History repeats: 1929 versus 1999

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 climaxusually accompanied by frenzy and excessand 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 marketFrom 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 academicWhat is important is that tomorrow or next week market values will riseas they did yesterday or last weekand a profit can be realized." We see that same manner of speculative temper today as countless millions willingly trade all their worthincluding money on loanfor 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 marginin 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 Galbraiththe 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 equationleverage. 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.

(Part 2 next week)

Clif Droke

13 May 1999

From Gold Eagle

-- Andy (2000EOD@prodigy.net), May 17, 1999

Answers

Kevin - do you have a link to your recent piece on 1929 - I couldn't find it - thanks.

-- Andy (2000EOD@prodigy.net), May 17, 1999.

"...faith in the efficacy of this incantation..." Sums it up pretty well. Let's see...Greenspan or Jesus, Greenspan or Jesus...

-- Spidey (in@jam.commie), May 17, 1999.

I read this book after it was suggested reading by Michael Hyatt. The more I read the more often I recognized headlines from the daily paper. All I could do was shake my head in wonderment and prepare all the more.

Recommended reading for sure.

-- Kay (jkbrooks@bellsouth.net), May 17, 1999.

Yes the parallels are indeed fearsome. In my mind the real questions as to the causes for the crash and the subsequent 10 years of economic contraction and instability, are what enabled the bubble to grow to the size that it did? What allowed for the distortions in "normal" cyclical economic growth and contractions, fueled by the normal desires of human beings? What happened that allowed people to seemingly have the where-with-all (money)to match their desires to obtain the greatest returns for the least amounts of investment? (whether those investments be ones time, effort, or capital - capital simply representing the product of other human beings time and effort.)

The answer in my judgment is the establishment of a central bank in 1913, wherein the financial discipline provided by the role of gold was effectively ended. It was substituted with a system wherby the judgment of people in positions, hertofore that had not existed, invested with power to extract benefits and costs all out of proportion to what any one person or group of people would otherwise have been able to do.

Think of it in this context: The founders of our form of Government knew that human nature is such that to vest too much power in too few of us, would inevitably lead to tyranny to the advantage of those in control over those controlled. history had repeatedly shown that in such instances, those in control would literally destroy their franchise in order to retain their power. The theme of our form of Government is therefore the sanctity of the individual, except when he/she is invested with political power.

The same functional restaints, brought to bear in the financial workings of the marketplace was initially provided by the much maligned "gold standard." It served as the political equivilant of the financial sovereignty or the individual, except when he/she is invested with financial power (bankers and other repositors of "money"). These financial entities, presided over by a few powerful people, would again because of human nature, literally destroy their franchise while in pursuit of furthering their financial power. Gold would serve as a mechanism to make it as difficult in financial terms, as the constitution, with its separation of powers would in political terms. It is no accident that a mere 15 years after the formal establishment of the Central Bank of the United States, those in positions of this new found power over the finances of the nation, almost destroyed it.

Fast forward to 1999. Alan Greenspan has in his hands, together with the support of the Board of Governors, the financial fate of the United States. It is a position that no one person or group of people, no matter how responsibly they attempt to administer this responsibility, should enjoy. personally, I admire him and his predecessor Paul Volker. They brought us back from the brink and then managed to fuel the tremendous growth of the past 20 years with a relatively small amount of currency destruction. The bubble grows however, made seemingly inconsequential by the tremendous advances in productivity in recent years. It will take but a modest amount of financial turmoil, together with the retirement of Greenspan, and a return to a Chairman whose eye drifts toward the political arena, and it will indeed be 1929 all over again........

Human nature will see to it that eventually, without the discipline of gold, that in the same way a dictator destroys, no matter how benevolent his/her intentions/capabilities, those to whom he dictates, so too will the concentration of financial/economic control in the hands of a few people, violently impact the very financial markets they seek to manipulate - all done of course for our own good........

-- Dave Walden (wprop@concentric.net), May 17, 1999.

Yea but in 1929 people pulled thier resources together and shared what they had. You know brother can you spare a dime, now days it's brother I will shoot you in the behind, and that is not right!!

-- Lyn Truss (StormieLyn@webtv.com), May 17, 1999.

Excellent piece. There are also a lot of differences between today and 1929, but the parallels drawn here, some of which I've previously remarked upon, are very disturbing. Take a look at the tremendous growth in "day trading" over the internet to get a sense of just how speculative today's stock market has become.

Greenspan has almost certainly known for years that this stock market is dangerously overvalued and becoming more overvalued all the time. Again, remember his comment about "irrational exuberance" in Dec. 96. What Greenspan will be chastised for someday is his unwillingness to take stern actions to deflate this bubble gradually and safely while there was still time. (It's probably too late now.) I sense that he caved in to Rubin and Clinton (the latter's political career eventually hinged on the stock market, and Rubin is a close Clinton buddy and longtime Wall Streeter), and America is likely to suffer severe consequences for Greenspan's failure to take appropriate and timely countermeasures.

-- Don Florence (dflorence@zianet.com), May 17, 1999.

When the bubble bursts, the current powers will be blamed. However, any government official will do what he can to put off the enevitable, and leave the excesses for the next administration and generation to clean up. What makes this particularly troublesome to the wary reader is two-fold... 1st....a massive government debt....6 trillion or so... 2nd....people will not ask or work when it gets bad...they will take. This bubble will burst, and will do so in October. I sincerely believe that. It may be that it happens sooner, but most likely..in October..the market will burst, the banks will be run on in reaction...and then everyone will wait on the turn of the century with a high level of fear and trepidation... just my thoughts...hope I am wrong...

-- rick shade (Rickoshade@aol.com), May 17, 1999.

Excellent treatise, but it's even simpler. If you capitalize earings at anything close to historic PE ratios, stocks are priced at twice their real value. Once things head a little south in the market, consumer confidence will erode leaving even less earnings to be capitalized at even lower PEs. All it takes is a little trigger...and the new paradigm is history. Y2k could be such a culprit.

-- ned (collum@rof.net), May 18, 1999.

Andy,

The piece on the stock market boom of the late 1920's is at this link:

http://www.greenspun.com/bboard/q-and-a-fetch-msg.tcl?msg_id=000mbl

"The Big Bull Market"

-- Kevin (mixesmusic@worldnet.att.net), May 18, 1999.