of new processes or new commodities and services. The speculator, even more than the investor, has a direct interest in economic processes.

3. The gambler

The gambler has no interest in economic processes. He is simply wagering. Insofar as the securities markets are concerned, the gambler is now of little or no significance. The regulation of the national exchanges by the Securities and Exchange Commission under the Securities Exchange Act of 1934 is broad and comprehensive and has been supplemented by policies taken by the New York Stock Exchange and other national exchanges.

Risk capital is usually invested directly in a new enterprise without using the mechanism of a capital market. However, the securities markets do perform a number of very important functions in the economy which help promote the flow of funds into new enterprises:

(a) The securities markets provide a ready mechanism for seasoned and sound companies to obtain new capital at reasonable rates.

(b) The markets perform the vital service of permitting individuals or corporations to sell. When the securities markets do not function properly it becomes difficult to retrieve capital once invested, even if the owners are desirous of reinvesting elsewhere.

(c) If the market for seasoned securities is thin, hesitant, and stagnant, individuals who otherwise would be inclined to embark on new ventures tend to lose enthusiasm. Moreover, the condition of the securities markets is an important factor in creating sentiment, and in the plans of business executives. In the past it has been assumed that there is only one relationship, namely, that business affects the securities markets. The reverse is also true, particularly now that manipulation has been curbed and the market is more responsive to natural economic forces; in fact, it is arguable that the condition of the securities markets is an important influence on the turning point of the longer business cycles."

(d) Prices of securities are important measures of value. Since securities of most of the leading American corporations are publicly owned, values are of great importance in measuring the wealth of individuals and estates, and in determining the position of financial institutions. According to a recent study, business loans of member banks of the Federal Reserve System in November 1946 were secured to the extent of approximately $1,000,000,000 by stocks, bonds, and mortgages, about half of which represented corporate bonds and stocks. Many of these loans were made to small and medium-sized businessmen.40 Over the years, as a greater part of the country's business activities has been carried on by corporations and the average size of the business units has increased, more of the country's wealth has come to be represented by corporate securities. There has been increasing emphasis on the liquidity and marketability provided by the securities markets. We turn now to evidence that the capital markets are not functioning properly. It is our conclusion that this malfunctioning is due mainly to the tax inequities discussed in previous chapters.

Whether measured in terms of national income, volume of production, or other economic indexes, the rate of stock trading has been declining. The long-term trend is noteworthy and is shown below:

Reported sales as percentage of mean number of shares listed

So far this year the volume of trading has been substantially smaller than in 1946. The number of shares traded on the New York Stock Exchange in the

39 Ross, J. A., Jr., Speculation, Stock Prices and Industrial Fluctuations (1938), 374 ff. 40 Federal Reserve Bulletin, June 1947, 665. These loans are not to be confused with loans for the purchasing or carrying of securitoes, which on September 30, 1947, amounted to approximately $500,000,000 for member banks in leading cities, exclusive of loans for the purchasing or carrying of Government securities.

first 9 months of 1947 amounted to 181,013,071 compared with 280,562,501 shares in the same period of 1946, a reduction of approximately 35 percent. This indicates that the breadth of the market, which is an important element in providing liquidity for the revolving fund of risk capital, is being severely restricted. We have excluded the boom years of 1928 and 1939. Last year's turn-over in relation to listings was only about one-fourth of that of 1926. It will be recalled that 1926 is the year which is used as the base in the index of wholesale commodity prices of the United States Bureau of Labor Statistics, and it is generally regarded by economists as a period when the economy as a whole was functioning well. The following chart showing the relation of national income and volume of stock trading seems to speak for itself.

Source: The Cleveland Trust Co.-Business Bulletin-October 15, 1945, extended to 1946 by Franklin Cole & Co., Inc.

For some time attempts of some of our largest and strongest corporations to provide funds for expansion through the sale of additional common stock offered to existing common stockholders by way of subscription rights have almost invariably had an extremely depressing effect on the price of the outstanding shares. The accompanying tabulation lists most of the major companies which resorted to common-stock financing this year and in the latter portion of 1946. It will be noted that in almost every instance the announcement of such financing sharply depressed the price of the stock relative to the comparable Dow-Jones average. In most instances the price remained depressed right through the expiration date of the rights or new offering. The most obvious illustration of the price-depressing effect of the announcement of new common-stock financing is found in the case of Northwest Airlines, Inc., common stock which declined from the closing price of 301⁄2 on the day on which notice of the new financing first appeared in the financial press, to 19 at the expiration of the rights, a decline of 37.7 percent. During this same period the Dow-Jones industrial average advanced slightly, while Barron's air transport average was off about 10 percent. At no time during this period did the industrial average decline more than 1 percent from its price on the day that notice of the financing appeared, while at its high point a 6-percent advance was recorded. On the other hand, Northwest Airlines common stock never exceeded the price registered on the day that the new financing was announced.

Taking an average of the 10 listed companies with new common-stock offerings, the average price decline was 12.5 percent from the date on which notice first ap

Offerings of new common stock (with or without preemptive rights)-1946-47

174.68

169.50

-17.4

170.64

163.59

-9.6

+6.7

176. 56

185.38

+5.9

-5.7

1 Period-from date of first notice of the new financing in financial press to date of expiration of rights on new offering. 22 to 1 stock split on Apr. 18, 1947, adjusted to previous capitalization.

3 Dow-Jones-Utility average.

peared in the financial press to the last day of the new offering. During this same period the average decline for the comparable Dow-Jones indexes was only 3.0 percent. The price range during this same interval of time also bears out the depressing influence of new common-stock financing on market valuation. The average stock price for the 10 companies advanced 2.0 percent at its highest point from the date of first notice of new financing and declined 17.3 percent at its lowest point, while the comparable Dow-Jones indexes averaged a slightly greater advance of 24 percent, but experienced a much smaller decline of 6.0 percent at the lowest point.

We illustrate the problem further by referring to an important industry which, by reason of its nature, must make long-range plans. At the meeting of the Edison Electric Institute earlier this year it was stated that the electric power and light industry planned to expend approximately $5,000,000,000 for new plant and equipment over the next 5 years. It is estimated that approximately 30 percent of the amount required outside of the funds generated internally through depreciation and retaining of earnings should be raised by the sale of common stock. It would be unwise and in conflict with the policy of the regulatory authorities to sell a disproportionate amount of senior securities, even if the buyers of such securities-mainly institutions-were ready to absorb them. Accordingly, if this vital industry is to go ahead with its plans for expansion-job-creating plans a healthy stock market is a necessary condition.

If the yield on outstanding common stocks is too high and the relation of price to earnings and prospective earnings inordinately low, the success of this program will be endangered. We are too often tempted to consider these matters as though they existed in tight, separate compartments. Deflation of security prices has a multiple effect. Holders of sound equities who find that their stocks are selling at prices which seem to be far out of line with earnings, dividends, and other accepted measures of value are likely to frown on investment in new and untried enterprises, or on adding to their holdings in the event that corporations seek additional funds as outlined.

In connection with the sizable amount of new offerings since the end of the war it must be considered that individual savings during the war period were unusually heavy and that we have passed through a period in which the fear of inflation was a factor in the purchase of equities. It seems absurd that, under the present circumstances of unprecedentedly high national income, stocks such as Atlantic City Electric Co. and Interstate Power Co. should fail of satisfactory bids for a new issue of common stock or that the divestment program of public-utility holding companies should be delayed because of fear of inability to dispose of common-stock interests in perfectly sound operating companies at satisfactory prices. There is evidence of a continued flow of stocks which have to be absorbed by the market although they do not represent company financing or new ventures. In numerous instances, often because of tax problems of individuals and estates, substantial stock holdings are disposed of by way of special offerings and secondary distributions. Representative issues of this character are the following:

Other evidence to the same effect may be found in the record of the disposal of equity holdings by large security holders, including officers and directors of corporations, pursuant to section 16 (a) of the Securities Exchange Act of 1934. Although complete analysis of the data has not been made by the Securities and Exchange Commission, from the information available it appears that, except for comparatively short periods of extreme weakness in the capital markets,

such as in the latter part of 1937 and in September of 1946, stockholders in the groups mentioned above on balance have been sellers."1

Because of the difficulties of accumulating capital in the last decade or more, capital has aged and, in order to pay estate taxes, assets have to be turned into cash. The assets to be liquidated are likely to be the most marketable; i. e., securities having good markets. Mr. Bernard Baruch has called attention to the constant pressure exerted on the stock market by estate taxes. The effect is that funds are diverted to purchase securities in well-established companies that might otherwise be used in venture-capital enterprises; nor do the funds raised by such necessitous selling add to the capital available for business expansion.2

The absence of as large a fund of venture capital as is generally assumed to exist is established by reference to two of the soundest and most basic industries; namely, fire insurance and commercial banking. The sharp increase in premium volume over the past several years has lowered the ratio of capital and surplus to premium volume in many companies to the point where additional capital is required. Yet, reports that such financing is contemplated have a depressing effect on the market value of insurance-company stocks, many of which now sell at substantially less than the stockholders' equity. Recently, Mr. Marriner S. Eccles, Chairman of the Board of Governors of the Federal Reserve System, declared that banks with low ratios of capital to risk assets should build up their capital, and that if retained earnings are insufficient, additional stock should be sold. The sale of additional stock, however, in effect is precluded by the fact that the stocks of most of even the strongest metropolitan banks have been selling at prices below their book value.

43

The current high price level and the expansion of industry required to meet our domestic requirements and position as the world's chief supplier of goods seem to assure the continued appearance of the "capital wanted" sign. Almost every important industry has indicated that large plans for capital expansion are under way. It remains to provide equal assurance that such financing can be done soundly. This will be true only if a sound condition prevails in the market for equity securities. We are not contending for any particular price level for common stocks. It is extremely significant that the spread between the yield on high-grade bonds and the dividend rate from stocks is greater than at any other time when common stocks were around the present prices.

At the beginning of October 1947 the yield on common stocks in the DowJones industrial average, which is composed generally of stocks of investment quality, was 4.97 percent, whereas the yield on high-grade bonds was approximately 2.78 percent. Any number of common stocks of sound companies are available at prices where the indicated yield is 6 percent and more. A continuation of this condition may well cause corporate executives to hesitate about carrying out their expansion plans. Such hesitation, if it develops into cancellation, would jeopardize the continuation of high employment.

Evidence of the difficulties of the capital market, as we have indicated, centers around

1. The inactivity of the stock market in relation to broad economic indexes. 2. The weakness of stocks of companies about to offer additional stock

for expansion purposes, and the increasing cost of equity money.

3. The flow of stocks on the market as the result of disposal by estates and large holders, and foreign liquidation.

Unfortunately, we have been lulled into complacency by the size of the liquid resources of business, the reported profits remaining after dividends, and the accumulated savings of individuals. Between March 31, 1946, and March 31, 1947, net working capital of corporations increased from 52.8 to 59 billion.* Never

41 Corporate "insiders" defined as officers, directors, and beneficial owners of more than 10 percent of any class of listed equity security must report transactions in such securities monthly to the Securities and Exchange Commission. Unquestionably tax considerations have been an important factor in such sales.

42 Mr. Bernard Baruch, testimony in hearings before the Senate Committee on Unemployment and Relief (1938), 75th Cong., 3d sess., p. 848. Estate taxes in 1936 totaled $449,000,000 compared with new money issues of $994,000,000. For the year 1946, estate taxes and gift taxes approximated $670,000,000, compared with new money security issues of approximately $$3,500,000,000. Federal Reserve Bulletin, July 1947, pp. 886 and 891. 43 Address before the National Association of Supervisors of State Banks, Washington, D. C., September 25, 1947.

44 Securities and Exchange Commission, Statistical Bulletin, vol. 6, No. 8, August 1947.