The Greatest Bull Market Begins as the Worst Bear Market Ends
On this day in economic and business history...
The worst secular bear market in American history ended on the same day that the greatest secular bull market in American history began: Aug. 12, 1982. Since peaking in 1966, the Dow Jones Industrial Average had repeatedly struggled and failed to overcome numerous economic headwinds, including Vietnam-related unrest, two devastating oil embargoes, the end of gold convertibility, and an extended period of high inflation. After bottoming out on Aug. 12, the market would surge further than it ever had before, propelled by economic reforms, globalization, and the spread of computing technology throughout American lives and businesses.
No one seemed to think the long slide was over or that a historic surge was about to start. A lingering recession and massive federal budget deficits worried investors as the Dow dropped for the eighth straight day, ending Aug. 12 with a final tally of 776.92 points. The bankruptcy of Lombard-Wall, a government bond trader, also worried investors who feared that the firm's $177 million in outstanding debts might cause problems for the banks and government agencies that held those debts. The ongoing effort of Federal Reserve Chairman Paul Volcker to break the back of inflation was seen as a major contributing factor in Lombard-Wall's demise -- despite dropping from the historic highs of 1979 and 1980, interest rates were still in double-digit territory in mid-1982.
Ronald Koenig of Ladenburg & Thalmann opined that the sell-off might still accelerate and "could drop as low as the 730-740 level before any meaningful recovery takes place." On the other hand, Joseph Broder of Stuart, Coleman said, "A resumption of the early summer rally is probable if interest rates move lower and the economy improves."
From 1966 through 1982, the Dow lost 22% of its nominal value, falling from a height of 995.15 points to the Aug. 12 low of 776.92. However, rampant inflation produced the greatest real losses of any secular bear market in Dow history -- a 72% drop in real terms for those who had been unfortunate enough to buy in at the 1966 peak. By comparison, the Great Depression produced a real loss of 67% between 1929 and 1949. Real corporate earnings fell by 17% over the course of the decline, and inflation rose more than it ever had before, producing a 205% rise in prices from 1966 to 1982.
The bull market that followed was in nearly every way the complete opposite of the "stagflationary" bear of the '70s. Its total gain of 1,400%, registered from 1982 to early 2000, still holds up as the greatest secular-market growth in Dow history when adjusted for inflation: Stocks rose by 685% in real terms, which is greater than the 460% gains registered during the Roaring '20s, although that period accomplished its growth in much less time. Corporate earnings doubled in real terms between 1982 and 2000, a rate of growth only surpassed during the '20s.
Such a change -- from grinding economic destruction to soaring market growth -- may not play out again in our lifetime. But then again, that's probably what most investors thought after they lived through the Great Depression and the ensuing postwar boom. The more things change...
One of the worst single-day declines in Dow history took place exactly 50 years before the start of its greatest bull market, when the index fell 8.4% on Aug. 12, 1932. Before the day's opening bell, the Dow had experienced an incredible 67% surge since bottoming out only one month earlier, so many observers simply pointed out that such a drop should have been expected. "The market [had] been moving too swiftly for its own good," according to The New York Times. Other market-watchers sought to blame the dip on President Herbert Hoover's acceptance of the Republican nomination to run for a second term, but there was little evidence to support this conjecture.
The Dow would recover quickly, and it nearly doubled by early September. However, the market endured a period of disappointing declines throughout the fall and winter that would not be shaken off until after the inauguration of President Franklin D. Roosevelt. After Roosevelt's reforms began to take hold, the Dow never again fell to the 63.11-point level where it ended on Aug. 12, 1932.
The scheme that started it all
Charles Ponzi surrendered to federal authorities on Aug. 12, 1920. The pyramid scheme he had devised was over, and forever after it would bear his name. The Washington Post ran the story as a headliner that day, as did many other notable newspapers:
Some 40,000 investors entrusted a total variously estimated at from $15 million to $20 million to Charles Ponzi in a moneymaking scheme which postal officials today declared to be absolutely impossible of fulfillment.
Ponzi surrendered to the federal authorities this afternoon, explaining that he was unable to meet his obligations, because of the closing yesterday of the Hanover Trust Company, where the bulk of his funds were deposited. He was arrested, charged with having used the mails to defraud, arraigned and held in bond of $25,000 for a hearing August 19. ...
Developments followed thick and fast today. As Ponzi was being arraigned before United States Commissioner Hayes, Edwin L. Pride, who is examining the books of the Securities Exchange Company for the federal authorities, announced that it had already been shown that Ponzi owed $7 million. ... State Bank Examiner Joseph C. Allen issued a statement declaring that the capital of the Hanover Trust Company, of which Ponzi was until yesterday a director, was seriously impaired and probably wiped out.
Until his arrest, Ponzi appeared to be the classic immigrant success story. His arrival in the U.S. from Italy perfectly encapsulates his later life: Ponzi landed in Boston with $2.51 in his pocket in 1903 after gambling the rest of his money away during the voyage. This willingness to play fast and loose with money followed him for the rest of his life. Several years later, Ponzi forged a check in Canada and eventually served three years in a Montreal prison.
After his release, Ponzi returned to Boston and would eventually hit on a scheme that seemed legal at the outset but would eventually devolve into a pyramid scheme to defraud increasingly larger numbers of overeager investors. In 1918 or early 1919 (facts about Ponzi's life are sometimes difficult to pin down due to his propensity for exaggeration and embellishment), Ponzi discovered postal reply coupons. These coupons were international versions of a self-addressed stamped envelope, allowing the bearer to pay for the cost of a piece of mail sent to or received from another country. Since the coupons were purchased at the price of one country's postage but meant for use in a different country, savvy recipients might use differences in the two countries' postage rates as an opportunity for arbitrage. It was classic "buy low, sell high," at least in theory.
Ponzi began to pitch the arbitrage opportunity as an investment with incredible returns. In late 1919, he founded the Securities Exchange Company (no relation to the Securities and Exchange Commission that now helps to regulate schemes of this very sort) and claimed that he could achieve a net profit of 400% through this postal-exchange transaction. By paying earlier investors with the money he received from later investors, Ponzi managed to keep this fiction alive, and the enterprise grew at an enormous rate. By the spring of 1920 Ponzi's company had expanded to 30 employees and required the use of two offices. Although it was theoretically possible to profit from postal-coupon arbitrage, the reality would have involved "astronomical quantities," according to Ponzi biographer Mark C. Knutson (link opens PDF), who paints a vivid but intentionally ludicrous picture of "hordes of Ponzi agents pushing wheelbarrows full of coupons to post offices, unloading them with shovels or pitchforks."
Coupons were merely a cover, but so long as investors got their money, none seem to ask where it was coming from. However, Ponzi's relationship to the Hanover Trust Company bank wound up shining a light on the shady enterprise. Ponzi bought a 38% stake in the bank shortly after opening hefty new accounts, and because the bank was required to report large transactions to the financial authorities, this soon came to the attention of Joseph C. Allen, the Massachusetts Commissioner of Banks. This eventually brought Massachusetts District Attorney Joseph C. Pelletier into the picture. Pelletier, lacking tangible proof of wrongdoing, nevertheless convinced Ponzi to stop taking on new investments. Since Ponzi's entire scheme depended on gathering ever more investors into the fold to pay off the insanely high returns he had promised, this quickly resulted in overdrafts and insolvency.
Ponzi amassed a fortune that would be worth more than $230 million today in less than one year, using little more than charm and cleverness to get huge numbers of people to buy in. The Ponzi scheme was raised to an art form decades later by financier Bernard Madoff, whose modern-day Ponzi scheme was eventually estimated to have lost some $65 billion in investor funds.
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