Putting a Leash on Wall Street

On this day in economic and business history...

Much of the structure of the American securities industry had to be rebuilt on sounder footing after the devastating crash in 1929 that began the Great Depression. The first major change came less than three months into President Franklin D. Roosevelt's first term, when the Securities Act became law. Almost exactly a year later, on June 6, 1934, the Securities Act got some enforcement muscle put behind it when Roosevelt's signing of the Securities Exchange Act created the Securities and Exchange Commission.

These two laws are more responsible than any others for the way the stock market works today -- in fact, most other securities laws simply build atop the foundation laid in 1933 and 1934. The difference in market activity before and after these changes is notable, as you'll soon discover.

The SEC has its own historical society, and its website offers an illuminating look at the political and financial environment that led to its creation. Here are a few interesting points:

Roosevelt understood that he faced two tasks: reform the way securities were sold, and reform the stock exchanges themselves. He began with the first task, introducing a bill written by FTC Commissioner Houston Thompson modeled on the blue sky laws. "It puts the burden of telling the whole truth on the seller," FDR announced. ...

The amended [SEC] legislation was not as liberal as the framers of the act had hoped. Some stock exchange practices that original drafts had prohibited were now simply to be subject to study. Margin purchases -- the buying of stock on credit -- had been a chief cause of the crash, and the legislation left margin specifications alone.

But the reformers had an agency, and the American people had the federal government's promise that it would do its best to do away with the excesses of the 1920s and make financial markets, if not entirely safe for the small investor, at least a bit less hazardous. The Securities Exchange Act, like so much of the legislation that marked the early New Deal, was an attempt by FDR at compromise -- an effort to get both private enterprise and the federal government working together to create a stronger, more equitable economy.

On June 6, 1934, FDR signed the Securities Exchange Act into law with [the architects of the bill] [Ferdinand] Pecora, [Benjamin] Cohen, [Thomas] Corcoran, and [James] Landis all standing by. At one point Roosevelt asked Pecora, "Ferd, now that I have signed this bill and it has become law, what kind of law will it be?" "It will be a good or bad bill, Mr. President," replied Pecora, "depending upon the men who administer it."

The 1933 Securities Act focused on regulating initial public offerings, and the 1934 Act enhanced the reporting requirements of larger public companies by enforcing the filing of quarterly financial disclosures for companies over a certain size. You can thank the 1934 Act for the 10-Ks and 10-Qs you use to determine whether a company is worth your investment. The Act also regulated stock sales from trading day to trading day, enforcing certain standards on the broker-dealers who typically made up the bulk of a given day's trading volume.

The SEC, under the leadership of its first chairman, Joseph P. Kennedy -- father of President John F. Kennedy and a notoriously successful pre-crash Wall Streeter -- targeted the men on the exchange floor trying to pull off fraudulent trades, or the lesser "curb" exchanges (analogues to today's over-the-counter exchanges) that played fast and loose with the government's new rules. Four curb exchanges were shut down, and two others closed due to SEC pressure. The SEC wound up investigating more than 2,300 cases of potential securities fraud in its first year of operation, 30 of which went to the Department of Justice for prosecution.

Through regulatory pressure and prosecution, investing in stocks became more of an investment and less of a gamble for millions of individuals, and as a result market volatility declined markedly as the SEC fully implemented its new rules. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) had existed for 38 years prior to the SEC's creation. In that preregulatory time, the Dow's average daily volatility, or the amount by which it might be expected to change in value, was 0.96% per day. In the 38 years immediately following the SEC's creation, the Dow's average daily volatility was only 0.58%. Even if you look all the way forward to 2004 -- a timeline of 70 years that includes stagflation, the crash of 1987, and the entire dot-com bubble-and-bust period -- the Dow's average daily volatility barely increases to 0.65%.

Volatility is what happens when expectations and reality don't match up. The gap will never be eliminated, but providing investors with accurate, truthful information can help narrow it quite a bit.

After the bear is gone
Regulation alone, however, isn't enough to create great market conditions. A sustainable long-term bull market, often termed a "secular bull market," needs to have strong economic underpinnings -- and, perhaps just as importantly, strong psychological appeal. The inverse is a secular bear market, which can persist through economic strength if the public's attitude toward stocks has soured. The psychological trauma wrought by the Great Depression kept the Dow from escaping its post-1929 doldrums until 1949 -- June 6, 1949, to be exact. That was the last day of the last bearish decline before the Dow finally climbed past its 1929 highs.

The bear market that ended in 1949 had started three years earlier as the American economy shifted its enormous wartime gears to produce industrial and consumer goods for a shattered world. A promising run of World War II-fueled growth that saw the Dow crest 200 points for the first time since it dropped below that mark in 1931 gave way to a long but modest decline based more on sentiment than on reality.

Real corporate earnings actually doubled over the course of this bear market -- more profit growth than was experienced in all but three bull markets throughout the Dow's century-plus history. By the time the Dow hit bottom in 1949, analysts and journalists were reduced to grasping at flimsy technical-chart-based reasons for the decline.

The secular Great Depression bear market lasted for two decades of negative real returns. It remains the steepest peak-to-trough secular bear market in more than a century. The Dow's June 6, 1949 closing level of 161.60 points was nearly 60% lower than its 1929 high. It was not until 1954 that the Dow surpassed the 1929 high-water mark, so investors had another five years to worry that the latest bull market would be as difficult to sustain as the others. The bullish market cycle that began in 1949 continued until 1966, adding more than 500% to the Dow's value -- a greater aggregate gain (though at a slower pace) than that of the Roaring '20s.

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