Fear and Loathing of Market Regulation

This article remembers key events that have shaped Wall Street history.

A fragile stock market recovery had long since fallen apart by the time Sept. 24, 1937 rolled around, but a fresh wave of panic sent the Dow Jones Industrial Average (INDEX: ^DJI) to two-year lows. The index lost over 4% of its value in one of the broadest sell-offs since 1929. The New York Times noted that a record 537 stocks reached their yearly lows today in 1937. Short-sellers couldn't keep up with the speed and breadth of the decline as 976 different stocks traded lower on the New York Stock Exchange.

Analysts, pressed to explain the decline, could only point to recent negotiations between U.S. Treasury Secretary Henry Morgenthau and a British Undersecretary of the Exchequer over a proposed foreign investments tax. This stand against so-called "hot money" in both countries, which the Chicago Daily Tribune calculated to be worth $8 billion in the U.S. (or nearly 9% of U.S. GDP in 1937), caused stocks in New York and London to fall across the board as investors in both countries worried that their overseas holdings might soon be subject to onerous taxes.

United States Steel (NYS: X) was one of the hardest-hit Dow components on Sept. 24, 1937, losing 6%. Its decline was rumored to be tied to sales by British insurance firms, which were coping with claims made in the aftermath of Japanese attacks that had damaged multiple Chinese cities over the past year. Reports of massive iron ore stockpiles holding down steel prices could have also been responsible for the drop.

General Motors (NYS: GM) and Chrysler, two other 1937 Dow components, were also part of the rumored British insurance-firm sell-off, as the three stocks saw large European-owned blocks trade on Sept. 24.

Regulation and the three bears
Wall Street insiders renewed their protest over market regulations in the wake of the sell-off, with the New York Times as a mouthpiece. A host of regulations had already been instituted by the Roosevelt administration by Sept. 24, 1937 to prevent another massive crash like that of 1929. Among the regulations argued against were:

  • Brokerage customers were prohibited from using margins of greater than 55% to buy stocks -- in other words, they had to put up at least 45% of the purchase price. Margins as high as 90% were commonplace prior to the crash.

  • This margin limit was claimed to prevent investors from offering "support" to falling stocks, as they might have otherwise snapped up bargain shares using leverage.

  • This margin restriction extended to floor traders and specialists, who (the horror) wouldn't be able to use other people's money to support declining stock prices.

  • Insider trading regulations had forced executives and shareholders that owned over 10% of any company to report trades in their company's shares to the SEC. Insider buying at depressed levels was claimed as another form of critical price support. Minimum mandatory holding periods of six months, in conjunction with mandatory reporting rules, supposedly scared insiders away from propping up their falling stocks.

  • SEC investigations into large trades were said to discourage well-heeled investors from making major purchases, creating a less liquid market.

  • Changes to the capital gains tax in 1934 had allowed greater portions of the tax to be withheld as the holding period lengthened, from a minimum of one year to as many as ten -- call it the buy-and-hold deduction. This, contrary to the other regulations, was blamed for allowing the market to increase more than it otherwise would.

From 1937 to 1942, the Dow would suffer three distinct bear markets that kept it from passing its 1929 highs until 1954. Regulation may have played a part in depressing stock prices, but an entire generation of potential investors also grew up with warnings and horror stories of the devastating 1929 crash, the aftermath of which shaped the lives of the Greatest Generation. Today's investors seem to share few of those fears, as the Dow currently sits less than 4% lower than the all-time highs it reached in October of 2007.

Market regulations today seem ineffective or nonexistent in many places. Knight Capital's (NYS: KCG) massive high-frequency-trading meltdown this summer was just the latest in a series of computer-driven cluster bombs lobbed at a market that's proven woefully incapable of erecting regulatory shields to defend itself against them. The JOBS Act, now a law, introduces significant new weaknesses into the market's regulatory framework by allowing established enterprises like Manchester United (NYS: MANU) to go public for specious reasons and with sparse disclosures. Dodd-Frank hasn't done much yet to prevent several high-profile financial collapses, and shareholders have been repeatedly shafted in recent years by a trend toward multi-class share structures that give executives control far in excess of their ownership stake.

Are things different this time? Does the market no longer need the sort of tight control forced on it so many years ago by a reform-minded Roosevelt administration? Investors must stay as vigilant as ever against irrational exuberance, and companies with integrity will always be great defensive picks in markets that may be spiraling out of control. Find out more about one bank with integrity to spare in a banking industry that sorely needs it. It's all in the Fool's latest free report on "The Only Big Bank Built to Last."

The article Fear and Loathing of Market Regulation originally appeared on Fool.com.

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