In the years following the Great Crash of October 1929, investors suffered harrowing losses as the Dow Jones industrial average declined by nearly 90 percent. Many leading speculators of the era were wiped out: Michael J. Meehan, the broker who arranged several stock market "pools," entered a lunatic asylum; William Crapo Durant, the founder of General Motors and the largest individual speculator of the 1920s, ended up washing dishes in a New Jersey restaurant; while another famed player, Jesse Livermore, blew his brains out in the bathroom of a New York hotel. Since the Great Depression, however, speculators have come to believe that safeguards introduced under the New Deal will protect them from a similar fate. They should not be so sure.
In several respects, the current bull market closely resembles its 1920s forerunner. The "New Era" of the '20s was based on the notion that modern technologies were stimulating economic growth and that the wise policies of the Federal Reserve would prevent future depressions. Together with a widely accepted statistical analysis showing that stocks were nigh certain to outperform bonds, the New Era thesis was used to justify higher share prices. In recent years, similar arguments have led to the "new paradigm" theory, more commonly known as the "Goldilocks economy," and have helped create an almost blind faith in stock market investment.
Back in the '20s, it was said that people were investing for the long run. Today's investors, many managing their own retirement funds, also say they are in the market for the long haul. Although the number of people who played the market was far smaller than today, the culture of speculation reflected the mores of the Jazz Age with, in F. Scott Fitzgerald's phrase, "the whole upper tenth of the nation living with the insouciance of grand ducs and the casualness of call girls." Then, the market attracted Broadway figures such as Irving Berlin and Groucho Marx. Now, according to a recent article in Fortune magazine, Barbra Streisand has taken to playing the market both for herself and her friend Donna Karan, the fashion designer. Streisand told Fortune that in five months of intensive trading she had managed to nearly double a $1 million stake Karan had entrusted to her.
The '20s bull market was led by companies introducing new technologies, such as General Motors, Radio Corp. of America, and a number of electric utilities and airplane manufacturers. Today, the fastest bucks are still made in technology stocks, such as Microsoft and Dell Computer, and anything related to the Internet. Like the Internet, radio in the '20s not only created exciting investment opportunities, it also purveyed news of the stock market far and wide, attracting new people to the speculation game.
In both the 1920s and 1990s, corporations reacted to the bull market on Wall Street by increasing their investment expenditure and merging with competitors. Even the current stock options mania has a parallel in the earlier period. By 1929, it was estimated that 80 top executives at General Motors owned an average of $3 million worth of GM stock. Today, around a third of Microsoft's employees are reckoned to have become paper millionaires thanks to the software company's options plan. In both periods, consumers responded to the boom by borrowing and spending more; thus creating what appeared to be a virtuous circle in which rising stock prices stimulated economic growth, bringing further gains for stocks. Much of the recent boom in consumption--the latest figures show that U.S. retail sales grew by almost 8 percent over the last 12 months--can be attributed to the "wealth effect" of a rising stock market.
After the bubble popped in October 1929 and the economy entered the Depression, there was a profound reaction against the wild speculations of the previous decade. In his inauguration speech in March 1933, President Franklin D. Roosevelt promised to drive the "moneylenders" from the "temple of our civilization." Congress soon established the Securities and Exchange Commission (SEC) to improve regulation of the stock market and inaugurated deposit insurance to bolster the confidence of bank customers.
Recently, however, several of Roosevelt's New Deal measures designed to protect investors have become ineffective or redundant, if not under strong attack from the banks and brokerage houses. The Glass-Steagall Act of 1933 led to the separation of commercial and investment banking after the securities affiliates of several leading banks, in particular the National City Bank of New York, were revealed to have flogged shoddy securities to their customers. Glass-Steagall is practically a dead letter now, awaiting repeal. Only last year, Citicorp, the corporate descendant of National City, merged with Travelers Group, owner of Salomon Brothers, the investment bank, and Smith Barney, the brokerage firm. The rationale for the merger was to revive the "cross-selling" between the firms' customer base that had formerly been outlawed because of a perceived conflict of interest.
The new securities laws of the 1930s also prohibited paying people to hype stocks or spread false market rumors. Nowadays, however, it seems that some analysts are only too willing to promote hot stocks at astronomical prices. Arthur Levitt, the SEC chairman, recently suggested a correlation between "the content of an analyst's recommendation [to buy or sell a stock] and the amount of business his firm does with the issuer" of the stock. Moreover, the rapid growth of the Internet as a forum for investment discussion has made it nearly impossible for the SEC to prevent the propagation of false rumors. The online "hypsters" and "bashers," their purpose and true identities concealed by digital anonymity, are little different from the disreputable stock promoters of the 1920s.
More significantly, New Dealers believed that excessive leverage caused by stock market credit, known as "margin loans," had stimulated the boom and contributed to the ensuing depression. As a result, margin loans were restricted to 50 percent of the collateral value of shares (compared to 10 percent or less during the '20s) and the Federal Reserve was empowered to raise margin reserve requirements to higher levels if it saw fit. Yet in recent years the total amount of outstanding margin loans has been rising in line with the Dow Jones index, increasing from about $100 billion in early 1997 to $173 billion last April, an increase of more than 70 percent. The same pattern was evident in the late 1920s. The Fed, under Chairman Alan Greenspan, has not exercised its discretionary powers to raise margin requirements.
Yet even had it done so, such a measure would most likely have proved futile since the rapid growth of the markets for stock options and futures has rendered old-fashioned margin regulation ineffective. The near collapse last fall of the hedge fund Long-Term Capital Management demonstrated how it was possible to achieve enormous leverage, equivalent to more than 100 parts debt to one part equity, without actually breaking the law. Anecdotal evidence also suggests that many day traders and online investors have been using home equity loans and credit cards to increase their exposure to the market. There is no way of knowing how great that exposure is, but it is some measure of the $1.32 trillion in consumer debt and nearly $6 trillion in mortgage debt (both in addition to margin loans).
One must not be seduced into thinking that similarities between the '20s and '90s bull markets mean history will necessarily repeat itself. The economic situation beyond Wall Street differs profoundly from 70 years ago. In those days, the U.S. economy was heavily dependent on agricultural commodities at a time when prices were falling, and the domestic banking system was experiencing a large number of failures even before the Great Crash. The government's adherence to the gold standard in the early 1930s, the growth of tariff barriers and the chronic weakness of Europe were essentially political problems that have no contemporary parallel.
But the telling signs of a stock market bubble are as evident today as they were in the 1920s: shares highly priced in relation to corporate earnings, public consumption sustained by stock market profits, a rising market turnover, a widespread public obsession with the stock market, and the general desire for capital gains rather than income from dividends. When people fear that their hopes of immediate capital gains are unlikely to be fulfilled, then the bubble will pop. The trigger for such a change in expectations is unimportant, although in the past it has often been accompanied by rising interest rates. Speculators today still suffer from the same delusions as their 1920s forebears. They should not rely on crumbling New Deal legislation to save them from the consequences of their folly.
Edward Chancellor is the author of the recently published "Devil Take the Hindmost: A History of Financial Speculation" (Farrar, Strauss and Giroux).