dreams and illusions of striking it rich "the American way." Retirements, college education, homes, businesses, luxuries all alike depend on it and if anything were to happen to upset this seemingly boundless fount of prosperity America herself would collapse in gigantic heap of broken promises and lost dreams. As fearful as it is to say, the events of 1929 would seem to betoken just such a possibility of which we will have more to say in our next installment.