Abstract
The paper investigates the causative factors of the 1929 stock market crash. With help of the economic data and previous researches, it has been highlighted that the tight monetary policy led to the crash and subsequent economic failure in 1932. Besides other factors, the prime lesson from the crash for investors in the 21st century is to adopt a diversification strategy, and that for government officials is to employ their power wisely and strategically.
List of Figures and TableTable 1: Economic Indicators of the US: 1929 to 1932. 5 ——————————————- 5
Figure 1: The Fall of the Dow Jones: 1928 to 1934. 4 ———————————————– 4
Figure 2: Unemployment rate in the US: 1929 to 1940. 6 —————————————— 6
AbbreviationsDJIA= Dow Jones Industrial Average
MS= Money Supply
NYSE= New York Stock Exchange
ROI= Return on Investment
Introduction
America’s economy suffered a massive stock market crash in 1929 when the “roaring twenties” bubble burst, resulting in eradicating $5 billion from the NYSE in a matter of 3 days(Lange, 2007). The objective of this brief is to investigate the elements which played a pivotal role in the crash and its impact on the American economy. However, this discussion cannot be comprehensive without highlighting the lessons which today’s economists and investors could learn from the 1929 crash.
Pre-crash Dynamics
In the early 20th century, US economy experienced exponential growth as a ramification of industrialization, advancements in technology, and expanding middle class; hence the economists referred to that era as the roaring twenties. The DJIA soared during 1921-1929, primarily driven by the aggressive share-purchase. The bull market sentiments found their roots in the belief that stock market investment was the safest because of the country’s strong economic boom.
Source: Gitlin, 2008, p.64The index skyrocketed; from 60 points reached 400 points within a small time span, as is shown in Figure 1 (Gitlin, 2008). However, the short-sightedness, or sheer foolishness of investors, reversed the situation.
How Did the Crash Occur?
The boom in the stock market provided an opportunity for margin purchasing; which simply means borrowing to purchase. The rationale behind this strategy is the effect of financial leverage; it increases ROI by manifolds (McLaney, 2003); for instance, a 1% increase in market return could result in 10% increase in ROI. However, the leverage effect can be opposite as well which was completely ignored due to over-optimism of the investors. Experts are of view that during 1929, the speculation about the rise in price, driven by strong economic growth gave birth to an abnormally optimistic investor attitude (Galbraith, 2009).
Nevertheless, when the Federal Reserve (Fed) increased the interest rate to cool the overheated stock market, a powerful bear market emerged. Investors, in a state of panic, started selling their shares, which made the DJIA drop from 400 to 145 points within 3 days (Lange, 2007). Investors, who purchased on debt paid for 10% in cash and 90% from borrowed funds, were not able to pay back their debt when the share prices fell very much contrary to their expectations; consequently they reached a point of bankruptcy. Experts in Behavioural Finance believe that acting in a state of panic was also one of the significant drivers for the stock market crash. Stock-market-behaviour observation asserts that investor sentiments are usually contagious and can cause a snow-ball effect, which in extreme situations, can lead to market crash (Reilly & Brown, 2007). The effect of crash augmented because many banks had also invested their customers’ deposits in the stock market; when prices fell, banks lost their deposits. Subsequently, bank runs occurred when depositors tried to withdraw their funds from the banks all at once. As a ramification of this, 10,000 banks were bankrupted, $140billion of saving was lost in the crash, and the financial system of the country was decimated (Galbraith, 2009).Impact of the Crash
Economists believe that Fed’s tight monetary policy was the main driver for the crash that subsequently resulted in the Great Depression of 1932.
Source: EIU, 2013 Source: EIU, 2013The degree of decimation brought by the stock market crash can be assessed by the fact that the economy had to suffer for four years before it reached the trough in 1932. American economy was unbelievably crashing; its unemployment rate increased from 3.2% in 1929 to 25% in 1932 (EIU, 2013) (See Figure 2). Its GDP fell by 26% within a span of four years. The decrease was primarily driven by 48.7% and 5.8% average decrease in investment and consumption respectively (EIU, 2013) (See Table 1). Moreover, the economy suffered deflation, that is, negative rate of inflation, which implies that the borrowers had to payback more valuable USD than the ones they had borrowed (Mishkin, 2007). The deflation occurred because the money multiplier decreased to such an extent that the MS increased despite the decrease in monetary base; this was the repercussion of the Fed’s short-sighted monetary policy.
This deflation along with 16% real interest rate in 1932 (McGrattan & Prescott, 2004), actually drove the collapse in investment. In fact, it was not only the economic loss, but the number of suicides, the decrease in the quality of life, the rise in the street crime, the lawlessness, and the despair in the society have also been highlighted as gruesome impact of the depressive economy.
What Does the Crash Teach?
There are many lessons which economists and investors can learn from the historic crash; however; few of the most applicable lessons in today’s market are;
Government actions can help strike a balance between optimism and pessimism pertaining to stock market investment. Therefore, if government would constantly pronounce markets as over-valued, investors would come to believe it and strategise accordingly (White, 1990). The fact that an investment could deteriorate by 40% in one month and by over 90% in three years time, highlights an immense need for diversification in a portfolio. Adding bonds, cash, and precious metals along with equity could help mitigate the risk (Reilly & Brown, 2007). Leveraged portfolio can be a blessing in disguise for uninformed investors. The positive leverage could help increase the profits provided that the sensitivity of cues for unfavourable conditions remains high at all times. There were people who were able to cap their losses in 1929, because they were more sensitive to indicators cueing problems than others (White, 1990). Last but not the least; banks, financial markets, and economy are all interlinked with each other. An issue in one could spread to all, within and outside domestic economy. Therefore, government policy makers must see the big-picture before devising changes in the monetary and fiscal policies.Conclusion
The stock market crash of 1929 was one of the most significant events in the history of America. It was the short-sighted tight monetary policy of Federal Reserve which fuelled the crash. Tight monetary policy created a fear of loss for margin buying investors, which subsequently resulted in panic driven bear market and an eventual crash. The economy suffered long-term effects of the crash in the shape of the Great Depression of 1932 when the country was at her deepest troughs. The crash of 1929 teaches that; investments are more sentimentally driven; therefore, if authorities constantly pronounce markets being over-priced, investors would eventually believe it. Secondly, diversification should be a significant element in one’s investment strategy. Lastly, magnification of returns by financial leverage should be done only when the borrowing cost is less than ROI.
References[1]EIU (2013) Economic data: The United States of America [Online] Available at: www.economistintelligenceunit.com [Accessed 8 October, 2013]
Galbraith, J.K. (2009) The Great Crash of 1929, n.d. London, Houghton Mifflin
Gitlin, M. (2008) The 1929 Stock Market Crash, n.d. Minnesota, ABDO
Lange, B. (1929) The Stock Market Crash of 1929: The End of Prosperity, n.d. New York, Infobase
McGrattan, E.R., & Prescott, E. (2004) The 1929 stock market: Irving fisher was right, International Economic Review, Vol. 45, pp. 991–1009.
McLaney, E. (2003) Business Finance: Theory and Practice, 6th ed. Essex, Financial Times Prentice Hall
Mishkin, F.S. (2007) Monetary Policy Strategy, n.d. Massachusetts, MIT
Reilly, F., & Brown, K. (2007) Investment Analysis Portfolio Management, 11th ed. Mason, South-Western
White, E. N. (1990) The stock market boom and crash of 1929 revisited, Journal of Economic Perspectives, Vol. 4, Issue no, 2, pp. 67-83 [Online] Available at: http://wwww.jstor.org/stable/1942891 [Accessed 8 October, 2013]