'How's the Market to-Day?'
I
IN the three months from August 15 to November 15, 1937, the market value of securities listed on the New York Stock Exchange declined by more than $25,000,000,000. This loss of values was, with one exception, the greatest ever suffered in any comparable period of time. But, considered in relation to the small volume of liquidation that brought it about, it was by far the worst break in history. Moreover — what is more important — it showed the inability of the present market to absorb any reasonable volume of liquidation without wide-open breaks.
The increasing sensitivity of markets is one of the most serious problems facing the country to-day. Yet few people seem aware of its importance. If markets are unable to absorb either buying or selling in moderate volume without gyrating wildly, it is entirely possible that the system of private investment we have built up will turn into a Frankenstein that will destroy all future chance of general economic stability.
A man with 10,000 shares of stock in his hand, seeking a market, is coming to be a potential panic-maker, and more to be feared than a man with a bomb. It is getting so bad that when a broker to-day receives an order to sell a substantial block of stock he shakes his head and mutters to himself, ‘ Hold your hats, boys! Here we go again! ‘
‘What of it?’ a lot of people will ask. ‘The movement of security prices is a matter of concern to only a few speculators and wealthy individuals. What has it to do with the masses of the people?’
The actual fact is that the welfare of every individual in the country is affected by violent fluctuations in security prices. Best estimates indicate that about 10,000,000 American citizens are direct holders of securities of one sort or another. Moreover, savings banks, insurance companies, and other fiduciary institutions have many billions of the public’s funds invested in securities and are dependent upon markets for an appraisal of the value of their assets as well as for liquidation of such assets, if necessary, to meet their obligations to depositors. Market quotations also serve as the basis for appraising the value of billions in collateral pledged for bank loans. But, aside from people who have either a direct or an indirect stake in securities, there are many other millions of people, regarding themselves as not even remotely connected with markets, whose welfare is adversely affected by the impact of market declines on the general economic structure.
Poor business is supposed to be the reason for a declining stock market. At the outset, that is usually the case — a falling market may be reflecting only a slight decline in business activity. But if the market cannot absorb selling in reasonable volume without wide-open breaks in prices, then unwarranted market losses become, of themselves, a reason for poor business. Cause and effect become reversed. The cart begins to pull the horse.
Millions of people who suffer market losses, either taken or untaken, curtail their buying, and the rate of business activity naturally declines. The downward spiral is on. And next come serious unemployment, reduction of tax revenues, government deficits, and all the other conditions that go to make up a major depression, with untold suffering for millions of people who feel that the securities markets are no concern of theirs.
When the financial community stresses the need for a ‘broader’ market, many people think it is a plea for greater market activity — that is, more business for the brokers. Accordingly, they regard it as an insincere argument prompted by self-interest. Such people fail to understand that a market can be broad without being active, and vice versa.
In the decline last October, when the volume of trading on the New York Stock Exchange one day exceeded 7,000,000 shares, the market was certainly active. But it was by no means broad, because prices in many cases were breaking several points between sales. A broad market is one in which there are plenty of bids below the current market price, and plenty of offerings above it, regardless of whether sales take place at those prices. An adequate supply of bids and offerings affords a cushion on each side of the current market price, and makes it possible for the market to absorb either buying or selling, if necessary, without violent price changes. This is something entirely apart from the actual volume of transactions in the market.
Now, fittingly enough, one of the avowed purposes of regulating the country’s securities exchanges was to prevent ‘sudden and unreasonable fluctuations in security prices.’ Paragraph 4 of Section 2 of the Securities Exchange Act of 1934, under the heading ‘Necessity for Regulation,’ reads in part as follows : —
National emergencies, which produce widespread unemployment and the dislocation of trade, transportation and industry, and which burden interstate commerce and adversely affect the general welfare, are precipitated, intensified and prolonged by . . . sudden and unreasonable fluctuations in security prices. . . .
But what has been happening?
A study, made by the New York Stock Exchange, of the recent price decline in relation to the volume of trading, as compared with other bear markets since 1916, shows that from August 16 to October 30 — a period of 64 trading days — the Dow-Jones Average of Industrial Stocks declined 27 per cent, which was a greater drop than for any other 64-day trading period studied, except between September 4 and November 25, 1929, when the Average declined 35 per cent. But in the 1929 period it took sales equivalent to 28 per cent of the total number of shares listed to bring about the decline of 35 per cent in values, whereas, in the 1937 period, sales of less than 7 per cent of the shares listed resulted in a 27 per cent decline in prices.
In the 1929 period, there was a price change of 4.36 per cent for each one per cent of listed shares traded, but in 1937 there was a price change of 12.54 per cent for each one per cent of listed shares traded. Stated another way, this means that in the 1937 break the market was nearly three times as sensitive as in 1929.
II
In each of the eight bear-market movements that have started since 1916, the sensitivity of the market has increased. The price change, as measured by the Average in the first 64 days of the 1916 bear market, was only 1.95 per cent for each one per cent of listed shares sold; in 1919, 1.99 per cent; in 1923, 2.82 per cent; in 1926, 2.92 per cent; in 1929, 4.36 per cent — the first big jump. Then, in the rather small decline that started in February 1934, the ratio of price change to volume increased to 6.92. In the decline beginning in March 1937, the figure rose still further, to 8.73; and the sensitivity index reached a new all-time high of 12.54 in the last decline. These facts make it clear that, although there has been a steady trend toward increased sensitivity since 1916, the greatest change in this respect has come about since 1934.
The sensitivity of certain leading issues has increased far more than is true of the market as a whole. The action of American Can common in comparable 12-day periods of declining prices shows that, in 1930-1931, the market in that issue absorbed 38,000 shares for each one per cent of price change, whereas trading of less than 3000 shares did the same price damage in the 1936-1937 period.
The story on U. S. Steel common is just the same. In the 1930-1931 period of rising prices, it took buying of 33,000 shares of Steel to change the price one per cent. In the 1936-1937 period, slightly over 10,000 shares of buying did the same trick. During periods of decline, the market in Steel common in the early period absorbed 43,000 shares of selling for each change of one per cent in price; in the later period the issue fluctuated one per cent in value on each 11,000 shares traded.
For each stock issue listed on the New York Stock Exchange there are one or more specialists on the floor of the Exchange who keep what is called the ‘book.’ This book is a record of the bids and offerings available for the stock in question, most of which are recorded with the specialist by other brokers. The specialist’s book does not necessarily contain all buying or selling orders, for other brokers may have orders which, for one reason or another, they do not place with the specialist; but the specialist’s book usually reflects most of the current buying and selling orders, and is likely to contain virtually all orders at prices above or below the current market price. Hence an examination of the specialist’s book reflects clearly the ‘breadth’ of the market in a given stock.
On three different dates during the month of September, 1937, specialists on the floor of the Exchange were asked unofficially to note cases in which there were no bids, or no offers on their books, or cases in which the spread between the bid and offer was at least $5.00 on issues selling under $25 or $10 on stocks selling above $25. The surveys applied only to active issues, the so-called ‘inactive issues’ being eliminated from consideration. The first inquiry showed 22 issues to be in the state described above. On the second checkup later the same month, there were 34 issues in those categories. On the third survey, the number increased to 46 issues.
Aside from these cases in which there was sometimes virtually no market at all, there are many other issues in which the market has been dangerously thin. One day in October, for instance, after the stock of one of the country’s largest industrial companies sold at 40 7/8, the only offerings in the market comprised 200 shares at 41; 100 shares at 42; 100 at 43 1/8; and 200 at 45. Thus the purchase of only 600 shares ‘at the market’ might have run the price of the stock up more than four points, which represents a 10 per cent increase in value. The issue in question has 28,000,000 shares outstanding. In 1930, during a period of market advance, it took transactions of 20,000 shares to bring about a one per cent change in the price of this same issue.
Another leading industrial issue, comprising 2,000,000 shares, sold at 156 one day in October. The next bid — for only 100 shares — was 154, and there were no other bids at all! On another day later the same month, the bid for another well-known industrial issue was 84, and the best offering on the books of the specialist was 99 1/2, indicating a spread of 15 1/2 points between the bid and the offer. These cases represent just a few of many that might be cited. They show clearly why the pressure of only a little buying can drive stocks up to unwarranted prices, and why a little selling can bring about an unjustified break in the price level.
Why has the market become so much more sensitive in recent years? The answer to this question is highly important to the welfare of the entire country; for if security prices henceforth are going to move up and down violently at the slightest buying or selling pressure, alternate periods of market inflation and collapse are going to make it exceedingly difficult to attain any real economic stability.
News — and news only — is what makes the average investor buy and sell. If all investors receive news together, they are likely to buy or sell together. But every investor is entitled to all the news he can get. And, as methods of communication improved, it was inevitable that investors generally would avail themselves of these improved methods to keep themselves better informed.
The stock market is like the old parlor diversion called ‘Going to Jerusalem’ — sometimes known as ‘Musical Chairs’ — which you probably played when you were a child. Someone plays a piano and everyone else walks around a double row of chairs, placed back-to-back. When there is no need to sit in them, it looks as though there were plenty of chairs. But when the music stops and everyone scrambles for a seat, there are n’t enough chairs to go round. Someone always gets left out.
A market is just the same. When you and millions of other people walk around with a few stock certificates you don’t want to sell, you read of the bids being made for your stocks, and there seem to be plenty. But when the sweet music of good news stops, and you all try to sell at the same time, you find that there are n’t enough bids to go round — except perhaps at shocking concessions in price.
The game is screamingly funny when played by children at a Christmas party, but when played by adults in the stock market it has been known to result in national calamity. All of which is by way of pointing out that concerted action in buying and selling by large numbers of investors raises a serious problem, unless the market is broad enough to absorb such buying or selling without undue damage to the price structure.
III
Many years ago news permeated a community slowly, and this meant that buying and selling came into the market slowly. A few well-informed people received news first and bought or sold, as the facts indicated. Gradually the news spread and was acted upon by other investors, when and if they heard of it. Many of them never heard the news at all, and so did not take any action that would tend to accentuate a market rise or decline. Under such conditions, a broad market was perhaps not necessary.
But consider the system of financial intelligence that is available to-day to the smallest odd-lot investor. Not only is it amazingly comprehensive, but it operates with a speed that is almost unbelievable. When an announcement is made at 12.30 on a Monday afternoon that the rate of operation in the steel industry has declined 5 per cent from the figure of the preceding week, virtually every man, woman, and child in the country has had the news brought to his attention before the opening of the market the next morning. This simultaneous transmission of information to millions of investors has inevitably resulted in more concerted buying and selling.
The transmission of financial information to-day is a great industry. The system of financial intelligence is so efficient and reaches so many people that the question, ‘How’s the market to-day?’ has become almost the national salutation.
To supply the demands of newspapers for financial news, the Associated Press operates 34,000 miles of wires devoted exclusively to the dissemination of financial material, in continuous operation every day from 9 A.M. to 6 P.M.
Complete tabular material — that is, quotations and volume of sales in all markets — is furnished by the Associated Press regularly to about 200 of the country’s most important papers. More than 1400 newspapers receive from the AP a steady stream of general financial and business news. On an average day, it sends out on its wires about 32 columns of such material.
The United Press likewise operates for its member newspapers a financial service with a wire system running from coast to coast. More than 200 newspapers take all or part of this service, which includes approximately 24 columns of financial news a day, plus complete tabular matter. The UP sends out continuous quotations on all financial markets from 10.05 A.M. until the close of markets. This service covers every issue on all exchanges as well as all commodity markets. In addition, the UP’s daily stock-market story goes over its general news wires to more than 1000 newspapers. The general news wires also carry closing prices of leading stocks and closing stock-market averages to this same group of 1000 papers.
But investors do not have to wait for publications of any kind to reach them. Nation-wide systems of news tickers flash developments affecting financial markets minute-by-minute as they occur all day long — dividends, earnings, production figures, and hundreds of other facts. Stock and bond tickers continuously flash quotations from the floors of leading exchanges as transactions occur. There are more than 2200 stock tickers and 300 bond tickers in the system that reports prices from the New York Stock Exchange alone.
There are more than 7000 brokerage firms and investment dealers in the United States at the present time, with some 9700 offices stretched from Maine to California. These financial firms last year maintained 310,000 miles of private wire for the transmission of orders, quotations, and financial information. As any good statistician will tell you, this network — which comprises private telephone, telegraph, and teletype lines — is sufficient to girdle the earth twelve times. Oh, shades of Mr. Rothschild’s carrier pigeons!
There are more than 75 recognized statistical services that furnish hundreds of thousands of investors with regular information on a subscription basis. In addition there are between 4000 and 5000 investment counsel firms whose function is to supply their clients with prompt information and advice. A number of radio stations now broadcast stock quotations locally. News commentators on national networks often refer to market developments. Latest stock quotations are posted in crack passenger trains before their departure. One enterprising brokerage house used to supply quotations to leading air lines, furnishing bulletins of up-to-the-minute prices to each airport at which planes landed. Plans are now being discussed for a resumption of this service. Quotations are sent by wireless to ships at sea, and at one time complete brokerage offices, transmitting orders by wireless, were maintained on luxury liners.
Prices of leading securities are cabled to Europe at regular intervals throughout the market day. An investor in Europe is at no great disadvantage in buying or selling securities on the New York Stock Exchange. Some time ago, an order placed in Paris was cabled, executed, and confirmed back to Paris in less than thirty seconds! Such is the proximity in which we all live, as a result of our high-speed systems of communications.
Now, all of this is inevitable. You cannot have a twentieth-century system of communications and expect that it will not be used for the transmission of financial information. Besides, no one wants a system that would keep the average investor in ignorance of developments affecting his securities, while permitting a few informed individuals to profit by exclusive knowledge.
But there should be a wide recognition of the fact that, under present conditions, the need for a broad and unhampered market is greater than ever before, if the market is to be able to withstand the shocks of concerted buying and selling that our modern system of communications is likely to produce. Otherwise, sudden rushes of buying and selling by a simultaneously informed investing public will result in dangerous fluctuations in security prices.
IV
The increasing efficiency of the financial news system is undoubtedly responsible for the gradual increase in the sensitivity of the market from 1916 through 1929. But since 1934, as previously explained, the trend has suddenly become dangerously accentuated. That date marks the point at which regulation, restriction, and new taxation theories were imposed upon the market, following the enactment of legislation intended to prevent ‘sudden and unreasonable fluctuations in security prices.’ It is becoming increasingly obvious that the practical effect of such governmental measures has been to increase, rather than decrease, security price fluctuations. If proof were ever needed that a highspeed communications system and a restricted market cannot be safely combined, there is plenty now.
Excessively high margin requirements, imposed in recent years, have greatly reduced the buying power that used to come into the market during periods of declining prices. People who owned stocks on margin used to buy more stocks at lower prices following a break, thus supplying buying support to the market. Under the new government restrictions, the minimum margin requirement was 55 per cent until very recently. This meant that to buy $10,000 worth of stocks an individual had to put up $5500 of his own money, and could borrow only $4500. Because of this extremely high margin requirement, many people, in making their original commitments, bought fairly close to the margin limit.
Then, if any decline occurred and reduced their margin to less than 55 per cent, their accounts became automatically restricted, and they were prevented from adding to their holdings. A test check of leading stock-exchange houses during September showed that the accounts of nearly half their customers were in this restricted category. Thus the tremendous buying power of those who already own stocks and have faith in the future of prices is bottled up when buying in the market is most needed. A recent reduction of this ‘ point of restriction’ from 55 to 40 per cent has helped somewhat to alleviate this situation and released buying power badly needed in the market.
In past years, when an unreasonable decline took place in the price of a corporation’s stock, the directors and officers of the company in question — who were usually good judges of the stock’s intrinsic value —would often buy it in substantial amounts. In most cases there was nothing philanthropic about this. They bought it in the hope of a profit. But this informed buying did have the effect of stemming an unwarranted decline in price.
To-day, if officers or directors of a corporation do that, they must hold the stock for at least six months before they can take any profit. If they sell before the six-months period expires, they must turn any profits over to the corporation, or be subjected to suits by other stockholders for the restitution to the company of any profits made. They are still entitled, however, to 100 per cent of any losses they suffer. Obviously few directors would care to take their chances under these rules.
The short-term trader, who buys and sells securities regularly, performs a very important function in the market. Short-term traders are usually willing to buy at a price a little under the current market price, or sell a little above it. Consequently they help to furnish a constant supply of bids and offerings against which long-term investors can buy or sell. People who trade for shortterm profits buy and sell for different reasons from those which actuate the general run of investors. A market made up entirely of long-term investors is likely to dry up when it is needed most.
The short-term trader has very nearly been put out of business by the combination of high capital-gains taxes, increased transfer taxes, higher commission charges, and high margin requirements, which have made it almost impossible for him to operate at a profit.
The capital-gains tax also works to create unwarranted fluctuations in prices. Take the case of a wealthy individual who held a large block of stock in which he had a substantial profit. His bankers advised him to sell, but he found that if he took his profit his income for the year — including the profit on his stock — would be subjected to a tax of more than 60 per cent. He did not need the money, so he refused to sell, even though he agreed that the stock was priced too high. He figured that any probable future decline in the stock would bring him very little, if any, net loss. This was especially true because the tax on capital gains declines the longer the investor holds a security. If a security is held one year or less, 100 per cent of any profit is subject to the capital-gains tax. If it is held from one to two years, only 80 per cent of the profit is subject to tax. If it is held from two to five years, only 60 per cent of the profit is taxable. On a holding of from five to ten years, only 40 per cent is taxable; while only 30 per cent is taxed if the security has been held over ten years.
Under such a schedule of taxes, an individual who has a large profit in the first year of holding can, by continuing to hold his security for slightly more than another year, reduce by 40 per cent the amount of his profit subject to tax. Even though the market drops substantially in the meantime, later sale at a lower price will often bring him a higher net profit after payment of taxes. Thus the present tax schedule provides him with a weird kind of price insurance. Consequently investors with large profits in a rising market are loath to sell. This reduces the supply of securities as the market rises and brings about an unwarranted inflation of prices. And the farther up they go, the farther they ultimately fall!
Many wealthy individuals who, under ordinary circumstances, would be active buyers and sellers of securities have withdrawn their funds and placed them in tax-exempt securities because of excessive tax rates. This not only removes needed buying power from the market in corporation securities, but also curtails the amount of funds available for new capital investment in private industry, upon which the country’s economic growth largely depends. Hundreds of millions of dollars that should be available in the market for corporation securities to-day have thus been ‘sterilized.’
A well-known capitalist in New York said a short time ago, ‘When people used to come to me with patents or processes to be developed, or ideas for new businesses, I used to advance them money if their propositions seemed to have merit. All of these ventures were highly speculative — not suitable for public financing. But I can afford to speculate. A man of my means ought to devote a part of his capital to speculative ventures and new promotions of that sort. The country needs such speculative investment to promote new enterprises.
‘Most of these ventures,’ he continued, ‘worked out badly. A few, however, were very profitable and developed into substantial businesses that employed many people. And, on the average, my profits in such ventures more than offset my losses.
‘To-day, however, I can’t afford to engage in that sort of activity. When I make a profit, I have to declare the government in as a partner — frequently to the extent of 50 per cent or more. But I still have to take virtually 100 per cent of the losses. It’s a one-way street now. The game is n’t worth the candle any more. And the same thing is true of investment in the securities of established companies. A four per cent income on a corporation bond means only a little over two per cent net after taxes to me. I’d be silly not to keep my money in tax-exempt securities.’
V
The tax on the undistributed profits of corporations has also been an important factor in creating more violent fluctuations in security prices. A stock that has been earning $10 and paying $6.00 annually, and selling at a price that fairly reflects that dividend rate, may now suddenly have an extra $4.00 declared because the directors decide to pay out all earnings, rather than a conservative 60 per cent, in order to avoid penalty taxes that seem to them wasteful. This sudden and entirely unsound jump in the yield of the stock has the natural effect of advancing the market price of the issue to an unjustified level, because it attracts buyers seeking high yield. The epidemic of extra dividends at the close of 1936 had much to do with the market rise late that year and the subsequent collapse in the summer of 1937.
Furthermore, if corporations continue to pay out virtually all their earnings in dividends because of the undistributed-profits tax, inability to accumulate surpluses will mean, in turn, inability to continue dividends in years when they are not earned. Sudden cessation of dividends is likely to result in violent price declines. With dividends varying as widely as earnings from year to year, more serious fluctuations in market prices cannot be avoided, for the price of a stock bears a definite relation to the income currently being paid on it.
Correction of past abuses in the securities markets is a highly laudable objective which every thinking person will support. But zeal for reform should not blind anyone to the fact that the securities markets perform an indispensable function in the present economic structure, by keeping vast amounts of capital liquid, mobile, and dynamic. When regulation, restriction, taxation, or any other measures result in the failure ol markets to perform their proper functions in providing liquidity at fair values, then reform defeats its own purposes. Properly regulated markets can be a great boon to our economy. Improperly restricted markets can be a great menace to economic equilibrium and a serious deterrent to new capital investment and economic growth.
Market developments of the past year constitute a clear warning signal that should be heeded. The recent debacle, brought about by a small volume of liquidation, calls for a thorough and objective examination of all possible causes for the dangerous increase in volatility of markets and a correction of all conditions responsible for it.