A Short History Of The Bear Market

The Daily Reckoning Presents: A Guest Essay in which Edward Chancellor, author of “Devil Take the Hindmost”, considers a recent proposal for legislation in the U.S. to temporarily ban short-selling.

A SHORT HISTORY OF THE BEAR

The professional life of the bear speculator is normally short and full of misery.

Powerful forces are aligned against the bear. They include, the bull speculators, whose capital outnumbers that of the bears by at least one hundred to one; the public, who perceive short-selling as an injurious activity; and politicians, who are always eager to blame the short-sellers for economic woes.

In addition, the bear pits himself against the forces of economic progress, which over the past two hundred years have been accompanied by the most tremendous gains in share prices, so that $100 invested in the U.S. market in 1802 would have been worth around $700m by the new millennium.

The earliest speculative markets witnessed the tussle of bulls and bears. In the second century before Christ, the playwright Plautus identified two groups in the Roman Forum engaged in trading shares. The first group he called “mere puffers” (the security analysts of the day), and the second group Plautus described as “impudent, talkative, malevolent fellows, who boldly, without reason, utter calumnies about one another.” In England, the origin of the term “bear” to describe speculating for a fall, deriving from a trader who sold the bear’s skin before he had caught the bear, first appeared in the early 18th century several years before the appearance of the corresponding “bull.”

Bears have always been unpopular. In 1609, Flemish-born merchant, Isaac Le Maire, organized a bear raid on the stock of the Dutch East India Company [even though a founding member of the company]. Although the Amsterdam bourse maintained that the decline in the East India stock was due to poor business conditions – not short- selling – in 1610 the government outlawed all short sales. As with most laws seeking to curtail the activities of bears – the market’s natural libertarians – this edict was a dead letter from the start. The Dutch banned short-selling again in 1621 but to no effect.

As the stock markets became established in Britain and France in the eighteenth century, further legislative traps were laid to catch the bears. Following the collapse of the Mississippi bubble in 1720, bears, who had profited from the decline in the Mississippi stock, were fined and a law was introduced outlawing short- sales.

At around the same time, the English had witnessed the startling rise and collapse of the South Sea Company, which had risen from around ?100 to nearly ?1000 in the first six months of 1720, only to fall back to where it started in the autumn of the same year. Some thirteen years later, a bill was brought before parliament by Sir John Barnard, M.P. Its aim was to “prevent…the wicked, pernicious, and destructive practice of stock-jobbing [speculation] whereby many of his Majesty’s good subjects have been directed from pursuing their lawful trades and vocations to the utter ruin of themselves and their families, to the great discouragement of industry and to the manifest detriment of trade and commerce.”

Sir John Barnard’s Act, as it was called, outlawed the use of futures, options, and short sales of stock (by an error of drafting, this was later understood by the courts to relate only to British government stocks).

It remained on the statute book until 1860. From its beginning, however, few paid attention to the letter of the law: brokers continued to engage in short sales which were enforced through a gentlemanly code of conduct – “my word is my bond” – rather than legal sanction.

These two early pieces of legislation against short- selling reveal a common theme in the history of the bears. Bubbles occur when speculators drive asset prices far above their intrinsic value. The collapse of a bubble is frequently accompanied by an economic crisis. Who gets the blame for this crisis? Not the bulls, who were responsible for the bubble and the various frauds and manipulations perpetrated to keep shares high, while cashing in their profits.

No, it is invariably the bears who are blamed for the post-bubble crises and are the main objects of anti- speculative legislation. Yet during the bubble periods it is the bears who are generally the lone voice of reason, warning people of the folly of investing in overpriced markets. In the aftermath of a bubble, they continue their forensic work of exposing unsound securities and bringing prices back in line with intrinsic values, a point which must be reached before the recovery can start.

Ever since the trauma induced by the collapse of the Mississippi Bubble, the French have retained a more pronounced aversion to financial speculation than the English. Napoleon disliked bears and believed that shorting was unpatriotic. In 1802, he signed an edict subjecting short-sellers to up to one year in jail. The French prejudice against so-called Anglo-Saxon capitalism continues to the present day: after George Soros and other speculators drove sterling from the Exchange Rate Mechanism in September 1992, the French finance minister, Michel Sapin, commented that “during the Revolution such people were known as agioteurs, and they were beheaded.”

Only the other day, following the fall of the markets after September 11, the Belgian finance minister said he had “strong suspicions” that the UK markets were used for speculative trading!

Bears have always operated more freely in the United States than in Europe. Despite a ban on short sales by the New York Legislature in 1812, the bear operator was a familiar figure in the nineteenth century. A few gained celebrity. Jacob Little, a saturnine figure, was a leading bear operator in the first half of the century. Known variously as the “Great Bear,” the “Old Bear,” and the “Napoleon of Wall Street”, Little also operated on the long side, and perfected the technique of catching shorts in corners, which became a characteristic feature of the U.S. market. Little was destroyed in the “Western Blizzard” crash of 1857.

His place was taken by Daniel Drew, also known as the “Great Bear”, “Ursa Major”, and the “Sphinx of Wall Street”. Drew was described by a contemporary as “shrewd, unscrupulous, and very illiterate – a strange combination of superstition and faithlessness, of daring and timidity – often good-natured and sometimes generous.” He was the great rival of Cornelius Vanderbilt and a sometime partner of Jay Gould.

Drew’s bear operations sometimes involved the Erie Railroad, of which he was a director. Drew would manipulate Erie’s stock upward, sell it short and then “water” the stock by issuing a vast number of unauthorized shares. Drew is famous for his ditty on the legal obligations of the bear:

“He who sells what isn’t his’n,
Must buy it back or go to pris’n.”

The roaring twenties, of course, belonged to the bulls. But as the market turned in September 1929, the bears regained control. The celebrated speculator Jesse Livermore, who as a teenager made his first fortune shorting the stock of the Union Pacific Railroad during the San Francisco earthquake of 1906, made another pile during the October crash.

[After the crash] stocks continued to fall, until by the summer of 1932, the Dow Jones reached a floor of 41.88, nearly 90% off its 1929 peak. By this date, the country’s national income had shrunk by 60% and one third of the non-agricultural workforce was unemployed. President Herbert Hoover, who came to office in early 1929 promising that “the end of poverty was in sight,” faced an uphill task in the forthcoming election. America needed a scapegoat.

Wild rumors spread of bear raids, of fabulous profits made by short-sellers, and of political conspiracies hatched by foreigners interested in bringing down the market, the dollar and the U.S. economy. In early 1932, the Philadelphia Public Ledger maintained that “European capitalists had supplied much of the cash needed to engineer the greatest bear raid in history. These proverbially open-handed and trusting gentleman had accepted the leadership of New York’s adroit Democratic financier, Bernard Baruch.” Baruch, the best known short-seller in the country, shrugged off the charge.

Hoover, on the other hand, apparently became convinced that bear raids on the stock market were intended to damage his presidency. In April 1932, a French stock market rag was raided by Paris police, its female editor accused of being in the pay of Russian and German interests who were trying to induce a panic on the New York market. In desperation, Hoover ordered the Senate to open an investigation into the affairs of Wall Street.

In fact, there is remarkably little evidence of organized bear raiding on the U.S. market following the October Crash. In order to dispel the myths, the economist of the New York Stock Exchange, Edward Meeker, published a book, entitled Short-Selling, in 1932. Meeker claimed that bears had not precipitated the crash. In November 1929, the NYSE found that around one hundredth of one percent of outstanding shares had been sold short. A later study in May 1931 found the short interest had risen to 3/5 of one percent of the total market value. More than ten times as many shares were held on margin. Nor could the stock exchange identify any bear raids in the subsequent market decline.

Meeker provided an eloquent defense of short sales. He argued that the bears stabilize prices by providing liquidity and creating demand – by covering their shorts – in a falling market. Shorting was not illegitimate, in his view. “A short sale,” wrote Meeker, “represents a debt contracted in goods rather than money.” In this it was similar to many other business contracts.

“Short-selling,” wrote Meeker, “is really an expression of opinion, subject to personal risk, as to the value of securities…Short selling has no effect upon the assets or earning power of operating companies, even in the case of banks. It cannot determine value, but only estimate what prospective values really are and will be.”

It is unlikely that many were swayed by Meeker’s argument. The politicians certainly were not. However, the Senate investigation into Wall Street, intended to uncover the nefarious activities of the shorts, found little to go on. A list of 350 leading bear speculators presented to the committee contained only one familiar name…Having no luck with the bears, the investigation turned its attention to the bulls of yesteryear. This was much more fertile ground.

The Pecora hearings, as they became known (after their lead counsel, Ferdinand Pecora), revealed the seamier side of Wall Street during the bull market: the involvement of leading firms and bankers in the manipulation of share prices, the dumping of unseasoned securities on an innocent public, the fleecing of the firms’ own clients, the preferential distribution of shares to favored friends, and so on.

In other words, rather similar behavior to what we have witnessed from the investment banks in recent years.These findings led to the New Deal legislation of 1933 and 1934, which involved among other things, thecreation of the Securities and Exchange Commission andthe separation of commercial and investment banking.

The bears of the early 1930s had a mixed fate. Joseph Kennedy, the father of JFK, was appointed the first chairman of the SEC shortly after participating in a bear pool in the stock of Libby Owens Ford. Roosevelt apparently decided he needed a fox to guard the hen coop. Jesse Livermore had a less happy time. He lost an estimated $32 million anticipating a bull market which never arrived. In 1934, Livermore was declared bankrupt. He blew his brains out in the washroom of the Sherry- Netherlands hotel in 1940. The note he left behind, repeated over and over again: “My life has been a failure. My life has been a failure…”

The pattern of boom and bust has continued in the post- war years. Inevitably the bears have been blamed during every major downturn…Japanese authorities complain[ed] that mysterious foreign interests were responsible for the decline in their stock market, following the great boom of the bubble economy. (In 1998, the Japanese imposed restrictions on short-selling in an attempt to shore up their market).

In every instance when bears are accused of bringing down a market, we find that it was the preceding bull market, with its accompanying misallocation of resources and unsustainable accumulation of debt, which was the root cause of the decline.

Today is no different. Earlier this year, as markets declined, there were isolated complaints of bear raids. After September 11 these complaints assumed a more hysterical tone. It was alleged that terrorists had arranged to short airline and insurance stocks prior to the attack on the United States. I do not know whether this is true.

However, I am doubtful. As we have seen in the past, foreigners have frequently been identified as leading a conspiracy of bear raiders. And besides, there were good fundamental reasons to short airlines and insurance companies even before their position deteriorated in September.

Nevertheless, last month lawmakers in the U.S. asked the SEC to consider a temporary ban on short trading. According to newspaper reports, UBS Warburg and Bear Stearns tried to limit short sales by their clients.

It has been said that “progress in finance is cyclical rather than linear.” Certainly attitudes towards short- selling seem to have progressed very little over the centuries.

The most eloquent justification for the bear is provided by the American financier Bernard Baruch, who was called to Washington in 1916 after a market panic to explain his short-sales of the stock of the Brooklyn Rapid Transport Company, a go-go stock of that era. At the time some members of Congress were calling for short- selling to be banned. Baruch stood his ground, politely explaining to the politicians that “bears can only make money if the bulls push up stocks to where they are overpriced and unsound.” He continued:

Bulls always have been more popular in this country because optimism is so strong a part of our heritage. Still, over-optimism is capable of doing more damage than pessimism since caution tends to be thrown aside.

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.

Cheers,

Edward Chancellor,
November 2, 2001

for The Daily Reckoning

Edward Chancellor is the author of “Devil Take The Hindmost: A History Of Financial Speculation.” To order a copy of the book please click here:

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A longer version of today’s guest essay by Mr. Chancellor is presented as a “guest analysis” on the Prudent Bear website

*** As if they were acting with “total clarity” in the first place, the anti-globalization movement has been “stunned” by the attacks on New York and Washington, reports the International Herald Tribune. What a pity… the Battle of Seattle was nothing if not entertaining. And the Daily Reckoning was agin’ to like dem folks.

*** Those pesky terrorists are spoiling everybody’s fun.

“Terrorism Cripples U.S. Economy,” says a headline in the IHT, overtly blaming the slowdown on the Sept. 11 attacks. “Consumer spending dropped 1.8% in September,” the article reports, “the largest drop since a similar fall in 1987. The last time spending fell by a greater amount was in May 1960, when consumers reduced purchases by 1.9%.”

*** A separate report released Thursday by the Commerce Department showed manufacturing activity dropping to its lowest level in 11 years.

*** The markets…presumably reacting to a calculated recall of the 30-year T-bill…leapt. The Dow gained 188 to close at 9263. The Nasdaq climbed 56 points to 1424. (By the way, the Daily Reckoning scorekeepers, Eric Fry and Bill Bonner, have both jetted off for Vegas where the Agora Wealth Symposium is in full swing. Here in Paris, we’re carrying on as usual, though our breaks down at Le Paradis seemed to have grown in length a bit…)

*** “Treasury officials said their decision to halt the issuance of the 30-year bonds was intended to save the government money,” writes Gretchen Mortgensen in the NY Times. “Traders scoffed at that explanation, viewing the move as an almost desperate attempt to push down long- term interest rates, and prod both corporate and individual borrowers to spend again.”

*** Prices of the long-term bonds soared on the announcement…yields plunged. “It was the biggest single-day move since investors fled to safety during the stock market crash of 1987…keeping consumers feeling flush has become a top priority.” Perhaps even a matter of national security.

*** “How much income is being lost by individuals and companies,” we wonder, as did Bill King this morning, “because the government is intervening on the side of the wanton at the expense of the savers and the prudent?”

*** Reviewing yet another of the government’s attempts to revive the economy, Christopher Byron writes (in MSNBC): “…the stimulus being proposed – roughly $100 billion at last tally – is utterly trivial when measured against the collapsed stock values in the tech sector. [It] doesn’t even offset the $450 billion in lost value in a single company – Cisco Systems, Inc.”

*** In fact, if you add the collapsed value of all the techs together – big and small alike – more than $4 trillion has been wiped out on the Nasdaq alone. “Which makes it pretty clear,” says Byron, “that a mere $100 billion of stimulus is not going to boost business spending by very much.”

*** Since the attacks, we at the Daily Reckoning – as stunned as the next group of conspirators – have been asking a question similar to one I’m sure has crossed your mind at least once: “Why?” The Sovereign Society’s John Pugsley offers one point of view: “It is not hatred for freedom or materialism that caused terrorists to sacrifice their lives.” Pugsley quotes Joseph Sobran: “You delude and flatter yourself if you think someone hates you for your virtues.”

*** “Their deep hatred is rooted in years of bullying by the U.S. government,” suggests Pugsley, “whose embargoes, bullets, bombs, and cruise missiles have been brought to bear on them whenever and wherever Americanpoliticians felt it in their own interests to do so.”

*** “As events in the Mideast and Afghanistan heat up and the economy melts down,” writes John Myers in the Resource Trader Alert, “flight-to-quality becomes more of a necessity than a choice. And if today’s paper flight-to-quality alternatives like the dollar and U.S. Treasuries lose their allure, investment demand for metals – like silver – could renew and pay off big for investors.”

*** “This past summer,” Myers offers by way of example, “we recommended purchasing December 2002 $4.50 Comex silver calls for 30 cents, or $1,500 each. We recommended selling them a week after the World Trade Center attack when they were going for 53.2 cents, or $2,660 each.” A tidy profit, indeed.

*** “October is typically a weak month for silver, and this October was no exception. The same calls we exited for over $2,000 are now going for roughly $1,000. With scary October now over, we believe the time hascome to venture back into silver.”

*** This morning the unemployment rate comes out…the expected rate is 5.2% – up .3% from September. You’ll find a guest essay by the author of “Devil Take The Hindmost” below…

Cheers,

Addison Wiggin