THE GREAT CRASH – Part VI

A more recent book published on the 1929 crash is The Causes of the 1929 Stock Market Crash, written by Harold Bierman, Jr., a professor at Cornell University. Bierman applies modern standards of market valuation to analyze 1929 stock prices.

First, he concludes that the market P/E ratio in 1929 was 16.3 to 1. Then, using the discounted cash-flow model developed many years after the 1929 crash, he finds that an annual rate of dividend increase of 3.6% would have been sufficient, by later standards, to support the 1929 market P/E.

In fact, the rate of dividend increases throughout the 1920s was significantly higher than 3.6%, and even conservative estimates of future dividend growth were at least as great. Bierman does admit that certain segments of the market appear to have been overvalued in 1929; he specifically cites electric utilities, which were among the speculative growth vehicles of the late 1920s. But, like Sirkin, Bierman argues that this overvaluation was confined to limited sectors and did not infect the market as a whole.

Bierman’s reasoning seems quite convincing. It is hard to argue, by modern standards, that the stock market as a whole was overvalued in 1929. But of course, modern standards were not used (and many of the models now employed to evaluate stocks didn’t even exist) in the late 1920s. This is the essence of the problem. If 1929 is judged by standards previously prevailing, stock prices were too high. But if the bull market of the 1920s is instead seen as part of a transition from traditional, conservative standards to the modern approaches used today, it does not appear that prices were far out of line.

The close association of the 1929 crash with the subsequent Depression invariably taints efforts to analyze the crash itself. It is commonly believed that the crash somehow “predicted” the onset of the Depression. In fact, the economy began to turn down in August 1929, two months before the crash. Such was the state of economic statistics at the time, however, that no one could have been certain a serious recession, let alone a depression, was developing until many months later. To argue that the collective action of market participants in October 1929 anticipated the Depression of subsequent years is to impute an omniscience to stock traders that is simply not credible.

While the crash could not have “predicted” the Great Depression, could not the precipitous market collapse have caused, or at least exacerbated, the economic contraction of the 1930s? John Kenneth Galbraith implies that the answer to this question is yes. His argument is based on what economists would now call the “wealth effect,” whereby a sharp drop in the stock market suddenly reduces the wealth of investors, causing them to feel less prosperous and to, therefore, spend less. Declining consumer spending slows the economy, perhaps resulting in a depression. If simultaneously affected by other contractionary economic forces, the recession could very well slip into a depression.

In 1929 one-third of all individual income in the United States was received by the top 5% of the population. According to Galbraith, this unequal distribution of income made the economy very susceptible to a stock market “shock” that would disproportionately affect the high-income individuals who were most involved in the market. If those people suddenly cut back on their spending, the economy could be adversely affected. Galbraith reasons that something like this may very well have happened in 1929.

If the 1929 crash did not either predict or cause the subsequent depression, what, then, is its significance? In reality, probably much less than has been made of it over the years. Stocks fell more than 40% from the September 3 high to the mid-November low, undeniably a substantial decline, but not much different in magnitude from what had occurred in several nineteenth century panics, 1907, or the bear market of 1919-1921. Declines of similar magnitude would later occur in 1937, 1969-1970, and 1973-1974, 2000-2001 and 2007-2008. On one day (October 19, 1987) the market would drop twice as much, in percentage terms, as it did on the single worst day of the 1929 crash. Seen from this perspective, the 1929 crash, while obviously severe, was not by any means unique.

Beginning in mid-November 1929 a subdued but steady recovery developed that stretched into April 1930. During the recovery, prices recouped nearly half the losses sustained in the crash. An observer of the market in April 1930 could be forgiven if he simply viewed the crash as having been another of the many market breaks that had occurred throughout history. It was only after the Great Depression of the 1930s set in that the crash was imbued with the ominous import so often attached to it since.

All sorts of explanations have been advanced to explain why the crash occurred, citing various events in the fall of 1929 that could conceivably have had an adverse effect on investor psychology. None of these explanations is particularly convincing, in that similar incidents had occurred before and had not led to market collapses. Galbraith says simply that the market was “shattered by a spontaneous decision to get out,” and that anything could have caused it. He goes on to write, “What first stirred these doubts we do not know, but neither is it very important to know.”

In a way, Galbraith is probably correct, although perhaps for the wrong reasons. Stocks had advanced to unprecedented levels in 1929. As has been seen, while Galbraith paints a picture of unrestrained speculative excess in 1929, there were, in fact, many voices sounding notes of caution, not the least of which was the Federal Reserve Board. Even if high stock prices would ultimately appear to be justified by modern analytical techniques, there is no question that the rapid rise in the late 1920s, and constant warnings about over speculation, made many people uneasy. It would not have taken much to convert this sense of unease into fear, and then panic.

In spite of its notable failure to face down Charles Mitchell and his fellow New Era advocates over the specific issue of broker loans in early 1929, the Federal Reserve had been pursuing a tight money policy for some time, a policy that in large part reflected concern about over speculation in the stock market. Milton Friedman and Anna Schwartz state quite succinctly, “There is no doubt that the desire to curb the stock market boom was a major if not dominating factor in Reserve actions in 1928 and 1929.” The tight money policy may well have induced the economic slowdown that began in August 1929. Although the eventual magnitude and duration of that slowdown could not have been evident in October, the first inklings may have been enough to tip the precarious psychological balance in the market.

According to this reasoning, the Federal Reserve, in its efforts to restrain speculation, pursued a policy that stalled the economy. The stock market, bounding ahead on the optimistic assumption that high rates of economic growth would continue unabated, stumbled over early hints of an economic slowdown. The initial decline in stock prices forced selling by heavily leveraged margin investors, accelerating the market correction into a rout.

Evidence to support this hypothesis was presented in a study completed in 1961, in which economic data from the late 1920s were analyzed. The study concluded, “The US authorities precipitated the crisis by the crusade against speculation, instead of leaving stock prices to their fate and supporting the expansion of economic activity.” In effect, this argument is the exact opposite of Galbraith’s. While Galbraith believes that unrestrained speculation created a bubble that inevitably burst, the “revisionist” interpretation is that efforts by authorities (notably the Federal Reserve) to restrain speculation unintentionally slowed the economy, which in turn brought the bull market of the 1920s to an abrupt halt.

Economic historians will likely never fully agree on the precise causes of the 1929 crash. Perhaps, as Galbraith suggests, an exact determination of the causative factors may not really be all that important anyway. Several conclusions about the crash, however, should be quite clear. First, by the standards of valuation that would prevail for most of the remainder of the twentieth century, stocks were not badly overvalued in the fall of 1929. The bull market of the 1920s, far from being a period of speculative excess, was instead simply part of a process in which stock valuations adjusted upward from the low levels of earlier years, toward the higher levels that would routinely prevail in the future.

Second, the crash could not in any realistic way have “predicted” the Great Depression that followed. There was no hard evidence in October 1929 that a serious downturn in economic activity was in the offing, and thus it is not reasonable to assume that the collective action of market participants anticipated an economic collapse.

Third, the crash could not have caused the Depression. Given the small number of people actually involved in stock speculation, and the fact that the crash merely returned stock prices to levels they had been at in 1928, the wealth effect of the market decline could not have been of sufficient magnitude to severely dislocate the economy.

And finally, if the crash is viewed independently from the Depression that came later, it was not really all that much different from other panics that had occurred in the past. Market declines of similar duration and magnitude had occurred before, and would occur later; 1929 was not in any way unique.

Such is the mythology that surrounds the crash of 1929 that these conclusions may seem almost heretical. Conventional wisdom has it that the crash of 1929 (the “Great Crash”) was a calamity of extraordinary significance that forever altered the lives of tens of millions of people and foreshadowed the Great Depression. The facts indicate otherwise.

Market crashes continue to happen in human history. It is an eventuality of “when” and not “if”. Do we need to know how it happens? Not necessarily. But we do need to see the signs, the foreshadowing and prepare to take actions with a clear mind. Whether you are reading this before the crashes in the 20th century or the 21st, you will surely be able to see some of the parallels and hopefully, benefit from knowing a bit more.

Credits: This series of articles on “The Great Crash” are primarily extracted from B. Mark Smith’s market history book, Toward Rational Exuberance, 2004.

 

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