[Article] The Timing and Character of Investment Legislation

References to this essay should use the following citation: Prechter, Robert R. (2003). Pioneering Studies in Socionomics. Gainesville, Georgia: New Classics Library, pp. 219-228.

Introduction
Until now, no researcher outside Elliott Wave International and the Socionomics Institute has applied the socionomic insight when investigating relationships in social data. I am proud to say that just prior to the completion of this book, two academics have made a pioneering mark in being the first outside researchers to test and apply the socionomic hypothesis.

Washington State University finance professor Dr. John Nofsinger, an expert on the psychology of investing, and his colleague, Kenneth Kim, have been writing a book characterizing the stock mania of the 1990s. Nofsinger was considering recommending laws to temper investors’ behavior to prevent the bubble and crash cycle from repeating. He wondered, for example, whether incentives would work better than regulations.¹ Implied in this line of inquiry was the idea that regulation is causal to investor behavior.

We at the Socionomics Institute, contacted Nofsinger for a discussion. We suggested that he consider viewing financial laws not as causes of social behavior but as products of social behavior. Intrigued by this statement of causality, Nofsinger reviewed all major investment legislation from the 1920s to present. He found that the character of each new investment law reflected the direction of the stock market prior to its enactment. Moreover, the relationship held every time; there were no exceptions. As I would hasten to add, these results suggest, per the hypothesis, a process of cause and effect.

This is another example of how a socionomic perspective leads one to search for the right relationships. It does not take social actions as “givens” independent of human thought but rather ties preceding thoughts to resulting actions, in this case government legislation related to investing. A simple change in perspective shed the light. Nofsinger’s work would support an assertion that the socionomic insight is a prerequisite for understanding the social forces behind the making and unmaking of financial legislation, and their timing. Expansive legislation is a symptom of a maturing or completed positive mood trend, and restrictive legislation is a product of a maturing or completed negative mood trend.

Consider the implications were economists and politicians to take the unlikely path of viewing most legislation primarily as products of social mood. The endless debates about which new policy should be adopted in response to a preceding trend would end. A wiser tone and a longer term perspective would prevail, unleashing resources available for more productive purposes. It would be real progress.

Nofsinger has provided a model for other academic economists to work from. We encourage all to take note and follow his lead in considering the socionomic perspective when investigating social history.

– Robert Prechter

The government continually tightens and loosens its laws regarding the investment industry just as it continually raises and lowers income taxes. After each major bear market or scandalous period, the government enacts new laws to protect investors. Consider the new laws shown in Table 1. The securities acts passed in 1933 and 1934 followed the corporate governance problems of the late 1920s, the 1929 stock market crash, and the beginning of the Great Depression. The investment company and advisors acts in 1940 followed a bear market that took 25% of the value of the stock market. The late 1960s experienced a 30% bear market. In 1970, the government created the Securities Investor Protection Corporation (SIPC). Investor protection laws also followed the bear market of the early 1970s and the Black Monday market crash of October 19, 1987. And, of course, the recent corporate scandals combined with the severe stock market decline spawned the 2002 Public Company Accounting Reform and Investor Protection Act.

Table 1

Table 2

Unfortunately, the laws that are enacted to protect shareholders and investors are often repealed during times of economic strength and stock market euphoria. The 1920s and the 1990s had many similarities. Both decades experienced strong economic expansions and powerful bull markets. Indeed, investors at the end of each decade could have been called irrationally exuberant. In the middle (or toward the end) of the excitement over stocks, the government changed its laws that protected investors.

Consider the examples in Table 2. In 1927, the stock market was toward the end of a bull market that increased values over 200%. There were many new companies conducting IPOs that were not really strong enough to be offered to investors. Investors did not seem to care and rushed in to snap them up. The commercial banks were prevented from getting into the investment banking activities to share in the lucrative fees. They lobbied the government to change the rules and succeeded. Commercial banks began helping companies issue securities. Unfortunately, the stock market crash of 1929 left commercial banks with many losses that jeopardized people’s bank deposits. The people panicked and demanded their money back. Of course, banks did not have the cash to return all the deposits at once. That cash was loaned out. So, the banks had to close their doors.

Now, examine the three law changes in the 1990s. The Private Securities Litigation Reform Act limited the ability of investors to sue companies and executives for damages due to corporate fraud in federal courts. This law was enacted in the midst of a strong bull market that increased the value of the Dow Jones Industrial Average by 60%. It was followed three years later with a similar act that applied to state courts. The Financial Services Modernization Act allowed commercial banks to associate themselves with investment banks again. This is similar to the 1927 capitulation. Again, this reduction in investor protection occurred toward the end of a market rally that increased the Dow 125%.

Another recent example is not listed in the table. In 1997, the SEC proposed new rules that would have severely limited the ability of shareholders to introduce corporate resolutions. The procedure for the SEC to enact new rules is that the regulator proposes a new rule and then provides a time period in which people can comment on the rule. A consortium of investor activists lobbied strongly against the new rule. In the end, the SEC decided not to enact the new limitations. Even though it was defeated, this is still an example of how investor protections are often reversed or limited during an extended bull market.

Our point is that laws are frequently made to protect shareholders and investors. This usually occurs after people become angry over scandals and a bear market. However, these protections can also be reversed in the midst of good times. A strong economy and good bull market lead to pressure on lawmakers to loosen restrictions on corporate participants. The loosened restrictions have the potential to help push the stock market from a bull market to a bubble market.³ When a bubble occurs, a crash will inevitably follow. This leads to more scandals and more investor protection laws. We need to avoid this cycle.⁴

Yet, the social mood can be represented by stock prices. The level of the stock market indicates what kind of mood the people are in. This dictates the tone and character of the resulting action by government, regulators, and investors. The relationship we show between how the stock market has performed and the resulting legislation5 illustrates this point.

EDITOR’S NOTES:
¹ This thinking reflects the conventional viewpoint, not the socionomic perspective.

² Excerpted from Nofsinger, John and Kenneth Kim, Infectious Greed: Restoring Confidence in America’s Companies, Financial Times Prentice Hall, forthcoming 2003, January.

³ Socionomists would maintain that loosened restrictions do not “push the stock market from a bull market to a bubble market” but rather that the shared psychology of a late-stage bull market pushes investors, CEOs and regulators to loosen restrictions.

⁴ Bull and bear markets can neither be avoided nor changed. Whether the behavior of lawmakers can change may be open to debate, but we are skeptical.

⁵ The August 1, 1997 issue of The Elliott Wave Theorist also cited the SEC’s adoption of “Rule 144a” in 1990/1992, which loosened reporting laws for restricted securities in order to induce foreign corporations to sell bonds – typically “junk” bonds – to U.S. institutions. The Wave Principle of Human Social Behavior cites related legislation, the Monetary Control Act of December 1980, which was enacted in response to the preceding entire decade’s accelerating inflation, which had in fact already ended in January of that very year.

A Graphical Summary of Nofsinger’s Observations
We always find graphics instructive. Figure 1 summarizes Nofsinger’s observations. The upper arrows mark the timing of expansive legislation, and the lower arrows mark the timing of restrictive legislation. Note that the former type occurs late in bull markets, the latter type late in or after bear markets. It should be particularly impressive to Elliotticians that the essentially identical laws of 1927 and 1999 combining commercial and investment banking (see the asterisks on the graph) occurred near the end of a stock mania within a wave V of Cycle degree (labels not shown; see Figure 1 on page 78).

Figure 1

Mr. Graham concurrently expanded upon this theme in response to an article in The New Republic.

The New Republic
October 21, 2002
Letter to the Editor

In the first part of “Busted,”¹ George Soros deftly outlines the nature of boom and bust market behavior. The theory of reflexivity is a step in the right direction, but it misses the big picture. Soros’s article sounds like an echo of the sentiments expressed in 1932. Then, as now, many prescriptions for controlling the behavior of market participants were implemented. Indeed, shortly after each bear market dating back to the Depression –1933, 1934, 1940, 1970, 1974 and 1988 – legislation was introduced to protect investors with the intention of producing a more stable investment environment. What happened?

As stocks broke out of their slump in the early 1980s, an increasingly positive social mood brought forth a new set of “values”: market fundamentalism. After the 1987 hiccup, the markets, propelled by social mood, gained a full head of steam, and the “protections” offered in the previous bear markets were altered, ignored and ultimately scoffed at, reflecting the blossoming euphoria and the desire for “financial gain irrespective of how it is achieved.”

Bear markets produce regulation in response to the public’s demand for protection, and bull markets dissolve them. As Mr. Soros points out, investors in the bull market had put a premium on management’s ability to massage the numbers; the euphoria driving outrageous stock valuations drives equally outrageous social events.

From this perspective, the concept of equilibrium seems mighty strange, for the market is in constant flux. Mr. Soros’s search for just the right amount of legislation and the proper values hints at “equilibrium seeking.” However, no such thing exists in society or has ever existed. The fluctuating patterns of social mood are fundamental and ceaseless. One silver lining of the current bear market may be that it will cause a paradigm shift away from the search for market equilibrium(s) and toward a model that reflects an obvious reality: Social mood is never at “equilibrium,” and its constant flux drives social action, including actions designed – futilely – to stop it.

-Gordon Graham
The Socionomics Institute
Gainesville, GA

Notes:
¹ Soros, George. (2002, September 2). “Busted.” The New Republic. http://www.tnr.com.

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Most economists, historians and sociologists presume that events determine society’s mood. But socionomics hypothesizes the opposite: that social mood regulates the character of social events. The events of history—such as investment booms and busts, political events, macroeconomic trends and even peace and war—are the products of a naturally occurring pattern of social-mood fluctuation. Such events, therefore, are not randomly distributed, as is commonly believed, but are in fact probabilistically predictable. Socionomics also posits that the stock market is the best available meter of a society’s aggregate mood, that news is irrelevant to social mood, and that financial and economic decision-making are fundamentally different in that financial decisions are motivated by the herding impulse while economic choices are guided by supply and demand. For more information about socionomic theory, see (1) the text, The Wave Principle of Human Social Behavior © 1999, by Robert Prechter; (2) the introductory documentary History's Hidden Engine; (3) the video Toward a New Science of Social Prediction, Prechter’s 2004 speech before the London School of Economics in which he presents evidence to support his socionomic hypothesis; and (4) the Socionomics Institute’s website, www.socionomics.net. At no time will the Socionomics Institute make specific recommendations about a course of action for any specific person, and at no time may a reader, caller or viewer be justified in inferring that any such advice is intended.

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