Sunday, June 28, 2009 3 comments ++[ CLICK TO COMMENT ]++

The great stock market crash - 1929 to 1932 (very long post)

I see quite a number of individuals comparing the current stock market crash to the one that started in 1929. I feel that many are performing the comparison without even knowing what happened from 1929 to 1932. You may have seen several charts floating around on blogs that plot the current crisis to the crash that started in 1929. I think it's worthwhile to look at that comparison but it is very important to understand what happened in the 1930's as well. I think the current period is quite similar to the early 30's but one needs to understand why the market fell so much back then. It would be a serious mistake to assume the same thing will happen now, unless you believe similar events will unfold.

I thought it is worthwhile to analyze a chart of the Dow Jones Industrial Average in that time period. Like many complex events, no one really knows exactly why something happened or what was driving the market so what I say should be taken as my opinion. It's a very long long post and hopefully it's benefitial to some.


The Approach

There are three aspects of any business environment that one can look at. You can look at the economic world; you can analyze asset prices (say the stock market or the bond market); and you can concentrate on the political environment. Some like to think that all three are correlated but they rarely are, and I never consider them as being similar.

There isn't one right way to look at the investing world. Some, such as Austrian Economists and their followers, seem to ignore the political aspects. For example, someone like Peter Shiff or Jim Rogers, who seem to share AustEcon thinking, rarely consider the possibility of the Chinese government collapsing because they are unable to keep the economic growth going; or how it is literally impossible to let whole sectors of the American economy collapse without serious political backlash from the voters.

Others, such as value investors, tend to ignore macro elements and they generally concentrate on asset prices. Sometimes this works but sometimes it doesn't. For instance, Warren Buffett staked a huge chunk of his, and Berkshire Hathaway's, wealth on Wells Fargo, which can easily be nationalized. Buffett keeps saying that the banks will earn their way back but what if they can't (if interest rates rise and spreads decline)?

As a macro-oriented investor, I look at all three and probably put too little emphasis on asset prices (although one of my goals is to put more effort into valuation and security analysis in the future.) So, I'm going to look at the crash of 1929 largely from a macro point of view. I am also going to look at it from the stock market's point of view.


The Great Crash

Like almost any critical period in history, there isn't a consensus on what happened in the 1930's. I mean, there are still some, who are fans of hard currencies and are generally anti-government, still blaming the 1930's on government intervention, when the government wasn't even that big back then, and the 20's were considered to be the glory days of unfetterd capitalism. So, there can easily be disputes. Even speaking in hindsight after many decades, when stock prices change, one can never be sure what is driving it.

I have chosen to analyze the period based on what Russell Napier has mentioned in his book. I chose Napier's suggestions because, first of all, I have his book and it discusses the period from an investor's point of view, and is easily understandable by a layperson like me. There are many economic textbooks written about the period but only economists who are trained in the field will understand them. Furthermore, those books also tend to debate economic policies and economic theories whereas I am more interested in what was driving stock prices.

The chart below illustrates the stock market crash that started in 1929, annotated with some events I felt were key (click on chart to enlarge.) I pulled the DJIA chart from Yahoo! Finance (since that's the only free one I have access to) but I should note that Yahoo's charts are sometimes slightly incorrect. The crash is primarily annotated based on what Russell Napier described in his book Anatomy of the Bear. There is also some minor discrepancy in the chart and the numbers from the book, which I suspect is probably because the chart might be plotting weekly or monthly prices, whereas the book probaby uses daily numbers (it is also possible that the numbers from the book include dividends whereas the chart does not.) I don't think the small differences detract from the arguments I make.



Basic Observations

The stock market from 1929 to 1932 is memorable for the size of the losses incurred by investors. The market, as measured by DJIA, dropped 89% from peak to trough and basically destroyed anyone who owned stocks. However, many don't realize that the crash wasn't as bad as it seems. First of all, there was an unbelievable 100%+ rally within an year, starting in late 1932 (I will discuss this below). This rally sort of saved many investors, especially those dollar-cost-averaging or re-deploying their dividends back into the market. Secondly, the period was marked by severe deflation so the losses in real terms were less than they seem. As crazy as it may seem, depending on how you measure, my understanding is that investors in the 1970's did worse than those in the 1930's in real terms.

The crash in 1929 is also generally thought to have provided an early signal for the Great Depression, although my opinion is that this seems more like a myth. The initial crash was typical after major bull markets, and many would not have foreseen a severe depression based on the crash alone. In fact, the stock market was rallying by 1930 and very few investors expected anything overly negative on the horizon.


I - The Crash

Speaking as a present-day observer, the 1929 crash isn't really a surprise, at least to me. It was inevitable! By the end of the Roaring 20's, valuations were so high that stocks made little sense for new capital deployment. It was similar to the stock valuations in the latter 1990's. Either stocks were going to collapse quickly or they were going to enter a multi-decade bear market. The initial crash of 1929 simply took down valuations to more attractive levels.

Contaray to some people's beliefs, the Federal Reserve did not seem to have pursued a loose credit policy before the crash. A lot of the excesses of the 1920's were built up by the private sector—largely private corporations. This is similar to the present crash, which I believe was due to, primarily, actions of private market actors. In the current crisis, it is largely consumers whereas the high indebtness was with corporations in the 1930's.

What turned a large, although not unexpected, crash, into the worst one ever seen, was likely due to the banking crisis.

II - First Banking Crisis

Russell Napier points out that banks failed all throughout the 1920's due to the suffering farming sector—USA was switching from an agricultural country to an industrial one—and increasing banking competition. Based on his writing, it seems that everything fell apart in 1930 after the public lost faith in bank deposits.

It seems that the trigger for a total loss of faith in the banking system may have been the collapse of the Bank of the United States. This was a FedRes member bank that was founded all the way back in 1791 (so it survived 139 years including the Long Depression!). When it failed, it was also the largest bank failure in American history. Given how there was no deposit insurance at that time (FDIC deposit insurance only started in 1933 with the Glass-Steagall Act), you can imagine how the public would panic if the largest bank failed. This wasn't some rural no-name bank; it was the largest bank located in the heart of New York City. To make matters worse, the Federal Reserve, as well as the politicians at that time, did very little—they were largely following the libertarian-oriented free-market policies of letting the market take care of itself, which was the norm for the prior few hundread years.

Russell Napier, in his book Anatomy of the Bear, argues that the 1930 recession turned into a depression largely due to the contraction of the money supply due to runs on the banks (I'm re-typing the quotation so any spelling mistakes are mine):

Before the public's withdrawal of its money was over, the deposit-currency ratio would be reduced to levels not seen since the end of the 19th Century. Given the operation of the fractional reserve banking system, where banks had to maintain cash balances much smaller than their deposit base, this drain of cash from the banks had a very negative impact. In this period the banks needed to reduce deposits by $14 in order to make $1 available for the public to hold as currency. (p95)


You can see how powerful the deflationary effect would be if the banks had to cut lending $14 for every $1 that a depositor took out. There were clearly excesses in the late 20's so lending probably should have gone down. But a drop of 14x deposit withdrawal is extreme.

You can see how the bank run problem was mitigated during the current crisis by pumping a huge amount of liquidity into the banking system. On top of deposit insurance keeping depositors at bay and preventing their loss of faith in the banks, the central banks of the world have managed to avoid a major liquidity crunch at banks by providing liquidity to almost anyone that wants it. I don't think bank runs, en masse, was likely in the US but it was definitely a possibility in places like Ireland and Britain. However, if Citigroup, which eerily parallels the Bank of the United States in 1930, collapsed, I think a run on all the major banks was a possibility.

Even with the serious failure of banks and the declining public faith in the banks, investors probably still considered the early 1930's as a normal bear market. Although bank failures are somewhat rare these days, they were pretty common in the prior centuries. On top of a lack of deposit insurance or anything resembling true insurance, banks never had enough (short-term) liquidity to cover their desposits. Even during the heydays of the gold standard, banks were practicing fractional reserve banking as far as I know. This meant that they always loaned out more than their deposits. So, citizens always took on a risk unlike anything a modern depositor would be familiar with.

Investors clearly thought the 1930 bank runs were a typical, although severe, situation, not too dissimilar from the past. They bid up the stock market in the early part of 1931, even after the major failures started in late 1930. Unfortunately for anyone investing in 1931, the unprecedented wealth destruction happened past this point, after the initial stock market crash and the onset of the banking crisis.

III - Second Banking Crisis

The second banking crisis, which is sort of a continuation of the first one, basically destroyed any hope of recovery for the banks. Although it's hard to pin a cause, the second crisis was probably made worse by the failure of Austria's main private bank, Credit-Anstalt. This failure caused serious banking problems in Austria and Germany, and capital controls were enacted. US bank deposits in those countries were frozen and this, as Napier asserts, may have weakened the confidence in the balance sheets of American banks.

The FedRes cut interest rates but it did not expand liquidity to its member banks. This was a serious mistake and essentially defeated one of the key reasons for the existence of a central bank. That is, central banks are supposed to increase liquidity during stressful times and shrink them when not needed (if you didn't have a central bank with its own currency, then everything would be rigid, as is the case under a gold standard.) If you didn't care about expanding or shrinking the money supply at opportune times then you probably don't even need a central bank.

To make matters worse, the gold exchange standard that USA was on at that time caused all sorts of weird, detrimental, actions to be taken. For instance, Napier points out that the FedRes actually raised rates in October of 1931 to halt the outflow of gold. Imagine the whole banking system is falling apart, and the economy is shedding jobs, and you tighten money supply. There was major inflow of gold into USA in the early part of 1931 as a safe haven (due to banking crises in Europe among other things) but gold started fleeing America after United Kingdom went off the gold standard.

The combination of a drain on gold reserves and currency withdrawals further exacerbated pressure on the commercial banking system, which was compounted by rising interest rates. The Federal Reserve acted as the gold standard dictated, raising the discount rate from 1.5% to 3.5% in October with a view to halting the drain of gold from the country. Commercial banks once against rushed to dump assets in the scramble for liquidity. Now, for the first time in the recession, even the price of government securities declined. Investors who expected that government bonds would provide nominal returns in a deflationary period were now in for a major surprise.


Government bonds, as should be expected, were in a bull market until that point (corporate bonds, however, were in a bear market.) The increase in interest rates, and consequently increase in government bond yields, seriously hurt the balance sheet of banks, who owned a lot of government bonds. The rigid nature of gold in forcing the FedRes to raise rates in the thick of an unfolding banking crisis and serious recession probably started the beginning of the end of gold. USA went off the gold exchange standard in 1971 but it is really the Great Depression that sealed gold's fate.

The stock market had no chance during the second banking crisis. It fell 56% and the economy kept deteriorating. I do not know the sector performance in this period but it would not surprise me if every sector got killed and there was probably nowhere to hide.

IV - Gold Drain

The Dow dropped another 50% in 1932. Russell Napier argues that the final collapse in the Dow was due to investor concern over gold:

The final blow to the market, which accounts for a quarter of the entire bear run, was primarily due to a renewed drain on gold from the US...The burgeoning fiscal deficit, it [The Wall Street Journal] argued, convinced foreigners that US adherence to the gold standard was under threat. However, it is more likely the Federal Reserve's move to large-scale open-market purchases of government securities caused foreigners to take fright. Still, there was a heady cocktail of reasons for foreigners to be selling US dollars in early 1932. Barry Eichengreen argues that devaluations elsewhere threatened to erode America's current account surplus.


Foreigners are usually the last ones to partake in bubbles and the last ones to exit crashes. Right near the bottom, it seems foreigners unloaded US$-denominated assets because of concern over the gold backing. UK, Canada, France, and others had gone off the gold standard and investors were wondering if America was the next one.

In the end, the sell-off due to concern over gold didn't matter much. The market rallied almost to the pre-sell-off level by the end of 1932. USA also never went off the gold standard until 1971 so foreigners bet incorrectly.

V - The 1932 & 1933 Super Rallies

The latter part of 1932, as well as 1933, were marked by events that have left a lasting impact on world history. Not surprisingly, given the massive suffering due to the economic depression, there were some crazy things that unfolded.

It is not clear to me what caused the massive rallies in 1932 and 1933. Russell Napier also looks at the issue and I don't really find any satisfactory answer. The stock market had two, roughly 100%, rallies during that period. The overall gain from the bottom to late 1933 was in excess of 100% and this ranks as the strongest—if you look at the amount and the time it took—bull market in history. The market largely went flat after 1933 but it is amazing if you think about a 100% rally for a broad index (the NASDAQ went up 100% in 1999-2000, but that is a narrow index consisting mostly of technology and bio-technology companies.)

Although the economic situation improved somewhat in 1933, this was still in the thick of the Great Depression, which was not to end for more than a decade (this is a good example of how the stock market is not perfectly correlated with the economy.) One of the things that is obvious is that stocks were extremely cheap in 1932. In terms of the CAPE (cyclically adjusted 10-year P/E), valuations in 1932 were near all-time lows and similar to what they were in two other major bear market bottoms, 1920 and 1981. But why the sudden buying in 1932 and 1933?

Franklin Delano Roosevelt, whom many liberals including me, consider one of the greatest politicians of all time, in any country, was elected during that period. Napier looks at his election and doesn't believe the market was influenced by his election. If anything, the market should have feared someone who was a socialist of sorts and was claiming that bankers and investors were the root cause of the problem. One would have thought that when Roosevelt said, in his inauguration speech, that "The money changers have fled from their high seats in the temple of our civilization" that Wall Street would have sold off sharply. Yet, the stock market kept going up.

It is possible that the market was taking a bullish view of Roosevelt and his policies given how if he didn't save capitalism, even with his socialist policies, America looked doomed. The Republicans ran out of ideas and probably couldn't have done much to restore confidence, given their disastrous strategies in the first few years of the (initial) recession. We also had a terrible event over in Europe with Adolf Hitler becoming Chancellor of Germany in March of 1933. Although Hitler was a strong capitalist and was probably favoured by some in America for his ideology, it is possible that the market favoured having a so-called "socialist" like Roosevelt in power rather than a fascist or a communist.

Another possibility is that the market may have rallied, especially the big rally in 1933, because of the devaluation of the US$ against gold. FDR banned private ownership of gold, except for some trivial amount, and de-valued the US$ against gold by 44%. He still kept USA on the gold exchange standard in foreign dealings. Such a de-valuation can cause stock markets to rally in nominal terms. It's not clear if something like that contributed to the rally.

Markets are mysterious and the massive bull market from 1932 to 1933 has to go down as one of the biggest mysteries. The economy certainly did not improve sufficiently to justify those 100%+ moves.


Final Note About That Period

One of the common things one hears is that the market hits a bottom with high volume. In other words, bottoms are thought to be marked by capitulation, consisting of high volume. Some also argue that volatility and panic measurements are high near the bottom.

Well, the 1932 bottom was not marked by any capitulation. As you can see from the volume at the bottom of the chart, volume consistently declined from the 1929 peak. The bottom was marked by very low volume. It's also worth keeping in mind that dollar volume (i.e. value of the transactions) was much lower at the bottom (since price is lower, the same volume yields a lower dollar value.) Regardless of how you look at it, interest in stocks kept declining until the very bottom.

I'm not a trader and don't buy or sell based on volume; but just saying that major bear markets can also be marked with disinterest and low volume.


How Does The Present Compare?

This post was triggered by those trying to compare the present to the Great Depression, so how does the present compare? Well, this is just my opinion right now and I may change it at any time, but here is how I see things:

If one considers the present as being somewhat similar to the 1930's, we are probably at the point after the first banking crisis. Things are not identical, of course, but, similar to 1931, the market isn't really overvalued right now. It isn't undervalued either. Similar to the past period, we have seen a major banking crisis, with the solvency of major international banks being called into question. We are also seeing a credit bust similar to the 1930's, except now the weak balance sheet lies with the consumer, whereas it was with corporations in the 1930's. We have also seen a stock market crash comparable to the early portions of the 1929-1932 crash. There is also a collapse in trade, although the present world trade might be larger and more important than in the past.

My opinion is that we are probably after the first banking crisis on that chart. Our banking problems are somewhat similar to the first banking crisis. There are some elements of the second banking crisis (such as the global nature of it) but it's not yet quite comparable.

Yet, I think the sequence of events is slightly different. I think we had something similar to the first banking crisis of 1930 before we had a stock market crash. I think our stock market crash, which I say happened in October of 2008, happened after our banking crisis, which was unfolding all throughout 2007 and 2008.

In terms of valuations, the period after the first banking crisis is probably similar to the present. Stocks weren't that cheap after the first banking crisis, in 1930, but the market did mark down the excessive valuation from the late 1920's. Similarly, coming to the present, the market has got rid of the high valuation of the last few years but it isn't cheap.

Some superbears plot the current stock market against 1929 and literally imply that we have another 50%+, on the downside, to go. I actually don't think it is helpful to have such a view. There is no reason to expect the present to be anywhere like the past. As I have suggested above, there were a lot of mistakes made by central bankers and politicians which have been corrected this time around. Yet, can the superbears be right? Can we end up with similar outcome?

I hate to say it but I think we can certainly end up with huge stock market losses under some, low probability, scenarios.

One of my big concerns is valuation. Admittedly this is something that is in the eye of the beholder and keep in mind that I'm just a newbie who really doesn't have a good track record of estimating valuations. The fact that the market is not cheap does not mean that it has to fall further. In fact, Warren Buffett, writing in The New York Times back in October of 2008, has suggested that the market is attractive at the October levels. But my view is that it is not cheap and hence further declines is a possibility. Again, I'm not saying it will happen but, just that you should think about the possibility.

If the market were to completely collapse, like in 1931, something resembling the second banking crisis must occur. We can get another major banking crisis if banks take losses from assets other than residential real estate (my feeling is that the market has largely accounted for losses from residential real estate.) I'm thinking assets such as commercial real estate, credit card loans, and so on. Delinquincies and losses are rising in these assets but they seem within expectations so far. If losses are very high in these asets, companies like American Express or GE Capital may face serious problems and may even go bankrupt. A second banking crisis may also erupt if, say Eastern European banks collapse. My impression is that Eastern Europe is somewhat small and containable. But you just never know. Ironically, similar to the failure of the Austrian bank, Credit-Anstalt, back in 1931, it's possible that Austrian, along with Swedish and maybe German, banks may fail if Eastern Europe collapses.

Again, I don't expect it, but something equivalent to the gold drain in 1932 would be a run on the US dollar. Foreigners are already getting nervous about the US$, with some, such as the Chinese, even supposedly considering a purely fictional currency by the IMF, the Special Drawing Rights (SDR) (John Maynard Keynes suggested a similar IMF currency and, although Americans may not want it now, it is probably better for America in the long run if SDRs were used instead of US$.) A rapid US$ sell-off would be similar to the concern over the gold backing in 1932 and cause chaos. Unlike the gold sell off, I'm not really sure what someone would exchange the US$ for. Nevertheless, if someone is looking for events that can trigger a similar outcome as the prior period, this is one.

Another event that may cause severe harm is a trade war. The Smoot-Hawley tariffs in the 30's were thought to have done serious damage to world trade and, if something similar is enacted, we may face a huge collapse in world trade—way beyond what we have seen so far. As I have speculated before, a comparable action to the Smoot-Hawley tariffs would be if China devalues their currency. The damage caused by Smoot-Hawley wasn't necessarily the tariffs contained in the legislation. Rather, the damage came from the start of trade wars and subsequent tariffs enacted by many other countries. The problem is never the tariff itself—there are many tariffs, taxes, duties, etc enacted and repealed every year—but the potential for a trade war.


To sum up, I don't think we are looking at anything like the 1930's. Expecting stocks to follow the path in the 30's is too simplistic of a view. However, one should keep in mind that some adverse events can materialize.

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3 Response to The great stock market crash - 1929 to 1932 (very long post)

Walter
January 12, 2012 at 3:14 AM

No mention of the Euro or a possible breakup of the Eurozone? I think that would certainly qualify as a trigger to the second banking crisis phase.

I would not be too quick to write off a nightmare scenario as a low-probability event. Clearly the probability is much higher now than at any time since the Depression. And given that we are in a unique environment, how many historical precedents can you draw on? Can you say that if repeated 99 out of 100 times, given similar circumstances, we don't repeat 1932?

Also, I got a kick out of this part: "There is no reason to expect the present to be anywhere like the past. As I have suggested above, there were a lot of mistakes made by central bankers and politicians which have been corrected this time around." You're implying our bankers and politicians today are much better? Even though I will concede that the US govt has handled the crisis better so far, they still leave much to be desired. And I feel Europe is not so lucky. It's a volatile situation politically and ripe for making serious mistakes.

And yes, we've definitely learned a few things from studying the Depression, but in an effort to prevent that crisis from happening again, we're trying things now that have never been done before. Who's to say that today's decisions won't be studied in the decades to come in the same way that we study the mistakes of the past? Remember, "it's every generation's conceit that no other came before it."

Despite my disagreements, I really enjoyed reading this and thinking about these issues. Thanks for the excellent article.

February 12, 2012 at 10:44 AM

Just want to say your article is as amazing. The clearness in your post is simply cool.
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February 14, 2012 at 9:36 PM

Hi Walter,

I didn't see your response until now. Sorry about not responding to it earlier.

WALTER: "No mention of the Euro or a possible breakup of the Eurozone? I think that would certainly qualify as a trigger to the second banking crisis phase."

I wrote this in early 2009 and the Euro breakup seemed remote. Nevertheless, I don't think a breakup of the Eurozone is as big a deal as it seems (don't forget that a union of some sort may still exist, albeit with less countries less cohesiveness). After all, it wasn't even 15 years ago when they were separate countries and the Euro didn't even exist.

The question with any Euro breakup--it won't be a complete dissolution of the union IMO--is not the break up per se, but the losses on any government bond defaults and corporate failures. My guess is that even a relatively negative outcome will hurt some European countries and slow down world GDP but it seems isolated. For instance, although one can't trust the banks, the American banks seem to suggest their Euro exposure is only in the single billions; similar Asian and South American banks appear to have limited exposure.

During the Great Depression, a lot of the capital was tied up across the continents. For instance, losses in America badly hurt European investors.


The biggest threat, and a huge risk to the world, is not Europe; but, rather, China. I'm bearish on China and if there is a credit bust of some sort, it'll shock the world.

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