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.

1. Speculation, euphoria, and greed take hold
2. Financial innovation run amok, fueled by debt
3. Inevitable punishment of those previously viewed as financial “geniuses”
4. 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. Continue Reading…