The cycles of speculation

Part I Chapter Page

I. Introduction ...-.-" 5

II. The Cycles of Speculation 21

III. The Gold Supply 37

IV. Money 59

V. Political Influences, Crops, Etc 77

Part II

VI. Puts and Calls 89

VII. The Question of Dividends 101

Basing Railroad Values 104

Effects of Business Depression 105

Undigested Securities 108

How to Compute the Value of Rights.-. ... 109

Barometer of Averages 110

Best Method of Trading Ill

Indication of Crises 112

The Ordinary Swing of Prices 113

The Factor of Safety 114

Borrowing and Lending Stock 117

Crop Damage 123

Selection of Securities 124

The Cycles of Stock Speculation 133

The Cycles of Grain Speculation 145

The Cycles of Cotton Speculation 155

The successful speculator requires four things :

1 — A knowledge of values.

2 — A knowledge of general conditions.

3 — A knowledge of the machinery of speculation — and

4 — Something besides.

Introduction

The first step in the education of the speculator should be to clear away the illusions which have grown rank through ignorance, and flourished through prejudice. We have heard, and continue to hear, a great deal of ethical talk on this subject, most of which emanates from people who are not authorities, and who have little real conception of the subject. It would be pretty safe to assume that a majority of these same instructors speculate themselves. They place an arbitrary construction on the word however, and draw a dividing line between stock or cereal operations, and other forms of speculation, although the basic principle is the same in all cases, i.e. : to buy what is cheap and re-sell at a profit. One of the most ridiculous forms which this pedantry assumes is the warning and preaching against speculation by very rich men who made their own money speculating and could not possibly have acquired it in any other way. Such expressions of opinion are born largely of an exaggerated ego.

The trouble with these critics and advisers is that they seldom approach the subject in the right way. With a full knowledge of the fact that speculation is an inherent part of human nature, and that a majority of human beings are bound to indulge in it in spite of everything, these sophists simply rail against the practice indiscriminately instead of attempting to point out what is foolish and fallacious. If we attack the practice in a general way little will be accomplished. If we say, "do not speculate," our audience will perchance give us a respectful hearing, — and go on speculating. If, however, we point out what is dangerous and unreasonable, confine ourselves to attacking the evils and explaining the delusions, some good may be done in an educational way. We may, if we show by simple logic that the education and qualifications necessary to success are too difficult to acquire, actually deter many people from speculating in certain lines at all, a thing which could not possibly be accomplished by mere blanket warnings against the practice. One of the most serious blunders in the world is the common one of under-estimating other people's intelligence. People are ready and willing to learn, and that they do learn is shown by the decreasing crop of lambs. It is not nearly so easy for the dishonest promoters and manipulators to market poor securities at high prices today as it was a few years ago. And in this regard it may be pointed out that the press has actually, although in many instances unconsciously, accomplished a great deal on exactly the lines suggested above. Magazines and newspapers have, in recent years, taken on an educational character. Periodicals once devoted to fiction or history now deal largely with business and social economics, and with the exposure of bad methods in high places, the ruthless uncovering of false or misleading statistics, and the simplification of questions hitherto involved; the public has been gaining rapidly in education and understanding. The fact that much space in leading periodicals is devoted to these subjects, is in itself prima facie evidence that the people can and will learn, for with all due credit to the editors and publishers, it is certain that the contents of magazines and newspapers are selected in accordance with what the public demands and likes.

No one will attempt to deny that a majority of public speculators lose. In a former volume, the present writer undertook to establish by analysis of a large number of public accounts, the fact that 80% of the participators lost money. A number of critics commented on this statement as a body blow to speculation, asserting that the writer had shown that there was "80% against the player." These writers proceeded to compare this percentage with that existing in games of pure chance, such as roulette, faro, etc., and wound up by pointing out the tremendous drawback to the speculator through percentage against the player. It seems incredible that any sane man should fall into such laughable confusion of ideas. The percentage of players who lose in any game has nothing to do with the percentage against the player. If these critics established anything at all, it was that speculation was not gambling; for it requires only a moment's reflection to see that in any mechanical gambling game where there is any percentage, no matter how small, in favor of the game, the percentage of players who eventually lose must be 100. This being the case, the gentlemen mentioned were at considerable pains to prove that, as 100 per cent, of the players did not lose, speculation was not a gambling game in the strict sense of the word. That is to say, it could not be correctly compared with any mechanical device where the element of skill was absent.

If we consider the matter in a gambling light, the percentage against the speculator can be determined by the proportions of commissions, interest, taxes, etc., to capital invested. Taking commission alone as our basis, we will find that he who purchases a stock at $100 a share and pays one-quarter of one per cent, commission, has a percentage against him of one-quarter of one per cent. If the speculator trades on limited margins the drawback increases accordingly. If we assume that 100 shares of stock are purchased in a bucket-shop on a one point margin, without intention or ability to "re-margin" the transaction, the mechanical percentage is large (25%) ; if 10 points margin is deposited, the mechanical percentage is reduced to 2 1 / 2 c fo, etc. In the first instance, $25 or 25% of the $100 involved was lost when the transaction was recorded, without any change in market price. In the second instance, $25 was again lost or 2y 2 % of the $1,000 involved.

There is no doubt that fluctuations in prices of securities, cereals and staples are frequently used as a basis for mere gambling transactions. But the most remarkable feature of the whole problem is the fact that the percentage of loss in transactions is greater than the mechanical percentage. In the work already mentioned, the writer undertook to establish this. In 500 accounts examined, there was a loss of $1,- 245,000, and profits of $288,000, leaving a deficit of $957,000. The commission charges and interest amounted to only $275,000. There thus appeared a loss of $682,000 which could not be attributed to a gambling percentage. It may be added that the period considered in the computations was from July, 1901, to March, 1903, and that the price of the stock considered (U. S. Steel Common) was the same at the beginning and the end of the period.

This tends to again refute the theory of mere gambling, with a ruinous percentage against the player, for no mechanical device could by any possibility operate against the player to a greater extent than the fixed percentage in favor of the machine. A gambling machine; will stick to its knitting. If, for example, we take the simplest form of gambling devicetwo dice thrown from a cup, — we know that certain numbers formed by adding the total spots which appear uppermost will show more frequently than others. Thus the number two can be effected in but one way, the number three in two ways, the number four in three ways, and so on up to the number seven, which can be formed by six different combinations, thus:

4 and 3

5 and 2

6 and 1 3 and 4 2 and 5 1 and 6

from which point the chances decrease until the number 12 can be formed in only one way — two sixes. This proposition applies to all forms of mechanical gambling, and is so simple in principle, and so distinct in operation that if we make a fair number of casts, say 1,000, and do not make more sevens than any other one number, we may be positive that the dice are defective, or loaded.

Therefore, if percentages hold true, we must attribute the surplus loss in speculation to mental operations. In the total results mentioned, these mental operations were so erroneous as to cause a loss greater than the percentage itself; but, on the other hand, a certain number of accounts showed profits ; that is to say, the percentage was overcome, which is again an obvious impossibility in true gambling.

The conclusion is offered, therefore, that not only can poor methods and imperfect understanding result in losses far in excess of a demonstrated drawback, but that this drawback may be overcome by other and more correct methods. It is difficult to understand why the opponents of speculation are continually harping on these points of gambling and percentage as bearing particularly on operations in stocks or commodities. If a man buys a certain security because it is cheap, or because he considers it cheap, and pays a certain commission to a broker for effecting the transaction, he is no more playing a percentage game than if he purchases a piece of real estate because it is cheap and pays the real estate broker a commission for his services.

Marginal trading is another abomination of the anti-speculative element, but here again the critics do not discriminate between use and abuse. Trading on insufficient margin is one of the greatest evils in the speculative world and when, as is frequently the case, this evil is combined with lack of knowledge as to values and conditions, the result is certain loss. But what is objected to here is the hazy view and comprehensive condemnation of all marginal speculation. The line of demarcation is usually carelessly drawn. If an individual buys 100 shares of stock for cash, has it registered in his own name and later borrows funds from his banker with these shares as collateral, he escapes impeachment as a marginal speculator; but if he buys on margin, and borrows from his broker the unpaid balance, he is a gambler. And yet it would be hard to point out the difference in the two methods. If we wish to go a little further afield, we may reduce a very large percentage of the commercial structure to marginal trading. We may, in short, place in this category every merchant who buys goods on credit and every man who buys real estate on payments, if their object when buying is to sell at a profit.

It is highly probable that these contentions will be vigorously attacked, on the theory that more evil than good results from speculative ventures, and that therefore the whole structure should be razed on a "greatest good to the greatest number" basis ; but aside from the intensely unphilosophical character of this view, it is not at all probable that any such thing can be effected unless human nature undergoes a radical change. Tear down every stock exchange in the United States tomorrow, and people will be speculating, a majority of them foolishly, in another week.. The cure lies not in paternalism, but in evolution and understanding. As has been said, more has been accomplished in recent years by the educational crusade of the press than by all the rantings and warnings of a century. We have our periods of reckless over-indulgence, it is true, but the evil is dwindling. The South Sea bubble would deceive a much smaller number of people today than it did in the days of John Law.

It is the object of the present work to point out, so far as the abilities of the writer will permit, what essentials are required in any form of speculation, whether on margins, or masquerading in the guise of investment. As to this last distinction, it may be stated that the word "speculation" is herein taken to mean the purchase of any security or commodity because it is considered cheap, with the ultimate intention of disposing of the property so purchased at a profit. In the writer's opinion this definition is correct. Speculation contemplates a rise in price, and an accretion in principal. Investment refers to interest returns on money.

One of the most flagrant errors in speculation is an entirely mistaken idea as to the possibilities in this field. Nine men out of ten have a deep-rooted conviction that if any individual could be right in his main deductions for, say one or two years, he should make millions on a small capital. This is a great mistake, and leads to numerous minor errors which are productive of much loss in actual operations. The business of speculation never did, and never will result in abnormal profits. Large returns are sometimes made, it is true, but this fact is also true of every other line of business. Certain individuals grow very rich in Wall Street; this again is true of every commercial branch. We hear now and then of a million dollar coup by a Morgan or a Rockefeller, and do not stop to consider the great capital behind it. If an individual makes five thousand dollars in a year's speculative ventures on a capital of twenty thousand, he is not considered a Napoleon of finance, but he has accomplished much more, in proportion to his capital, than Rockefeller would have accomplished if he had made five millions on similar operations.

In a recent conversation with a number of gentlemen who clung tenaciously to this idea of sudden riches, the writer undertook to establish his contention. Tapes were secured recording the fluctuations of sugar stock during a twenty point decline. The skeptics were given a hypothetical capital of $10,000 each, subjected to the ordinary rules of trading as to margins, etc., informed that sugar would decline twenty points before it again touched the first quotation established, and invited to "get rich quick." The result was ridiculous in the extreme. Two of the experimenters lost their imaginary capital trying to double up and show large returns. The third took an unfair stand, by selling the maximum amount at the inception of the experiment and closing it after the 20 point decline had appeared. His operations, therefore, proved nothing. Here was a case where two traders, possessed of an absolute fore-knowledge of what was to occur, lost everything through the fault of over-speculation and the belief that abnormal returns could be made if the ultimate fate of a market could be correctly forecasted. Even if we assume that e very intermediate movement were known in advance, that after a ten point decline there would be a five point advance, and that transactions v/ere conducted to the full possibilities of both original margin and accrued profits, the result would not be the millions which dazzle the eyes and imagination of the unsophisticated. But to assume any such trading is foolish. The factor of safety would be wholly absent. No wise man will ever attempt pyramiding, and no foolish man who does, will succeed.

In order to clear the ground for discussion or study, the first thing to eliminate is this wholly unsupported and mistaken idea of sudden riches. No matter how correct the forecast of the future may be, safety disappears in inverse ratio to the increased possibilities of abnormal returns ; and with the factor of safety continually ignored, the final results are bound to be disastrous.

It will also be necessary to dispel another illusion. If the speculator imagines that he can operate successfully without preliminary hard work to fit him for the business in hand he is grossly mistaken. It is necessary to qualify in this field as well as in any other. Knowledge of monetary conditions, values, interest rates, and in fact, of all influences bearing directly or indirectly on the future of prices must be acquired and thoroughly understood. Ignorance on any one point may mean defeat. On the other hand, a study of such conditions means a liberal education, valuable in every line of business life. It may be further stated that the man who attempts to evade necessary labor and research by placing his dependence on tips or charts, or the opinions of others, cannot hope to succeed. The gambling idea must be put out of the question entirely, and means sought whereby intelligent opinions may be formed by both inductive and deductive reasoning.

In preparing this work the temptation to enter more extensively into fundamental principles has been great. It would be impossible to do more than suggest a line of procedure in a single volume, and only the most elemental requisites are set forth. And not only do the prescribed limits of this volume forbid any exhaustive discussion, but such discussion is unnecessary. On every subject of importance we have books written by men of soberness and judgment, each a specialist in his field. A bibliography has been appended to this volume suggesting such works as are considered helpful. In this bibliography an attempt has been made to choose such books as are clear and simple, rather than those which are profound. If the task as herein outlined, appears formidable, it may be said that it is absolutely necessary, and not so difficult as may appear. Before the student has entered far into the subject, he will find the matter interesting and will very quickly realize that the well grounded contentions and discussions of men who examine and diagnose economical questions correctly, are of more value than the combined tips, guesses and poorly based opinions of all the professional speculators and gamblers from one end of Wall Street to the other. This form of basic knowledge is just as important to the active trader as it is to the investor. If he can correctly judge of the general trend of future prices, he may operate safely with that trend instead of floundering around helplessly in a slough of indecision, or possibly working directly against the current. If, for example, he has good solid reasons for expecting ultimately higher prices, he will not be disturbed by temporary reactions and, instead of being frightened out of his position through ignorance, he will take advantage of such reactions to make his purchases or cheapen his holdings. Knowledge, in this particular line as in all others, is the foundation of successful ventures.

II

The great upward and downward swings of speculative prices, herein referred to as cycles, have invariably preceded or accompanied periods of business inflation or depression. This fact, apparently so elemental, is often disregarded by that very large class of speculators which is continually looking for artificial and unpregnant explanations of price changes. There can be no doubt as to the existence of manipulation, and, in rare cases, movements of considerable importance may be traced to this source alone ; but manipulation consists, in its fullest sense, of the tactics resorted to for the purpose of liquidating shares in anticipation of a decline which the long-distance thinkers believe to be inevitable ; or, per contra, for the accumulation of shares prior to a great recovery or readjustment. It is seldom employed as a positive means of enhancing or depressing values. In fact, to do either by mere manipulation would be an impossibility. Every observer of great speculative movements knows that at the highest point of a movement, and during the first half of a decline everything appears roseate, while at the lowest prices, and during the first half of an advance, the reverse is true.

There are several contributory causes which operate to produce these false appearances. The primary cause is the curtailed perspective and imperfect logic of the public investor or speculator. The most difficult thing to drill into the mind of the unsophisticated is the fact that speculation cannot possibly be successfully based on appearances which are open and obvious. Such a process is a flat contradiction of the word itself. It is unseen future developments or, in some cases, hidden and submerged present truths which must be consulted. Yet we find a great majority of the ( public element who seek riches in the speculative arena, constantly harping on the large business of certain corporations, and the excellent state of general trade as a reason for purchasing shares. These factors have, in all probability, been discounted in current prices. Generally speaking, the present is of no more use than the past in forming opinions of future price changes. It is a certainty that sales of stocks could not be made in great volume to good advantage unless everything did look rosy, for who would purchase shares at high prices if the future appeared threatening or unpropitious, and who would sell holdings in the face of encouraging and inspiriting prospects.

This brings us to the second phase of the question — the creation of false appearances, which is, in truth, the highest form of manipulation. When so-called inside selling is going on, great business is reported by railroad and producing corporations; dividends are increased, and public expressions of confidence emanate from men of high standing in the financial world. The effect of all this expressed optimism is, market-wise, of a negative character. When it is most prevalent and most decisive, prices halt or even decline. This period and action represents selling at the only time when advantageous selling is possible. In the main the truth only is told about existent conditions, possibly about the near future. Nothing else is necessary ; but nevertheless the sellers are anticipating, not the events of the next week or the next month, but of a more remote period where they see probabilities in regard to which a discreet silence is maintained.

The constantly recurring cycles of prices, the alternate inflation and depression, must therefore be traced to something far more important than the grossly exaggerated potentiality of mere manipulation.

Principal Crises of the Last Century.

That crises in the financial world have occurred at more or less regular periods is a matter of history. Since the beginning of the nineteenth century ten of these readjustments have occurred. In 1812, after ten years of prosperous conditions preceding the war of that year, business fell off materially. The real panic, however, occurred in 1814. Washington was taken by the British on August 24th, 1814, and suspension of specie payments was general in the following two weeks.

In 1824, the protective tariff enactments were followed by general inflation in all lines of business. Two years later, in 1826, a general depression occurred with many failures. The depression at this period was even greater in England than in the United States, and many writers attribute the entire trouble to European business reverses, but it is probable that we had been living beyond our means and that this fact, to say the least, aggravated the disturbance.

In 1837, after six years of good times, another crisis occurred. This depression was attributed to various causes. The great New York fire of 1835, the loss of charter by the United States Bank in 1836, and the calling in of $37,500,000 of government deposits by

President Jackson, are all given due consideration. The actual panic, however, did not appear until May 10, 1837. All the banks suspended specie payments, and securities, — in fact all properties of whatever kind — fell rapidly in value. The most plausible explanation of this crisis is overspeculation in land. The other evils mentioned might easily have been rectified by the recuperative powers of a growing country, had the more serious element of wild inflation been absent.

In 1848, after a long period of prosperity, broken only by the war with Mexico, business inflation and overspeculation again brought about the logical and inevitable result. Europe also had been over-speculating again and a crisis in England soon extended to the United States. Liquidation was drastic and the depression lasted until the discovery of gold in California began to bear fruit.

In 1857, one of the most serious, as well as the most short-lived, of our crises occurred. Again speculation was extreme; December, 1856, marked the high point in securities, and prices continued to sag for some months; but it was not until August, 1857, that a panic occurred.

In 1864, came a crash in speculative prices following tremendous inflation. Between April, 1864, and April, 1865, leading stocks declined from $50 to $100 per share. As the inflation of this period was caused largely by the high prices of commodities and greatly increased railroad earnings occasioned by the events of the Civil War, most writers on the subject do not consider it in their theoretical discussions of crises.

In 1872, another boom was on, particularly in Iron and Steel. The Chicago and Boston fires had not been as effective in breaking stock prices as might have been expected. Prices of stocks began going down materially in April, 1873, and in fact had been rather "toppy" during the preceding years. This panic, like most of the others, was preceded by enormous speculation and high prices. It is interesting to note that while stocks were declining, general business was booming. The trained minds of Wall Street were learning to discount the' future at longer range and more accurately. The iron and steel business exceeded all former records in 1873, both in the matter of normal price and actual production.

In January, 1884, numerous failures and suspensions produced a panic which was in reality the culmination of a long decline. As in 1872, this panic was preceded by enormous general business. The steel and iron trade again broke all records in 1882, and other lines were equally prosperous.

In 1893, the period of prosperity which followed the enactment of the McKinley bill was rudely broken. Speculation kad been rampant, as usual. On May 4th, 1893, the National Cordage Company went into the hands of a receiver. Only a year prior to that date, this corporation was paying 12% in dividends and the stock was selling well above par. There were many badly inflated stocks and many rotten spots in the speculative stock markets. The Distillers and Cattle Feeders shares fell from $70 to nothing, and were assessed $20 per share. The aggregate liabilities of business failures in 1893 were almost $350,000,000, over 20% greater than in 1892. Banks failed right and left, and several leading railroad companies went into the hands of receivers.

In 1903, another period of depression occurred. It is doubtful if this period can be rightly classed with the other crises already mentioned, for it was more in the nature of a drastic but orderly retrenchment than a panic, and the bull stock market of 1902 was again in full swing early in 1904.

In thus briefly detailing the crucial points of nineteenth century financial affairs, there is no intention of entering an economic discussion, and no pretence of giving anything like a comprehensive history of the events preceding or following their recurrence. The subject here discussed is speculation, and the object sought is to gain knowledge that may be of value in forming opinions as to future prices. We may gain some information of this character by analyzing the following points:

1 — Did price declines in stocks precede, accompany, or follow panics, crises, or general business depression?

2— What are the signs which usually precede such periods?

3 — What are the salient causes?

4 — Can any dependence be placed in the regularity of these recurrences?

On the first head it will be found that in all cases the top of the stock market has been reached prior to the actual eruption in general business. Stock speculation in 1814 and 1826 was not of great volume nor importance, and cannot be given much consideration.

Beginning with the panic of 1837 we find that the highest prices for stocks were made in October, 1836, while panic conditions did not occur until May, 1837. Preceding the panic of August, 1857, highest prices were reached in the last months of 1856. Highest figures were recorded in April, 1872, just one year prior to the panic of 1873. The stock market anticipated the troubles of 1884 by 17 months of declining prices. In January, 1892, stocks began declining and continued their downward course until the panic of 1893 cleared the atmosphere. In our last period of depression (1903) stocks had reached their pinnacle in September, 1902, just one year before the market turned for the better.

We find therefore that in the majority of instances, highest prices for stocks were reached long before business troubles were openly apparent. This action represents to a certain extent the selling of stocks by men who were wise enough to foresee trouble.

Another interesting fact in regard to crises is that they are usually preceded by recordbreaking business in all directions. As iron and steel may be considered the best barometer of business conditions, the following tables are instructive :

PIG IRON PRODUCTION IN THE UNITED STATES SINCE i860.

Production Year Tons

1861 731,544

1862 787,662

1863 947,604

1865 931,582

1866 1,350,344

1867 1 ,461 ,626

1868 1,603,000

1869. , 1,916,641