Certain years, such as 1066, 1492, and 1789, stand out in history, important because of a single, seminal event. Nineteen twenty-nine is such a year. It was not a year of conquest, discovery, or revolution; rather, it was defined by something much more arcane–a stock market crash.
In many ways, the crash was not much different from other panics that had preceded it. But while most of those earlier events have long been forgotten by all but market historians, the crash of 1929 still looms large in the popular consciousness. In a visceral, almost palpable sense, something about the 1929 collapse makes it seem different from all the panics that had gone before.
Writing in the 1950s, John Kenneth Galbraith declared, “On Jan. 1, 1929, as a matter of simple probability, it was most likely that the stock market boom would end before the year was out.” Of course, Galbraith had the benefit of twenty-twenty hindsight. Other scholars have not claimed such prescience. Economist Paul Samuelson wrote in 1979 that “playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught in the 1929 debacle… The collapse from 1929 to 1933 was neither foreseeable nor inevitable.”
Samuelson was not alone. Noted economist John Maynard Keynes lost heavily in the crash, as did other leading members of the academic community. Apparently, the warning signs so obvious to Galbraith were somewhat more obscure to other students of the market.
This is not to suggest that the warning signs were invisible. Cautionary notes were frequently voiced by market analysis in early 1929 and can be divided into two broad categories. First was concern over “high” stock prices, and second was the worry that too many people were speculating with borrowed money.
By historical standards, stock prices certainly did appear high in 1929. P/E ratios on most stocks had climbed well above the traditionally accepted 10 to 1 ratio that had been the rule ever since industrial stocks began to trade on the New York Stock Exchange in the late nineteenth century. Perhaps more important, the spectacular rise in the stock market in the late twenties had caused dividend rates on stocks to fall almost to the level of long-term interest rates. This threatened to reverse the relationship between dividends and interest rates that had held since data began to be collected in the nineteenth century and presented a warning signal that could not be ignored by adherents of traditional norms of stock valuation. If stocks were riskier than bonds, they must yield more than bonds to compensate investors for that risk. By definition, if dividend rates fell below bond yields, stocks must be overvalued.
Even the normally reticent secretary of the treasury, Andrew Mellon, took note of the low dividend rates. In March 1929, he publicly urged “prudent investors” to buy bonds, implying that relatively low dividend rates made stocks unattractive compared with bonds. Mellon may have been urged to make this comment by President Hoover, whom he had met with at length before speaking to the press. Whatever the case, for the secretary of the treasury to render such advice was quite unusual, and Mellon’s statement attracted a great deal of attention. But he was certainly not the only person to express concern about high stock prices and low dividends.
The burgeoning use of “leverage” in the stock market was another source of alarm for skeptics of the bull market. Derived from the physics associated with the use of a lever to magnify a force, the term “leverage” in the financial markets referred to the use of borrowed money to “magnify” potential gains in investment results. If an investor expected his stocks to appreciate at least 20% per year (seemingly not an unrealistic appraisal in the late 1920s), why not borrow money at the going rate on broker loans of between 5% and 12% to buy more stocks, using the stocks themselves as collateral?
By mid-1929, the dollar amount of margin loans used to finance stocks totaled more than three times the amount that had been outstanding at the beginning of 1927. The risk, as seen by critics who frequently cited these figures, was that a serious decline in the stock market would imperil the value of the collateral, forcing the margin investors to sell out their stocks to repay the loans. This forced selling would exacerbate the market drop, potentially causing a crash.
Leverage was also employed by popular new investment vehicles that had begun to appear after 1921, called investment trusts. In theory, these entities served a purpose similar to that of mutual funds of the second half of the twentieth century. Individual investors would buy shares in the trusts, which would then reinvest the money in a portfolio of stocks. The investor who could not afford to hire a professional investment manager, or did not have the resources to buy a diversified portfolio of stocks, could achieve both professional management and diversification by means of the trust.
Most mutual funds, however, do not employ leverage, whereas most investment trusts did. In essence, the trusts borrowed money to supplement the funds raised from selling stock to investors, with the intent of enhancing the fund’s overall rate of return. This was no different in principle from the investor who bought stock “on margin.” Like the margin investor, the leveraged investment trust was willing to take more risk (buying stocks with borrowed money) in order to reap greater rewards if stock prices rose.
The impact of leverage can be seen through the following example, that of a hypothetical investment trust organized in early 1929. (New investment trusts were created at a furious pace throughout most of 1929, with a new trust appearing approximately every business day.) The hypothetical new trust would be capitalized at perhaps $150 million, of which $50 million would be raised from the sale of common stock, and $100 million from the sale of fixed-income securities, such as bonds and preferred stock. Since the holders of the bonds and preferred stock expected only to receive a fixed return, all the gains (if any) beyond the amount necessary to pay the fixed-income investors would go to the common holders.
Say the value of the stocks in which the trust had invested rose by 50%. The value of the trust’s assets (before interest, preferred-stock dividends, and expenses) would increase from the original $150 million to $225 million. Since the holders of the bonds and preferred stock had a claim on only $100 million, the common shares of the trust would now be worth $125 million, or 150% more than at the creation of the trust. In effect, “leverage” had magnified a 50% gain in the market into a 150% gain in the value of the trust’s common shares.
This leverage could be further increased if the hypothetical investment trust invested in the shares of other leveraged trusts, to the point where a relatively small gain in the overall stock market could be magnified into large gains for the shareholders in the trust. Unfortunately, leverage worked in reverse as well. A relatively small decline in the market, when magnified by a chain of leveraged investments, could completely wipe out the trust shareholder. This possibility was discounted by trust investors, who were convinced that professional investment managers who ran the trusts were sufficiently insightful to prevent such an eventuality.
The reputation of many trust management was enhanced by the presence of noted members of the academic community as directors or advisors; it was not uncommon for leading economists and finance professors from major universities to be associated with investment trusts. (Not until the appearance of large multinational “hedge funds” in the 1980s and 1990s would such a premium again be placed on academic advice.) With or without the learned professors, however, leveraged investment trusts were feared by critics to be ticking time bombs that would eventually explode, destroying trust investors and perhaps bringing down the entire market as well.
To be continued…
Credits: Much of this article is extracted from B. Mark Smith’s book, Toward Rational Exuberance, 2004