Bear Markets: The Impulse for State Meddling
In the twentieth century, war has been a leading force driving the growth of the state. When it comes to the government’s role in the world of equities, the equivalent of war has been bear markets. Consider the panic of 1907, during which J.P. Morgan was called upon to save the financial system after the collapse of a stock-manipulation scheme. That panic led to the establishment of the Pujo Committee five years later. This Congressional body produced a report calling for a raft of government regulations of stock market activity. Much of this had to wait for implementation until a more vicious and prolonged bear market changed the political equation. Before that occurred, the 1920’s witnessed a historic bull market, which saw the DJIA rally from 63.90 in mid-1921 to a high of 381.17 in September 1929. Mirroring a pattern seen in previous market manias, such as the Mississippi and South Sea Bubbles, the upward trend in prices became nearly vertical in the latter stages of the move. The DJIA skyrocketed from the 154 level in early 1927, more than doubling over the next two-and-a-half years. As everyone knows, the 1920’s bull market ended with a crash in October 1929. This actually occurred over two days, on the 28th and 29th of that month, with the DJIA falling a total of 24.6 %. Not until the Black Monday crash of October 1987, during which the DJIA dropped 22.5 % in a single day, would an equally spectacular meltdown be repeated.
It is telling that after the 1987 crash, the government’s response was limited to the addition of a few regulations. Most notable was the introduction of circuit breakers mandating a temporary halt of trading whenever the DJIA either rises or drops a certain amount from the previous day’s close, a threshold initially set at 250 points and 500 points. These circuit breakers, as they are called, are now triggered when the S&P 500 falls 7 %, 13 %, and 20 %. The minimal political fallout from the 1987 meltdown suggests that it was not the 1929 crash as such which caused the far greater fallout that occurred afterwards. For what differentiated the 1929 and 1987 crashes was that the second was followed by a sustained recovery in stock prices, while the first was not. To be sure, the stock market managed to make up about half the losses suffered over the fall of 1929, as the DJIA closed as high as 294.07 in April 1930. During this phase, the political pressure on Wall Street had noticeably abated. But then a brutal negative trend set in which eventually took the DJIA down 89 % from the pre-crash high. To this day, the 1929-1932 bear market stands as the largest peak-to-trough decline in American stock market history.
Of course, this descent paralleled the Great Depression, then at its most acute stage in ravaging world economies. At the time, however, there was also a widespread belief among politicians and the public that the stock market prompted the sharp downturn in economic activity, instead of simply reflecting it. It is now widely agreed by economists that the 1929 crash did not cause the Great Depression. This view is borne out by the fact that a recession was not a part of the immediate aftermath of Black Monday in 1987. Still, in trying to account for causes in human affairs, we must recall that it is does not suffice to consider objective factors. We must also attend to, and indeed place explanatory priority upon, the subjective factors of experience. Human action is always driven by interpretations of what is, and what ought to be. Recognizing this, we avoid the mistake of concluding that the occurrence of a major bear market, in and of itself, calls forth a political reaction against Wall Street. The DJIA suffered a 49 % decline in 1937-1938 as well as 46 % drop in 1973-1974 without eliciting a major increase in government regulatory oversight of the markets.
Indeed, one of the more remarkable characteristics of the regulatory structure is its relative stability. When an alteration does occur, it tends to be large and implemented in one fell swoop. The previous equilibrium of political interests, it seems, can only be shaken up by a dramatic event. Only then can the forces for change seize the opportunity provided by the discrediting of the status quo. As the 2000-2002 and 2007-2009 downtrends confirmed, both of which were followed by significant state intervention, the rise preceding the fall has to be widely perceived as manifesting a laissez-faire approach to economic affairs before pro-regulatory forces are able to obtain political leverage. Accordingly, for many in the 1930s, the reality of the stock market as they saw it was that it epitomized the failings of the free market vision that held sway under the Calvin Coolidge and Herbert Hoover administrations. Their ideological shortcomings were taken to justify not merely a stricter regulation of the markets by the government, but that of the entire economy. As Franklin Delano Roosevelt said in his 1933 inauguration speech: “our distress comes from no failure of substance ... the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion”.
The fundamental lineaments of the regulatory structure governing the American equity market, a good deal of which is mirrored around the world, were established in the wake of the 1929-1932 bear market. Among the pieces of legislation passed in Roosevelt’s famous 100 days was the 1933 Securities Act. This requires that any shares offered for sale to the public be registered with the SEC and that full disclosure be made by the issuer of all information that could materially impact investor decisions. Instead of caveat emptor—Latin for let the buyer beware— securities regulation enshrines the principle of caveat vendor, let the seller beware. To ensure that everything disclosed is true, the act prohibits fraud and misrepresentation by security issuers even if a deceived investor did not rely on any disclosures provided by the company. This is a more stringent standard for sellers than that traditionally required by the courts. In 1934, the Securities and Exchange Act created the SEC (before that, the Federal Trade Commission was briefly charged with enforcing federal securities laws). At the same time, legislation was passed banning manipulative trading practices, limiting the use of margin credit to buy stock, and mandating firms to publish periodic reports of their financial performance. The worldview guiding this intervention effectively likens the stock market to a game favoring both corporate elites and investment professionals. Stock market regulation is thus mostly about neutralizing the perceived unmerited advantages of these two groups with a view to evening the playing field between them and the general investing public. An egalitarian spirit—so congenial with democracy—animates the entire regulatory enterprise.
The cardinal principle of securities regulation is the primacy of disclosure. Consequently, the main advantage which the government deems unmerited in the hands of an investor has to do with superior access to information. In its supervision of the markets, the government does not intend to certify the quality of securities for investors. Rather, the government seeks to ensure that investors receive all the information they need to make an informed decision whether to buy, sell, hold, or abstain. As I pointed out earlier, the provision of limited liability is a way to allay the informational disadvantage that investors face vis-a-vis the management of the companies into which they entrust their money, a disadvantage arising from the fact that investors are not privy to the company’s day- to-day operations. Governments have concluded, though, that limited liability does not suffice to address what economists refer to as information asymmetries. Nor, apparently, does the shareholders’ right to vote for board directors and sell one’s shares at any time one is dissatisfied with the company. Management must be compelled to tell what they know. The state’s reasoning is that managers could otherwise influence the price of the firm’s shares so as to advance their own interests. Managers could delay the dissemination of any bad news to give themselves time to sell their own shares before the company’s poor condition becomes widely recognized. They could even prevent good news from being divulged so that they can buy shares before the investing public’s discovery of the fact raises the stock price. Managers might even want to keep the good news from coming out all at once so that it can instead be revealed in smaller dollops so as to create the impression of consistently good performance. Not only the managers, but anyone they talk to in the course of their jobs could also gain an informational edge. For this reason, securities regulation covers people like lawyers, investment bankers, stock brokers, and equity analysts—indeed, it can go so far as to embrace anyone receiving material information not already in the public domain.
Nicely illustrating the egalitarian-democratic impulse behind this is a rule instituted in 2000 pertaining to equity analysts. The rule goes by the name of Regulation FD. It requires that any information that management offers to equity analysts be simultaneously provided to the general run of investors. While fears that it would reduce the general quantity of information supplied by companies have not materialized, there is evidence that Regulation FD increased the costs of capital for smaller firms. Because such an increase is associated with greater uncertainty about the firm’s situation, a higher discount rate (R) in other words, analysts became more apprehensive about covering their stocks and hence talked less with managers of entrepreneurial companies. These companies are left with far fewer options than larger firms of getting their story out to investors. Regulation FD has certainly democratized the markets by reducing the impact that analyst reports have upon release. Shares move noticeably less than they did before, which means investors are now sharing with analysts the task of assimilating information into prices. The disparity between analysts with the highest forecast accuracy and those with the lowest has also narrowed. One group that has gained, though, has been the bond rating agencies. Exempted from the equal information provisions of Regulation FD, the market’s reaction to their downgrades and upgrades of company debt has magnified. If the government does not certify the quality of corporate shares, it has delegated that task, at least with respect to corporate debt, to the bond raters.
-  Robert Higgs, Crisis and Leviathan: Critical episodes in the growth of American government(New York: Oxford University Press, 1987).
-  Franklin D. Roosevelt, “Address by Franklin D. Roosevelt, 1933”, Joint CongressionalCommittee on Inaugural Ceremonies, (1933), http://www.inaugural.senate.gov/swearing-in/address/address-by-franklin-d-roosevelt-1933
-  Louis Loss and Joel Seligman, Fundamentals of Securities Regulation., 5th ed. (AspenPublishers, 2004), 36-39.
-  Jefferson, Duarte, Xi Han, Jarrad Harford, and Lance Young. “Information asymmetry,information dissemination and the effect of regulation FD on the cost of capital”. Journal ofFinancial Economics 87, no. 1 (2008), 24-44.
-  Andreas Gintschel and Stanimir Markov. “The effectiveness of Regulation FD”. Journal ofAccounting and Economics 37, no. 3 (2004), 293-314; William J. Kross and Inho Suk.“Does Regulation FD work? Evidence from analysts’ reliance on public disclosure”. Journalof Accounting and Economics 53, no. 1 (2012): 225-248.
-  Scott Findlay and Prem G. Mathew. “An examination of the differential impact ofRegulation FD on analysts’ forecast accuracy”. Financial Review 41, no. 1 (2006): 9-31.
-  Jorion, Philippe, Zhu Liu, and Charles Shi. “Informational effects of regulation FD: evidence from rating agencies”. Journal of Financial Economics 76, no. 2 (2005): 309-330.