PHL and the crash of 1929

Published on Monday, 26 November 2012 19:09

Written by John Mangun / Outside the Box

THE stock market crash of October 1929 was the most significant event of the 20th century. That experience has shaped government policy around the globe for more than 80 years. The world was plunged into a depression and that fact was a major, if not the single most important, contributor to World War II.

In 2012 dollars, $5.2 trillion of share value was lost in two days. In comparison, the total annual gross domestic product of the Philippines is only 10 percent of that amount. By the time the stock market stopped going down in 1932, the New York market had lost 90 percent of its pre-crash value.

The events leading up to “The Crash” could be taken from today’s newspaper headlines. The market had gone up nearly 1,000 percent in the previous 15 years, almost like US housing prices. Post-World War I America was riding an economic boom with housing construction, railroads and new technology from the automobile and telephonic communications leading the way.

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The newly created Federal Reserve Bank had converted a sizable portion of the US gold reserves into cash and loaned these funds at lower-than-market rates to the banking system. Money supply increased 20 percent from 1927. The 10-year stock-market rally was fueled by borrowing. The average person only had to deposit 30 percent cash to buy shares; the “big boys” did not have to put any cash up-front. At the time of the 1929 crash, banks had loaned $8.5 billion (in 1929 dollars) to buy shares. This amount was greater than the entire amount of dollars in circulation.

When an initial wave of selling hit in September 1929, as always happens in high-flying markets, investors were forced to sell to cover their loans. The amount of borrowed funds used for investing was so large that investors had to see weekly price increases just to cover the interest payments. Defaulting loans caused hundreds of banks to fail. This rippled through the banking system for another five years. Sources of capital stopped causing businesses to fail. The US economy collapsed,
creating a tidal wave of depression around the world as the globe depended on the US as the engine of economic growth. Sounds familiar.

The most profound and lasting result of the crash was a new theory of economics in part created by John Maynard Keynes. In his 1936 book, The General Theory of Employment, Interest and Money, Keynes wrote, “The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.” Keynes advocated that the State, the government, create money to “a level which will allow the growth of capital up to the point where it ceases to be scarce.”

His view was that if the government had just printed enough money, the economic expansion of the early 20th century could have continued forever. This is the origin of Quantitative Easing.

President Roosevelt took Keynes as an advisor and adopted Keynes theories by devaluing the dollar by 75 percent, in effect printing 75 percent more currency. That worked so well that the US economy did not come back to pre-depression levels for 20 more years.

Stock-market traders, who had relied on the idea that markets were always efficient at pricing shares at the proper level, were thrown into chaos. From that, investment guru Benjamin Graham wrote his 1934 book Security Analysis. Graham created the idea that markets were often inefficient, over and underpricing shares and that the inefficiency of the market could be taken advantage of. He offered the idea of setting standards to determine the value of a company in relation to share price using Price Earnings and Book Value, among other factors.

However, in 1949 Graham wrote The Intelligent Investor concluding that it is generally impossible for any individual to consistently outwit the market, thus denying the possibility of any distinction between “market price” and “value” of a security. Before he died in 1976 he all but gave up on individual issue value analysis, saying that his techniques were only of use for comparing companies within a sector and not for broad market moves. In effect, he repudiated his own long-held theory that the market was inefficient.

While the US may not have learned from the experiences of the 1930s, much of the developing world did learn, particularly after the 1997 financial crisis. For the Philippines, the best is yet to come. Buy the peso. Buy the PSE.

E-mail to mangun@gmail.com, Web site is www.mangunonmarkets.com and Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by COL Financial Group Inc.