Early Development of the Stock Market
The same complex forces that forged modern capitalism and the modern corporation produced the stock market and its inherently speculative personality. The foundation of the stock market developed from 1897 to 1919 in three phases. In the first phase, more middle-class citizens became investors. Investment no longer remained the exclusive domain of the rich.
“Nowhere in American society is violent, competitive individualism more rampant than in the modern stock market.”
In the second phase, common stocks emerged as a new engine for creating wealth. Though riskier than bonds and other alternative investments, common stocks became an egalitarian means for the average American to gain higher returns on investment. Regulatory protections for investors gradually took form in the early 1900s, encouraging speculation.
“The stock market started as a tool that helped to create new businesses. It ended by subjugating business to its power. ”
The third phase, the rapid development of the securities brokerage industry, began after the outbreak of World War I. Millions of American investors bought Liberty Bonds from the federal government to fund U.S. involvement in the war, and securities brokerages that sold war bonds branched into other types of securities as they refined their retail sales networks.
“Securities regulation as an independent force would slowly begin to emerge from a legislative chrysalis after 1907.”
During these three phases, government efforts to restrict monopoly power, particularly in the railroad industry, led indirectly to legislative initiatives to protect average investors from unscrupulous securities brokers.
Business Competition Versus Combination
Letting businesses cooperate, not just compete, was a transformational idea in the 19th century. Many Americans had embraced the ethos of brash competition espoused by economists John Stuart Mill and David Ricardo. But in the 1880s, some economists began criticizing the laissez-faire concept of minimal government involvement in the private sector of the economy. They called for new government regulations to enable cooperation among companies.
“The Panic of 1907 was a watershed event for currency regulation, banking regulation and securities regulation.”
At the time that more forward-looking economists were proposing new national government regulations, corporations faced strict state-by-state governmental sanctions that prohibited interstate cooperation and, thus, restricted growth. In 1882, Standard Oil attempted to avoid these sanctions by arranging for shareholders of Standard Oil companies in four states to exchange their shares for interest in a management-run trust, which maintained control of the four companies. Other firms used trusts to circumvent similar anticompetitive laws. However, the state courts ruled these arrangements illegal. In 1892, the Ohio Supreme Court dissolved Standard Oil’s trust.
“The new legislation accepted the speculation economy that had been embraced by the American people.”
Many of the corporations that wanted greater freedom to pursue mergers had potent allies. In 1885, the influential American Economic Association distributed widely read articles criticizing unrestrained competition as destructive and unproductive. One of the association’s charter members was Woodrow Wilson. The influence of the group was apparent in the regulatory framework of Wilson’s presidential administration from 1912 to 1920.
“Watered Stocks” and Secret Trusts
The holding company eventually replaced the stigmatized trust as the preferred legal vehicle for business acquisition and industry consolidation. In the late 1800s, New Jersey became the first state to permit the formation of holding companies and allow corporations to buy stock in each other. Other states, notably Delaware, enacted similar laws to accommodate merger-driven big businesses.
“Speculation as a function of the nature of investment rather than the behavior of the investor began to develop in a way that forever changed the American stock market.”
A nationwide flurry of business mergers from 1897 to 1903 increased stock prices and lured more investors into the stock market. But stock price manipulation was rampant, and calls for better regulation ensued. A common form of manipulation was the issue of so-called watered stock. The term originated with ranchers who would arrange for cattle to drink plenty of water just before weighing them and selling them at market.
“The establishment of common stock as a legitimate investment vehicle was critically important in determining the course of American corporate capitalism.”
Companies would dilute the value of stock in the hands of existing shareholders by selling additional watered stock for sums exceeding the book value of their assets. A firm that sold watered stock would become “overcapitalized,” which, in the parlance of the times, indicated a condition that would encourage the organization to invest not only in its business but also in speculative securities, including the stocks of other companies.
“Non-dividend-paying stock – what today is called growth stock – was considered nothing but speculative, and the speculator needed no knowledge of the business in which he was investing.”
The most powerful companies defied easy appraisal. Many individual investors struggled to evaluate firms that issued watered stock but disclosed no information about their financial condition. Such organizations valued secrecy and abhorred publicity. They wanted to keep financial disclosure limited to existing stockholders and management.
“The move from bonds to stocks linked the performance of the banking sector, and thus the money supply and the nation’s entire economy, to the performance of the stock markets.”
The New York Stock Exchange went along with these firms’ contention that the public had no right to know their financial or operational details. Before 1900, the Big Board was toothless in its dealings with the excesses of trusts and other types of listed companies. Starting in 1866, the exchange technically required financial disclosures by listed companies but did not enforce that requirement for decades.
The Panic of 1907 and Its Aftermath
In 1907, stock prices collapsed after several years of rapid increase. Banks, trust companies and securities clearinghouses failed in large numbers. The panic sent the U.S. economy into a 13-month industrial depression followed by nearly seven years of stagnant growth.
“The widespread shift from buying for income to buying for price growth had profound consequences for American corporate capitalism that would not have existed without the trend to common stock.”
The Panic of 1907 triggered a significant change in regulatory direction. Federal incorporation efforts and antitrust debates eased as legislative priorities switched to protecting average investors. As lawmakers rolled out more investor protections, investment risk started to wither and the “speculation economy” began to sprout.
“In a complete perversion of the 19th-century view of the corporation, the 20th century dawned with corporations that had no specific businesses of their own.”
From 1909 to 1913, two key reports and a congressional investigation improved investor protections. The Hughes Committee, which was nicknamed after New York Governor Charles Evans Hughes and officially known as the Governor’s Committee on Speculation in Securities and Commodities, focused mainly on securities-trading abuses in New York state. In 1909, the committee released a report recommending that the New York Stock Exchange regulate its members and curb futures trading and short selling. The committee also proposed that companies should meet more detailed requirements for publicly listing their shares.
“The combination of advertising and salesmanship used in the Liberty Bond drives catalyzed the transformation of the American middle class into the American investing class.”
In 1911, a group called the Hadley Commission (named after its chairman, conservative economist Arthur Hadley) put out another influential report. It highlighted the importance of financial disclosure in securities regulation. President William Howard Taft had pushed for passage of the federal law that created the commission, which was formally known as the Railroad Securities Commission. Its mission was to restrain the monopolistic excesses of railroads. The commission said that railroads should disclose their cash reserves and other financial data to the Interstate Commerce Commission and that a federal agency should set accounting rules and investigate malfeasance. The Hadley Commission’s recommendations created a broad policy foundation for financial disclosures by all types of companies that issue securities to the public.
“Property’s almost mystical power in American social thought derived from the notion that it was the extension of the individual.”
From 1912 to 1913, a congressional committee investigated Wall Street institutions to determine whether they needed stronger regulations. The so-called Pujo Committee, named after chairman Arsène Pujo, ultimately concentrated its investigation on securities issuance by industrial corporations. The committee inspired the New York Stock Exchange’s board (which had ignored the Hughes Committee) to take steps toward effective self-regulation.
At the same time, efforts to replace state standards of incorporation with new federal standards were gaining momentum. The idea was to centralize and tighten government control of massive companies. The federal incorporation movement was unsuccessful, but it helped spur the creation of the Federal Trade Commission and the enactment of the Clayton Antitrust Act of 1914.
Bonds Versus Stocks
Bond financing for the U.S. military during World War I indirectly contributed to the postwar popularity of investing. About 25 million Americans acquired war bonds and, in the process, got an introduction to retail brokerage firms. They came to believe that common stocks were suitable investments for average folks.
During the war, U.S. Treasury Secretary William Gibbs McAdoo allowed the sale of Liberty Bonds on credit. Installment payment plans helped establish the idea of buying securities on margin, or with borrowed money. The marketing push for Liberty Bonds was quite impressive. Volunteers ranging from “bankers to Boy Scouts” became war-bond salesmen in local communities. The four Liberty Bond issues, all oversubscribed, raised $21 billion.
The Liberty Bond sales campaign led banks to form separate companies or create partnerships with affiliated firms to sell stocks to individual investors. Banks also established margin-lending operations and stock-research departments. These banks used the same techniques they had developed to sell war bonds, including selling on credit. One pioneer in developing techniques to sell securities was Charles E. “Sunshine Charley” Mitchell, president of a bank called National City Corporation. National City made a lucrative transition from selling Liberty Bonds to middle-class investors to selling them common stocks.
In 1918, the stock market was booming. Investors began to sell government bonds and use the proceeds to buy higher-yielding stocks. Facing reduced bond demand, the federal government tried to exert greater control over the allocation of capital between the private sector and the public sector – but only temporarily. McAdoo convinced Congress to create an entity called the War Finance Corporation to ensure adequate financing for military operations in World War I. The law Congress passed also established the Capital Issues Committee of the Federal Reserve. The committee was supposed to distinguish corporate stock issues that advanced the war effort from other stocks.
Braced for Stock Market Crashes
The federal government stopped acting as the gatekeeper of the capital markets after the war ended. Indeed, by the end of World War I, the key elements of modern financial capitalism – the stock market, a large middle class of speculative investors, securities regulations for investor protection – were in place.
Two federal laws enacted in 1919 advanced the development of regulations to protect investors. One required corporations that marketed stock in more than one state and that paid sales commissions to file an offering document with the Federal Trade Commission. Another required stock issuers to disclose enough information so that an investor could make an intelligent decision to buy or sell. These laws helped pave the way for the groundbreaking 1933 Securities Act, which penalizes companies that file financial statements with material misstatements of fact.
In 1920, Warren Harding won the presidential election, and his Republican administration faced a slower economy. Liberty Bonds were trading below par value, the country was in a brief economic depression and the cost of living was high. Prosperity returned after Americans elected Republican lawyer Calvin Coolidge president in 1923. The stock market soared until the autumn of 1929, when it famously crashed. By then, however, the U.S. had embraced common stocks, and speculation had become an accepted part of American life.