The Stock Market: Party Like It's 1929!

 

 

INTRODUCTION:  SIMILARITIES AND DIFFERENCES BETWEEN 1929 AND 2020

 

Gamestop! Short squeeze! Bitcoin! Options! IPOs! SPACs! Hydrogen trucks! Tesla up 800%! Market valuations in bubble territory. And my favorite “blue sky” stock - Virgin Galactic.    

 

At first sight, there was nothing in 1928-1929 similar to the impact of Covid-19 on the economy. Actually, there was. In 1927, Ford closed down his entire company to retool for a new line of cars. 70,000 people were thrown out of work; many more at suppliers also lost their jobs. But everyone knew that Ford would start up production again.  

 

Ford began production in 1928; 1929 was a record year for auto production. But in late summer and early fall, inventories began to build up.

 

Both periods were preceded by speculation in real estate. Both ended badly, closing off an alternative area of speculation.

 

Both periods (1920s and 2010s) saw an increase in income inequality. Large parts of the labor force, particularly farmers in the 1920s, saw stagnant or falling real income. 

 

The assumption of endless growth based on new products, new forms of energy and mass production provided the foundation for the speculation in 1928 and 1929. Over the last 10 years, investors have believed there will be endless growth based on the development of new information technologies combined with the commercialization of an explosion of new knowledge, in biotechnology for example.

 

The long bull market starting in 2009 was accelerating in late 2019 and early 2020, similar to the long bull market of the 1920s. Then the virus hit, sending the economy into a deep recession. But unlike the Great Depression, the federal government stepped in with massive income maintenance programs. Despite high unemployment in 2020, real disposable income and consumer spending rose. Savings also rose, some of which found its way into stocks. As vaccines became available, it was assumed that economic growth, fueled by innovation and low interest rates, would continue.

 

One similarity was the Fed reacted quickly to the 1929 crash. It lowered interest rates and made substantial sums available to the banking system to support the stock market.

 

In 1929, high-tech companies like RCA and growth companies with new products and services such as the electric utilities, were especially hard hit. Unlike the beginning of the Great Depression in 1929, the impact of Covid-19 led to massive changes in behavior that benefitted information-based companies. A handful of very large companies already dominated the market indexes; they would drive the indexes higher. Other companies such as Zoom and Teledoc saw a huge increase in demand. Media concentration on the race to develop a vaccine focused attention on small biotech companies developing new drugs and health care systems. All of this drove the stock market higher in the face of a sharp recession.

 

The economic decline stage of the Great Depression lasted for almost four years. The Covid recession was sudden and sharp. With the development and production of vaccines, it has an endpoint in the middle of 2021. And, learning from the “malign neglect” of the Hoover administration, the federal government, as in 2008, reacted quickly with massive income maintenance and aggressive monetary programs to limit the economic damage. 

 

The rapid development of vaccines convinced investors that the economy would return to normal growth during 2021. Investors also believed that the subset of high-growth technology companies would continue their superior performance into the foreseeable future. All this sustained high stock market growth rates into early 2021.

 

Most of the stocks with the highest percent gains in 2020, gains of 3-10 times for the year, are equities of companies that are losing money. Most have innovative, even disruptive, technology that would make them attractive parts of a long-term growth stock portfolio. But because of large R&D expenses, long and expensive drug trials, upfront capacity growth expenses, they will lose money for the foreseeable future. But large stock price increases in 2020 have already priced in spectacular long-run success. The best-case scenario is that their stock prices will not continue to rise. Many of the companies will fail.  

 

PSYCHOLOGY OF 1928-29 AND 2020-2021 ARE SIMILAR (SO FAR)

 

In both periods, negative economic data and bear market sentiment were ignored. There were scattered indications in the late summer and early fall of 1929 that the economy might be entering a recession or at least had stopped growing. But almost no one paid attention. Anyone expressing bearish sentiments in 1929 was roundly denounced as a party pooper. Even un-American. 

 

While there are now a few bearish voices, they are drowned out by the steady optimistic drumbeat of media commentators, brokerage and investment bank projections, and social-media driven popular culture. New investors believe the title of the most famous article written about the stock market in 1929 – Everyone Ought to Be Rich.   

 

A few large investors were getting nervous or paying attention to the economic news in 1929. Jesse Livermore, maybe the most famous big-time speculator on Wall Street. J. P. Morgan partners; while they were putting out optimistic press releases and interviews, many were personally selling stock.

 

In both periods, there was a big increase in small individual (“retail”) investors (speculators). Estimates of new investors during 2020-early 2021 are as high as 10 million. As in 1928-29, these new investors expect big gains in a short period of time. In both periods, there was a large increase in trading volume, compounded in 2020-2021 by a huge increase in options. Risk was ignored. Speculations were leveraged; options in the current period played a similar role as margin accounts (put up 10%, borrow the rest to buy stocks) did in the earlier period.

 

In both periods, stock market speculation became a part of the popular culture. It seemed everyone was talking about the stock market, in private conversations and mass media. Investment decisions were based on rumor and gossip that went viral.

 

But it wasn’t just the extreme examples. The whole market was in bubble territory. In early 2021, market indexes were at historically high levels compared to earnings (P/E and other ratios), even assuming a complete recovery of total sales and earnings over the next 12 months.

 

In 2020, a small number of companies benefitted from the changes caused by the virus. They dominated the indexes and accounted for much of the market rise. For example, about ten huge technology companies accounted for about 25% of the S&P 500 and most of the increase. Large parts of the economy, like farming in the 1920s, were hurt. 

 

 

PSYCHOLOGY OF SPECULATORS

 

Why did the stock market “crash” in October and November of 1929?

 

The stock market peaked on September 3, 1929. It then drifted slightly lower for seven weeks. But speculators were expecting large gains in a short period of time. Many had margined accounts, paying interest on broker loans. Their patience ran out and some began selling in late October. Volume, already at record levels, rose even higher. Sellers overwhelmed buyers, including professional attempts to “support the market.”

 

Many middle-class families, the source of much of the new money in stocks, were also leveraged in their finances. The 1920s saw large increases in mortgages and consumer credit to buy new products such as cars and radios (which could cost as much as a new car). Farmers, collectively experiencing declining income in the 1920s, were saddled with long-term debt used to buy land and equipment before and during World War I. Middle-class families with assets in 2021 held most of them in the form of illiquid assets such as home ownership (with mortgages) and retirement accounts. 

 

Many investors were sitting on unrealized (paper) gains in October, 1929. But the market has stopped going up. This may have indicated that the supply of new investors (greater fools) was not increasing. I expect something similar to happen later in 2021. 

 

WHAT HAPPENS NEXT? 

         

In early 1930, the stock market had a partial recovery. But the economy was in a  recession. The recession got worse every month. In April, the stock market turned down; it would not start to recover until 1932.

 

Stock market investors are assuming that the economy will grow in 2021 and 2022. Even if true, real economic growth could be low. Lowered expectations of corporate sales and earnings growth, especially of large growth stocks and beneficiaries of the forced change in behavior in 2020 - 2021, could lead to a market correction.

 

The massive federal “stimulus” programs have done nothing to stimulate (increase) long-term economic growth. No increase in public infrastructure investment. No increase in government-funded R&D outside of Covid-19 vaccine development. No increase in government programs to reduce and reverse climate change. Because so much was borrowed during this crisis (over $4 trillion), it may be difficult for the federal government to borrow to adequately fund these programs in the future.

 

Even without any new government programs, the federal government will be running annual deficits of $1-$2 trillion a year. Unlike Japan, where large annual deficits are necessary to counter deflationary and recession tendencies, large deficits in the U.S. could lead to higher inflation rates. That would lead to higher nominal interest rates. The Fed would find it very difficult to keep short-term rates near zero. Every one percent increase in interest rates would add over $200 billion a year to the deficit.

 

Market indexes are already higher than the prior all-time high in February, 2020. Valuations (market P/E ratios) then were already at historically high levels. Even if corporate earnings and earnings per share reach 2019 levels over the next 12 months, they are being valued at higher, near-record historical levels.

 

The forecast here is that sometime in the first half of 2021, there will be a market correction. The proposed “stimulus” program will get the economy through the next 4-6 months as the adult population become immunized. It will be the last large such program, although the federal government will still have a large structural annual deficit. After adjustments in the service sectors of the economy, countered by much slower growth in the sectors and companies that benefitted from the adjustments during the epidemic, the economy will experience slower than historical growth. Growth will be concentrated in high tech, innovative sectors and companies. Interest rates outside of the short-term, low-risk debt will rise. 

 

AN ALTERNATIVE SCENARIO

 

The main similarity between the two speculative periods is the increasingly speculative behavior of investors, especially the large number of new investors. Investors expect larger returns in shorter periods of time, ignoring the underlying fundamentals. Both periods became “momentum” markets.

 

A market correction in this environment, like in 1929, could happen for no apparent reason, no large “external” shock or internal surprise like a fall in earnings. Most likely, it might occur because of a fall in expectations.

 

Imagine, for example, that most adults who want the vaccine have received it by early summer. The economy returns to its economic growth path. Earnings of public corporations in 2021 accelerate and quickly return to 2019 levels; projections of 2022 earnings reflect historical growth. The bull market that began in 2009 continues.

 

But the market has already “baked in” high earnings growth in 2021 and 2022. Imagine a different scenario. Most of the proposed “stimulus” spending other than unemployment benefits is spent. The tremendous support for total disposable income and consumer spending stops. Despite widespread vaccine use, the virus continues at a lower level. The economy does not revive at expected high levels as there is still some hesitation to return to prior levels of demand for recreation, entertainment, leisure and travel. Many companies that benefitted from the “lockdown” find their sales and earnings stop growing, or even fall. Their stock prices fall. Other companies build on their experience during the virus to continue to reorganize their companies to cut costs and increase productivity by reducing overhead costs of offices and travel, and reducing employment by accelerating the substitution of software and automation for employees.

 

The increase in disposable income and consumer spending from increased employment does not make up for the loss of “stimulus” income. Projections become more uncertain.

 

I have no idea exactly when a market correction will occur, just as no one had any idea the market would fall in October, 1929. But I think it is most likely to happen sometime in the period of late May to mid-July. By late May, it may seem more probable the economy is not going to recover as vigorously as expected. Mid-July is when the first of the second quarter earnings are reported. Since the market anticipates change, especially short-run change in this environment, I would guess the correction would be more likely in the beginning of this period.

 

HOW LARGE A CORRECTION?

 

It is possible that the stock market could fall at the same time the economy is expanding, assuming the expansion and earnings growth are less than currently forecasted. 

 

So, assume it is a typical market correction of a bull market. Maybe around 20%. If the S&P 500 had reached 4,000 or somewhat above, a 20% correction would bring the index back to its previous high of around 3,400 reached in February, 2020. Market valuations would still be at historical highs; the market could fall further.

 

What does this mean for individual stocks? Since the indexes are dominated by the large growth companies, this implies that as a group their stock prices will fall an average of 20%. But much of the rest of the last year’s tremendous stock market growth was caused by large percent increases in the prices of smaller growth companies. Many are technology companies that are losing money, especially small biotech companies. Many have doubled or tripled (or much more) since last March. There is no earnings or dividend floors under these stock prices. They could, on average, fall by two or three times more than the market – 40%-60%.

 

To the extent that travel and leisure stock prices had already recovered in anticipation of a return to pre-Covid behavior, these stock prices will also probably fall.

 

CONCLUSION

 

Current market multiples assume historically high economic growth rates in sales and earnings. It is more likely that for a variety of reasons, intermediate and long-term growth rates may be historically low. A reduction in growth rate expectations could lead to a market correction.

 

As in 1929, a change in expectations, even if not caused by any major expected change in the economy, could precipitate a market correction. It is a change in the expectations of some investors, in both cases expecting large returns in short period of time, that cause market corrections.

 

It is a cliché of investing that stock prices, and the market as a whole, are determined by the conflict between greed and fear. In a long bull market that has entered bubble levels of valuation, the conflict is between momentum based on optimistic assumptions and projections, and doubt (increased uncertainty about the projections). A market correction occurs when doubt increases and more investors decide to reduce risk or realize paper gains by selling growth stocks, hedging, or moving to a more conservative portfolio (so-called value investing).

 

 

For a detailed look at the events leading up to the Crash of 1929 and what happened, see my The Crash of 1929 and the Start of the Great Depression.