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Generational Dynamics Web Log for 16-Feb-07
Stock market margin debt reaches March 2000 all-time high

Web Log - February, 2007

Stock market margin debt reaches March 2000 all-time high

The manic stupidity of investors today continues to duplicate 1929.

Margin Debt - $ billions - 1960-2006 <font size=-2>(Source: Sudden Debt blog)</font>

Margin Debt - $ billions - 1960-2006 (Source: Sudden Debt blog)

I'm grateful to Friday's entry in the Sudden Debt blog for pointing out that margin debt has reached its previous all-time high, just prior to the Nasdaq crash in 2000.

Margin is the amount of money that an investor must pay the broker in order to purchase stock. In the 1920s, typical margin rates were 10-25%, which meant that the broker loaned the investor 75-90% of the price of the stock.

Seeing this blog entry motivated me to return to John Kenneth Galbraith's 1954 book, The Great Crash - 1929, to see what he had to say about margin debt in the 1920s.

Galbraith gives the following as the purpose of margins:

"The purpose is to accommodate the speculator and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and call for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one. At best this is a dull by-product and a dubious one. Wall Street, in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woolen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot."

Well, if the 1929 stock market was a harlot, then I can't even imagine what words we'd have to use to describe the incredible level of financial depravity and debauchery exhibited today by financial advisors, hedge fund managers, and real estate public relations people today. About the only positive thing that can be said is that a lot of these people will be going to jail.

Margin Debt - $ billions - 1920-1929 <font size=-2>(Source: John Kenneth Galbraith)</font>

Margin Debt - $ billions - 1920-1929 (Source: John Kenneth Galbraith)

Galbraith doesn't give a complete set of figures for the amount of margin debt leading up the 1929 crash, but he does give some figures buried in the text. Combining those figures with a couple of inferences, we get the adjoining graph for the level of margin debt throughout the 1920s.

The New York Stock Exchange web site has a page giving history margin debt amounts, but it only goes back to 1959. However, it is worth noting that in 1959, total margin debt was just $3.4 billion, same as in 1927.

That shouldn't be surprising when you recall that the stock market itself didn't return to its 1929 peak until 1954.

In reading Galbraith's book, I re-discovered something I had completely forgotten -- that there WAS a trigger after all to the 1929 Wall Street Crash.

Recall that that I wrote a few days ago that the Hamburg crisis of 1857 (panic of 1857) was triggered by a small event -- an employee of the New York branch of the Ohio Life Insurance and Trust Company was found to have embezzled money. I added that no one, to my knowledge had identified any "small event" that triggered the Wall Street crash of 1929.

In his book, Galbraith actually does identify a "small event" that triggered the crash:

"On September 3, by common consent, the great bull market of the nineteen-twenties came to an end. Economics, as always, vouchsafes us few dramatic turning points. Its events are invariably fuzzy or even indeterminate. On some days that followed -- a few only -- some averages were actually higher. However, never again did the market manifest its old confidence. The later peaks were not peaks but brief interruptions of a downward trend.

On September 4, the tone of the market was still good, and then on September 5 came a break. The Times industrials dropped 10 points, and many individual stocks much more. The blue chips held up fairly well, although Steel went from 255 to 246, while Westinghouse lost 7 points and Tel and Tel 6. Volume mounted sharply as people sought to unload, and 5,565,280 shares were traded on the New York Stock Exchange.

The immediate cause of the break was clear -- and interesting. Speaking before his Annual National Business Conference on September 5, Roger Babson observed, "Sooner or later a crash is coming, and it may be terrific." He suggested that what had happened in Florida would now happen in Wall Street, and with customary precision stated that the (Dow-Jones) market averages would probably drop 60-80 points. In a burst of cheer he concluded that "factories will shut down ... men will be thrown out of work ... the vicious circle will get in full swing and the result will be a serious business depression."

This was not exactly reassuring. Yet it was a problem why the market suddenly should pay attention to Babson. As many hastened to say, he had made many predictions before, and they had not affected prices much one way or another. Moreover, Babson was not a man who inspired confidence as a prophet in the manner of Irving Fisher or the Harvard Economic Society. As an educator, philosopher, theologian, statistician, forecaster, economist, and friend of the law of gravity, he had sometimes been thought to spread himself too thin. The methods by which he reached his conclusions were a problem. They involved a hocus-pocus of lines and areas on a chart. Intuition, and possibly even mysticism, played a part. Those who employed rational, objective, and scentific methods were naturally uneasy about Babson, although their methods failed to foretell the crash. In these matters, as often in our culture, it is far, far better to be wrong in a respectable way than to be right for the wrong reasons." [pages 84-85]

As Galbraith indicates, Babson was not exactly well known as an economist or financier. He's an interesting person, having founded Babson College here in Massachusetts in 1919, and also founded the Gravity Research Foundation in 1948.

He gave many speeches at many different times, and presumably had predicted a financial crisis in those speeches as well, but it was this particular speech at this particular time that triggered the 1929 Wall Street crash.

This illustrates the point of why I keep mentioning Chaos Theory on this web site. Most people have heard of the "Butterfly Effect" in weather forecasting: if a butterfly in China flaps its wings, then it can start a chain reaction that leads to a hurricane in America a week or two later. This idea, that a tiny event can lead to major consequences, was popularized in the 2004 movie, The Butterfly Effect, starring Ashton Kutcher.

In this case, the "tiny event" was Babson's speech. Last year, a "tiny event" -- the decision by a Danish magazine to publish cartoons depicting Mohammed exploded into the "Danish cartoon controversy," with worldwide confrontations between Muslims and Westerners. Last week I went into detail about how another "tiny event," Ariel Sharon's visit to the Temple Mount in Jerusalem in 2000 triggered the second Palestinian Intifada.

Now, Galbraith writes, "The immediate cause of the break was clear ...." He identifies Babson's speech as the CAUSE of the 1929 crash, or at least the "immediate cause."

I use the word "trigger," rather than cause. Other possible words are "catalyst" or "incitement" or "impetus."

The conditions for the 1929 crash were already there -- the generational changes that led to the abuse of public and private debt, resulting in a vastly overpriced stock market. All it took was the right trigger to cause the bubble to explode.

As we careen towards a new international financial crisis, there's no way to predict, of course, what "little event" will trigger the worldwide panic that will bring it about. It might be something that someone in Chicago says, or it might be some financial data out of Ecuador, or it might be something stupid that someone in China does. There's no way to predict either the event or the timing. It might happen next week, next month, or next year. But the global financial system becomes more imbalanced every day, with the imbalances growing exponentially quickly, so it can't be too far off.

Here's something that made me chuckle. On Friday morning a little after 10 am, the Census Bureau announced that housing starts had fallen 14.3% in January, far lower than economists had predicted, and were at the lowest level since 1997.

CNBC reported this just after 10 am, and CNBC economics guru Steve Liesman looked very glum as he relayed the bad news. Economists had been fearing a fall in housing construction, because of its domino effect throughout the economy -- on lumber, pipes, copper, furniture, craftsmen, community welcome wagons, and so forth, with a deleterious on employment and production.

But it took less than five minutes for another CNBC analyst to say (paraphrasing): "Hey! This is good news! This will reduce the inventory of unsold homes, and housing prices will start rising again!!" It was another one of those bizarre moments that have become so common. If housing starts had risen 14.3%, they would have been talking about how great it was that the economy was expanding. But it fell 14.3% and it's still wonderful news. There's never any bad news on Wall Street.

An even more ridiculous example is an article by CNBC comedian/analyst James J. Cramer.

As we've written several times, many homeowners are defaulting on subprime mortgage loans, and they're losing their homes. The rate of default has been increasing dramatically.

Well, to Jim Cramer, this is not just good news, it's VERY GOOD news:

"I wish the bears understood how important subprime lending is to my thesis about the market going higher. But then again, if they did, they would be forced to cover everything.

For as long as I have been at this game, it has taken a crisis for the Federal Reserve to move. The Fed is always reluctant to move because it needs the crisis as a cover so it doesn't look like it's soft on inflation. ...

When you have the housing industry building a fraction of the homes it was building and credit hard to come by, you are giving Benanke the crisis cover he needs.

Some of my friends who read RealMoney are freaking out about the negative columns that are being written about how dangerous this subprime crisis is. I'm taking those columns very seriously, which is why I am growing more bullish by the day. The fact that the Fed chairman bought into it today in front of the House of Representatives shows me that the Congressional drumbeat -- remember, prime is Republican, subprime is Democrat -- could be building and building fast. ...

If anything, they're saying there might be a fire. I say it's raging, which is why I believe the crisis is about to give us that May cut that I am counting on to take the Dow up 17% this year."

In other words, if the subprime mortgage collapse causes a real financial crisis, then the Fed will have to cut interest rates, and the market will start going up again. I don't even know what to say because I just can't stop laughing at this. I'll leave it to the reader to figure out what's wrong with this reasoning.

So, once again, we see the Principle of Maximum Ruin in action.

In the quote above from Galbraith's book, he alluded to a housing bubble that had occurred in Florida starting in 1925. Here's what he writes about it:

"On that indispensable fact men and women had proceeded to build a world of speculative make-believe. This is a world inhabited not by people who have to be persuaded to believe but by people who want an excuse to believe. In the case of Florida, they wanted to believe that the whole peninsula would soon be populated by the holiday-makers and sun-worshippers of a new and remarkably indolent era. So great would be the crush that beaches, bogs, swamps, and common scrubland would all have value. The Florida climate obviously did not insure that this would happen. But it did enable people who wanted to believe it would happen so to believe." [pages 3-4]

According to Galbraith, areas of land were subdivided into small plots. A plot of land that might have sold for a few hundred dollars in the early 1920s might sell for thousands of dollars in 1925. Some of the better seashore sites sold for $20-75,000.

Prices began leveling off in 1926, but then two hurricanes hit Florida in fall, 1926, killing hundreds of people and destroying thousands of houses. By 1928, the bubble had completely collapsed, and prices fell by as much as 75%. Unfortunately, investors didn't learn the lesson of the bubble.

"The Florida boom was the first indication of the mood of the twenties and the conviction that God intended the American middle class to be rich. But that this mood survived the Florida collapse is still more remarkable. It was widely understood that things had gone to pieces in Florida. While the number of speculators was almost certainly small compared with the subsequent participation in the stock market, nearly every community contained a man who was known to have taken "quite a beating" in Florida. For a century after the collapse of the South Sea bubble, Englishmen regarded the most reputable joint stock companies with some suspicion. Even as the Florida boom collapsed, the faith of Americans in quick, effortless enrichment in the stock market was becoming every day more evident." [pages 6-7]

Galbraith's statements apply to an even greater extent today. You'd think that investors would have learned something from the 1990s stock market bubble, and 2000 Nasdaq crash. But incredibly, they learned absolutely nothing. Lots of people took "quite a beating" in 2000, but it makes no difference. The "faith of Americans in quick, effortless enrichment in the stock market [is] becoming every day more evident," just as it did in 1929 prior to the crash. (16-Feb-07) Permanent Link
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Generational Dynamics Web Log for 16-Feb-07 Stock market margin debt reaches March 2000 all-time high

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Generational Dynamics Web Log for 16-Feb-07
Stock market margin debt reaches March 2000 all-time high