Stock prices; factors in their rise and fall

Contents

Chapter Page I— THE DISTRIBUTION OF SECURITIES 1

Stocks and Bonds — T\"hat They Represent — Investment vs. Speculation — How Stocks are Floated and How Sold on the Exchangres — The New York Stock Exchange ; Methods of Trading- There — Investment Stocks — Ratio of Investment to Speculative Transactions — Marginal Trading.

II— FACTORS OF SHARE PRICES 17

I. The Distribution of Securities

THE stock of a corporation is its ownership; its bonds are the evidence of its funded debt. Usually, for business purposes, the stock of a company is represented by certificates, each of one or more of the shares into which the stock as a whole is divided. All the shares of a company's stock thus represent the whole ownership, and each share represents such part of the ownership as it is part of the whole number of shares.

Shares of stock sell without entailing liability on the purchaser beyond such as is involved in a possible decline in price. The advantages in the power to transfer any part of the ownership of a concern without necessarily interfering with the conduct of the business and without the purchaser assuming risk beyond an impairment of the worth of his purchase money, are the chief causes of the strong disposition, in the last two decades, to prefer the corporate form of business to the older partnership form.

Formerly, a business man owned one concern or a certain share of it as a partner ; occasionally, he might have interests in another property, but even this was rather rare. At the present time, the ability to buy and sell the stock of a corporation in small parcels has distributed the ownership of these companies among very many holders.

There is now probably not a steam road of importance whose stockholders do not number well into the hundreds, while in the case of the great railways the owners are to be counted by the thousands till they reach their maximum in the number of the Pennsylvania Railroad stockholders, over 55,000 in December, 1909. Not only is one concern owned by many persons, but, conversely, many persons may each own a small parcel of very many concerns. In this way a community of business interests arises, which reaches its apex in the case of great capitalists with interlocked holdings in very many huge corporations.

Shares are often of two sorts : preferred and common. Shares of preferred stock have usually a limited claim on the yearly earnings of a corporation prior to the claims of the common stock. In the event of the company's liquidation, preferred stock has, also, very often, preference as to the assets. Common stockholders, as a rule, get whatever earnings may be distributed as dividends after the preferred shareholders have received their limited but prior distribution. When there is but one class of stock it has, of course, all the rights of ownership.

Since the days of early railroading, it has been the custom in America to let the nominal, or par, value of bonds and preferred stock represent roughly the valuation of a corporation, or, sometimes, the actual capital invested at its start. In this way, the common stock means merely the business possibilities of the concern at its inception. When a company is successful, the common stockholders receive ultimately the lion's share of the

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profits, but if the concern fails such stock is not infrequently totally valueless. This method of capitalizing has been objected to on the ground that the nominal, or par, valuation (usually $100) of a share gives the impression of a real value, which does not exist, and that the pressure which the desire to earn dividends on a mass of overrated shares exercises on managers leads to detrimental business practices. Stock, whether common or not, which, in this manner, has, at the outset of a concern, little or no actual equity in the assets and earnings has been termed ^'watered stock.'' But the price paid for such shares by any buyer represents his estimate of the business possibilities they connote, and is not based on the nominal value of the share or on the number of shares issued. Of course, the nominal capitalization should not exceed the value of the actual condition into which, in the end, it is believed these possibilities will issue. The shares of Adams Express Company and of some other concerns have no nominal valuation, but represent, each, a certain percentage of the whole stock; such shares sell at about $100 apiece whenever the number of dollars received on each, yearly, as a dividend, is regarded as a fair percentage return on its class of business.

In commerce the things dealt with are concrete. Commodities have value in exchange because of their value in use to the last purchaser, or consumer ; they are produced to satisfy a want and used up in its satisfaction. But the use of stock, on which its value in exchange depends, is simply to increase or conserve wealth by affording an income to a holder or through a change in price. Strictly speaking, stock, or ownership, can be neither produced, in an economic sense, nor consumed ; it is a business relation which appears and disappears in accordance with other business facts and relations.

Holders of stocks are investors and speculators. A desire to avoid the latter term has led to a tendency to make the word 'investor" cover more than it rightly should. An investor is one who buys a bond for its income or stock for its dividends. A speculator buys or sells in hope of a change in price which will redound to his advantage. The difference between investor and speculator is thus one of intention, not of outward fact. An investor may change his mind about shares purchased for dividends and sell them at a speculative gain. Conversely, a speculator buying in hope of a rise in price may determine to hold the stock bought, permanently for the sake of its dividends. The only usual outward difference between the two sorts of purchasers is that an investor, as a rule, holds his stock very much longer than a speculator does his, and that operations for a fall in prices are always speculative. The element of difference in length of holding as well as the different motives actuating the two sorts of buyers renders the distinction one which clarifies discussion. Between speculation and gambling, the common element of uncertainty and the frequent similarity of the motives of the participants have caused some confusion. Gambling, however, "consists in placing money on artificially-created risks of some fortuitous event, speculation consists in assuming the inevi-

DISTRIBUTION OF SECURITIES. i

table economic risks of changes in value/' Gambling is always betting : speculation, no matter what the intention of the trader may be, always vests in him the rights and duties of a property owner.

A corporation may offer its stock for sale in part or in whole ; or, the shares may be sold privately or on the exchanges. Stock sold in the first instance directly by a corporation is afterwards subject to sale, usually through private transaction or on the exchanges only. The stock exchanges of the different cities — which are organizations, sometimes incorporated, sometimes, like the New York Stock Exchange, having the status of a private club — are limited to a certain number of members who assemble together at certain hours each day and execute with one another orders of customers to buy and sell stocks and bonds. The stocks traded in on each exchange are limited to those formally admitted to such privilege. Nearly every large city in America has a stock exchange of more or less local prominence, but those of Boston and New York only stand in the first rank. Boston is the centre of trading in the mining stocks of the country, particularly those of copper ; New York in the railroads and industrials. As the two latter classes of business are much the more extensive of the three sorts, the New York Stock Exchange is, by far, the most important in the country.

On the New York Stock Exchange the number of brokers is limited to i,ioo. Many members are connected with firms in which there are other partners, not members of the Exchange. Besides the New York City offices, there are branch offices of Exchange firms in all of the important Eastern cities and in not a few of the Western. Probably several hundred members of the Exchange, known as "room traders," are engaged in the business of speculation for themselves alone. The majority of these room traders are "scalpers"; that is, they buy and sell stocks for their own account and then close the transaction the same day whether it shows a loss or a gain. In this way, they rarely have commitments open overnight. It may be added that some of the stocks traded in on the New York Stock Exchange are bought and sold on other exchanges, also.

On the New York Stock Exchange, the dealings are ordinarily in loo share lots or simple multiples of such amount. Many brokers refuse to buy a smaller number of shares unless they are to be paid for in full at once and taken off the market. Stock bought for speculation is usually purchased with the aid of the broker's resources, the customer depositing a sum, called his "margin," equal to so many "points" (or dollars a share) on the purchase price of the stock; the certificates purchased are retained as a pledge by the broker and are generally repledged by him at his bank. When the price of stocks bought on margin declines below the number of points covered by the margin, the shares pledged with the broker are either sold by him to ensure himself against loss or, further margin is obtained from the customer.

It is customary on the exchanges to trade not only for a rise in stock prices, but for a fall. A trader who believes that a stock is selling too high and who thinks the

DISTRIBUTIOX OF SECURITIES. 7

price will decline, may "sell short" shares of that security. In doing this through a broker, the latter contracts to deliver the shares in question to a purchaser before a fixed time, generally the usual time for stock deliveries, or a quarter past two the afternoon of the next full business day. He then borrows the stock of some owner, putting up against it, as security, the full amount, in cash, of its selling price. The stock so borrowed is then delivered at the appointed time to its purchaser. This completes the first part of a short sale. When it is wished to close the operation, the broker buys in the same amount of shares as he had previously sold short and delivers them to the person of whom he had borrowed them, receiving back his security money, usually with interest. The price between which the broker sold the borrowed shares short, and the price at which he bought them back to reUr them to the lender shows whether a gain or a loss ha . been made by the'transaction. If the shares have fallen in pri^e, the short seller makes the difference between the higher price at which he sold them short and the lower price at which he bought them back for their lender; if the price rises, he loses the difference between the lower price at which he sold them short and the higher price at which he was obliged to re-purchase them. When a customer engages in this transaction the usual margin is still required by the broker, because, if the shares go up in price, the lender may demand them back, and the broker be forced to buy them in at the higher price, at a loss to himself unless protected by margin of his customer.

The advance of funds by the broker against the pledge of shares is simply the extension to speculative operations of the principle of credit. It enables the purchaser to take larger risks and obtain, if successful, greater gains than his own capital would allow him to do ; in doing this, it ofifers, also, speculative chances to many who. otherw^ise, would be unable to enter into commitments of sufficient size to warrant the making. In a marginal market the commitments are, therefore, much more extensive than in a market void of this sort of speculation. How much larger is difficult to estimate exactly. As $100, or par, is probably about a fair average price of the shares sold on the Exchange from year to year, and as one-tenth of this sum, or $io a share, is the usual margin required, it might be hazarded that the trading in a mar* ket such as the New York Stock Exchange, were there no marginal dealings, would be but one-tenth in amount of what it now is. But, probably, it would be much less, as many traders would not deal speculatively at all if their possible profits were divided by ten, and they, themselves, forced to pay in full on all their commitments. In any event, the transactions in a market where marginal trading obtains are very much more frequent than in a market of similar size for the same stocks but devoid of this species of trading.

Stocks which for years pay good dividends go more and more into permanent investment hands. Pennsylvania Railroad stock, which has never failed to receive a dividend of some size since the beginning of the company, has its 317 millions of dollars of shares owned by

DISTRIBUTIOX OF SECURITIES. 9

over 55,000 registered holders ; while Union Pacific common, though paying 10 per cent dividends against Pennsylvania's 6 per cent, has its 214 millions of dollars of shares held by but 10,000 registered holders. (December, 1909). Generally speaking, the better thought-of a stock, the greater the number of its registered holders and the less the amount of the average holding of each. The Journal of Commerce of New York City has for some years past compiled annually a list of the registered holders of the great corporations, its information being furnished directly by such concerns as are willing to afford publicity to their figures. From these statistics it appears that the average number of shares, at the close of 1909, of Pennsylvania stockholders is about 60; of Lackawanna, 180; of Delaware and Hudson, 70; of New York Central, no. On the other hand, a speculative stock like Union Pacific has average holdings of about 200 shares; Southern Pacific, 240; Southern Railway, 300, and Reading, nearly 700 (par $50 in this case). As the stocks, with the large average holdings, are the speculative leaders, and as those with the smaller average holdings are the ones thought best of by investors, it is evident that the better a stock is thought-of by investors the smaller become its average holdings as the number of share owners increases.

When shares are bought by investors and taken oflf the market, almost invariably they are registered on the transfer books of the company in the investor's name and a new certificate is issued to him. He wants the certificate in his own name, both as a token of ownership and so that the dividends paid will come to him directly instead of going first to some previous owner, in whose name the shares stood before purchased by the investor in question. But, when stock is bought for speculation, "on margin,'' a transfer on the company's books is infrequent. Let us suppose that shares have been sold by Jones in whose name they are registered. Smith, the customer of a brokerage firm, buys in these shares for speculative purposes through his broker. Jones' signature on the back of the certificate has been witnessed by his broker and the shares thereby made a ''good delivery.'' In this condition they are received by Smith's broker. But Smith has no intention of keeping these shares. Soon he sells them. The speculator buying them of him, also, holds them but a short time before he sells. In this way the shares are handec^ successively from one broker to another, each of whom executes speculative orders in connection with them for his own customer. All the time, the certificates are in the physical possession, not of anyone of the speculators, but of either a broker or a bank at which the broker pledges them as security for loans. If the shares are ''cleared" — ^that is, if the purchases and sales are offset against each other through a "clearing house," the actual certificates may pass into the hands of a brokerage house which has nothing at all to do with their particular purchase or sale but which received them in settlement, in part or in whole, of its own dealings in the shares of that stock. But, in any event, whether the shares are "cleared" or not, they may during all this period stand in the name of Jones, their first, registered owner. But,

DISTRIBUTIOX OF SECURITIES. ii

it is more probable that they will soon be transferred, for convenience, into the name of some broker, and in this shape undergo their successive passages from hand to hand. In this way, the great bulk of the stock floating around Wall Street stands in the name of a member of the New York Stock Exchange. Unless the stock is bought by an investor, a transfer, afterwards, on corporation books will be made simply for the sake of getting the dividends directly from the corporation instead of having the trouble of applying to the broker in whose name the shares stand.

It thus appears that while all investment stock, the country over, is transferred almost invariably on the corporation books, speculative stock is thus registered very infrequently and usually only for convenience in obtaining dividends. Thus, the number of shares transferred during the year on the books of a company will necessarily be greater than the number of investment trades, because a certain indefinite number of shares carried speculatively on margin will also be transferred. Now, if the great corporations published the number of shares registered by them year by year, it would be easy in any instance to state at least the maximum relation between the amount of investment and the amount of the total dealings, by simply comparing the amount of stock registered with all the stock sold during the year. The figure arrived at would be too high because some of the registered stock, as already said, is for speculation ; but it would be still near the exact facts. By comparing the Journal of Commerce figures from year to year with the average stockholdings in that sort of business, the country over, and with the quantity of shares sold on the New York Stock Exchange, a close approximation in the matter can still be arrived at.

For example, during 1909 the registered stockholders of Reading common decreased 750 in number. That same year, general railroad stockholdings all over the country averaged about 150 shares per holder. Reading shares being **half shares" (par, $50 instead of $100), it IS easy to see that probably a quarter of a million shares (750 X 150 X 2) of the stock sold all over the country, were that year transferred on the company's books.

But, during 1909, no less than 28 million shares of Reading common were sold on the New York Stock Exchange alone. In other words, the investment dealings in this stock all over America must have been less than I per cent (250,000 divided by 28,000,000) of the total transactions in the stocks on the New York Stock Exchange.

In this calculation the number 150 as the total average amount of stockholdings in all the important roads is obtained by dividing the capitalization of all these roads by the number of registered stockholders they report. Reading's own average is several times greater (350 shares), but as a large amount of the stock is held for purposes of control it seems fairer to take the average holdings in all roads. To the calculation itself, the only objection that can be made is that the figure representing the decrease, 750, is necessarily a net figure and that it may simply represent the remainder of a large number

DISTRIBUTION OF SECURITIES. 13

of increases and decreases. But this is not quite so ; during that year the stockholdings in nearly all the roads decreased, and moreover, such inaccuracy as necessarily exists in the matter is probably more than offset by the fact that this figure includes decreases arising from registrations of speculative stock. A broker, for instance, coming into possession of ten ''odd lots'' of shares aggregating 100 shares, will have them tranferred into a single looshare certificate, this amount being the unit of trading on the exchange.

To test the correctness of this mode of estimating, let us apply the same method to Pennsylvania, Atchison and Union Pacific. Pennsylvania stockholdings in 1909 decreased about 3,500. The same year the sales on the New York Stock Exchange were nearly 6 millions. Performing the calculation as before, we get (150 X 3,500 X 2 divided by 6,000,000) 17^ per cent as result. It is worth notice that, whereas, if instead of the figure of 150, the Reading's own average stockholdings were used our result in that case w^ould be several times larger— in the case of the Pennsylvania, that road's own average holdings, about 60 shares, would greatly reduce the proportion shown of investment to speculative dealings. Reading, it may be added, is the most speculative great railroad stock on the exchange and Pennsylvania the most favored by investors, so these two extremes of i per cent and 173^ per cent correspond with the trend of facts. Proceeding similarly with Union Pacific and Atchison, we obtain in the former case (4,000 X 150 divided by 21,000,000) nearly 3 per cent, and in the lattei* case (700 X 150 divided by 5,500,000) about 2 per cent — as representing the percentage of investment dealings everywhere to speculative dealings on the New York Stock Exchange. It should be observed that the par of both these stocks is $100, so that the number of shares in these two last calculations does not need to be multiplied by two, as in the case of Reading and Pennsylvania. Also, that, in all the calculations, an investment deal is assumed to be one in which at least one of the parties is an investor. No attempt has been made to distinguish the case where investor sells to investor, separately.

These percentages are estimates. In some instances they may be too high, in others too low. But taking them all in all, noticing how generally consistently they work out, it is a fair conclusion that on the New York Stock Exchange, the total of investment dealings, at least in the great railway securities, is considerably below 5 per cent of the total transactions.

■, It might be expected that the multitude of transactions on the New York Stock Exchange would ensure sales at every allowable figure between the upper and lower prices of the day. An inspection of the daily sales list (published, for instance, in the New York Evening Sun) shows this to be so. Stocks frequently traded in are sold at every eighth of a dollar fluctuation between the highest and lowest prices of the day, and would be sold at even closer differences did the Exchange permit sales at prices involving sums of less than an even eighth of a dollar a share. A stock like Union Pacific will move by eighths of a dollar a share on every trading day, unless

DISTRIBUTIOX OF SECURITIES. !.«;

in the event of a sudden panic or of some other unusual and potent market influence ; while shares of a much less active stock, such as Wabash, may be sold a few times during the day's session at diflferences between each sale of a quarter of a dollar a share, a half or more. Lastly, the inactive stocks — often largely confined to investment dealings — are often without any sales on many days and frequently vary from transaction to transaction by several dollars a share. The greater the amount of speculative trading, the greater the activity in a stock; and the greater the activity, the more continuous its price range; the less active, the more disjointed this range, ^larginal trading thus aflfords not only an instant market for stocks, but a market of minimum diflference between successive sales.

Without stock speculation, investment dealings in stocks would take on the same character as purchases and sales of a partnership in a firm. The relatively very small amount of investment buying at one time compared with the amount of speculative, shows how few shares Avould be bought at the outset of a company if they had to be taken on the basis of the dividend returns now customary. It is the speculator who, in consideration of the chance of profit, is willing to take the burden and the risk at the inception of an enterprise. To dispose of the stock of a new railroad or industrial company to the "public" without the intermediation of speculators, returns analogous to those oflfered by partnerships would have to be paid as dividends to attract sufficient buyers to the spot. Only in the course of years does a stock i6 STOCK PRICES.

pass slowly into permanent investment hands, after it has long paid good dividends and has become valued not only for these dividends themselves, but for the certainty of their return. Indeed, shares disposed of to investors •by new corporations not listed on the Exchanges, are readily sold only when large dividends are paid at the very start, or when emphatic statements (whether true or false) that such will be paid are made and believed. But large dividends in the case of great corporations would mean much smaller capitalizations, and, in particular, the extinguishment of the peculiar speculative position so often held in American finance by common shares.

II Factors of Shar« Prices

A speculator wishes to make as much money as he can; an investor, to get as large an income as possible. The dealings of each in the stock market are a reflection of their wishes. But both wish, also, to avoid loss ; hence another motive impelling them to action. On the beliefs of speculators and investors, therefore, and on their consequent hopes and fears depend the prices paid for stocks and the stocks bought and sold. As this is true of everyone in the market, it follows that prices are but the resultant of the interaction of the hopes and fears of all traders. As the late Walter Bagehot put it, in the stock market, and there only, does the ''economic man" of political economy, actuated solely by the desire for gain, cease to be a convenient fiction and become a reality.

To say that nothing afifects stock prices save through the minds of buyers and sellers might seem a mere platitude, but, as a matter of fact, it is common to hear a rise in the rate of interest, the defeat of a nation in war, an earthquake or some other notable event ascribed as a cause of stock movements; the seeming implication being, often, that in some vague way these facts do, of themselves, make the prices. In a sense, indeed, such statements, as well as the metaphor which i8 STOCK PRICES

speaks of the stock market as the "barometer of business/' are convenient shorthand expressions, but, in another sense, they are not infrequently the token of a confusion of thought. A puzzling feature of the market to many is its occasional opposite response at different times to the same sort of business happenings; thus, in December, 1905, the steadiness of quotations in the face of call money rates of extreme stiffness was a source of excessive perplexity to those aware of the singularity of the fact but who failed to note that it is not an event itself but its influence in affecting the acts of the market participants which determines the course of prices. The knowledge of an occurrence and the feelings which it singly awakens, mingle with a host of other ideas and feelings in each trader and modify the resultant of their interactions. It is this mental factor which judges that railroad shares are better investments than industrial, though, in certain respects, the justness of this inference may be open to challenge. Dividend paying stocks sell ordinarily at about prices which net the purchaser not so far from the current interest rates for money expected on the security they offer. Stocks guaranteed by high-grade companies and those which have come to be held entirely by investors, or almost so, pay a return on the purchase price little, if at all, higher than that derived from a first-class bond or mortgage or from the highest sort of commercial discounts. Railway stocks paying dividends of from 4 to 7 per cent are expected in good times to net the investor

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from about 4>^ to 6 per cent, while from 6 to 8 per cent return is generally looked for from industrial shares paying dividends of from 5 to 10 per cent. The ease of investment and the absence of personal liability make dividend paying shares on the great exchanges a receptacle for the spare funds of the community in exactly the same w^ay as real estate, mortgages, bonds and deposit accounts.

For these reasons, no matter how 'Svatered'' the stock of a company may be at its outset, if it comes to pay dividends at about the rate expected in its class of corporate business, and if its earnings seem likely to enable it to continue such disbursements straight on, the share price will approximate toward par, and the stock, as time goes on, will become more and more absorbed by investors, the extent of such absorption depending largely on the quantity of stock outstanding. The history of the common stock of the United States Steel Corporation furnishes a good example of this state of things.