The Rise of Common Stocks

IN view of the phenomenal advance in common stocks during the past five years, any attempt to discover what lies ahead would be hazardous without careful consideration of what have been the chief factors causing this rise.

Opinions in this respect are bound to differ, and the subject is so complex that the limitations of this paper do not permit lengthy discussion; consequently the writer can only submit his own conclusions. In his opinion the following have been the chief causes of the extensive rise in commonstock prices during the past five years; —

1. Good general business.

2. Propaganda bearing on the merits ol common stocks versus bonds or preferred stocks.

3. Operations of investment trusts in withdrawing common stocks from the security markets.

4. Abnormal gold holdings of the United States.

5. Effectiveness of the Federal Reserve System.

6. Issuance of excessive bank credit for the purchase of securities.

The item of good business needs no elaboration further than that the years 1925 and 1926 were exceptionally good, while 1927 might be termed a year of moderate depression; and it is probable that 1928 will be recorded as a good year, though not quite up to the level of 1920.

Relative to the second item, many books have been written and articles published showing that the holders of common stocks during the past twenty years have occupied a position of advantage over holders of fixed obligations — to such an extent that, with consideration of the declining purchasing power of the dollar, the bond or preferredstock holder is in reality worse off than he was twenty years ago, while the commonstock holder is materially better off.

Much can be said in favor of these arguments, and, assuming only that the purchaser of common stocks avoided many which have suffered severely during the period and purchased only from among those which have prospered, undoubtedly it could be shown that the holder of such common stocks is better off than his brother with bonds and preferred stocks.

However, admitting that such has been the ease during the past twenty years, it by no means follows that the same will be true during the next twenty years.

The war period was chiefly responsible for the operation of this phase, in that a temporary shortage of investment capital raised the interest rate and depressed bond prices, while greatly augmenting the earnings of common stocks and at the same time causing such inflation in commodity prices that the purchasing power of the dollar suffered severely.

It is not only possible but more than probable that, barring unforeseen contingencies, the trend during the next twenty years will be in quite the other direction. The accumulation of wealth, depressing the investment interest rate, should cause advancing prices for fixed interest-bearing obligations, while the purchasing power of the dollar should tend toward a restoration, though to what extent is still problematical; and keen competition among producers in a country where the capacity to produce exceeds demand tends to check earnings upon common stocks.

The writer does not question the iaet that common stocks are good investments, but only points out that common stocks arc good investments only when purchased upon a proper price-level basis.

Investment trusts have been tremendous purchasers of common stocks, and many of them are of the ‘fixed type’ which precludes the sale by the investment trust, and it is safe to say that the amount of common stocks purchased by investment trusts, estimated at roughly $1,200,000,000, has been a factor in the advance of common stocks by the withdrawal of this amount from the market.

The Federal Reserve has contributed its share by making it possible for banks to lend more credit on smaller reserves; it is safe to say that had not the Federal Reserve System been in existence the shortage of bank credit alone would have checked the advance of the security market long since.

In behalf of the Federal Reserve System, however, it is only fair to say that during 1926 and 1927 its problem was a difficult one. In order to permit gold shipments to Europe, where they could serve the best purpose for all concerned, it desired to keep the reserve rate low and not attract more gold by increasing the rate. On the other hand, the maintenance of the low reserve rate stimulated speculation and influenced in perhaps too large a measure the extension of bank credit based on security loans. When later, during 1928, large amounts of gold were exported, the reserve ratio quite naturally suffered severely, and now stands at 66.4 per cent as compared with a high of over 79 per cent during 1927.

This explanation also covers the factor of abnormal gold holdings of the United States.

The issuance of excessive bank credit is of great importance. It is a well-established fact that when business is less active there is less need for commercial credit. As general business was undeniably less during 1927 than in 1926, it would seem to follow that less commercial credit should be outstanding during 1927 than during 1926.

However, the reverse was true. The demands for credit for the purchase of securities not only absorbed whatever commercial credit was released, but in addition resulted in a net increase of roughly one and one-half billions of dollars for the member banks of the Federal Reserve System alone, and a considerable increase for all banks.

The tremendous increase in brokers’ loans in New York City alone is further evidence, as these loans have increased more than three billions since May 1926, though it should be realized that a very substantial part of the total is provider! by corporation’s and individuals and thus that proportion does not represent inflation of bank credit.

This large issue of bank credit for the purchase of securities exerts a continuous inflationary effect upon security prices. To appreciate this, one should realize the difference between a commercial loan and a loan made for the purchase of securities.

To illustrate: A manufacturer borrows from the bank one million dollars to fill orders on hand. By a simple bookkeeping entry, this loan increases the item of ‘ Loans and Discounts’ on the asset side of the bank’s balance sheet by one million dollars and causes a corresponding increase of the item ‘Deposits’ of a like amount on the liability side; thus creating one million of deposits which stand to the credit of the manufacturer. The manufacturer spends this deposit in the purchase of materials and labor, and it is so to speak, ‘absorbed’ in the general life of the community with no harmful effect, unless carried to excess. When the manufacturer completes his production. he recovers a similar amount of ‘bank deposits’ by the sale of his goods. If business warrants, he repeats the operation; if not, he pays off the bank, thus canceling the amount of bank deposits which was created by his original loan.

This constitutes the proper use of bank credit. But when a similar loan is made to purchase securities, while the operation is precisely the same, there is a vast difference in the effect. The borrower buys securities from ‘A,’ who now holds the ‘bank deposit’ in its entirety, there being no element of absorption. ‘A’ buys from ’B,’ and ‘B’ from ‘C,’et cetera, each stimulating the market price, and the amount so borrowed continues to churn in an endless chain from buyer to seller until someone goes back to the bank and pays off the loan.

It would appear a safe estimate that two billions or more of bank deposits have been so created during the past year or two and have been operating continuously since in this vicious cycle of inflation in the security markets, and will continue to do so until security loans are reduced.

To summarize, then, the force exerted by these combined factors upon the public mind has been the chief cause of the extraordinary advance in common-stock prices, to which should be added a general belief on the part of the public that the United States is entering an era of unprecedented prosperity Under which earning capacities of industry will continue to increase in geometrical rather than arithmetical progression.

Thus stimulated, the spirit of speculation has obtained such a hold upon the investment public that previously accepted standards of value and the operation of economic laws have been discarded in the blind belief that the old order has changed and old methods should be abandoned.

A. M. CLIFFORD