Economics and The Public Welfare
68: The Stock Market Crash of 1937—A Major Cause of Business Crisis
Chapter 68
The Stock Market Crash of 1937—A Major Cause of Business Crisis
A major factor partly precipitating and certainly intensifying the collapse in industrial activity in the autumn of 1937 and the winter and early spring of 1938, was the sudden break in the stock market and the revelation of an extraordinary weakness in the internal stock market situation. A recapitulation of stock market history following the Supreme Court decision on May 27, 1935, and continuing through 1938 will be useful here. The following table for the Dow-Jones Industrials will tell the story.
| Dow-Jones Industrials—1935-1938 | |||
|---|---|---|---|
| High | Low | ||
| 1935 | |||
| June 24 | 121.30 | June 1 | 108.64 |
| July 31 | 127.04 | July 3 | 117.80 |
| Nov. 20 | 149.42 | Nov. 4 | 139.99 |
| 1936 | |||
| April 6 | 163.07 | April 30 | 141.53 |
| Oct. 19 | 178.44 | Oct. 1 | 167.54 |
| 1937 | |||
| Mar. 10 | 195.59 | Mar. 22 | 179.28 |
| June 5 | 175.66 | June 17 | 163.31 |
| Aug. 14 | 190.38 | Aug. 27 | 175.09 |
| Sept. 1 | 176.11 | Sept. 24 | 146.22 |
| Oct. 1 | 155.11 | Oct. 19 | 115.84 |
| Nov. 1 | 137.01 | Nov. 23 | 112.54 |
| 1938 | |||
| Mar. 1 | 131.03 | Mar. 31 | 97.46 |
| Oct. 24 | 155.38 | Oct. 1 | 141.56 |
| Nov. 10 | 158.90 | Nov. 28 | 145.21 |
It will be observed here that the market began an almost immediate advance following the Supreme Court decision on NRA, May 27, 1935, moving up from a low of 108.64 on June 1 of 1935 to a high of 121.30 on June 24, and advancing with very little interruption to a high of 195.59 on March 10 of 1937.
Stock Market and Supreme Court Fight. The market yielded with the attack on the Supreme Court, reaching a low of 163.31 on June 17 of 1937, from which point it moved upward to a high of 190.38 on August 14, the rally coinciding with favorable developments in the Supreme Court fight, and the high of August 14 being almost as high as the top figure of the year on March 10.
Startling Break After August 14, 1937. Then with startling rapidity the market weakened, dropping from 190.38 on August 14 to 175.09 on August 27, to 146.22 on September 24, to 115.84 on October 19 to 112.54 on November 23, and finally to 97.46 on March 31 of 1938, which was the low for the downward move.
With Business Still Good. The break came with the weekly business figures still good, and the weekly business figures continued good in the early stages of the break. The business community in general was incredulous when the stock market break began, though the leaders of the automobile industry had been very apprehensive well before the break. They had stood the main impact of the rising labor costs which unionization involved. They had done extraordinary things in making managerial adjustments to offset these costs, but they felt that they had reached the end of their rope in this matter, and that profits were certain to go down drastically. The business community as a whole, however, was still hopeful. They had orders on their books. They felt that they could still make adjustments to offset a part at least of the rising wages, and they saw no valid reason for the violent break in stocks when it first came. The table on page 449 shows the New York Times weekly index of business for August, September, and October.
The break was not due to a heavy volume of selling and it was not due to foreign selling. Over the period August 4 to September 29, foreigners bought more than they sold. Foreign buying and selling, moreover, were at no time large in volume during the break. There was no extraordinarily disturbing news, for the most part, except the appointment of Justice Hugo Black to the first vacancy in the Supreme Court after the President’s defeat on the Court packing bill. This startled the business and financial community a great deal, and disclosure that Justice Black had belonged to the Ku Klux Klan, which speedily followed, shocked and frightened the country.
| Weekly Series “New York Times,” 1937, Combined Business Index (Seasonally adjusted) | |
|---|---|
| August 7 | 108.2 |
| August 14 | 111.2 (stock market, 190.38) |
| August 21 | 109.9 |
| August 28 | 109.4 (August 27, stock market, 175.09) |
| September 4 | 109.3 |
| September 11 | 106.6 |
| September 18 | 104.9 |
| September 25 | 104.6 |
| October 2 | 103.5 |
| October 9 | 101.3 |
| October 16 | 100.2 |
| October 23 | 97.9 |
The declining prospects of profits due to the developments in the labor and wage situation, referred to above, taken in conjunction with the very high level to which the stock market had risen, could well have been expected to lead to stock market reaction and to business reaction. But the violence and the severity of the stock market break were due to internal factors in the stock market, and to impaired efficiency in the stock market, due to governmental policy.
Governmental Policy Impairs Efficiency of Stock Market—A “Thin Market.” The market had grown extraordinarily “thin”; that is to say, the stock market, which, in the past, had been capable of absorbing an immense volume of selling with moderate recessions in price, had been brought to a state in which very moderate selling brought very large changes in price.
Officials of the Stock Exchange itself had realized this before the break came. Mr. Gay, the President of the New York Stock Exchange, in his annual report for the year ending May, 1937, dated August II, and released to the press on August 18, had given a warning on this point. A small volume of selling would make sharp breaks in price, a small volume of buying would make sharp rises in prices—the market had grown very “thin.” The following table shows the progressive “thinness” of the market.1
| Share Sales on Days of Declining Prices, Related to Net Changes in Closing Prices of the Included Stocks | ||
|---|---|---|
| Thousands of Shares Sold | ||
| Group of 30 Common Stocks | Per 1% Price Decline | Per $1 Price Decline |
| 12 days, 1930-1931 | 13.1 | 23.1 |
| July 21, 1933 | 8.9 | 23.4 |
| 12 days, 1936-1937 | 4.7 | 6.7 |
| May 13, 1937 | 3.6 | 5.4 |
| September 7, 1937 | 2.1 | 3.4 |
| September 10, 1937 | 2.6 | 4.2 |
High Income Taxes. The causes for this change and for the acute “thinness” of the stock market are to be found in a variety of governmental policies. One was extraordinary rates of taxes and especially the tax on capital gains, which was at that time part of the general income tax. We have seen in a preceding chapter the levels to which income taxes had run in the upper brackets. These rates, applied to profits made in the stock market, meant that men of substantial means simply could not engage in many stock market transactions. If they were successful, the Government took most of the profits. If they had losses, they took them themselves. They bought and sold only when they had a very powerful reason for doing so, such as the conviction that a particular security was no longer a good investment. Moreover, if a man of substantial fortune sold a security in which he had a profit, he was very likely to sell at the same time a security in which he had a loss—a double selling which added very substantially to the burdens of a “thin” market. The extraordinarily high income taxes, moreover, largely eliminated the current savings of men of substantial means, savings which had formerly gone into the stock market to a greater degree than other savings.
Elimination of Informed Traders—“Insiders’” Trading. The elimination of men of substantial means from the stock market, moreover, tended to eliminate informed trading in the stock market. In the past, on bad days in the market, we could expect that men with knowledge, buying power and courage would be on the lookout for bargains and would buy them. Even when the trend was definitely downward such men would come in on days of sharp breaks, cushioning the market, selling out again on the automatic rally, moderating the movements and increasing the breadth of the market.
The securities and exchange legislation and the rulings of the Securities and Exchange Commission under this legislation had added a great many additional burdens. In the past, insiders of a corporation, informed as to its affairs—officers, directors or large shareholders—seeing the stock of the corporation beaten down in the market, would step in and buy, expecting to be able to sell again at a profit when the movement was arrested and the market had steadied itself. This was informed buying, and in general was very useful to the market and to the small investors in the corporation’s stock. The Securities and Exchange Act of 1934, Section 16b, operated to prevent this. It provided that if officers, directors, or large stockholders of a corporation should buy their stocks and sell them again within six months, or should sell their stocks and buy them again within six months and make a profit thereby, they would be liable to suit by any other stockholder of the corporation to recover the profit for the corporation itself.
The Congress in this legislation had a commendable purpose. That purpose was stated in Section 16b as follows:
“For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer. . . .”
However, the Congress recognized that not all such buying and selling by insiders was of an unfair character, and in the same Section it provided for exemptions to be given by the Securities and Exchange Commission, in the following language:
“This subsection shall not be construed to cover . . . any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection.”
The Securities and Exchange Commission had not given the exemptions contemplated by Congress, giving freedom of action to insiders where this does not involve unfair use of inside information. At the time of the stock market break in 1937, three years had passed without these exemptions being given. In 1944, ten years after the passage of the act, no such ruling had been given, though the Congress had clearly contemplated that such rulings should be given.2
Now this is a very unfortunate situation and one for which the Securities and Exchange Commission is to be sharply condemned. It is right that the insider should be forbidden to take unfair advantage of inside information to the detriment of less informed shareholders, or of the public. It is wrong that the insider should be forbidden to act in the stock market on the basis of inside information when such action is to the interest of the corporation and of the other shareholders, and of the public.
It is perfectly possible to distinguish in objective terms between fair and unfair buying and selling by insiders. The typical case where an insider is trading against the interest of the corporation and the other shareholders would be where the chief executive, knowing before anybody else knows that the dividend is to be cut or omitted, because he is himself making the decision, proceeds to sell his stock with a resultant break in price, and buys it back later after the bad news is out; or where, knowing before others know it of some favorable development affecting the corporation, he buys the stock to sell it out at a higher price when the good news is generally known. On the other hand, the case where his action is clearly in the interest of the corporation would be where a break has occurred, not initiated by him, and where he steps in and steadies the market; or where a rise has occurred, not initiated by him, and where he sells the stock because he thinks it is going too high. In the first case, he prevents other shareholders from suffering losses if they are obliged to sell in a weak market, and in the latter case, he prevents uninformed buyers from paying too much for the stock of his corporation.
A rule differentiating fair and unfair use of inside information in perfectly objective terms should be easy to formulate, and the Securities and Exchange Commission should long since have done it. It could exempt transactions by insiders which follow a break or rise of a certain per cent, say 5% or 7%, which takes place within a stated period of time, say two days, the first transaction by the insider being at a price 5% or 7% below the highest price of the preceding two days in the case of a purchase on a break, or, in the case of a sale on a rise, 5% or 7% above the lowest price of the preceding two days. This would be an absolutely definite rule. It would eliminate the initiation of price changes by insider action. It would limit insider action to resisting price changes initiated by others. It would bring back the informed, protective trading of insiders concerned with the good of the corporation and concerned with the market for the corporation’s securities.3
Inquisitorial Practices of S.E.C. A further very important factor reducing trading by men of substantial fortune and by informed men, was the frequent inquisitorial visits of agents of the Securities and Exchange Commission to brokerage houses when large transactions appeared on the ticker. These agents would demand full information not only as to the name of the customer for whom the transaction was put through, but also the details of all other transactions by that customer for a period preceding, and in some cases would then go to the customer himself. In any case, the broker would feel obliged to inform the customer of the visit. In one case in 1937, an agent of the Commission visited the executor of a large estate to inquire why he had sold a quarter of a million dollars’ worth of securities in a single morning. The agent was informed that the executor was selling to get cash with which to pay the United States Treasury the estate tax! A great many men simply withdrew from the market rather than have the details of their transactions thus inquired into by the Government. However innocent their purposes, however legitimate their transactions, men do not welcome Governmental inquiry into them. The effect upon the stock market was very bad. In more recent years there has been a shift in the occasion of these inquisitorial visits. They come less frequently upon the appearance of a large number of shares in a particular transaction on the ticker tape, and they come more frequently when transactions appear at a substantial change in price.
As late as February 23, 1947, the New York Times reports an elaborate investigation made by the Securities and Exchange Commission of the stock market break of September 3, 1946, involving such voluminous detail that the report, based on data in the Commission’s hands by October 7, 1946 had not yet been completed.
“In addition to the data obtained from member firms of the Stock Exchange, the commission’s investigators also interviewed 100 of the largest buyers and sellers of stocks on that day in a nation-wide canvass. Besides these individuals, a random selection [italics mine] of 450 buyers and sellers, together with a miscellaneous number of firms throughout the country, was asked to give information on the subject. . . .
“The investigation was ordered on Sept. 23, when the SEC said it would attempt to learn the cause of the market’s decline on Sept. 3 by reconstructing all roundlot transactions on the Stock Exchange on that date. . . . At the time, it was stated that if any irregularities in the sale of stock or if any pool operations were uncovered, the SEC was prepared to take swift actions against such manipulators.” (New York Times, Feb. 23, 1947, p. 2F, col. 4.)
We have here apparently a pure fishing investigation, digging into the private affairs of a large number of people at random without even the pretext that the particular individuals investigated had acted in a suspicious manner, but merely on the chance that somewhere something suspicious might turn up. A Federal Grand Jury would be much more respectful of the rights of people to privacy in their personal transactions!
Action of this kind by the S.E.C. continues to deter men from taking part in the stock market, and is no small part of the explanation of the “thinness” of the market which makes possible wide breaks on a single day—which in turn start the S.E.C. on a new investigation!
Specialists and Floor Traders. At the instance of the Securities and Exchange Commission, the Stock Exchange itself had adopted complicated rules sharply restricting the activities of specialists and floor traders. These rules created a great deal of uncertainty as to what specialists and floor traders might do. It was often necessary at critical times, when quick action by specialists and floor traders was needed, for specialists to confer with members of the Stock Exchange Committee instead of taking the prompt action called for.
The Securities and Exchange Commission had even made a ruling putting the burden of proof upon the specialist, requiring affirmative proof that the specialist’s action was beneficial. It is not easy for a man to act quickly with such a burden of proof against him. There was an immense area of uncertainty, paralyzing action.
The Margin Requirements. A further factor narrowing the market and intensifying the difficulties of the 1937 break was the high and inflexible margin requirement. The Congress, desiring to regulate the use of credit in the stock market, had given the Federal Reserve authorities control over margin requirements—a control that had previously been in the hands of the banks and the brokers. The Federal Reserve authorities had raised margin requirements to a very high level. As they calculated margins, it was called a margin of 55%. As the brokers calculated, it was a margin of 122%. If a man bought $10,000 worth of stock, the rule required that he pay in cash $5,500 and that he borrow only $4,500. His margin was 55% of the cost of the stock, but it was 122% of the $4,500 loan. In ordinary times, bankers and brokers had usually considered that 20 to 25% of the loan was a satisfactory margin from the standpoint of the safety of the loan, assuming that the loan was well diversified, though they always reserved the right to raise the margin if special circumstances called for it. Very much higher margins had been required by bankers and brokers in the wild stock market of 1929.
This sharp increase in margin requirements from 20% to 25% of the loan to 122% of the loan meant that anyone purchasing securities on margin must employ very much larger sums of capital than formerly. His capacity to act was greatly reduced. It further meant that his account was frozen the moment the market receded. Even with a very high margin from the standpoint of the loan, he could not buy any more stocks on moderate declines, nor could he withdraw any cash from his account. This last factor intensified the break very decidedly in September of 1937, because many individuals had to use their large margins with the brokers for the purpose of paying the September 15 income tax, and this made it necessary for them to sell a great many shares of stocks in order to bring the margins up above the 122% so that cash could be withdrawn for income tax purposes.
In 1929, in the stock market break, the bankers and brokers who had raised margin requirements and placed “loan values” far below market values while the boom was on, promptly reduced margin requirements in the midst of the crash as a means of easing the credit situation, always keeping them high enough, however, to protect the loans. The Federal Reserve authorities should have done the same thing when the 1937 break began, but they did nothing until after the break had gone very far, and until after the Chairman of the Chase National Bank had made the demand that they lower the margin requirements, and the Chairman of the Rules Committee of the House of Representatives had reinforced this demand. Governmental regulation of the stock market in 1937 by the Securities and Exchange Commission and by the Federal Reserve authorities was not a brilliant performance.
The margin requirements for customers were very high, but the margin requirements were made still higher for specialists and floor traders on the floor of the Stock Exchange. In May of 1937 the rule was promulgated that floor traders and other Stock Exchange partners must have a margin of 122% on their maximum obligations during the course of the day, whereas customers need not put up additional margin until their net position was ascertained at the end of the day. It was estimated at the time that with margin requirements at 122%, the ability of the floor traders and specialists to carry stocks was reduced by approximately 70% from what it had been under the old 20% rule, and that this was still further reduced by the rule promulgated in May.
Restrictions on Short Selling—Stock Exchange Rules, 1931-May, 1935. A further factor involved in the thinness of the market was the restrictions on short selling. These had been operative from late 1931 through the stock market smash of 1937, and continue operative today—originally as a matter of New York Stock Exchange voluntary action, and since 1935 as a matter of S.E.C. recommendation or action. We have noted, in discussing the decision to keep the Stock Exchange open on September 21, 1931, when England abandoned the gold standard, that a rule forbidding short selling was adopted by the President and the Governing Committee of the New York Stock Exchange, due to the emergency. On September 23 this rule was rescinded. But on October 5, 1931, the Business Conduct Committee of the Stock Exchange ruled that before executing any sell orders on the floor, members should ascertain and notify floor members whether such orders were long or short, and that members would be held responsible under Section 4, Article XVII, of the Stock Exchange’s Constitution which covers the bringing about of a condition of demoralization in prices. At that time a practice grew up of giving preference to orders to sell for long account. On November 23, 1931, the Business Conduct Committee, in conjunction with other committees, decided that no stock could be “stopped” 4 for short account below the last sale, and on January 22, 1932, the Business Conduct Committee ruled that identification of orders applied to bonds as well as stocks. So far we have restrictions voluntarily created by the Stock Exchange itself on short selling.
S.E.C. Rules on Short Selling Begin May, 1935. On May 27, 1935, however, a recommendation by the S.E.C. led to a Stock Exchange rule that no member of the Exchange should use any facility of the Exchange to effect on the Exchange a short sale in the unit of trading below the last regular sale price. Exemption was provided for “odd lot” dealers and for equalization of prices on other exchanges. This rule went into effect on June 3, 1935, and remained in effect until 1938. It was under this rule, growing out of a recommendation of the S.E.C. which the Stock Exchange felt obliged to accept, that the great smash of 1937-1938 occurred on the Stock Exchange.
In 1938, on February 10, the S.E.C. began to make direct regulations which took the place of rules by the Governing Committee of the Stock Exchange. The rule of the S.E.C. as it appears in General Rules and Regulations . . . as amended to and including February 15, 1944, “Rule X-104A-1 Short Sales,” reads in part as follows:5
“(a) No person shall, for his own account or for the account of any other person, effect on a national securities exchange a short sale of any security (1) below the price at which the last sale thereof, regular way, was effected on such exchange, or (2) at such price unless such price is above the next preceding different price at which a sale of such security, regular way, was effected on such exchange.”
This rule is stricter than the rule which prevailed in 1937, although a little less strict than the rule first promulgated by the Securities and Exchange Commission, effective February 8, 1938. That rule forbade “short sale of any securities at or below the price at which the last sale thereof, regular way, was effected.” The difference between the rule quoted above, which was in effect in 1944, and the rule promulgated in February of 1938 seems to be that under the 1938 rule, short sales could be made only at rising prices, whereas, under the rule in effect in 1944, short sales could be continued at an unchanged price, provided that the last different price had been lower.
The rule in effect in 1937 eliminated an effective short interest, which would bring about rallies in a declining market. It was a rule that prevented the short sellers from initiating a downward move in the market. Short sellers could operate only on a rising market. This was a very nice rule for the “bulls,” superficially viewed, but it did not help if the purpose was to create a steady market for investors.
The short seller is extremely useful when prices are breaking. He must cover (i.e., buy) then to take his profits. It is perfectly legitimate that the short seller should be active in the early stages of a break, and, indeed, desirable that he should be, in order that there may be an adequate short interest in the market to cushion the bottom, in order that the magnitude of the break may be lessened by short covering, and in order that there may be frequent strong rallies in the course of the break.
Now, all of this legislation and all of these rulings were benevolently designed to protect investors and to prevent wild excesses in the stock market. They were designed to prevent a repetition of such events as the stock market rise of 1924-1929, and the stock market crash of 1929. But the Dow-Jones Industrials rose from 108.64 on June 1 1935 to 190.38 on August 14 of 1937 and then dropped to 97.46 by March 31 of 1938. This is not a brilliant record for a governmentally controlled, daily inspected, constantly managed stock market, designed to give protection to investors and designed to eliminate wide fluctuations in security prices.
- 1This point will be discussed at length in Chap. 34.
- 2I have not been able to find that this article was ever published. However, the reader will find much of it in two books by Veblen: Imperial Germany and the Industrial Revolution, New York, 1915; and The Nature of Peace and the Terms of Its Perpetuation, New York, 1917.
- 3See my book The Effects of the War on Money, Credit and Banking in France and the United States, published by the Carnegie Endowment for International Peace, Oxford University Press, New York, 1919. For London, see the interesting articles by Mr. J. M. Keynes in the British Economic Journal in late 1914.
- 4O. M. W. Sprague: “Crisis of 1914 in the United States,” American Economic Review, September, 1915; H. G. S. Noble: “The New York Stock Exchange in the Crisis of 1914,” Garden City, N. Y., Country Life Press, 1915. These two papers are classics of permanent value.
- 5The figures of all the State and National banks and trust companies appear only once a year in the Comptroller’s report as of approximately June 30. For dates other than June 30, it is necessary to make estimates. During the war period these estimates are made on the basis of variation in the National Bank figures.
