The Corner

After the stock market crash of 1929-1932 congress initiated the Pecoria Investigations to look into the reasons for the great decline. This resulted in the 1933 and 1934 securities acts, which created the Securities and Exchange Commission (SEC) and regulated the issuance, trading, regulatory reporting and brokerage of securities.

Just like the Pugo investigation of 1912, which ushered in new reforms and helped to create the Federal Reserve System, the reform era of the 1930s left most Americans by the middle of the century believing that things on Wall Street were cleaned up and all was well. Then in 1962 the market crashed, which spurred the 1963 special staff investigation, headed by the SEC. Like most other investigations, the 1963 report shed light on a number of Wall Street abuses. However, unlike previous investigations, nothing new was actually done about the abuses other than recommendations.

By the time of the great bull advance of 1982-1987, young baby booming investors had developed a great deal of faith in both the markets and their own abilities to analyze risk. However, like most speculative eras, investors were wrong. In 1987 the market crashed and Treasury Secretary Nicholas Brady headed an investigation which ended in the famous Brady Report. The results of this investigation were confusing in its conclusions as to why the market declined as it did in the fall of 1987. Even with such a confusing report, the New York Stock Exchange instituted some “trading collars,” putting limitations on program trading. This once again left investors feeling as if the market excesses had been curbed and all was well.

As the market recovered and moved higher after 1987, investors slowly became complacent as to the excesses and risks that the market can generate. Without any significant and long-term declines to “washout” market speculators and abusive practices, the use of borrowed money in the stock market entrenched itself. Over the decades since the late 1920s, most professional and general investors came to believe that the use of borrowed funds in the market was well under control through the margin requirements of the 1930s securities regulation. However, in late 1990s a number of hedge funds developed problems, leading to the collapse of long term capital. At that time most people had not been aware of the new forms of borrowed money that were used to finance the purchase of investment vehicles such as derivatives on stocks, bonds and currencies. With a few problems here and there the average investor was barely aware of how the use of “leveraged contracts” could create structurally mechanical deficiencies within the market.

After the long term capital cleanup, the market chugged along until the great late 1990s Dotcom Bubble. Many investors defied the rules of being diversified in their portfolios and the judicious use of margin. The result was the collapse of NASDAQ stock market followed by another round of investigations and regulation, eventually leading to the Sarbines Oxley Act of 2002.

It is almost always the case that great and long-term bull markets create an environment of complacency. In the waning days of the great bull market of the late 1920s, the newspapers columns were engaged in comparing the then current market to the 1902-1907 bull market and crash, concluding that “things were different” in the late 1920s—so different that nothing as bad as the 1907 crash could ever happen again. In fact, a peruse of the Wall Street Journal during the summer of 1929, leading up to the crash, is hilarious reading, given what we now know happened back then.

Speculative times come and go and are often followed by a crises. In his classic book, “Manias, Panics, and Crashes,” Charles Kindleberger tells us, “Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common.” He goes on to say, “What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute a mania. Once the excessive character of the upswing is realized, the financial system experiences a sort of ‘distress,” in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic.” And no amount of investigation and regulation can gain control of the human emotions of fear and greed.

Quote of the Week: “Methodology is the last refuge of a sterile mind.” – Marianne L. Simmel

Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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