This affords an opportunity to say that the local evil of stock speculation arising from insufficient margins is one that may be laid at the door of outside Exchanges rather than the “Big” Exchange, as it is called, because, in the minor Exchanges, margins are notoriously small, and the smaller the margin the greater the number of “victims.” Indeed, if it were not for this practice it would be difficult for members of smaller Exchanges to exist at all. In so far as speculation in securities may merit criticism, this tendency to attract poor people by the bait of slim margins is undeniably a very real evil, and one which can only be corrected by the brokers themselves. The Hughes Committee, after devoting much time and labor to this matter, put its conclusions in these words:
“We urge upon all brokers to discourage speculation upon small margins, and upon the Exchange to use its influence, and if necessary its power, to prevent members from soliciting and generally accepting business on a less margin than 20 per cent.”[22]
Every one connected with the New York Stock Exchange knows that this suggestion, like all the others made by the Commission, was received with approval by all hands, and, if a hard and fast rule could have been devised to meet not merely the spirit but the letter of the recommendation, the Governors of the Exchange would have put it into instant operation. But there are difficulties in the way, and one of the duties of the Governors is to consider very carefully all sides of each perplexing question that comes before them, not merely in the interests of the Stock Exchange, but with due regard to the common law and the interests of the public. Margin trading is a matter of contract, and “the right of one private person to extend credit to another,” as the Chairman of the Hughes Commission himself points out, “is simply the right to make a contract, which, under the Federal Constitution, cannot be impaired by any State Legislature.”[23]
Here is a very considerable difficulty in the way of restricting margin trading, and one that is not fully understood by the outsider. He is prone to speak of contracts thus made as “gambling transactions,” missing altogether the essential point that there is a vast difference between a transaction with a contract behind it, enforceable at law, and one that has to do with bucket-shops and roulette, in which there is no contract, and is expressly prohibited by law. No matter what his intent may have been when he bought, and no matter what margin the broker accepted--the buyer has the right to demand his securities at any time, and the broker must always be prepared to deliver them; conversely, the broker may compel the buyer to pay for and to receive the securities he has bought. Motives and methods have nothing whatever to do with the transaction.
The broker who buys for a client to-day does not know, and sometimes the client himself does not know, whether the securities are “bought to keep,” or are to be sold to-morrow; similarly the broker has no means of knowing whether the client, who deposited a ten-point margin at the time of his purchase, will or will not deposit another ten points to-morrow, and continue such payments until his securities are wholly paid for. In the large majority of cases the intent of the speculative buyer is to sell as soon as he can get a satisfactory profit, but that does not make him a gambler by any means. Why? Because, if he bets $1000 on a horse race, one party to the transaction wins and the other loses; whereas, if he deposits $1000 as margin against a stock speculation and makes a profit of say $500, the broker loses nothing by paying him that profit when the account is closed. No property changes hands in the one case, while, in the other, actual property is purchased and held ready for delivery on demand. The law is clear in classifying the operations of bucket-shops with gambling transactions, because in a large majority of instances no actual purchase is made; the “buyer” merely bets in that case as to what subsequent quotations will be; the “trade” is between two principals, one of whom must lose if the other wins.
The Hughes Commission, as I have said, went very fully into all these matters. It was in session six months, and many witnesses were examined. After considering all the pros and cons of margin trading, the experience of England and Germany in dealing with speculation, the three-years’ debate in Congress on the Hatch Anti-Option Bill, and the voluminous reports of the Industrial Commission, the conclusion was reached “to urge upon all brokers,” as shown in the paragraph cited, a general agreement on margins of not less than 20 per cent. It must be borne in mind that this was not in the nature of a formal recommendation, but rather as the expression of a hope that some measure of reform might be accomplished if such concerted action by brokers were feasible.
That members of the New York Stock Exchange endorse this view goes without saying. They realize more fully than is generally known by the public that indiscriminate and reckless speculation by uninformed people who are beguiled into it by the lure of small margins is an undoubted evil that should be checked, and they are doing what they can to check it by discouraging such operations. For example, it would be very difficult to-day for a woman to open a speculative account with any reputable firm of brokers on the major exchange unless she were well known, peculiarly qualified for such transactions, and abundantly able to support them. Accounts will not be accepted from clerks or employees of other brokerage houses or of banks and other corporations in the Wall Street district; indeed, such transactions are expressly forbidden by the rules of the Exchange. No accounts will be accepted from any one who is not personally known to one of the firm’s partners--and the practice resorted to in earlier years of employing agents to solicit business under the nominal title of “office managers,” “bond department managers,” and all that sort of technical subterfuge, is likewise forbidden.
Members of the Exchange are not permitted to advertise in any way save that defined as of “a strictly legitimate business character,” and the governors are the judges of what is legitimate. The layman has but to glance at the bare and colorless announcements made by Stock Exchange houses in the advertising columns of our newspapers to see how rigidly this rule is enforced; indeed 90 per cent. of the members do not advertise at all. Best of all, speculation on “shoe-string” margins is now almost eliminated from the major exchange. The houses that notoriously offended in this respect ten and fifteen years ago are to-day inconspicuous in the day’s dealings. Their business is gone--in its very nature it could not last long--and if rumor be credited its demise carried with it a part of the capital of the firms involved. It was a lesson and a warning. All these instances serve to show that the Stock Exchange is doing what it can to remedy this evil, and, if circumstances arise in which more can be done, the governors and members will be found a unit in enforcing whatever restrictions are necessary.
At the moment it is difficult to see how an inflexible rule of 20 per cent. margins could be put in practice without seriously interfering with really sound business. A telegraphic order may be received from a customer of the utmost responsibility who may happen to be in Europe. Any stockbroker, and any business man in mercantile trade, would be glad to execute for such a person all the orders he chose to entrust, regardless of margins. In such a case no question of motive enters into the transaction; it may ultimately prove to be a speculation pure and simple, or the buyer may cable instructions to deliver the securities to his bank, in which case it would seem to be an investment; but, regardless of that, an insistence by the broker on a 20 per cent. margin would be silly, and would merely drive the business elsewhere or prevent it altogether.
Numerous instances of a similar sort might be cited to show how difficult it would be to enforce margin prohibitions in all these perfectly legal contracts. Germany tried it in the law of 1896, with disastrous consequences, which I have described elsewhere. It is a matter that will always be a fruitful topic of discussion, yet it differs in no essential respect from the practice of a speculator in real estate who pays down a small percentage of a purchase price and borrows the balance on mortgage. It is similar to what the merchant does when he fills his shelves with goods bought with a fractional payment in cash and the balance at some future date. In all these cases involving property let me repeat that the deposit of a specified sum by the principal and an agreement or contract with the broker is a perfectly valid transaction.[24]
That newspaper criticism and attacks by social mentors should go to extreme lengths in deprecating stock speculation by crude, greedy, and unsophisticated people is perhaps, after all, a perfectly useful function, and if such critics err in going to great extremes, that too may be set down as right and proper, for it is perhaps better to go too far than not to go far enough. The interests of the Stock Exchange are the interests of the whole country; its welfare depends upon an intelligent and thrifty people; its aims are public-spirited and patriotic. Whatever it may lose in the way of business from ignorant and silly people who are driven out of blind speculative undertakings leading to losses which they can ill afford, it will gain tenfold in imparting sound information through candor and publicity. On the other hand, unless we are prepared to abolish property altogether, do away with the instruments of credit, and suppress all forms of trading designed to supply our future requirements, we may as well reconcile ourselves to the inevitable and take what comfort we may in the reflection that prudence, thrift, and foresight are not to be eliminated, merely because the proletariat below stairs sometimes indulges in speculation and suffers the consequences of its folly.
“Finally,” writes Professor Emery, “the question must be faced of the effect of eliminating the public from the speculative market even if it could be accomplished. It is supposed sometimes that such a result would be all benefit and no injury. On the contrary, the real and important function of speculation in the field of business can only be performed by a broad and open market. Though no one would defend individual cases of recklessness or fail to lament the disaster and crime sometimes engendered, the fact remains that a ‘purely professional market’ is not the kind of market which best fulfils the services of speculation. _A broad market with the participation of an intelligent and responsible public is necessary. A narrow professional market is less serviceable to legitimate investment and trade and much more susceptible of manipulation._”[25]
One of the difficulties with which men have to contend in a big country like this is the apparent inability of large masses of the people to understand other large masses. Distances are so great, occupations so diverse, and enterprise so confining, that one whole section of the country may not and often does not know what another section is doing. Men are too busy to learn by travel and reading that which, in the interest of the whole country, they should thoroughly understand. Thus it happens that a section of the country given over, let us say, to agricultural pursuits, having first acquired the notion that speculation in securities is only a form of legalized robbery, assumes that to New York City and the New York Stock Exchange is confined a greater part of the stock speculation of the world. We have seen the fallacy in the first of these hasty conclusions; the second may easily be explained away.
Yankee speculation in securities is not a marker to speculation in London, where the day to day trading vastly exceeds ours, and where the “Kaffir Circus” of 1894–5 and the “Rubber Boom” of 1909–10 exceeded any similar outburst ever known in America. France is the most prudent and thrifty of nations, yet the Panama mania which collapsed in 1894, although followed by a period of the utmost repentance and conservatism, found a parallel in the crazy French speculation in Russian industrials which crashed in 1912. There was an extraordinary speculation in Egyptian land and financial companies in Cairo in 1905–6, which, in proportion to the number of participants, greatly exceeded any boom in New York. China awakens slowly, but, once its political reforms are effected, a field of extraordinary speculation will open there without a parallel in history. The Chinaman is not only a shrewd and competent business man, but he is, Mr. Hirst tells us, “a confirmed and incurable” speculator. “From time to time,” says this writer, “the Shanghai Stock Exchange becomes a scene of the wildest speculation, and it is safe to predict that, when a new China is evolved, Stock Exchanges will spring up in all the large towns. Of this, a foretaste was afforded in the spring and summer of 1910, when Shanghai caught the rubber infection from London. All classes and races took part, but the native Chinaman plunged deepest. When the break in prices came, one Chinese operator was so heavily involved that, on his failure, many of the native banks had to suspend payment, with the result that for months the trade and credit of this great shipping and business centre were disorganized.”[26]
I mention these incidents to show that speculation is not confined to geographical limits. It is all a part of the “divine unrest” inherent in each of us, and it develops and grows intense just in proportion with the march of the civilization it serves to benefit. In new countries, as in China, it may often go too far; sometimes in old countries it oversteps the bounds of prudence, but any student of these phenomena knows that, as economic processes become understood by the masses, the intervals of time between the panics that result from over-speculation grow wider and wider.
Another mistake of those sections of the country that do not understand the Stock Exchange results from the indiscriminate blending of that institution with Wall Street. Let us hear from Mr. Horace White on this point. He was the chairman of the last committee that investigated the Stock Exchange; he is one of our foremost economists, and he may be assumed to understand his subject:
“There is a widespread belief that Wall Street and the Stock Exchange are one and the same thing, and that all the fluctuations on the Exchange are caused by Wall Street. This is an error as glaring as it would be to suppose that all the water in the Mississippi River comes from the adjacent banks, ignoring the innumerable streams and rills that contribute their quota from countless unseen sources. Wall Street and the Stock Exchange are two different things. The men on the floor of the Exchange are the agents of others, executing the orders which they receive both from Wall Street and from other parts of the habitable globe. Some of them speculate on their own account, but the speculating members of the Exchange are divided into bulls and bears. They do not all push in the same direction at any one time. They simply aim to anticipate, each for himself, the drift of financial public opinion in order to take advantage of it.
“This is what Wall Street outside of the Exchange does; and the only advantage which speculators in Wall Street have over those in other parts of the country is derived from larger capital, more direct and ample sources of information, and greater skill and promptness in the use of it. Wall Street speculators are likewise divided into bulls and bears pushing against each other; and all their advantages do not save them from making mistakes, which often result in losses proportioned to the magnitude of their operations. The ‘rich men’s panic’ of 1903 was such an instance. The panic of 1907 was another. It is sometimes said that Wall Street can put prices on the Stock Exchange up or down at its own pleasure. This is a delusion.”[27]
Members and friends of the New York Stock Exchange view with apprehension the periodic attacks upon their great institution made by those who, for reasons not to be discussed here, wish to attract popular attention. But there is no reason why these matters should excite alarm. The Exchange purified itself long ago of the old abuses, new ones as they occur meet with severe disciplinary measures, and it has a certificate of good character in the report made to the sovereign State of New York by the Hughes Commission. This commission has stated explicitly that margin trading is a matter of contract guaranteed by the Federal Constitution. It is not conceivable that any legislature can ignore such a report, by such a commission, nor is it possible that, in such event, any court could be found to uphold legislation directed at random against an institution that bears the endorsement of all students of economics.
One has but to read the decisions of the courts to see that the matter of non-interference with the great Exchanges, on technical grounds, has become a fixture in our jurisprudence. “The Exchanges,” said Judge Grosscup of the United States Circuit Court, “balance like the governor of an engine the otherwise erratic course of prices. They focus intelligence from all lands, and the prospects for the whole year, by bringing together minds trained to weigh such intelligence and to forecast the prospects. They tend to steady the markets more nearly to their right level than if left to chance or unhindered manipulation.”[28] In somewhat similar vein Justice Holmes of the United States Supreme Court, said: “Speculation ... is the self-adjustment of society to the probable. Its value is well known as a means of avoiding or mitigating catastrophes, equalizing prices, and providing for periods of want. _It is true that the success of the strong induces imitation by the weak, and that incompetent persons bring themselves to ruin by undertaking to speculate in their turn. But legislatures and courts generally have recognized that the natural evolutions of a complex society are to be touched only with a very cautious hand, and that such coarse attempts at a remedy for the waste incident to every social function as a simple prohibition and laws to stop its being, are harmful and vain._”[29]
With these opinions before them, so long as the governors of the Stock Exchange continue their policy of a wise and dignified administration in the interest of the public they serve, there is nothing to fear. Corrections, remedies, improvements, and reforms will be found to be necessary from time to time--some of them are necessary at this moment, and the governors are hard at work on the task. To accuse them of indifference or neglect of duty is to deny them that form of intelligence which enables a man to protect his property. Their splendid institution has grown to its present importance and power through economic development that could not have been foreseen nor prevented. Speculation on a large scale has accompanied its growth, and contributed to it; and speculation, as we have seen, is a highly desirable and useful part of all business. This speculation numbers among its adherents people in all parts of the world who have a perfect right to speculate, and who do vastly more good than harm in their operations.
It has also attracted a great many people who have no business to speculate, and who would be prevented from doing so if it were possible. The ignorance and cupidity of these people is so great, and the pitfalls provided them by unscrupulous, methods outside the Exchange are so many and various that something has to be done to protect them. The Stock Exchange does not encourage them, but it recognizes that they have legal if not moral rights, and it stands ready to help them. It gives to such people the same information that it gives to the richest investor in the land. The securities in which it deals are known to be free from taint; all forms of crookedness are prohibited; every transaction within its walls is made openly, as a result of free competitive bidding, and published broadcast to the world. What more, and what less, can be done? Has there ever been a time in the world’s history when property and trade were so secure, and when speculation, which makes property and trade, was so jealously safeguarded?[30]
CHAPTER III
THE BEAR AND SHORT SELLING
The operations of “bears” in the great speculative markets and the practice of “short selling” are riddles which the layman but dimly comprehends. Buying in the hope of selling at a profit, and if need be, “holding the baby” for a long time and “nursing” it until the profit appears, is simple enough; but an Oedipus is required to solve the enigma of selling what one does not possess, and of buying it at a profit after the price has cheapened. It is the most complicated of all ordinary commercial transactions. How the thing can be done at all is a mystery; how such a man can serve a really useful economic purpose by this process is unfathomable. The layman who tries to figure it out thinks there is an Ethiopian somewhere in the wood-pile; the thing is unreal and fictitious. The only way he can understand it is to turn bear himself and learn by experience.
Why there should be so many bulls and so few bears can only be explained on the ground that optimism is the basis of speculation, and hope the essence of it. Yet the market can only go two ways: it is quite as likely to go down as up. Since sentiment should have no place in speculation one would think there should be as many bears as bulls, more of them, in fact, because the market almost always goes down faster than it goes up, and because nine out of ten of the unforeseen things that occur result in lower prices.
Accidents like diplomatic entanglements, rumors of war, earthquakes, and drought are constantly occurring to upset the plans of bulls and bring fat profits to bears in a hurry, while matters that bring about higher markets are generally things long anticipated, in which the profits that accrue to the bulls come about slowly and laboriously, and always with the attendant risk that a disturbance in any corner of the globe may bring on a sudden smash that will undo the upbuilding of months. In theory, therefore, there should be at least as many bears as bulls in all active markets, but in practice the large majority are always bulls, to whose sanguine and credulous natures the bear is a thing apart--a gloomy and misanthropic person hovering about like a vulture awaiting the carrion of a misfortune in the hope of a profit. Naturally the layman cannot understand him, and would like to suppress him.
Despite the fact that the odds seem to favor the bears, there is an old and true saying that no Ursa Major ever retired with a fortune. Wall Street has seen many of them, and with perhaps one exception the records agree that the chronic pessimists have not succeeded. Fortune seems to have smiled on them at intervals; in the country’s early days of construction and development mistakes were made that brought about disaster, but in the long run such tremendous progress has resulted in America as to defeat the aspirations of any man or group of men who stood in its way. The big bears, as a rule, have “over-stayed the market.” Imbued with the hope that worse things were in store, they have been swept away by the forces they sought to oppose. One of them, a power in his day, was so obsessed with the notion that all prices were inflated, that he has been known to sell stocks short “for investment.” One night when a lady at his side remarked on the beauty of the moon, he is said to have replied with that absent-minded mechanical skepticim inherent in the bear, “yes, but it’s too high; it must come down.”
One would think the ideal temperament for a speculator would be absolute impartiality, with an open mind uninfluenced by sentiment, ever ready to take advantage of all fluctuations as they occur. The ups and downs of a stock market always show, on average long periods, a practically equivalent swing each way, so it would seem that the speculator most likely to profit by these fluctuations would be one without preconceived prejudices, ready at all times to turn bull or bear as the occasion required. As a matter of fact, this type is the rarest of all, being confined, generally speaking, to the professional “traders” on the large exchanges, necessarily a very small minority of the speculative group, yet withal perhaps the most uniformly successful. These men, it must be understood, are not speculators, but traders, a nice distinction involving “catching a turn,” as opposed to the speculative habit of “taking a position.”
In active times I have known one of them to operate simultaneously in the New York Stock market, in the cotton market, and in the wheat market, trading at the same time in London and Paris, “shifting his position,” or “switching” from the bull to the bear side twice in a single day, and closing all his trades at three o’clock with a total net profit of less than a thousand dollars on a turnover of 30,000 shares, to say nothing of the transactions in cotton and grain. It goes without saying that to do all these things in one day requires a curiously mercurial temperament, and calls for nerve and celerity altogether foreign to the average speculator. Such a man, moreover, contributes but little to the making of prices and values, which is the function of large markets; his chief economic usefulness lies rather in the enormous revenues he pays to the State. The man whose operations I have just described contributed in a single year $75,000 to the State Government in stock-transfer taxes.
The scientific way to measure the value of speculators in wide markets is to consider the bull as one whose purchases in times of falling prices serve to minimize the decline, and the bear as one who serves a doubly useful purpose in minimizing the advance by his short sales and in checking the decline by covering those sales. All these operations serve useful economic purposes, since the more buyers and sellers there are, the greater the stability of prices and the nearer the approach of prices to values.
This, as I have said, is the scientific way to look at it, and the correct way, but the popular way is something quite different. From this point of view the man who sells property he does not immediately possess is thought to be a menace, who depresses prices artificially and works a disadvantage to the investor or, in the produce markets, to the producer. Nothing could be more fallacious than this, because of the fact that just as every routine sale of actual stock requires a buyer, so every short sale by a bear requires a purchase by him of equal magnitude. And it is precisely these repurchasing or “covering” operations of the bears that do the utmost good in the way of checking declines in times of panic or distress.
When there are no bears, or when their position is so slight as to be inconsequential, declines are apt to run to extreme lengths and play havoc with bulls. One often hears among acute and clever speculators the expression “the bears are the market’s best friends,” and, though this may seem incongruous, it is quite true. In the month in which these lines are written there has occurred, for example, a really severe break in prices on the Stock Exchanges at London, Paris, and Berlin, arising from the periodic Balkan crisis. This decline ran to disproportionate extremes, and, in fact, approached such demoralization that more than 300,000 shares of American securities held abroad were thrown on the New York market for what they would bring. The reason for the severity of this decline was easily explained. The outstanding speculative account at all European centres, while not actually unwieldy, was almost entirely in the nature of commitments for the rise. There was no bear account. Therefore all Stock Exchanges were supersensitive since they lacked the steadying influence which covering by the bears invariably brings about. The bears are then, in truth the market’s best friends, and the more there are of them, the better for all concerned when trouble comes.
Throughout all the political agitation in Germany which culminated in that disastrous failure, the Bourse Law of 1896, there appears to have been very little opposition to the bear and the practice of short selling; nevertheless in that section of the law which prohibited dealings for future delivery the bears found their activities restricted. The law has now been amended, having proved a wretched fiasco, but in the decade which attended its enforcement it was curious to note the unanimous cry that went up in Germany for the restoration of the bear. His usefulness in the stock market no less than in the commodity market was recognized; his suppression was deplored. It was found that just as his activities were restricted so the tendency toward inflated advance and ultimate collapse was increased. The market became one-sided, and hence lop-sided; quotations thus established were unreal and fictitious. Moreover there was an incentive to dishonesty, for unscrupulous persons could open a short account in one office and a long account in another, and if the bear side lost they could refuse to settle on the ground customarily resorted to by welchers.