What Caused The Stock Market Crash Of 1929?Guest Post
By the end of the October 1929 stock market crash, investors had lost $25 billion – $364 billion in today’s terms. Why did the stock markets crash? Are the causes of the crash true today?
The answer is that it’s complicated. Rather than a single catalyst, mounting pressures from multiple factors contributed to the crash. These included:
- Overpriced stocks. Overpriced stocks are frequently cited as a main cause of the crash. However, pre-crash stock prices were not wildly out of line with the reality of their economic fundamentals. Stock prices increased by 120% between 1925 and the third quarter of 1929, an average annual increase of about 22%. This is a big increase but in the context of a period of tremendous economic growth, it is not unreasonable. It’s also worth noting that price increases were not uniform across sectors – stocks with strong fundamentals, like airplanes and utilities, saw the biggest increases. Additionally, financial reports showed that corporations were on solid footing and price-to-earnings (P/E) ratios did not indicate overvaluations. In 1929, the average P/E ratio of stocks was around 15. In January 2018, the S&P 500’s P/E ratio was just under 23. It may be more accurate to say that it was the perception of overpricing that contributed to the crash as public figures and news headlines expressed this view.
- News headlines. In early October 1929, newspapers stoked concerns with sensational headlines. Most notably, on October 3, 1929 Britain’s finance minister, Phillip Snowden, called the U.S. stock market a “perfect orgy of speculation” and the next day, The Wall Street Journal and The New York Times ran stories agreeing with him. The New York Times’ page one headline blared “Year’s Worst Break Hits Stock Market.” On October 17, The Washington Post ran a headline “Crushing Blow Dealt to Stock Market” following a market dip the previous day. Associated Press stories – which were picked up by other outlets and therefore widely read – focused on the poor performance of public utilities, which generated significant worry among investors. Public utilities stocks were more than triple their book value in 1929 so these headlines did generate valid concerns. In the run up to Black Thursday, major newspaper headlines continued to focus on market dips, the lack of alarm among Washington officials about these dips, and the rising panic of investors. Newspapers cannot be faulted for reporting the news but the headlines certainly heightened people’s fears. The effect of these news headlines was roughly the equivalent of yelling “fire” in a crowded movie theater. Could this happen today? There is no shortage of reasons for instability in the world today from a trade war with China to more war in the Middle East.
- Margin buying. In times of fear, people stash money under their mattress. In times of optimism, they invest it. In the Roaring Twenties, optimism and affluence had risen like never before and investing in the stock market became like baseball – a national pastime. Everyone wanted to get in on the action and credit was readily available. In particular, businesses and individuals borrowed money to buy stocks “on margin.” Buying on margin meant that an investor could put down 10-20% of their own money and borrow the rest from their stock broker. This type of leverage was extremely risky because if the stock price fell below the loan amount, the stock broker could issue a “margin call,” requiring immediate repayment of the loan. Despite this risk, even banks were buying stocks on margin, and, since no law prevented it, some used their customers’ deposits to do so. Before the crash, nearly 40 cents of every dollar loaned in America was used to buy stocks, typically through margin buying. When the market started to take nosedives, brokers began to make their margin calls and borrowers were often unable to pay up. When that happened, brokers simply sold those stocks, wiping out savings and increasing panic.
- Trouble in London. On September 20, 1929, the London Stock Exchange suspended shares of the Hatry group after its leader, Clarence Hatry, was found to have purchased United Steel Companies with fraudulent collateral. The Hatry group collapsed, costing investors billions and sending the London Stock Exchange into a tailspin. This news put US investors on edge.
- Federal Reserve policy. Economists and historians have long argued that Federal Reserve policy contributed to the crash. In 1928 and 1929, the Fed raised interest rates in an effort to limit securities speculation. Higher rates caused economic activity to slowdown in the US. The Fed’s actions also had unintended global consequences. Because of the international gold standard, foreign central banks were forced to raise their interest rates as well, and this monetary tightening triggered recessions in several countries and caused global commerce to contract. In 2002, Ben Bernanke (then a member of the Federal Reserve Board of Governors) publicly acknowledged the Fed’s role in the crash, saying that the Fed’s mistakes contributed to the “worst economic disaster in American history.”
- Lack of legal protections. The legal protections we have today through the FDIC and SEC on bank deposits and securities transactions did not exist in 1929. After the crash, banks were only able to honor 10 cents on the dollar because they had used customers’ deposits to purchase stocks without their knowledge. Additionally, investors had no recourse to recover funds if their brokerage firm went out of business.
Hindsight is always 20/20 but in the run-up to the crash, there really were no glaring signals of severe economic weakness. Instead, news headlines created nervousness, risky borrowing fueled panic and the Federal Reserve’s interest rate hike caused an economic slowdown at exactly the wrong moment. While we like to think that consumer protections and lessons learned will insulate us from another crash, we also know that black swan events can always happen.
So if markets crashed tomorrow, how could investors protect their assets? One way to minimize the risks from a potential market crash is to capture a moderate amount of upside market growth while ensuring that savings are fully protected over the long term. This can be done through a new type of fixed index annuity called Benjamin. By putting the right amount of money in bonds and allocating the rest to common stocks, the Benjamin Annuity ensures that the worst-case scenario for an investor’s portfolio will be to break even.
Another option is to make sure that your portfolio has a sufficient allocation to bonds or bond like instruments such as certificate of deposits. With fixed income instruments such as these, your principal is protected while you earn a fixed rate of interest. The key insight is to make sure your portfolio is sufficiently diversified away from the risk of
Article by HiBenjamin