So What The Sky Is
Not Falling
By Melvin J. Howard
Why are we so surprised of what is
happening today in the markets and in China its happened before. I remember I
use to hate history I always thought history was always shaded by whom was ever
telling the story. But when it comes to financial models and market history
it is worth revisiting. The crash of 1929 was not without its Enrons and Worldcom's.
Clarence Hatry and his associates admitted to forging the accounts of their
investment group to show a fake net worth of $24 million British pounds -
rather than the true picture of 19 billion in liabilities. This led to forced
liquidation of Wall Street positions by harried British financiers.
The collapse of Middle West
Utilities, run by the energy tycoon, Samuel Insull, exposed a web of offshore
holding companies whose only purpose was to hide losses and disguise leverage.
The former president of NYSE, Richard Whitney was arrested for larceny.
Analysts and commentators thought
of the stock exchange as decoupled from the real economy. Only one tenth of the
population was invested - compared to 55 percent today. "The World"
wrote, with more than a bit of Schadenfreude. "The country has not
suffered a catastrophe ... The American people ... has been gambling largely
with the surplus of its astonishing prosperity."
"The Daily News"
concurred. "The sagging of the stocks has not destroyed a single factory,
wiped out a single farm or city lot or real estate development, decreased the
productive powers of a single workman or machine in the United States." In
Louisville, the "Herald Post" commented sagely: "While Wall
Street was getting rid of its weak holder to their own most drastic punishment,
gain was stronger.
That will go to the credit side of
the national prosperity and help replace that buying power which some fear has
been gravely impaired." During the Coolidge presidency, according to the
Encyclopaedia Britannica, "stock dividends rose by 108 percent, corporate
profits by 76 percent, and wages by 33 percent. In 1929, 4,455,100 passenger
cars were sold by American factories, one for every 27 members of the
population, a record that was not broken until 1950.
Productivity was the key to
America's economic growth. Because of improvements in technology, overall
labour costs declined by nearly 10 percent, even though the wages of individual
workers rose."
Jude Waninski adds in his tome
"The Way the World Works" that "between 1921 and 1929, GNP grew
to $103.1 billion from $69.6 billion. And because prices were falling, real
output increased even faster." Tax rates were sharply reduced.
John Kenneth Galbraith noted these
data in his seminal "The Great Crash" "Between 1925 and 1929,
the number of manufacturing establishments increased from 183,900 to 206,700;
the value of their output rose from $60.8 billion to $68 billion. The Federal
Reserve index of industrial production which had averaged only 67 in 1921 ...
had risen to 110 by July 1928, and it reached 126 in June 1929 ... (but the
American people) were also displaying an inordinate desire to get rich quickly
with a minimum of physical effort. "Personal borrowing for consumption
peaked in 1928 - though the administration, unlike today, maintained twin
fiscal and current account surpluses and the USA was a large net creditor.
Charles Kettering, head of the
research division of General Motors described consumeritis thus, just days
before the crash. “The key to economic prosperity is the organized creation of
dissatisfaction.”
Inequality skyrocketed. While
output per man-hour shot up by 32 percent between 1923 and 1929, wages crept up
only 8 percent. In 1929, the top 0.1 percent of the population earned as much
as the bottom 42 percent.
Business-friendly administrations
reduced by 70 percent the exorbitant taxes paid by those with an income of more
than $1 million. But in the summer of 1929, businesses reported sharp increases
in inventories. It was the beginning of the end. Were stocks overvalued prior
to the crash?
Did all stocks collapse
indiscriminately? Not so. Even at the height of the panic, investors remained
conscious of real values. On November 3, 1929 the shares of American Can,
General Electric, Westinghouse and Anaconda Copper were still substantially
higher than on March 3, 1928. John Campbell and Robert Shiller, author of
"Irrational Exuberance", calculated, in a joint paper titled
"Valuation Ratios and the Lon-Run Market Outlook". An Update posted
on Yale University' s Web Site, that share prices divided by a moving average
of 10 years’ worth of earnings reached 28 just prior to the crash. Contrast
this with 45 on March 2000. In an NBER working paper published December 2001
and tellingly titled "The Stock Market Crash of 1929 - Irving Fisher was
Right", Ellen McGrattan and Edward Prescott boldly claim.
"We find that the stock market
in 1929 did not crash because the market was overvalued. In fact, the evidence
strongly suggests that stocks were undervalued, even at their 1929 peak."
According to their detailed paper, stocks were trading at 19 times after-tax
corporate earnings at the peak in 1929, a fraction of today's valuations even
after the recent correction. A March 1999 "Economic Letter" published
by the Federal Reserve Bank of San-Francisco wholeheartedly concurs. It notes
that at the peak, prices stood at 30.5 times the dividend yield, only slightly
above the long term average.
Contrast this with an article
published in June 1990 issue of the "Journal of Economic History" by
Robert Barsky and Bradford De Long and titled "Bull and Bear Markets in
the Twentieth Century": "Major bull and bear markets were driven by
shifts in assessments of fundamentals. Investors had little knowledge of
crucial factors, in particular the long run dividend growth rate, and their
changing expectations of average dividend growth plausibly lie behind the major
swings of this century."
Jude Waninski attributes the crash
to the disintegration of the pro-free-trade coalition in the Senate which later
led to the notorious Smoot-Hawley Tariff Act of 1930. He traces all the
important moves in the market between March 1929 and June 1930 to the intricate
protectionist dance in Congress.
This argument may never be decided.
Is a similar case happening now? This cannot be ruled out. The late 2000’s
resembled the 1920's in more than one way. Are we ready for a recurrence of
1929? No not by a long shot but we have a short attention span. Human nature -
the prime mover behind market meltdowns - seemed not to have changed that much
in seven decades.
Will a stock market crash, should
it happen, be followed by another "Great Depression"? It depends
which kind of crash. The short term puncturing of a temporary bubble - e.g., in
1962 and 1987 - is usually divorced from other economic fundamentals. But a
major correction to a lasting bull market invariably leads to recession or
worse.
