Introduction to the Stock Market Crash of 1929 and the Start of the Great Depression

INTRODUCTION

Before reading this essay, I strongly recommend you see the PBS video on YouTube. Type in Stock Market Crash 1929. Look for US – The Crash of 1929 (PBS), ALLHISTORIES – PLAYLIST.  Documentary broken into 6 parts to show commercials. Great documentary with wonderful photos, videos, and scenes from movies of the 1920s and the crash. Shows what a crazy time this was. 

 

I also recommend you read Frederick Lewis Allen, Only Yesterday; An Informal History of the 1920’s. This a wonderful popular history on the 1920s and the crash. It shows how the economic, social, and psychological changes in the 1920s contributed to the speculative frenzy in the stock market.  Author lived through it all. You can skip some of the chapters the first time through; for example, skip Chapters III, VI, IX, And X.

 

DEFINITIONS

The Stock Market. In the 1920s, this meant the New York Stock Exchange. This is where stocks (shares of part ownership of companies) were bought and sold. The New York Stock Exchange was a private company, owned by its members. Until the 1920s, most stock traders were professionals. There were no rules or laws. Traders could lie, cheat, and deceive among themselves. In the 1920s, they could do this to naïve small investors. They viewed small investors as sheep to be shorn.

 

A little more background. In 1929, there were 1,334 companies whose stock was traded on the New York Stock Exchange. This was a tiny percent of all the farms and businesses in America. But these were most of America’s largest companies. They accounted for much of the economic growth in the 1920s.

 

Dividends. Some stocks pay dividends but they don’t have to. Not fixed like bond interest. Management can raise or lower or eliminate dividends.

 

Bonds. When companies borrow money, they often issue bonds. Bonds pay a stated amount of interest. They also say when they mature (due date, when the lender gets paid back).

 

Economic Growth. When total output of the economy goes up, as it did between 1921 and late 1929. Total output is now measured by a statistic called the Gross Domestic Product (GDP).

 

Recession and Depression. A recession happens when an economy’s total output goes down. Usually, unemployment goes up. A depression is a really, really, bad recession.

OUTLINE

This essay of the stock market crash of 1929 comes in three parts – the 1920s economy leading up to the crash, the crash itself (1928 - 29), and the immediate aftermath of the crash in 1930 (the beginning of the Great Depression).

 

Part 1 – 1920s. 

American industrialization, urbanization and mass consumption goes into high gear. Agriculture stagnates.

       

Part 2 – 1928-29.

       Speculative stock buying frenzy leading to the crash.

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       Trending enthusiasm leading to mass speculation.

              FOMO – Fear of missing out.

“Irrational exuberance” of ignorant speculators buying on margin (mostly with borrowed money).

                     Trend and herd mentality.

 

Part 3 – 1929-30.

       Rapid recession of real economy (total output).

       

       Conclusion – interaction of real economy and stock market

 

 

Part 1. ECONOMIC OVERVIEW OF THE 1920s

 

The 1920s was a decade of economic growth and development but it was very uneven. It began with a severe deflationary (prices going down) recession as the economy adjusted from the World War I wartime economy to a peacetime economy. Economic growth began in 1922. The stock market grew rapidly in 1922 and 1923, and kept growing until late in 1929. But in 1927 and 1928, the economy hardly grew at all. Growth for the two years was about 1% per year. One reason for the 1927 stagnation was the bursting of the Florida land boom bubble (in video). This bubble showed large numbers were willing to speculate on something they knew nothing about but thought they would get rich quick. 

 

Another reason was the total shutdown of Ford in 1927. Henry Ford finally scrapped the Model T and retooled his plants to produce an entirely new auto. He laid off 60,000 workers. There were spillover effects on other major industries such as steel, tires, and glass. Full production was not reached until 1929.

 

Auto production was an important part of the industrial economy. The auto industry produced approximately 4 million cars in 1926, fell to 3.1 million in 1927 because of the Ford shutdown, recovered in 1928, and reached a record 5.4 million in 1929. But in 1930 auto production fell 40% to 3.3 million.

 

The structure of the economy changed in the 1920s, with consequences for the stock market and financial markets in general. Agriculture stagnated. In 1920, agriculture accounted for 18% of Gross Domestic Product (GDP, a measure of total output); by 1929, agriculture’s share had fallen to 12%. 

 

The drivers of economic growth were the new and developing technologies.

·      consumer durables, especially autos and radios. 

·      electricity utilities.

·      mass communication (phones) and entertainment (radios, phonographs, movies). 

·      mass-produced consumer nondurables such cosmetics, toiletries, processed food, and cigarettes. 

 

The foundations of the new economic structure were the large-scale manufacturing plant with electricity replacing steam as the power source, new machinery, increased productivity (output per worker), and lower unit cost.

 

Industrial production, especially of large corporations, were a larger and more important part of the total economy. This helped to create and expand a new middle class including managers, engineers, accountants, and lawyers. So did the expansion of the financial sector. This middle class had rising income and savings. They provided many of the new speculators in stocks in the 1920s. 

 

Much of this industrial growth was financed with debt (bonds) and new stock sales. Debt helped financed the large capital requirements of new manufacturing equipment and electric power plants and distribution. Demand for homes and consumer durables were largely financed with mortgages and consumer borrowing. New financial institutions such as saving banks and building societies (now called savings and loans) and new forms of debt were created or were expanded. Financial institutions and markets became a larger part of the economy.

 

1929 was an outstanding year for real economic growth. The economy grew at a rate of at least 6%. Auto production skyrocketed to new highs. Total profits, corporate investment, and dividends were up, raising expectations about future growth. Stock prices rose faster than corporate earnings. But toward the end of the year, part of the industrial economy stalled out and probably started contracting. Auto inventories grew as sales lagged production. Scattered data suggested a possible recession. But this negative economic news had to compete with a constant drumbeat of optimistic forecasts and stock market hype. The stock market had taken on a speculative life of its own, divorced from the underlying economic reality.

 

 

Part 2.  THE STOCK MARKET BUBBLE AND CRASH OF 1929 AND 1930

 

The story of the stock market crash of 1929 starts in 1928. Stock market prices started going up again in March 1928. Between then and September 1929 prices on average doubled. Millions of small investors piled in because all their friends and relatives were getting rich. FOMO (fear of missing out).

 

About 10% of American families owned stock by 1929. About half bought stock on margin (with borrowed money).

 

Another problem would be over 90% of all banks had invested in the stock market. When the stock market crashed, many banks, like small investors, didn’t have the cash to meet obligations and expenses. This would contribute to the bank failures in the Great Depression. (Also, some bank managers and owners embezzled bank funds to personally speculate in the stock market.)

 

From March of 1928 to September of 1929, the stock market rose at a rate of about 50% a year, with a surge in the summer of 1929 after a scare in the spring. Families that invested in the stock market felt wealthy. They saved a smaller percent of wage income. They took out mortgages to buy homes. They borrowed more to buy new cars, new furniture, and radios. (Believe it or not, a top-of-the-line radio cost as much as a new car.)

 

But not all speculators bought stock in March 1928. Daily volume rose during this period. New speculators came in at higher and higher prices. 

 

Who were the sellers? One source were the large pools of money from rich people. These pools routinely manipulated stock prices, as did insiders and professional speculators. They would buy into a stock, partly with borrowed money, start rumors about how great the stock was, and bribe journalists and analysts to recommend the company’s stock. Then, as more and more small speculators bought the stock at higher and higher prices, the pool began to sell. After they finished, the stock’s price often fell. The pool then moved on to a different stock. Or in the example of RCA, the hi-tech, high-growth company of the 1920s, the stock was manipulated more than once by the same group.

 

Companies, seeing the increased demand for stock, issued a great amount of new stock to raise money for future expansion.

 

SPECULATORS BUYING ON MARGIN

 

What caused the speculative frenzy? The PBS video shows part of the answer.

Psychology – everyone with money (savings) thought they were going to get rich by buying stock.

 

The problem was the large increase in small investors borrowing to finance buying stocks. Called buying on margin, this introduced an increased source of leverage (buying with borrowed funds) and financial risk into the economy.

 

If the new investors had just converted cash, bank deposits and bonds into stock, there probably would not have been as great an impact when the market crashed. Stock is a form of wealth that generates income from dividends and realized capital gains (the prices of stocks go up). About half of the new investors had bought stock on margin, that is, partly with borrowed funds. Typically, an investor put up cash for 10-25% of the cost of stock and borrowed the rest from the broker. The amount of borrowing (margin) doubled between the start of 1928 and October 1929.

 

If on margin, as the value of their stocks went up, speculators could borrow more money to buy more stock. They would still be wiped out when the market crashed.

 

THE STOCK MARKET CRASHES

 

The stock market, according to the Dow Jones Industrial index (a weighted average of 30 stock prices), peaked on September 3, 1929. The market drifted lower for almost two months. Then, suddenly, it fell 30% in one week in October! There are some dramatic photos and other footage of the week of the crash in the video.

 

When the market broke in 1929, margined investors were asked to put up more cash. If they didn’t immediately, the broker sold the stock, contributing to the selling pressure. So, for these accounts, the investors were wiped out. All others had lost about 50% of their stocks value in October 1929. They were to lose even more later. 

 

After hitting new lows in November, the market partly recovered. By April 1, 1930, the market was back to levels reach in mid-1929. With a renewed retreat, the market in early June had fallen to levels in mid-1928. But by then it was obvious the U.S. economy was in a recession that was getting worse. The market continued to turn down. By the end of the year, all the gains from 1928 and 1929 were wiped out. By the end of 1930, the market index was below the low reached in November 1929.

 

Part 3.  THE RECESSION IN 1930

 

The recession in 1930 was severe. Real GDP – total output – fell about 8.5%. This was the second worst year in the entire Great Depression. Also, this was after the fall in output from late summer to December in 1929. Industrial production fell a greater percent, possibly as much as 25-30% from the highs of the middle of 1929. The price level fell about 6.4%. The unemployment rate went up from 3.2% to about 8.7%, from about 1.5 million employees out of work to about 4.5 million by the end of the year.

 

In 1930, farmers were hit with lower prices, the Dust Bowl (huge dust clouds), loss of deposits in local failed banks, and inability to make loan payments on equipment. Farmers started to lose their farms; banks foreclosed on about 100,000 farms in 1930. (See the movie and/or read the book about this – Grapes of Wrath.) The Dust Bowl continued until 1940, helping to wipe out many more farmers (see PBS video on the Dust Bowl; the dust clouds are unbelievable).

 

The number of bank failures were rising. When banks went under, their depositors lost most or all their savings in the bank. 

 

Total income fell somewhat more than 10%. Total consumer debt fell 10%, reflecting the fall in income and widespread defaults on consumer loans. Total mortgage debt stayed stable, implying no widespread mortgage defaults and loss of home ownership (that came later).

 

For speculators who held on to their stock, the loss was on paper (unrealized). But their total loss got worse; by the end of 1932, the market was down 80-90% from the September 1929 high. 

 

The severe recession of 1930 took the floor out of the stock market. The big runup of the market in the first eight months of 1929 was partly based on expectations of continued high economic growth, and high growth rates in profits. But the economy stalled out in late 1929 and started its contraction that continued even when the stock market rallied in the first quarter of 1930. Profits plunged. Expected dividend increases failed to materialize. Decreasing expectations led to lower price/earnings per share (P/E) ratios on falling earnings per share. The stock market was not driving the economy; the economy was driving the stock market. But there were feedback effects.

 

Just as expectations of rising sales, earnings, and dividends in 1928 and 1929 helped create the bubble, the worsening economic news in 1930 stopped the stock market recovery and drove the market even lower than during the 1929 crash.

 

The number of bank failures increased. During the 1920s, up to 1928, an average of about 700 banks failed every year, in total about 20% of the 27,000 banks in the U.S. Most were small, local banks in rural areas and small towns and cities. But the total number of banks increased as new banks, and new types of banks, were established. In 1929, the number of failed banks rose to 1,250; in 1930, the number was 1,350. While the total for the two years was about 10% of the total number of banks, they were mostly small, local banks. The loss in total deposits because of bank failures was substantially less than 10%. Total deposits for the entire banking system showed no decrease in 1930 compared to 1929. The big increase in bank failures and depositor losses would come later as the economy deteriorated more.

 

CONCLUSIONS

 

Overall, there was little evidence in 1930 of the severe weakening and collapse of the financial sector that later played a major role in turning the severe recession into the Great Depression. None of the other financial sector variables exhibited the collapse of the stock market. This is not surprising; none of the other financial variables were as directly connected to the sales and earnings of large public companies. Or based on near-term expectations of these companies’ continued growth in sales and earnings.

 

But the dynamics of the Great Depression had begun. Unemployment rose rapidly, meaning millions of families lost their incomes. Families with savings lost some or all of it in the stock market or as depositors in banks that went under. Although many families lost their income and savings, they still had to make mortgage payments and pay off consumer loans used to buy cars and other goods.

 

Economic historians concentrate on financial reasons for the Great Depression. This is understandable because of the dramatic stock market crash of 1929. But the early and swift decrease in the real economy in late 1929 and during 1930 was internally generated; real economic factors caused the early recession. Financial factors – the stock market crash, bank failures where depositors lost their savings, speculating on margin, families unable to pay on loans and mortgages - would help deepen and lengthen the early recession into the Great Depression.

 

AFTER 1930

 

As the Great Depression got worse, stock prices kept going down, about 5,000 more banks went under wiping out depositors, unemployment rose to catastrophic heights, families couldn’t meet loan payments and lost their houses and cars.

 

The highest rate of U.S. unemployment was 24.7% in 1933. An unemployment rate of 25% meant that at any one time one-fourth of all workers were unemployed.

Unemployment remained above 14% from 1931 to 1940.

 

Two industries did well in the Great Depression of the 1930s – tobacco (cigarettes) and movies. By 1930, most movies had sound; by the end of the 1930s, some movies were in color. They were a cheap way to forget the grim reality of the Great Depression.

 

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If you would like to read a fuller discussion of this complicated topic, see my

The Stock Market Crash of 1929 and the Beginning of the Great Depression