History of the Stock Market

Amazing Market

Why does the stock market exist?

The answer begins in the formative years of the United States, in our first capital, New York. This was where the new government looked when it wanted to borrow money from the public to pay debts from the Revolutionary War. Following Alexander Hamilton's Report on Public Credit in 1790, the fledgling government decided to sell bonds and use the funds to pay back at face value the IOUs both it and the states had issued to finance the war. These bonds marked the beginning of America's financial markets because they were the first major issue of publicly traded securities. Once the bonds were issued, private investors began trading them among one another.


Essential Liquidity

Hamilton understood the importance of a financial market that provided liquidity and allowed investors to trade securities among themselves. Hamilton also understood that unless investors could later sell the bonds for cash, they'd be unlikely to buy them from the government in the first place. As a result, early in our nation's history, a stock market was created to provide investors with the ability to exchange a financial asset for cash. The stock market enabled the newly established government to sell bonds to pay the war debt - a debt that Hamilton called "the price of liberty" because it helped finance the nation's independence. The New York Stock Exchange made its formal appearance in 1792. It was literally a place on a New York City street (Wall Street) where people gathered and traded bonds like those of the new government. "The New York Stock Exchange, in fact, originated in 1792 as a bond exchange," said former chairman of the Securities and Exchange Commission (SEC), Arthur Levitt. In 1792 the word stock referred to a long-term IOU, such as a government bond. The word didn't mean what it does today, a share of ownership in a corporation.


New Companies for New Challenges

Stocks, as we now know them, became more numerous in the next century as the American economy outgrew the business organizations common in those times. Building a railroad, for instance, was no task for a small proprietorship or partnership with its limited funds. Instead, it required large organizations able to attract sufficient savings from the public to tackle these enormous tasks. A corporation could do just that by selling shares of ownership to many stockholders. Shareholders would then own a portion of any earnings, while their potential loss was limited to the amount each had invested in a company's stock. As Hamilton had earlier recognized with government bonds, investors will buy new shares of stock only if they're able to sell them later on if they want their cash back. Here again the "market of stocks" provided the liquidity for investors to do just that. By the late 1800s, stocks of publicly owned corporations were trading on the New York Stock Exchange. When Charles Dow created the Dow Jones Industrial Average in 1896, it consisted of stocks from the 12 industrial companies shown below:

The Dow has changed over time as new companies sold stocks or bonds and thereby put investors' savings to work. Here again the liquidity provided by the stock market offered the necessary reassurance for investors to buy the new stocks when issued. As the new companies grew and prospered, they were able to provide a return to investors in exchange for the risk they assumed by buying and owning their stocks.


Market Signals

By bringing investors together, the stock market performed another important function. It generated prices that reflected investors' best estimates of each company's future potential. Technological changes - such as the telegraph, ticker tape, telephone, and now the Internet - have broadened and deepened the market by assembling in one marketplace buy and sell offers from investors everywhere. The stock prices that emerge from these offers provide important signals to direct the nation's savings to those companies most likely to use the money productively. As investors avoid companies with poor prospects for growth and earnings, their stock prices fall and thereby direct savings away from them. Conversely, investors bid up the stock prices of companies with bright prospects. These companies find it easier to sell new shares to raise money for their expansion.

The stock market exists to provide investors with the liquidity they require to invest in the stocks that corporations want to sell to raise funds for their start-up and expansion. In providing this service, the stock market plays a more profound role. It identifies and directs the nation's savings to the most productive companies - companies which then generate the employment, income, and taxes that support the high living standards we enjoy today. The stock market accomplishes these important tasks even if investors themselves have little or no understanding of them. By seeking the best return in the stock market over the decades, investors have helped build America's prosperous economy.

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