B. Mark Smith
Toward Rational Exuberance: The Evolution of Modern Stock Market

What a pleasant surprise Toward Rational Exuberance turned out to be! In this very well-written account of a history of the stock market Smith keeps things lively while still doing an excellent job of educating.

I would recommend this book to practically anyone. Those who dabble in the market or those who are planning to should find it especially interesting and informative. The book provides a perspective that every investor should have in the back of their minds somewhere. Too often in the 90s that perspective was lost (and most seemed to assume that the market would post double digit gains yearly despite the fact that the economy wasn't growing that fast) and again in the early part of this century it seems to be lost again with many people becoming overly bearish. We seem to look at the short run results too much and forget about the long run and general, overall reasonableness when it comes to valuation.

The book is not without its flaws, however. For instance, when discussing the 1929 crash and the subsequent depression, Smith downplays the events as if the stock market piece of the depression wasn't that big of a deal. Later in the book he seems to reverse this thought without explanation. Also, while initially seeming to fall into the "behaviorist" camp when it comes to the market he later becomes very anti-behaviorist and pro-efficient market hypothesis. In order to do so he has to eliminate looking at individual companies, sectors, or the short term. By watering down the theory so much anyone could hop into bed with the efficiency advocates, but in so doing the hypothesis becomes almost meaningless. The market simply isn't as efficient as the non-behaviorists would have you believe. You can just look at any stock or index that drops several percent before rebounding several percent on no news that should cause such swings to see that fact. If the market was efficient we'd see far more smoothness in the trends on a daily, weekly, monthly, etc. basis. But emotions and follow-the-leader strategies seem to play a part in things. On pages 228-9 Smith seems convinced that "bubbles" have never existed. He completely ignores the internet stocks, however, which had already begun their downfall before this book was published. I wonder if his tone on this issue would have changed a bit had he been writing in 2002 instead of in 2000 and 2001? Probably not.

A point on the subject of market efficiency that I do agree with Smith on is that the market is evolving toward greater efficiency. (See page 304.) That's what we'd all expect though with better and faster access to information. As mentioned on page 290 (and then irrationally discounted on the following page), however, more information can frequently lead to predictable behavioralist reactions. A particular stock that I watch, for instance, always jumps a few points when a new analyst issues a "buy" or "strong buy" rating on it, only to settle back to its former level within a week or two. I get the feeling that the brokerage house of the analyst takes a position, issues the good rating, and then sells into the strength the rating (and not any fundamental changes with the company) provided. Nothing has changed with the company during the time frame so the price jump and then relaxation can only be attributed to the irrational behavior of investors relying on biased analysts with their own interests and not to an efficient market valuing the company at what it is worth.

Even though I disagree with some of Smith's interpretations I still think this is a great book. His descriptions of things that are sometimes difficult for new investors to grasp such as preferred stock, short positions, options, risk/return, and other items are clear and concise. As mentioned above, the most valuable feature to be gleaned from Toward Rational Exuberance is the broad overview of the history of the market which provides a vantage point that should never be forgotten by those of us who sometimes have a hard time remembering the long run and history itself.

from the publisher:
To an unprecedented degree, the health of the American economy, and the financial well-being of the average American, is tied to the stock market. Toward Rational Exuberance tells the story of how the market came to be what it is today, providing an in-depth understanding of the theories that drive investor behavior, the vivid personalities who have dominated the stock market's turbulent history, and the processes by which the market has evolved to its present state -- elements essential to anyone seeking to understand the workings of the modern economy.

The stock market is big news now, influencing every aspect of the modern economy. Accepted wisdom has it that the market will provide retirement security for anyone willing to diligently save and invest.

Yet many people still alive can remember a very different time, when the stock market was little more than a primitive insider's game viewed by most Americans with skepticism and suspicion. In Toward Rational Exuberance, B. Mark Smith, a retired stock trader with nearly two decades of practical experience, tells the story of how this stunning transformation occurred. It is a fascinating story, involving colorful personalities, dramatic events, and revolutionary new ideas. In the course of the narrative, Smith traces the evolution of popular theories of stock market behavior, showing how they have become widely accepted over time and have greatly influenced the way the investing public views the market. But he also shows how some of these theories -- such as the notion that the market is often susceptible to speculative "bubbles" that will inevitably burst -- are based on faulty interpretations of market history that may lead investors to draw inaccurate conclusions about the market today.

The central thesis of Toward Rational Exuberance is that the modern stock market is the product of a dynamic evolutionary process; it is very different from what it was in the past. It cannot be measured simply by comparison with arbitrary historical standards, and its behavior cannot be predicted by extrapolating those standards into the future. It is only by understanding the process by which the modern market has been created that today's investor can begin to understand the market itself.

B. Mark Smith was a professional stock trader for nearly two decades, first with CS/First Boston Corporation, where he became director, then as a vice president of Goldman, Sachs & Co.

"Smith is savvy . . . [His] history of the modern stock market, detailing its transmogrification from a 'gambling hell' run by speculators and cronies to a rational, sophisticated exchange open to all, [is] exquisitely revealing and written with real polish: a first-class account." --Kirkus Reviews
The following is an excerpt from the book Toward Rational Exuberance: The Evolution of the Modern Stock Market by B. Mark Smith.

The story of the American stock market actually begins late in the eighteenth century, along a narrow lane at the southern end of Manhattan Island. Given the name Wall Street after a wall built in the 1600s by Dutch authorities administering the colony of New Amsterdam, the seemingly insignificant street would soon come to symbolize the country's financial markets. Eventually, no other street in the world would carry with its name such connotations of wealth and power.

The first marketplace of sorts developed at the eastern end of Wall Street as early as the 1600s; the first items traded were not stocks but commodities and slaves. By the 1790s, after the United States Constitution established a strong federal government, trading in financial instruments became predominant, consisting mostly of U.S. government bonds and the bonds sold by various states to finance internal improvements. A few bank and insurance stocks (totaling no more than half a dozen) were also traded. In the spring of 1792, a group of twenty-four merchants banded together to form an association of "Brokers for the Sale of Public Stock." Called the Buttonwood Agreement because transactions among the brokers were to take place near a buttonwood (sycamore) tree, the regulations establishing the new association were simple. Essentially, all that was required was that the broker-members agree to charge customers a minimum commission and give each other preference in all dealings.

Not long afterward the nascent stock market suffered its first scandal. The crisis was precipitated by aggressive speculation led by former Assistant Secretary of the Treasury William Duer. In early March 1792, when an audit uncovered a $250,000 discrepancy in the government accounts Duer had controlled in his Treasury job, confidence in him was lost and the prices of securities he was heavily involved in tumbled. On March 10, Duer announced that he would be unable to meet his obligations; he was subsequently thrown into debtor's prison. The market was paralyzed by panic. It was estimated that the total losses ran to as much as $3 million, a fantastic sum at the time, an amount equal to the savings "of almost every person in the city, from the richest merchants to even the poorest women and the little shopkeepers."

One stunned New Yorker commented, "The town here has rec'd a shock which it will not get over in many years." Many leading merchants were ruined, and trade came to a halt as ships languished at wharves with no buyers for their cargoes. Artisans and laborers suddenly lost their jobs, and farmers were unable to sell their produce. Duer was lucky to be in jail, where he was at least protected from angry mobs. But critics turned their attention to what they saw as excessive speculation in the market itself, with even Treasury Secretary Alexander Hamilton denouncing "unprincipled gamblers."

It was a condemnation that would be repeated many times throughout American financial history. Hamilton's caustic remarks anticipated a debate about the nature of the stock market that continues to this day. The economic purpose of a stock market is to raise equity capital for businesses that need it and to provide a mechanism for valuing shares of those businesses on an ongoing basis. But does the market consistently accomplish these tasks in a rational, efficient manner? Or do periodic bouts of speculative excess, followed by "panics" like the one in 1792, cause the market to take on the characteristics of a gambling casino?

Fortunately, in the 1790s the stock market was relatively small and, outside New York City, of limited importance in an overwhelmingly agrarian economy. In spite of dire predictions to the contrary, the country soon recovered from the panic of 1792. Subsequent decades would bring the industrial revolution to the United States, with a concomitant increase in the size of the stock market and its importance to the national economy. But the issues raised by Hamilton's comments would not go away. In 1815 the first stock issued by a business other than a bank, insurance, or canal company -- the New York Manufacturing Company -- appeared in published quotations. It began trading at $105 per share, then declined steadily into the 60s, finally disappearing in 1817. But other industrial concerns soon followed, as mechanical power, in the form of steam engines, became available to factories. Businesses now often required more capital than a single individual could provide; hence the "joint stock" company (the forerunner of the modern corporation) over time became a popular form of business organization, replacing sole proprietorships and partnerships. And the stock market became the vehicle through which joint-stock companies could raise the capital they needed.

In 1817 the New York Stock and Exchange Board (the predecessor of the New York Stock Exchange) was formed by brokers who felt the market needed more structure than was provided by the original Buttonwood Agreement and its subsequent modifications. The constitution drawn up for the Exchange Board has survived, with various amendments, to the present day. However, the marketplace in 1817 was very different from that which now exists. Trading took place in a restricted format that did not permit a continuous market, and most of the transactions that occurred still involved government bonds, not stocks.

The means by which business was transacted on the Exchange Board appears quite antiquated today. Each business day the president of the board would call out, one by one, the names of the securities listed on the board. After each "call," broker-members could bid for or offer that particular security; when a buyer and seller agreed on a quantity and a price, a transaction would occur and be duly recorded. As soon as activity ceased in a given name, the president would call out the next name, and so on.

From its moment of inception, the board sought to achieve a certain exclusivity of membership, to ensure that members were of appropriate social standing and also to limit competition. After the board was organized, only one new member was admitted in 1817, even though there were numerous applications. The broker-members earned their income as agents, buying and selling securities for their customers, rather than actively trading for themselves. Efforts to manipulate prices were forbidden. One of the first rules promulgated was a ban on "wash" sales, where one individual would effectively sell stock to himself through the board in order to create the false appearance of activity at a particular price. The Exchange Board was a gentlemen's club, and meant to remain one.

One problem that plagued the early stock market was a dearth of information about the companies whose shares were traded. The first recorded instance of the Exchange Board requesting financial data on a listed company occurred in 1825, when the board wrote to the New York Gas Light Company requesting information so that "the public might be informed through us of the existing state of things in relation to this company." This request was refused. Most companies took the position that information on company finances was nobody's business but their own and refused to divulge anything meaningful.

In its early years activity on the Exchange Board was sporadic. Large transactions, when they occurred, would usually be negotiated privately, outside the board itself, despite periodic efforts by board authorities to prevent this from happening. On March 16, 1830, in what would be the slowest day ever, only 31 shares officially changed hands. But this was soon to change. In the fall of 1830, shares of the first railroad to trade on the board, the Hudson and Mohawk, were listed. Many other railroads would follow. The substantial amounts of capital needed to finance the new industry required large numbers of stockholders and greatly increased the importance of an open stock market, accessible to all investors.

By 1837 the United States had more miles of completed railroads than any other country. But in that year the nation experienced a very unpleasant shock -- a severe stock market crash. The nation's unstable banking system, consisting of poorly regulated state-chartered banks, collapsed under the burden of rampant speculation in western lands and in the new railroads. The banking crisis pulled down the stock market and left a bitter hangover in the form of a depression that would last six years. The rapid stock price fluctuations of the period also brought to the fore a new type of professional market participant, more interested in exploiting short-term moves in share prices than in executing orders for outside investors. A former clerk named Jacob Little was the most prominent of the new breed, and was soon almost universally despised in the small Wall Street community.

Little was a tall, slender man, with a slight stoop and a curt, cold manner. He dressed carelessly and made no real effort to fit into the clubby atmosphere of the Exchange Board. He profited from the 1837 market collapse through a technique he is credited with inventing -- the "short sale" of stock. As practiced by Little, short-selling involved the sale of stock for delivery at a future date, often six to twelve months later. Little would gamble that share prices would fall in the interim, allowing him to buy back at a lower price the stock he would be required to deliver in the future. While this method of short-selling differs mechanically from the way in which short sales are transacted today, the objective is the same -- to profit from a decline in the market. Needless to say, in a time of crisis such as the 1837 panic, a short-selling market operator who openly profited from the distress of others could be (and was) quite unpopular.

Little was the first professional "bear" in the history of the American stock market. The term "bear," as applied to a speculator who believed prices would fall, was derived from the well-known proverb "to sell the bear's skin before one has caught the bear" -- in other words, to contract to sell something one does not yet own. "Bears" were opposed in the market by "bulls " -- strong, powerful animals who would push prices higher. Little's practice of aggressively trading stocks to profit from short-term fluctuations did not sit well with the gentlemen members of the Exchange Board. Over the next two decades Little would be forced into bankruptcy four times, at least partly as a result of organized efforts by other brokers who reviled him. He was able to recover and resume his activities three times but was finally done in by the panic of 1857. There would be many others to replace him. As much as the leading members of the Exchange Board wished to preserve the genteel character of their business, economic realities did not allow them to do so. The stock market was now a fundamentally different game, with a different set of players.