Tuesday, March 10, 2015

Everything You Know About 1929 Is Wrong

It may come as a shock to you (as it did to me) to discover that most of what you know about the 1929 stock-market crash is wrong.

People lined up outside the stock exchange to get
updates on the October 28 ticker, which ran as
much as four hours behind.
The "crash" was not much of a crash, for example, and it did not "cause" the Great Depression. Stocks were not overvalued (the market's P/E was just 13.5), and margin buying (while certainly a factor in the rate of decline) was not the cause of the crash. People did not jump off of buildings after losing their life savings. The myths go on and on. But they're just that: myths.

Let's take some of the myths one by one.

The crash: How big was it? The largest one-day move, Black Monday (October 28, 1929), was a drop of 12.8%, followed a day later (Black Tuesday) by a drop of 11.7%.  What's seldom reported is that the day after Black Tuesday, the market went right back up 12.3%, finishing at 258.47.

Dow Jones Industrial Average
Black Monday and Black Tuesday
Date Change % Change Close
October 28, 1929 −38.33 −12.82 260.64
October 29, 1929 −30.57 −11.73 230.07

"But surely 1929 was a down year?" Yes, it was. The Dow was down 19% from the start of the year to the last day of trading. But considering the fact that the market was up almost 50% the previous year, a drop of 19% is hardly upsetting. We constantly read that "billions were lost" in 1929. But even more billions were gained in 1928.

Did the 1929 "crash" cause the Great Depression? It's hard to see how. The 1987 crash (October 19) saw the Dow fall 22.6% in a single day. The 1929 U.S. economy was vibrant compared to 1987. In the 4 years leading to 1929, GDP had increased by 15.3%, while inflation was near zero. Short term interest rates fluctuated between 4% and 5%. The Federal Budget ran a surplus in 1929 and 1930. If anything, the 1987 crash should have caused a Depression—yet it didn't.

Didn't people jump off of buildings? Actually, no. I could find no substantiated accounts of this, except for Winston Churchill's account of one incident.

Wasn't the crash caused by margin buying? It's true that prior to 1929, you could legally borrow money from a bank for the purpose of investing in the stock market. However, in February 1929 the Fed outlawed margin borrowing from banks, which means that by October the only way to obtain margin was from a brokerage, directly; and brokerages were conservative about this back then, as now, requiring 50% coverage. (Note that no large brokerages went bankrupt in 1929.) Brokers' loans, in 1929, totalled around $5.5 billion, less than 5% of the combined value of all stocks. So all the nonsense you've read about shoe-shine boys speculating in stocks, using margin, is mostly that: nonsense. (Joseph Kennedy famously got out of the market pre-crash when he realized that "shoe-shine boys" were talking investment strategy. However, I find this story fishy. Anyone attempting to make a living shining shoes on Wall Street would naturally develop a certain fluency in stock-talk; it's just good business.)

It is true that certain "investment trusts" (forerunners of today's hedge funds), prior to 1929, borrowed a significant amount of money to speculate in the market. The Fed's February 1929 edict was aimed at halting such activity.

What, then, was the 1929 crash about?

It was actually a classic tech bubble. Electricity was the high tech of the era; stocks like RCA (with a P/E ratio in the 30s) and Edison Electric Illuminating Company of Boston (with a share price of $440) were the Google and Priceline of their day. Electrification was still in its infancy, of course. (As late as 1939, less than 25% of rural America had electric power.) But "bright lights" had come to the major cities, where scores of power companies, as yet largely unregulated, made huge profits in local markets, often operating without competition. Electric utilities were seen by many as having an almost magical ability to mint money. Accordingly, utility stocks had the highest P/Es, as a group, ran up the most prior to the crash, and went down more than any other group after the crash. (Read an excellent analysis here.)

The importance of the utility sector in the crash is underscored by the fact that:
  • Utility company shares often sold at more than 3.0 times book value.
  • Utility shares were largely owned by investment trusts.
  • Investment trusts sold their shares at a substantial premium to underlying holdings.
  • Investment trusts often purchased utility shares with borrowed money.
  • Investors used margin to buy into investment trusts.
Thus, hidden leverage compounded the utility sector's woes. When the high-flying utiliy sector finally went down, contagion ensued.

Ironically, some historians have suggested that the lack of strict(er) Fed control over monies flowing into the markets played a role in making the Crash possible. But it's equally possible aggressive Fed action is what actually triggered the Crash. One of Herbert Hoover's first actions as President, in early 1929, was to pressure Secretary of the Treasury Andrew Mellon and Governor of the Federal Reserve Board Roy Young “to strangle the speculative movement.” In his memoirs (1952), Hoover titled his Chapter 2: “We Attempt to Stop the Orgy of Speculation.”

Milton Friedman has said (and he may actually be right) that a contracting money supply after 1930 is what ultimately triggered the run of bank failures that led to the Great Depression (which quickly spread around the world due to rigid adherence to the Gold Standard).

But the real lesson of 1929 is that lack of transparency (in investment trust finances, particularly), coupled with non-real-time dissemination of market information (through newspapers, and tickers that ran four hours behind), plus copious amounts of hidden leverage concentrated in one high-flying sector, can do nothing good for a market that's in bubble mode. One wonders if we've learned some of these lessons, even now. The crash of 2008 says we haven't.

☙ ❧

I've made some improvements to my Twitter timeline-scraping code and can now thank even more people for retweeting me. The following list (of people who retweeted me yesterday) might still not be 100% complete, but it's more complete than it would have been with my old code. In any case, you should get busy following the folks shown below. They retweet! (Click their pictures; the pics are live links.)

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  1. As I understand it (and I'm certainly no expert), deflation also played a major role in turning the correction into a depression. As you said, inflation was very moderate leading up to it. The correction quite naturally led people to hold off on major purchases they had been considering, such as automobiles and appliances. This led to price drops, causing deflation.

    The problem is that deflation causes people to hold off even more, waiting for a better price. This starts a vicious cycle of drops in sales leading to drops in employment, leading to further drops in purchasing, and further drops in prices, completing the cycle.

    If there is one lesson most governments have learned, it's to avoid deflation at all costs. They try to keep inflation low, but not too low. The Canadian government has a target of 1-3%.

    Arguably, deflation would not be a problem in an economy based on living within one's means, saving, and rational long-term investment. But that's largely theoretical, and a moot point. In a credit-driven instant gratification economy, deflation is deadly.

    1. Yes, there was some deflation already in 1929, in agriculturals particularly.

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