Bierman beating the bear; lessons from the 1929 crash applied to today’s world (2010)

By accurately assessing the causes behind the 1929 stock market crash that led to the Great Depression, and the causes that led to the decline of 2008 – 2009, readers can better grasp th

BEATING THE BEAR

Lessons from the 1929 Crash Applied to Today’s World

Harold Bierman, Jr

Beating the Bear

BEATING THE BEAR

Lessons from the 1929 Crash Applied to Today’s World

Harold Bierman, Jr

Copyright 2010 by Harold Bierman, Jr

All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, except for the inclusion of brief quotations in

a review, without prior permission in writing from the publisher

Library of Congress Cataloging-in-Publication Data

Bierman, Harold

Beating the bear : lessons from the 1929 crash applied to todayÊs world / Harold Bierman, Jr

p cm

Includes bibliographical references and index

ISBN 978-0-313-38214-7 (alk paper) · ISBN 978-0-313-38215-4 (ebook)

1 Stock Market Crash, 1929 2 Global Financial Crisis, 2008–2009 3 Bear markets·History 4 Investments I Title

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John Kenneth Galbraith

CONTENTS

5 Practice for the October Crash: The Week of

6 The 1929 Market in Depth: The Ups and Downs

7 The Great Crash of 2008: The 2008–2009 Market in Depth 77

8 Stopping the Speculators: Margin Buying, Pools, Trusts,

12 The Prime Cause of the 1929 Crash: The Public

13 Lessons to Be Learned 167

14 Post-Crash Investment Strategies:

ACKNOWLEDGMENTS

Many people contributed to this project Among those who were especially helpful were: Betsy Ann Olive and Don Schedeker of CornellÊs Johnson Graduate School of ManagementÊs library staff; Rosemary A Lazenby of the archives division of the Federal Reserve Bank of New York; Seymour Smidt, Jerome Hass, and Maureen OÊHara, faculty colleagues at Cornell made useful suggestions Barb Drake typed untold revisions Dick Con-way called my attention to the article that motivated my initial research efforts

Sections of this book were written during a study leave spent at the Judge Institute of Management, University of Cambridge The leave and the research were financed by the Arthur Andersen Foundation and Cor-nellÊs Johnson Graduate School of Management Richard Barker, Sandra Dawson, Gishan Dissanaike, Geoff Meeks, Christopher Pratt, and Geoff Wittington all facilitated my visit and made it a very pleasant experience

At Cornell, Sheri Hastings kept my faxes flowing Above all, I want to thank the people at the University of Cambridge Library, especially Ann Toseland; Ann kept me supplied with film of the newspapers of 1929 to

1950, and did not complain of my repetitive requests While the others are unnamed by me (unfortunately), their helpfulness is well remembered

I also want to thank Burton Malkiel, who offered a friendly intellectual challenge that led to my initial interest in the events of 1929

INTRODUCTION

Senator Glass: „Mr Whitney, right on that point may I ask you

a question: What percentage of the public is [sic] speculating in stocks of the stock exchange understand the real intrinsic value

of the stocks in which they deal?‰

Hearings before the U.S Senate Committee on Banking and Currency on stock exchange practices

Admittedly, it is preposterous to suggest that stock speculation

is like coin flipping I know that there is more skill to stock speculation What I have never been able to determine is·how much more?

·Fred Schwed, Jr., Where Are the CustomersÊ Yachts?

The year 1929 stands out as the most significant year of the decade of the 1920s In the minds of most people, the year 1929 marks the crash

of the stock market, the beginning of the Great Depression, and the end

of a 10-year period of prosperity that exceeded anything the United States had ever known

In 1955, John Kenneth Galbraith published his very readable and

enjoy-able classic The Great Crash, 1929 A reader of that popular book might

well conclude that it would be foolhardy for someone to retrace the same path And it would be; but I will follow a different path and arrive at a different set of conclusions

What actually was the economic situation in 1929? How does it compare

to the economic situation in 2008 – 2009? To better illuminate the current dark financial picture, I take a fresh look at the Crash of 1929 and then compare that period to the stock crash of 2008 – 2009 I challenge the facts

„everyone knows‰ and overturn previously held assumptions concerning the catastrophic events that led to 10 years of economic depression Like-wise, todayÊs news is filled with stories about what is happening and why While itÊs still too soon to come to rock-solid conclusions about the financial market meltdown of 2008 – 2009, much of what has happened could have been foreseen and even avoided · just as it could have been

in 1929 By accurately assessing the causes behind the 1929 stock market crash that led to the Great Depression, and the causes that led to the decline

of 2008 – 2009, readers can better grasp the present market situation and more wisely make financial decisions

This book considers the economic situation in 1929 and the events ing up to the stock price declines in October of that year It concludes that the 1920s were a wondrous period of economic prosperity for the United States, and that in 1929 it was far from obvious that the stock market was

lead-in trouble But somethlead-ing very serious happened lead-in 1929 to stock prices, and we should try to understand it

There are many myths about 1929 that are incorrect The myth that

is most relevant to this book is „Stocks were obviously overpriced (the evidence suggests stocks were reasonably priced.)‰ While stocks were not obviously overpriced in general, there was one sector of the market, public utilities, that can be shown to have been overpriced

This book is an attempt to refute unjustified myths and to define the causes of the 1929 stock market crash There were several factors that combined in October 1929 to bring about the crash

It is important that the causes be properly understood, because the 1929 stock market was not that much different from the market today or different from what the market could be at any time in the future

The 2008 – 2009 stock market crash was actually more severe than the

1929 – 1930 crash, and it is equally important to understand that event During the 1920s, commerce in the United States attracted truly outstanding individuals who achieved successes of an international nature The stories and achievements of such business people as Benjamin Strong, Owen D Young, and Alfred P Sloan are inspirational What went wrong and caused the stock market to crash in October 1929?

What did happen in 1929? Herbert Hoover, the president of the United States, saw increasing stock market prices as a speculative bubble manu-factured by the mistakes of the Federal Reserve Board: „One of these clouds was an American wave of optimism, born of continued progress

over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississipi Bubble.‰ 1 But the optimism was justified The „bubble‰ did not have to burst The Federal Reserve Board did not create the bubble, but it may have contributed to the destruction of stock market values

During 1928, in hearings before the Senate Committee on Banking and Currency, Senator Glass asked Whitney to reveal the percentage of inves-tors who were speculators and who understood the real intrinsic value of the stocks they bought Whitney (and others) could not distinguish between

a speculator and an investor Also, no one in 1929 knew how to determine, with any degree of confidence, the real intrinsic value of stocks (in fact, the determination of stock value still remains a challenge) Stock picking requires more skill than coin flipping, as Fred Schwed maintains, but it

is not clear how much more skill we have to pick stocks or to determine when the market is too high (when it becomes necessary to make the sell decision) or too low (when it becomes necessary to make the buy deci-sion) Overconfidence on the part of investors who „know‰ that the market

is too high or too low is very dangerous, as the following conversation suggests:

Investor: „I am developing a feel for the market.‰

Friend: „Take an aspirin You are probably just catching a cold.‰

Many financial decisions made today are heavily influenced by what

we understand to have happened in the past It is important that we try

to understand what the actual economic situation was in 1929 and what happened to the stock market

In 2008, the stock market again crashed The 2008–2009 crash was actually more severe than the 1929–1930 crash We should look to the events of 1929 in order to better understand the events of 2008–2009 The first lesson for an investor is that even in a normal year, the stock market can fall 50 percent in a matter of months The investor who does not recognize that fact is vulnerable to unnecessarily large losses The stock market is volatile and always will be Diversify!

·Rappoport and White (1993, p 570)

On Black Thursday, October 24, 1929, the stock market (New York Stock Exchange) fell 34 points, a 9 percent drop for the day The trading volume was approximately three times the normal daily volume for the first nine months of the year There was a selling panic But the series of events leading to the crash actually started before that date

THE STOCK MARKET 1922–1932

Table 1.1 shows the average of the highs and lows of the Dow Jones Industrial Stock Index for 1922 to 1932

Using the information of Table 1.1, from 1922 to 1929 stocks rose in value by 218.7 percent This is equivalent to an 18 percent annual growth rate in value for the seven years From the low of 245.6 in 1928 to the high

of 386 in 1929, there was a 57 percent growth; but using the 290.0 sure for 1929, the increase for 1929 was only 15 percent From 1929 to

mea-1932, stocks lost 73 percent of their value (different indices measured

at different times would give different measures of the increases and decreases) The price increases were large but not beyond comprehen-sion, given the real prosperity taking place in the United States The price decreases from 1929 to 1932 were consistent with the fact that by 1932,

there was a worldwide depression, and stock price expectations were not optimistic

If we take the 386 high of September 1929 and the 1929 year-end value of 248.48, the market lost 36 percent of its value during that four-month period John Kenneth Galbraith apparently would have had no difficulty forecasting the crash: „On the first of January of 1929, as a matter of probability, it was most likely that the boom would end before the year was out‰ (1961, p 29) Paul A Samuelson, on the other hand, admits that „playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught by the 1929 debacle‰ (1979, p 9)

Most of us, if we held stock in September 1929, would not have sold early

in October In fact, if I had liquidity, I would have purchased stocks after the major break on Black Thursday, October 24 For the next 10 years, I would have been sorry, since Black Thursday was not the end of the decline The 1929 stock market, for many reasons, was like a large boulder on top of a hill Given enough pushes to get it started, the boulder would roll down the hill, accelerating as it went We want to consider why the market was in such a sensitive position and what factors acted to start its down-ward fall We will find that there were many contributing factors leading

up to the crash Each of them is small taken individually, but together they helped create the right situation for the debacle

Table 1.1 Dow-Jones Industrials Index,* Average of the Highs and Lows

Observers were not pleased with the severity of the crash Thus John Maynard Keynes (Moggridge 1981, p 1, and 1992, p 480), in a letter

to his wife, Lydia (October 25, 1929), wrote, „Wall Street did have a go

yesterday The biggest crash ever recorded I have been in a oughly financial and disgusting state of mind all day.‰ Before the events played out, many others would share KeynesÊs despondency

There is evidence that the stone on the hill is an apt description of the market in 1929 In a recent study, Rappoport and White (1994) treat brokersÊ loans as options written by the lender and bought by the borrowers They conclude ( p 271), „The sharp rise in implied volatility coincident with the stock-market boom suggests the fear of a crash.‰ This conclusion, that there was fear of a market crash, is easily acceptable given the statements and positions of the Federal Reserve Board and the U.S Senate, to be described later

One position is that the stock market was too high; thus a crash was inevitable Reasons will be given to justify the level of prices I conclude that the market was not too high in 1929

There are two basic but nạve and incorrect methods of „proving‰ that the stock market was too high in September–October 1929, using only stock prices One is to compare the stock market prices for some prior period, say 1925, with those of September 1929 The stock price increases for this time period are impressive Balke and Gordon (1986) show a 155 percent increase (the third-quarter 1929 stock prices are 2.55 times as large as the

1925 prices) During the first nine months of 1929, the increase was 15 cent The market did go up dramatically from 1925 to October 1929 The second popular method of „proving‰ that the market was too high

per-is to compare the September 1929 prices with those in November 1929 or, more impressively, with prices in 1932 In 1932, prices were 32 percent of the year-end 1929 prices They went down Malkiel (1996, p 50) uses the following stock prices (Table 1.2) to illustrate the excessive heights that stocks reached in September 1929

Obviously, either the September prices are too high, the November prices are too low, or the world changed But comparing stock prices merely shows that changes took place There is a plausible explanation for the high prices of September 3, 1929

In evaluating the P/ EÊs of firms in 1929, it is useful to estimate the costs of capital Long-term debt was yielding approximately 5 percent and preferred stock 6 percent Dividend yield on the average stock was 3.19 percent in August, and the dividend payout rate was 0.64 For comparison, U.S Trea-suries in August of 1929 yielded 3.7 percent

With a retention rate of b = 0.36 and a return on new investment of

r = 0.14, the expected growth rate is g = rb = 0.14(.36) = 0.05 Assume that

the cost of equity is approximately 8.2 percent With these assumptions and facts, a P/ E of 20 is justified for the average firm

With a growth rate of 0.06, a P/ E of 29 would be justified

Adding growth from the use of debt and from issuing new equity capital, a larger P/ E than 20 would be justified There is a wide range

of calculations of actual average P/ EÊs for 1929 One estimate in man (1991, p 59, based on statistics from MoodyÊs) is an average P/ E of 16.3, which is low compared with the 20 computed above Wigmore (1985, p 572) found a P/ E of 29.8 using the high stock prices and 12.4 using the low prices of 1929 These P/ EÊs are based on the data

Bier-of 135 companies Irving Fisher estimated the P/ E ratio to be 13 for

the market as of August 1929 ( Commercial and Financial Chronicle,

October 26, 1929)

The use of different companies and data from different times results

in different measures of the P/ E ratio in 1929, but the range of estimates seems to be from 12.4 to 29.8, with 16.3 being a reasonable estimate Let us consider (Table 1.3) the price – earnings ratios of the same six companies that were included by Malkiel, using the high and low prices of

1929 (numbers from Wigmore, 1985, pp 34 – 87)

Using the low 1929 prices for all the stocks, we have very reasonable P/ E ratios ranging from 7 to 18 If anything, given the low cost of equity and high expected growth rate, these P/ EÊs are too low Using the high prices in the numerators, the ratios are somewhat high, especially RCA, with an indicated P/ E of 73

Table 1.2

Selected Stock Prices in 1929

High Price September 3, 1929

Low Price November 12, 1929

American Telephone &

Telegraph

304 197 1 Î 4 ¼ Bethlehem Steel 140 78 1 Î 4 ¼

Table 1.3

Price – Earning Ratios for the Corporations of Table 1.2

Using the High Price for 1929

Using the Low Price for 1929

American Telephone &

Telegraph

20 13 Bethlehem Steel 13 7

The Wall Street Journal on October 9, 1929 (p 17), had an article with

the heading „Rails Sell 11.9 Times Earnings.‰ This multiple was before the October 24 crash, but it reflected the stock price decreases of September and the first week of October The P/E measure was for 27 dividend-paying rail-roads During October, the Dow Jones railroad index dropped from 173 to

159, a drop of only 8.1 percent Railroads were not a bubble on October 1

On October 22 the Journal ( p 3) reported „Utilities Sell at 24 Times

Net.‰ The net was for the 12 months ending June 30, and the multiple was for 20 representative companies (6 were below 20 times earnings)

At the end of July, they had been selling for 35 times earnings A day

later, the Journal ( p 1) reported that aviation issues were selling at

12 times net after their market value was reduced 56 percent (the P/ E had been 23) The earnings used were the estimated 1929 earnings The above P/EÊs were all before Black Thursday

THE REAL ECONOMY

The 1920s were a period of real growth and prosperity Real income rose 10.5 percent per year from 1921 to 1923 and 3.4 percent from

1923 to 1929 The gross national product (GNP) increased in real terms from 296.22 in 1928 to 315.69 in 1929 (Balke and Gordon, 1986, p 782)

The year 1929 was the best year ever for the U.S economy The Federal

Reserve Bulletin showed production at 119 in July; in August it increased

to 121, and in September to 123 In October, it dropped to 120, but this level of production was still higher than JulyÊs level

There was a widespread feeling that real business activity was in good

shape For example, consider the following from the Economist,

Octo-ber 5, 1929 ( p 616): „Meanwhile, business news continues rather good,

with exceptionally high rate of production during the summer months Excellent autumn and holiday trade is anticipated.‰

During the period 1919–1929, total factory productivity increased at an annual rate of 5.3 percent for the manufacturing sector This was twice the rate for the entire period studied (the last year studied was 1953 [Kend-rick, 1961]) Farming, mining, transportation, communications, and public utilities all did well Across all industries the period 1919–1929 was the

period of most productivity improvement The Federal Reserve Bulletin

(1930, p 494) showed total industrial production at 83 in 1919 and 118 in

1929 (the maximum was 125 in May and June) This was an annual growth rate of 3.6 percent

There were warning signs, not necessarily observed in October 1929, that real economic activity was slowing Steel output in September was 416,000 tons below August, and „automobile production decline[d] 82,000 cars practically to level of 1928.‰ These observations were from

the New York Times, December 31, 1929 (p 30) They were not likely

to be widely known in October Balancing these belated negative reports

were two front-page headlines in October from the Wall Street Journal

(October 2): „Steel Activity in Sharp Rise‰ and (October 7) „Motor Output Above Normal.‰ The majority of the economic news reports in October were very favorable

On October 4, the Wall Street Journal (p 1) had a major headline: „Best

September in Typewriters.‰ The article went on to say that sales of

type-writers were regarded as a reliable index of business activity The Journal

editor concluded that there was little chance of a recession

All of the following measures for September – October 1929 were above the 1923 –1926 index measure of 100:

Freight car loadings

Commodity prices were less than 100 and the prices of farm products were

at 105

The business news during the summer and fall of 1929 was very good

On May 24, the Magazine of Wall Street carried an article describing the

expansion possibilities for electricity in rural areas The October 1, 1929,

issue of Forbes described record-breaking rail earnings The June 15

issue of the Magazine of Wall Street stated, „Business so far this year has

astonished even the perennial optimists.‰

When the stock market price break came on Thursday, October 24,

the Economist (p 805) observed, „The final collapse of the Wall Street

Boom has confounded optimists and pessimists alike.‰ And an important point that is frequently ignored (p 824): „The share boom

of 1926–29 originated in a period of industrial prosperity which has never been surpassed in the worldÊs history.‰ Thus the business news immediately prior to October 24 was extremely positive (except for the

regulatory news applicable to the utility sector) As the Economist states,

it was a period of industrial prosperity that had never been surpassed Of course, stock prices went up They went up not because of speculators but primarily because of economic facts If this had not been true, the speculators would have sold the market (or more exactly its components) short and put an end to the boom long before October 24, 1929

Cecchetti (1992, p 576) writes, „We will never know exactly what caused the stock market to fall by nearly 30 percent in late October 1929.‰

He is correct, but there is more to be learned He also states, „First, there

was no reason to believe a priori that stock prices were too high before

the crash.‰ He identifies (p 574) as causes the „Federal Reserve behavior, together with the public statements of numerous government officials.‰ The research conducted for this book allows us to agree with and expand

on these thoughts

Chapter 2

THE EVENTS PRIOR TO THE

1929 AND 2008 CRASHES

However, if the attitude of the Federal Reserve officials can

be properly construed from statements of its friends, there are those who are just as apprehensive that the market may go up as the average small investor is afraid that it might go down

·The Magazine of Wall Street, May 18, 1929

From 1925 to the first three quarters of 1929, the stock market increased dramatically Table 2.1 shows an index of all common stock prices and the changes in value from 1925 to 1929

The fact that common stocks increased in value by 120 percent in four years (1925–1929) implies a compound annual growth rate of 0.218 Although this is a large rate of appreciation, it is not obvious proof of an orgy of speculation

The decade of the 1920s was extremely prosperous in real terms, and the stock market, with its rising prices, reflected this prosperity as well

as the expectation that the prosperity would continue But Congress and the Federal Reserve Board worried about the speculation taking place in New York The hearings held by the Senate Committee on Banking and Currency on broker loans in February and March 1928 and the hearings

on stabilization held by the House Committee on Banking and Currency

in March, April, and May 1928 are very helpful in understanding the subsequent actions of the Federal Reserve Board in 1929

The Senate committee was concerned because total loans secured by stocks and bonds of the member banks of the New York federal reserve

Table 2.1

Common Stock Prices, 1925–1929

Year

Index of All Common Stock (1941– 42 = 10) Growth Rate

Cumulative Change from 1925

Source: N S Balke and R J Gordon, „Historical Data,‰ in The American Business Cycle (Chicago:

University of Chicago Press, 1986), p 802.

district on January 11, 1928, exceeded $3.8 billion, and „the largest part

of this sum is used for speculation in the New York Stock Exchange.‰ 1 The desire to control the speculation taking place in the New York Stock Exchange (NYSE) was primary The senators did not define speculation, but they knew it was evil and had to be controlled

Senator Robert LaFollette of Wisconsin led off the 1928 hearings by quoting H Parker Willis, an ex-secretary of the Federal Reserve Board:

„it remains a fact that our reserve system has excited no real remedial influence upon the great American evil of stock-exchange gambling.‰ 2 Roy Young, the newly appointed governor of the Federal Reserve Board (he had been the governor of the Minneapolis Reserve Bank), defended the reserve system and pointed out that the increase in broker loans between January 6, 1926, and February 29, 1928, „came about entirely in the ad-vances that were made by corporations and individuals‰ and was not the result of actions taken by the Federal Reserve or by New York banks 3 Young asked the rhetorical question: „Is this volume of credit that is going to the stock market denying commerce and industry credit?‰ 4 He concluded that he could find „ no evidence of credit being denied to com-merce or productive industry.‰ 5 Young concluded by stating, „Now, I am not prepared to say whether the brokersÊ loans are too high or too low

I do not think anybody else can say so I am satisfied they are safely and conservatively made.‰ 6

Senator Carter Glass responded by asking, „Would you not modify that and say they are safely made?‰ 7

Young did not object to the elimination of the word „conservatively.‰

He stated, „Yes, I am; however, speaking from the Federal Reserve Bank standpoint, I do not think the Federal Reserve should say whether they are too high or too low Now if there is a further expansion of this bro-kersÊ loan account and it gets to the place where it is dangerous and borders on unwarranted speculation, I have enough confidence in the American banking fraternity to believe they can correct that situation themselves.‰ 8

This positive statement is important, since it separated Young from the other members of the board The five other members of the board con-cluded that there was excessive speculation and the board had to take action

Edmund Platt, vice-governor of the Federal Reserve Board ( Platt was an ex-newspaper editor from Poughkeepsie, New York), also testified that he did not know that the market was too high 9

Mr Platt: It looks as if it was an inflation in the price of securities On the

other hand, I do not believe anybody can positively and definitely say that a security like United States Steel, for instance, should not sell on a 5 percent basis With all the saving of capital that Professor Sprague has told you about and everything, maybe there is so much capital seeking investment that securities that appear to be reasonably sound, with a future prospect perhaps ought to sell on a 5 percent or even a 4½ percent basis I do not see how anybody can tell positively

Senator Glass: Do you think that bets are always made with reference to the

soundness of the security?

Mr Platt: Not always; but I think that is pretty generally true with relation to

the higher grade ones · such securities, for instance, as the investment trusts all buy There is another thing injected into the situation We have had a tre-mendous growth in investment trusts lately by which the smaller investor can put in a thousand dollars and have his investment scattered among such stock

as American Telephone and Telegraph, United States Steel, etc His thousand dollars are spread among the whole lot of them so there is not very much risk

of loss in the long run

Platt failed to realize that investment trusts could not protect the tor from changes in the level of the stock market He also did not realize that some of the trusts were using large amounts of borrowed funds to leverage the returns on equity investment and thus had large amounts of risk

Glass then „established‰ the presence of gambling in the market

Senator Glass: I have in mind just a single security right now among many others

that occupy a similar position It was quoted in last January at 1081Î4¼ There has been no change in the management of the corporation, there has been no

approximate increase or diminution in the supply and sale of the product The same security is selling on the market, or was yesterday, at 69

Mr Platt: It was selling at 108?

Senator Glass: It was selling at 108 in January It was selling on the market

yesterday at 69 Now, what is that but gambling? 10

Glass seemed to suggest that buying a stock that decreased in value was gambling Platt was correct about „not much risk of loss in the long run,‰

if „long run‰ is defined to be in excess of 20 years In the short run, the risk prospects are much different

Charles Hamlin of the board (a lawyer from Boston) declined the invitation to testify, but E H Cunningham of the Federal Reserve Board (an ex-Iowa farmer) did offer some comments He made clear that he was against the use of credit for speculative purposes: „I do feel, how-ever, that the rapid increase of the past three years in the use of credit for speculative purposes is a tendency in the wrong direction Credit used for such purposes is a part of the credit availability of the country, and in the event that the credit supply should become or limited, the amount invested in stock loans will naturally have the effect of limit-ing credit availability, and might possibly, if some measure of control is not provided, reach such proportions as to seriously embarrass the credit requirements of business and commerce.‰ 11 The inability of the board to distinguish between credit being used to finance security purchases and credit used to finance the purchase of real goods and services was to cost the country dearly

In March, April, and May of 1928, the House Committee on Banking and Currency held hearings on stabilization These hearings were relative

to the consideration of an act that would amend the Federal Reserve Act of

1913 to have the federal reserve system promote the stability of commerce and a more stable purchasing power for the dollar

The first person to testify was Adolph Miller of the Federal Reserve

Board, a former economics professor He quoted extensively from The Behavior of Prices by Frederick C Mills There followed an interesting

exchange between Miller and Otis Wingo, a congressman from Arkansas:

Mr Miller: Well, I have had this book in my hands only a couple of days, so

I cannot tell you all that is contained in the volume

Mr Wingo: I think you will find when you read it clear through that he says that

the behavior of prices is largely like the behavior of individuals That is his theme 12

Wingo later asked a series of questions that anticipated perfectly the misguided actions of the board in 1929

Mr Wingo: IsnÊt this the major question that governs your board in deciding such

questions? DonÊt you consider what your policies should be in regard to ing the needs of legitimate business in the country, and not the effect on the stock market? If the needs of legitimate business require easy money, then you will meet that need and not be scared off because perchance there is an atten-dant evil that there may be a lot of speculation in the stock market?

Mr Miller: How do you propose to reconcile those two purposes? We have a

securities market in this country that generally is ready to take advantage of easy and cheap credit

Mr Wingo: I donÊt think you caught my point My point is this The factor that

should control in fixing the rediscount rates and in determining whether or not you will put more money in the market or take money out is not what is going

on in the stock market · that is not the prime consideration · but what are the necessities of legitimate business?

Mr Miller: Yes

Mr Wingo: And the fact that in meeting the necessities of legitimate business you

happen to stimulate a little bit the amount of speculation in the stock market should not deter you from meeting the major needs of business? 13

Miller kept responding and Wingo kept pointing out to Miller that „You still donÊt get my question.‰ 14 If Miller had understood Wingo, the course

of history might well have been changed Wingo was intelligent and knowledgeable He was even a fine pragmatic teacher (as evidenced by his questions) Unfortunately, Miller and four other members of the board did not understand the difference between the stock market and the real economy Wingo finally declared: „That is, you cannot always determine when a brokerÊs loan or a stock loan is one for speculative purposes.‰ 15 Miller did not speak directly to that statement but he did finally state,

„ I am of the opinion that for the purposes of good administration in the federal reserve system a tight control over the diverting of its credit into any kind of speculative loans is necessary.‰ 16

When one of the congressmen asked „As a matter of practical banking, you would know where the money went to, wouldnÊt you?‰ 17 Miller responded „It is not always easy to know it But it can be sensed.‰ 18 Remember, Miller was the intellectual leader of the board in 1929 and the most forceful of its members The board was in deep trouble

Hamlin, who declined to testify in earlier hearings, testified at this hearing and revealed that he thought the board had a right to act when

„speculation so threatens business, threatens to curtail, perhaps, business credits that may be demanded.‰ But he also stated „I should always be reluctant to act.‰ 19

Young, governor of the Federal Reserve Board, also testified, but his testimony can be summarized by his statement that „stability is a big ques-tion and a big problem It is one that I am not capable of talking about

definitely at this time.‰ 20 Miller thereby became the de facto leader of the board

No one can support or contradict conclusively the conclusions resulting from „ what if ‰ statements But we should ask, what if a healthy Otis Wingo

of Arkansas had been the governor of the Federal Reserve Board in 1929? His questions during the hearings indicated a knowledge of economics and finance exceeding that of all members of the board Unfortunately, the cards were not dealt that way, and Adolph Miller was the guiding force behind the actions of the board in 1929

Wingo deserves more than a few words of praise He was admitted to the bar in 1900 and practiced law in Sevier County, Arkansas He was elected to Congress nine times and served in Congress from 1913 until his death in 1930 He was one of the prime authors of the Federal Reserve Act When he died on October 21, 1930, he was replaced in Congress

by his wife, Effiegene Loeke Wingo, who then ran for Congress, was elected, and served in Congress from 1930 to 1933 She did not offer herself as a candidate for renomination in 1932 but proceeded on to other activities

A contemporary offered the following description of Wingo: „A man of commanding appearance, self-confident, fearless, and aggressive, Mr Wingo was a natural leader His ideals were high, his emotions deep, and in all relations he was loyal, kind and considerate.‰ 21 Despite the fact that he was suffering from ill health during the hearings, his questions were unusual in their consistent fairness, insightfulness, and intelligence It is a tragedy that Miller did not listen more carefully to the congressman from Arkansas The congressman did well We are in his debt He effectively dispelled the myth that credit given to brokers kept credit from being given to the real economy Unfortunately, Miller did not learn the lesson

We cannot be sure of cause and effect in 1929 But we can be sure that Miller did not understand the lesson being taught by Wingo in 1928 In

1929 the Federal Reserve Board, with Miller as the intellectual leader, tried by several significant actions to stop stock market speculation By August it had succeeded We will not be able to conclude that the board caused the stock market price declines in the fall of 1929, but there is evi-dence that the stock market price increases (arising from speculation) were

a major concern of the board, which took actions to stop them

On Sunday, October 13, 1929, the Times ( p 7) reported that Professor

C A Dice of Ohio State, an economist, had declared, „Stock Prices Will Stay at High Level for Years to Come.‰ He gave the following justifica-tions ( p 7): „the great economic developments in wealth, in efficiency of production and transportation, in cheapness and adequacy of distribution,

in invention and engineering and in public good-will and confidence.‰

He concluded „The day of the small investor is here.‰ Dice was an cate for the „new era.‰

Consider the following information regarding performance of U.S corporations, which was readily available in 1929:

1 In the first nine months of 1929, a total of 1,436 firms announced

increased dividends ( Forbes, October 15, 1925, p 95) In 1928, only

955 announced an increase

2 In the first nine months, cash dividends were $3.1 billion, up from

$2.4 billion in 1928 (a 29 percent increase)

3 In September 1929, dividends were $399 million compared with $278 lion in 1928, an increase of 44percent

4 The dividend payout was 64percent in September 1929, compared with

75 percent for September 1928, reflecting increased earnings

5 Earnings compiled for 650 firms showed a 24.4 percent increase

versus 1928 for the first six months ( National City Bank of New York

Newsletter, August 1929) The earnings for the third quarter for

638 firms were 14.1 percent larger than for 1928 For the first nine months of 1929, the earnings of the 638 firms had increased 20.3 per-cent compared with 1928 (November 1929, p 154) The March 1930 issue showed that for 1,509 firms, annual earnings had increased by 13.5 percent for 1929 compared with 1928

It is not difficult to see why the market was using high expectations

of earnings growth With reasonable (for the time period) estimates of growth, most of the industrial stock prices for September 1929 can be justified with a dividend growth valuation model

It is important that we more fully understand the causes of the 1929 stock market crash and correct some of the widely held misconceptions

If stock prices were too high because of speculative buying and the crash was inevitable, then the lesson to be preached is simple, if not easily executed One should not invest in stocks if stock prices are too high The conventional wisdom is that speculation was the cause of stock prices being too high Thus Malkiel (1996) writes ( p 51) about a speculative

boom: „Perhaps the best summary of the debacle was given by Variety,

the show-business weekly, which headlined the story, ÂWall Street Lays

an Egg.Ê The speculative boom was dead and billions of dollars of share values · as well as the dreams of millions · were wiped out.‰

Laying the blame for the „boom‰ on speculators was even more mon in 1929 Thus, immediately upon learning of the crash of October 24,

com-Keynes wrote in the New York Evening Post (October 25, 1929): „ The

extraordinary speculation on Wall Street in past months has driven up

the rate of interest to an unprecedented level‰ (Moggridge, 1981, p 2 of

vol xx) And the Economist, when stock prices reached their low for the

year, repeated the theme that the U.S stock market had been too high (November 2, 1929, p 806): „There is warrant for hoping that the defla-tion of the exaggerated balloon of American stock values will be for the good of the world.‰

The key phrases in the above quotations are „exaggerated balloon of American stock values‰ and „extraordinary speculation on Wall Street.‰ The common viewpoint was that the U.S stock market was too high But if the conventional view of history is not correct and if U.S stocks were not universally too high, then what did cause the great crash? The stock market index hit a high of 386 in September 1929; by November,

it had dropped to 230, a drop of 40 percent By the time the crash was completed in 1932 · and thanks to the oncoming of the real economic depression · stocks had lost in excess of 70 percent of their value The results of the crash were devastating to individuals and to nations The crash helped bring on the depression of the thirties and the depression helped to extend the period of low stock prices, thus „proving‰ that the prices had been too high This book reviews a small set of possible causes

of the crash and reaches specific conclusions that might cast some light

on this important event The lessons for investors and students of history are important Although I cannot prove that I know the exact specific causes of the crash, I present some reasonable evidence supporting my hypotheses

A CATALOGUE OF EIGHT CAUSES

Consider the eight „suspects‰ that may or may not have caused the crash The identified possible causes include the following:

1 The stock market was too high in September 1929 (values did not justify the prices) because of excessive speculation, making the crash inevitable

2 There was a real downturn in business activity

3 Actions of the Federal Reserve Board excessively restricted growth of the money supply

4 On both sides of the Atlantic, a message was being sounded by both the media and important governmental figures that the U.S stock market was too high; hence there was a „war‰ against the speculators

5 There was excessive buying on margin and excessive buying of ment trusts; relative returns and costs of buying on margin are relevant

invest-to evaluating margin buying

6 There was excessive leverage when the debt of operating utilities, ing companies, investment trusts, and margin buying are all considered

7 There was a setback in the public utility market arising from an adverse decision for utilities in Massachusetts combined with an aggressively priced utility market segment

8 The market overreacted

We will choose number 7 as the triggering event The leverage ber 6) and the repetitive statements that the market was too high were also major factors

THE 2008–2009 MARKET CRASH

When real estate prices started to go down in 2007 and homeowners found that their mortgages were larger than the value of their houses, many borrowers stopped making their mortgage payments The mortgage defaults spread to the default on collateralized mortgage obligations held

by financial institutions financed with over $30 of debt for each dollar

of equity This led to a string of financial institutions having more debts than assets, resulting in a drastic restriction of credit available to industry The stocks of the financial sector were battered; then, as business activity slowed, other stocks tumbled With falling operating results, the lower stock prices observed in the fall of 2008 were soon justified, given the lower operating earnings

The problems in the financial sector led to an inability of these firms to lend The drying up of credit led to a decrease in business activity, which led, in turn, to a worldwide recession in 2008 – 2009

In 1929, the stock market crash led to a decrease in business activity in

1930 –1932

In 2008, financial events (house prices decreased in value, subprime mortgages defaulted, and business activity decreased) triggered stock price decreases, which were rapidly validated by poor income measures

in the fourth quarter of 2008 The stock price decline in 2008 was more severe than that in 1929

Alan Greenspan wrote in The Wall Street Journal (March 11, 2009) that:

„ There are at least two broad and competing explanations of the origins of this crisis The first is that the Âeasy moneyÊ policies of the Federal Reserve produced the U.S housing bubble that is at the core of todayÊs financial mess The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria How-ever, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.‰

The long-term fixed rate was more relevant, since it is the rate that should be used to value long-lived real estate

Thus we have low long-term interest rates fueling a vigorous real estate market Wall Street encouraged the real estate boom by packaging the mortgages so that even segments with the worst credit were given

a triple-A rating In addition, the buyers of risky components seemed

to be able to divest themselves of the risk by engaging in credit default swaps

All seemed to be going well until 2008, when real estate prices stopped going up and borrowers lost the incentive to pay on mortgages that were larger than the value of the real estate

Credit default swaps (CDSs) grew from a market of a few billion dollars

in 2001 to $60 trillion in 2007 Banks bought subprime mortgages and then engaged in swaps, where they paid the risk taker in good years, but the banks were paid if the borrower did not pay the mortgage in a timely fashion Since the bank unloaded its risk to the swap counterparty, it could buy additional risky mortgages

Unfortunately, the risk still existed If the counterparty who promised to pay in case of mortgage default accepted too many swaps in a bad year, it would be unable to pay The banks that had purchased protection would (and did) find that the losses were not effectively hedged

Why were credit default swaps a reasonable strategy for the banks buying the subprime mortgages? The mortgage originators were lending money to real estate buyers with a low probability of being able to make their mortgage payments and with little incentive to pay if the value of the real estate was less than the value of the mortgage obligation

In a letter to the editor ( The New York Times, May 10, 2009), Ian Jarvis

makes the point that if a real estate investor „would have walked down Main Street just once pretending to be a homebuyer and spent one day having liarsÊ loans thrust at him, he would have met the real estate agents selling overpriced merchandise to underinformed dreamers and heard the agentsÊ pitch ·„Investors like you, sir, are making a fortune.‰ If he had done his homework, Mr might not have played the part he did

in devastating our economy.‰

·The Magazine of Wall Street, November 16, 1929

There is a great deal wrong with our understanding of the 1929 stock market crash Even the name is inexact The largest losses to the market did not come in October 1929 or the winter of 1930 but rather in the following two years In the calendar year 1929, the market lost only 11.9 percent of its value, after having gained 37.9 percent in the previous year In Decem-ber 1929, many expert economists, including John Maynard Keynes and Irving Fisher, felt that the financial crisis had ended, and by April 1930 the Dow Jones Industrial Average had recovered a large percentage of the October losses By contrast, from September 2008 to March 2009, the stock market lost in excess of 50 percent of its value

Our misconceptions about the events of the fall of 1929 have been fed

by the easy generalizations of authors more interested in being cally clever than in analyzing the facts We will show that there are good reasons for thinking that the stock market was not obviously overvalued in

dramati-1929 and that it was sensible to hold stocks in the fall of dramati-1929 and to buy stocks in December 1929 (admittedly this investment strategy would have been terribly wrong)

We want to consider two basic questions in this book: Was the stock market unreasonably high in October 1929? Was a crash inevitable? We will present explanations for the initial decline in stock market value which are

not dependent upon an assumption of overvaluation But we will not fully explain why the market turned down in the fall of 1929 Changes in market psychology are not perfectly explained by reference to specific events.The objective of this book is not to determine whether the fall in stock prices triggered the Great Depression of the 1930s but to describe more accurately the stock market crash of 1929–1932 so that we can better under-stand the present stock market situation and better predict the future.

It is normal practice to describe the 1929 stock market prior to October

as a bubble or speculative orgy Throughout economic history many events have been defined as bubbles Historically, the existence of price bubbles (large price increases followed by large price decreases) in financial mar-kets has been explained, in part, by the assumption of irrationality on the part of traders For example, C R Kindleberger explains bubbles in the following way: „speculation for profit leads away from normal, rational behavior to what have been described as manias or bubbles The word mania emphasizes the irrationality; bubble foreshadows the bursting.‰1 In

2008, the real estate bubble burst How do we now there was a bubble in 2008? Prices went down in 2008 and 2009.2

One empirical investigation of the existence of a price bubble was performed by R R Flood and R M Garber.3 They were unable to reject the hypothesis that bubbles were absent from the German hyperinflation

of the 1920s Since their research dealt with rates of changes associated with an overall price level, they are appropriately circumspect in making claims about more specialized asset markets: „The professionÊs folklore

on the existence of bubbles emphasizes such markets, for example, the Tulip Bubble, the South Sea Bubble, the Mississippi Bubble, the crash of

1929 However, no one has verified that a bubble of the type defined in the current rational-expectations literature has ever existed.‰4

Many of the so-called bubbles are actually interesting economic ventures that failed or well-managed scams that were vigorously sold by expert con artists The famous „South Sea Bubble‰ was a combination of the above two factors

The South Sea Bubble (1711–1721) occurred in England It started out as

a legitimate business enterprise (the South Sea Company with a charter for monopoly of trade with Latin American countries) but ended up being the high-pressured selling of nearly worthless securities The South Sea Com-panyÊs first ship to approach Latin America was driven off by the Spaniards

in 1717 In 1718, England was at war with Spain and the companyÊs original charter lost its value Faced with the loss of its reason for existence, the company then proceeded to repackage the debt securities of the English government The firmÊs stock tremendously increased in value as new capi-tal was used to pay old capital and more government debt securities were

purchased Before concluding that only fools get taken in by such bubbles, consider the fact that Isaac Newton in a single month sold his £7,000 of South Sea Company stock at a profit of 100 percent; several months later, however, he lost £20,000 after making further investments in the company.5

It has been said of John Blunt, a director of the South Sea Company and the prime promoter of its securities from 1717 to 1721, that „he continued

to live his life with a prayer-book in his right hand and a prospectus in his left, never letting his right hand know what his left hand was doing.‰6The 1929 stock market situation was intrinsically different from the classic examples of bubbles, including the South Sea Bubble The 1929 stock market crash was more the result of the misjudgments and bad decisions

of good people than the evil actions of a few profiteers There were solid reasons for buying stock in October 1929, but the market sentiment soon shifted from optimism to pessimism, and the negative psychology of the market became more important than the underlying economic facts

BEFORE 1929

It is important to understand some of the most significant events that led to the 1929 stock market decline In 1920, Warren G Harding was elected president of the United States, and in 1924, Calvin Coolidge was elected These two presidents do not rank high in performance, and their appointees left something to be desired At the beginning of 1929, the Federal Reserve Board consisted of Harding – Coolidge appointees

or reappointees (three members of the board · Edmund Platt, Charles

S Hamlin, and Adolph C Miller · had originally been appointed by Wilson) Unfortunately, these appointees were not the most talented or best prepared for controlling the U.S banking system The Federal Reserve Board in January 1929 consisted of the following six members (omitting the two ex-officio members: Secretary of the Treasury A W Mellon and Comptroller of the Currency J W Pole):

Roy A Young, Governor Young had been governor of the Minneapolis Reserve Bank before joining the board

Edmund Platt, Vice-Governor Platt was an ex-newspaper editor and ex-congressman from Poughkeepsie, New York

Adolph C Miller Miller had been a professor of economics at Harvard, the University of Chicago, and Cornell

Charles S Hamlin Hamlin was a Boston lawyer who had been an assistant secretary of the treasury with Cleveland and Wilson He was the first governor of the Federal Reserve Board

George R James James was a Memphis merchant

Edward H Cunningham Cunningham was an Iowa farmer

Young, Hamlin, and Miller had relevant experience or academic qualifications, but the other members of the board required on-the-job training Neither Young nor Hamlin were very insightful or forceful and did not supply the leadership needed by the board, although Young actu-ally opposed many of the boardÊs actions in the first six months of 1929 Miller was by far the most decisive member of the board and became the de facto intellectual leader Although he had an academic background, his style was that of an autocrat Hamlin kept a diary that is an impor-tant source of our understanding of what happened in the meetings of the Federal Reserve Board.

Benjamin Strong, the most respected (internationally) of U.S bankers, was the head of the New York Federal Reserve Bank from 1914 until the fall of 1928 In 1925, when direct pressure on banks to control speculation was recommended by the board as a strategy, „Governor Strong disagreed, pointing out that direct pressure could not succeed in New York unless the Federal Reserve Bank refused to discount for banks carrying specula-tive loans, and that it would mean rationing of credit, Âwhich would be disastrous.ʉ7

Although he died in 1928, StrongÊs influence extended to 1929 From

1921 to August 1928, the real financial genius and power in the United States was Benjamin Strong, governor of the New York Federal Reserve Bank Lester V Chandler has written the definitive biography of Strong.8Strong was an acknowledged leader of international finance and truly a giant in U.S banking Most important, StrongÊs intellect and personality (including a great sense of humor) led to New York being the power center

of U.S banking from 1921 to 1928 This frustrated several members of the Federal Reserve Board, especially Young and Miller

In the summer of 1927, the United States was on the verge of a sion Productivity had dipped down and significant economic signs were negative In addition, Europe was losing gold to the United States and European bankers feared an international disaster

reces-Strong led a move to reduce the discount rate and increase the reserve banksÊ holdings of U.S securities This easy money policy succeeded and the recession was avoided Later Miller would blame the resurgence of stock speculation in 1928 on StrongÊs easy money policy of 1927 Miller was very influential in leading the board to avoid this „mistake‰ in 1929

STOCK SPECULATION

Throughout the 1920s, New York banks had financed broker loans The

„speculation‰ being financed by the New York banks became ingly distasteful to members of the Federal Reserve Board The board

increas-advocated „direct pressure‰ on New York banks to limit borrowing by member banks from the Fed, which was then used to finance broker loans Strong disagreed with the Federal Reserve Board He successfully argued that penalizing banks that carried speculative loans would be a disastrous policy In October 1928, Strong died after a long illness After his death, the dispute between the board and the New York Reserve Bank acceler-ated, with the board advocating restricting broker loans and the New York Bank wanting to increase the rediscount rate.

The Federal Reserve Bulletin of February 1929 made it clear that the

federal reserve banks would take steps to decrease the flow of credit to

„speculators.‰ The bulletin stated that the Fed „means to restrain the use, either directly or indirectly, of Federal reserve credit facilities in aid of the growth of speculative credit.‰

By early 1929, the board had sent out a clear signal that it believed there was excessive speculation in stock, and that it wanted the banks to decrease their broker loans Over the next several months, there evolved a series

of explicit conflicts between the board (wanting to control speculation by direct pressure) and the New York City Reserve Bank (wanting to avoid

an arbitrary tightening of credit · with the banks deciding who would get credit) Beginning in February 1929, the Reserve Bank of New York wanted to increase the rediscount rate from 5 to 6 percent The Federal Reserve Board refused the repeated requests until August 1929

A commercial bank that had made a loan, wanting to expand its ability to make more loans, would send the loan to the reserve bank in its district and receive in return federal reserve notes or the accounting entry equivalent The rate paid by the commercial bank to the federal reserve bank is called the rediscount rate; it represents a cost to the bank and defines the rate it must charge (This bank loan rate must be larger than the rediscount rate.)

An increase in the rediscount rate translates immediately into an increase

in the rate the banks charge their customers

The U.S Senate reacted immediately to the boardÊs public tion of the bankÊs practices of fueling the „speculative boom‰; it adopted the following resolution in support of the board:

condemna-Whereas in press dispatches recently, the Federal Reserve Board has complained that money is being drawn from the channels of business and used for speculative purposes, and that some of said speculation is illegiti-mate and harmful:

Therefore, be it

Resolved, That the Federal Reserve Board is hereby requested to give to

the Senate any information and suggestions that it feels would be helpful in securing legislation necessary to correct the evil complained of and prevent illegitimate and harmful speculation.9