John Kenneth Galbraith kicked off 1987 with a warning of excessive speculation in the stock market. Black Monday came nine months later. A 22% loss for the Dow. The worst single-day drop in market history.
Was it prescience or luck? Who cares. Galbraith, as usual, offered a history lesson worth learning.
He specifically covers four parallels between 1929 and 1987.
- Speculation, euphoria, and greed take hold
- Financial innovation run amok, fueled by debt
- Inevitable punishment of those previously viewed as financial “geniuses”
- Policy changes meant to “stimulate the economy” just flowed into the market
The second is worth highlighting because of the long history of financial innovation run amok.
By the late ’20s, companies were creating companies out of thin air, issuing bonds and a minority of the stock to the public. The newly created companies had no other purpose but to own stock.
But it didn’t end there. The new company would create a company, issue a minority of stock to the public, and the process would repeat all the way down. Investment trusts would do the same. The entire process drove the market. And easy access to leverage magnified it.
The “innovation” was seen as ingenious at the time, yet looking back it all seems ridiculous. As Galbraith concludes — we prematurely ascribe genius to anyone associated with large amounts of money. It’s a repeated trend that gets investors into trouble.
A second, rather stronger parallel with 1929 is the present commitment to seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures. Here the similarity is striking and involves the same elements as before. In the months and years prior to the 1929 crash there was a wondrous proliferation of holding companies and investment trusts. The common feature of both the holding companies and the trusts was that they conducted no practical operations; they existed to hold stock in other companies, and these companies frequently existed to hold stock in yet other companies. Pyramiding, it was called. The investment trust and the utility pyramid were the greatly admired marvels of the time. Samuel Insull brought together the utility companies of the Midwest in one vast holding-company complex, which he did not understand. Similarly, the Van Sweringen brothers built their vast railroad pyramid. But equally admired were the investment trusts, the formations of Goldman, Sachs and Company and the United Founders Corporation, and — an exceptionally glowing example of the entrepreneurial spirit — those of Harrison Williams, who assembled a combined holding-company and investment-trust system that was thought to have a market value by the summer of 1929 of around a billion dollars. There were scores of others.
The pyramids of Insull and the Varr Sweringens were a half dozen or more companies deep. The stock of the operating utility or railroad was held by a holding company. This company then sold bonds and preferred stock and common stock to the public, retaining for itself enough of the common stock for control. The exercise was then repeated — a new company, more bonds and stock to the public, control still retained in a majority or minority holding of the stock of the new creation. And so forth up the line, until an insignificant investment in the common stock of the final company controlled the whole structure.
The investment trusts were similar, except that their ultimate function was not to operate a railroad or a utility but only to hold securities. In December of 1928 Goldman, Sachs and Company created the Goldman Sachs Trading Corporation. It sold securities to the public but retained enough common stock for control. The following July the trading corporation, in association with Harrison Williams, launched the Shenandoah Corporation. Securities were similarly sold to the public; a controlling interest remained with the trading corporation. Then Shenandoah, in the last days of the boom, created the Blue Ridge Corporation. Again preferred stock and common were sold to the public; the controlling wedge of common stock remained now with Shenandoah. Shenandoah, as before, was controlled by the trading corporation, and the trading corporation by Goldman Sachs. The stated purpose of these superior machinations was to bring the financial genius of the time to bear on investment in common stocks and to share the ensuing rewards with the public.
In all these operations debt was incurred to purchase common stock that, in turn, provided full voting control. The debt was passive as to control; so was the preferred stock, which conferred no voting rights. The minority interests in the common stock sold to the public had no effect of power either. The remaining, retained investment in common stock exercised full authority over the whole structure. This was leverage. A marvelous thing. Leverage also meant that any increase in the earnings of the ultimate companies would flow back with geometric force to the originating company. That was because along the way the debt and preferred stock in the intermediate companies held by the public extracted only their fixed contractual share; any increase in revenue and value flowed through to the ultimate and controlling investment in common stock.
It was a grave problem, however, that in the event of failing earnings and values, leverage would work fully as powerfully in reverse.
Ever since the Compagnie d’Occident of John Law (which was formed to search for the highly exiguous gold deposits of Louisiana); since the wonderful exfoliation of enterprises of the South Sea Bubble; since the outbreak of investment enthusiasm in Britain in the 1820s (a company “to drain the Red Sea with a view to recovering the treasure abandoned by the Egyptians after the crossing of the Jews”); and on down to the 1929 investment trusts, the offshore funds and Bernard Cornfeld, and yet on to Penn Square and the Latin American loans — nothing has been more remarkable than the susceptibility of the investing public to financial illusion and the like-mindedness of the most reputable of bankers, investment bankers, brokers, and free-lance financial geniuses. Nor is the reason far to seek. Nothing so gives the illusion of intelligence as personal association with large sums of money.
The 1929 Parallel
- The Risk of Outsourced Thinking – J. Huber
- Debunking the Silly “Passive is a Bubble” Myth – A Wealth of Common Sense
- An Analysis of “Benjamin Graham’s Net Current Asset Values: A Performance Update” – Alpha Architect
- Improving the Odds of Value – Factor Research
- How to Get Better at Embracing Unknowns – Scientific American
- Uncertainty Isn’t Always a Problem, It Can Be the Solution – Wired
- Robert Shiller: Narrative Economics (video) – RA Conversations
- Why Value Investing Has Been Doing Terribly (podcast) – Odd Lots
- Ian Cassel: Intelligent Fanatic, A Masterclass In Microcap Investing – Acquirer’s Multiple
- The Commuting Principle That Shaped Urban History – CityLab
- How to Major in Unicorn – NY Mag