The Speculative Cycle

Most experienced professional traders in the stock market will readily admit that the minor fluctuations, amounting to perhaps five or ten dollars a share in the active speculative issues, are chiefly psychological. They result from varying attitudes of the public mind, or, more strictly, from the mental attitudes of those persons who are interested in the market at the time.

Such fluctuations may be, and often are, based on "fundamental" conditions — that is, on real changes in the dividend prospects of the stocks affected or on variations in the earning power of the corporations represented — and again they may not. The broad movements of the market, covering periods of months or even years, are always the result of general financial conditions; but the smaller intermediate fluctuations represent changes in the state of the public mind, which may or may not coincide with alterations in basic factors.

To bring out clearly the degree to which psychology enters into the stock market problem from day to day, it is only necessary to reproduce a conversation between professional traders such as may be heard almost any day in New street or in the neighboring cafes.

> "Well, what do you know?" says one trader to the other.

> "Just covered my Steel," is the reply. "Too much company. Everybody seems to be short."

> "Everybody I've seen thinks just as you do. Each one has covered because he thinks everybody else is short — still the market doesn't rally much. I don't believe there's much short interest left, and if that's the case we shall get another break."

> "Yes, that's what they all say — and they've all sold short again because they think everybody else has covered. I believe there's just as much short interest now as there was before."

It is evident that this series of inversions might be continued indefinitely. These alert mental acrobats are doing a succession of flip-flops, each one of which leads up logically to the next, without ever arriving at a final stopping-place.

The main point of their argument is that the state of mind of a man short of the market is radically different from the state of mind of one who is long. Their whole study, in such a conversation, is the mental attitude of those interested in the market. If a majority of the volatile class of in-and-out traders are long, many of them will hasten to sell on any sign of weakness and a decline will result. If the majority are short, they will buy on any development of strength and an advance may be expected.

The psychological aspects of speculation may be considered from two points of view, equally important. One question is, What effect do varying mental attitudes of the public have upon the course of prices? How is the character of the market influenced by psychological conditions?

A second consideration is, How does the mental attitude of the individual trader affect his chances of success? To what extent, and how, can he overcome the obstacles placed in his pathway by his own hopes and fears, his timidities and his obstinacies?

These two points of view are so closely involved and intermingled that it is almost impossible to consider either one alone. It will be necessary to take up first the subject of speculative psychology as a whole, and later to attempt to draw conclusions both as to its effects upon the market and its influence upon the fortunes of the individual trader.

As a convenient starting point it may be well to trace briefly the history of the typical speculative cycle, which runs its course over and over, year after year, with infinite slight variations but with substantial similarity, on every stock exchange and in every speculative market of the world — and presumably will continue to do so as long as prices are fixed by the competition of buyers and sellers, and as long as human beings seek a profit and fear a loss.[^1] Beginning with a condition of dullness and inactivity, with small fluctuations and very slight public interest, prices begin to rise, at first almost imperceptibly. No special reason appears for the advance, and it is generally thought to be merely temporary, due to small professional operations. There is, of course, some short interest in "the market, mostly, at this time, of the character sometimes called a "sleeping" short interest. An active speculative stock is never entirely free from shorts.

As there is so little public speculation at this period in the cycle, there are but few who are willing to sell out on so small an advance, hence prices are not met by any large volume of profit-taking. The smaller professionals take the short side for a turn, with the idea that trifling fluctuations are the best that can be hoped for at the moment and must be taken advantage of if any profits are to be secured. This class of selling brings prices back almost to their former dead level.

Soon another unostentatious upward movement begins, carrying prices a trifle higher than the first. A few shrewd traders take the long side, but the public is still unmoved and the sleeping short interest — most of it originally put out at much higher figures — still refuses to waken.

Gradually prices harden further and finally advance somewhat sharply. A few of the more timid shorts cover, perhaps to save a part of their profits or to prevent their trades from running into a loss. The fact that a bull turn is coming now penetrates through another layer of intellectual density and another wave of traders take the long side. The public notes the advance and begins to think some further upturn is possible, but that there will be plenty of opportunities to buy on substantial reactions.

Strangely enough, these reactions, except of the most trifling character, do not appear. Waiting buyers do not get a satisfactory chance to take hold. Prices begin to move up faster. There is a halt from time to time, but when a real reaction finally comes the market looks "too weak to buy," and when it starts up again it often does so with a sudden leap that leaves would-be purchasers far in the rear.

At length the more stubborn bears become alarmed and begin to cover in large volume. The market "boils," and to the short who is watching the tape, seems likely to shoot through the ceiling at almost any moment. However firm may be his bearish convictions, his nervous system eventually gives out under this continual pounding, and he covers everything "at the market" with a sigh of relief that his losses are no greater.

About this time the outside public begins to reach the conclusion that the market is "too strong to react much," and that the only thing to do is to "buy 'em anywhere." From this source comes another wave of buying, which soon carries prices to new high levels, and purchasers congratulate themselves on their quick and easy profits.

For every buyer there must be a seller — or, more accurately, for every one hundred shares bought one hundred shares must be sold, as the actual number of persons buying at this stage is likely to be much greater than the number of persons selling. Early in the advance the supply of stocks is small and comes from scattered sources, but as prices rise, more and more holders become satisfied with their profits and willing to sell. The bears, also, begin to fight the advance by by selling short on every quick rise. A stubborn professional bear will often be forced to cover again and again, with a small loss each time, before he finally locates the top and secures a liberal profit on the ensuing decline.

Those selling at this stage are not, as a rule, the largest holders. The largest holders are usually those whose judgment is sound enough, or whose connections are good enough, so that they have made a good deal of money; and neither a sound judgment nor the best advisers are likely to favor selling so early in the advance, when much larger profits can be secured by simply holding on.

The height to which prices can now be carried depends on the underlying conditions. If money is easy and general business prosperous a prolonged bull movement may result, while strained banking resources or depressed trade will set a definite limit to the possible advance. If conditions are bearish, the driving of the biggest shorts to cover will practically end the rise; but in a genuine bull market the advance will continue until checked by sales of stocks held for investment, which come upon the market only when prices are believed to be unduly high.

In a sense, the market is always a contest between investors and speculators. The real investor, looking chiefly to interest return, but by no means unwilling to make a profit by buying low and selling high, is ready, perhaps, to buy his favorite stock at a price which will yield him six per cent, on his investment, or to sell at a price yielding only four per cent. The speculator cares nothing about interest return. He wants to buy before prices go up and to sell short before they go down. He would as soon buy at the top of a big rise at any other time, provided prices are going still higher.

As the market advances, therefore, one investor after another sees his limit reached and his stock sold. Thus the volume of stocks to be carried or tossed from hand to hand by bullish speculators is constantly rolling up like a snowball. On the ordinary intermediate fluctuations, covering five to twenty dollars a share, these sales by investors are small compared with the speculative business. In one hundred shares of a stock selling at 150, the investor has $15,000; but with this sum the speculator can easily carry ten times that number of shares.

The reason why sales by investors are so effective is not because of the actual amount of stock thrown on the market, but because this stock is a permanent load, which will not be got rid of again until prices have suffered a severe decline. What the speculator sells he or some other trader may buy back tomorrow.

The time comes when everybody seems to be buying. Prices become confused. One stock leaps upward in a way to strike terror to the heart of the last surviving short. Another appears almost equally strong, but slips back unobtrusively when nobody is looking, like the frog jumping out of the well in the arithmetic of our boyhood. Still another churns violently in one place, like a side-wheeler stuck on a sand-bar.

Then the market gives a sudden lurch downward, as though in danger of spilling out its unwieldy contents. This is hailed as a "healthy reaction," though it is a mystery whom it can be healthy for, unless it is the shorts. Prices recover again, with everybody happy except a few disgruntled bears, who are rightly regarded with contemptuous amusement.

Curiously, however, there seems to be stock enough for all comers, and the few cranks who have time to bother with such things notice that the general average of prices is now rising very slowly, if at all. The largest speculative holders of stocks, finding a market big enough to absorb their sales, are letting go. And there are always stocks enough to go around. Our big capitalists are seldom entirely out of stocks. They merely have more stocks when prices are low and fewer when prices are high. Moreover, long before there is any danger of the supply running out, plenty of new issues are created.

When there is a general public interest in the stock market, an immense amount of realizing will often be absorbed within three or four days or a week, after which the deluge; but if speculation is narrow, prices may remain around top figures for weeks or months, while big holdings are fed out, a few hundred shares here and a few hundred there, and even then a balance may be left to be thrown over on the ensuing decline at whatever prices can be obtained. Great speculative leaders are far from infallible. They have often sold out too soon and later have seen the market run away to unexpected heights, or have held on too long and have suffered severe losses before they could get out.

In this selling the bull leaders get a good deal of undesired help from the bears. However wary the bulls may be in concealing their sales, their machinations will be discovered by watchful professionals and shrewd chart students, and a considerable sprinkling of short sales will be put out within a few points of the top. This is one of the reasons why the long swings in active speculative stocks are smaller in proportion to price than in inactive specialties of a similar character — contrary to the generally received impression. It is rare that any considerable short interest exists in the inactive stocks.

Once the top-heavy load is overturned, the decline is usually more rapid than the previous advance. The floating supply, now greatly increased, is tossed about from one speculator to another at lower and lower prices. From time to time stocks become temporarily lodged in stubborn hands, so that part of the shorts take fright and cover, causing a sharp upturn; but so long as the load of stocks is still on the market the general course of prices must be downward.

Until investors or big speculative capitalists again come into the market, the load of stocks to be carried by ordinary speculative bulls increases almost continually. There is no lessening of the floating supply of stock certificates in the Street, and there is a gradual increase in the short interest; and of course the bulls have to carry these short sales as well as the actual certificates, since for every seller there must be a buyer, whether the sale be made by a short or a long. Shorts cover again and again on the sharp breaks, but in most cases they put out their lines again, either higher or lower, as opportunity offers. On the average, the short interest is largest at low prices, though there are likely to be periods during the decline when it will be larger than at the final bottom, where buying by shorts often helps to avert panicky conditions.

The length of this decline, like the extent of the preceding advance, depends on fundamental conditions; for both investors and speculative capitalists will come into the market sooner if all conditions are favorable than they will in a stringent money market or w r hen the future prospects of business are unsatisfactory. As a rule, buyers do not appear in force until a "bargain day" appears. This is when, in its downward course, the heavy load of stocks strikes an area honeycombed with stop loss orders. Floor traders seize the opportunity to put out short lines and a general collapse results.

Here are plenty of stocks to be had cheap, and shrewd operators — large and small, but mostly large or on the way to become so — are busy picking them up. The fixed limits of many investors are also reached by the sharp break, and their purchases disappear, to be seen in the Street no more until the next bull turn.

Many shorts cover on such a break, but not all. The sequel to the "bargain day" is a big short interest which has overstayed its market, and a quick rally follows; but when the more urgent shorts get relief, prices sag again and fall into that condition of lethargy from which this consideration of the speculative cycle started.

The movements described are substantially uniform, whether the cycle be one covering a week, a month, or a year. The big cycle includes many intermediate movements, and these movements in turn contain smaller swings. Investors do not participate to any extent in the small swings, but otherwise the forces involved in a three-point turn up and down are substantially the same as those which appear in a thirty-point cycle, though not so easy to identify.

The fact will at once be recognized that the above description is, in essence, a story of human hopes and fears; of a mental attitude, on the part of those interested, resulting from their own position in the market, rather than from any deliberate judgment of conditions ; of an unwarranted projection by the public imagination of a perceived present into an unknown though not wholly unknowable future.

Laying aside for the present the influence of fundamental conditions on prices, it is our task to trace out both the causes and the effects of these psychological elements in speculation.

[^1]: The writer discussed this subject rather fully in the Quarterly Journal of Economics, Vol. XVI, No. 2. The article will also be found extensively summarized and quoted in Vol. VII of "Modern Business," edited by Joseph French Johnson, Dean of New York University School of Commerce.