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Why The 1929 Stock Market Crash Could Happen In 2018


Why The 1929 Stock Market Crash Could Happen In 2018


By Mark Kolakowski

| Updated January 16, 2018 — 10:35 AM EST SHARE






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As U.S. stocks continue soaring to record high after record high, investors anticipating an inevitable plunge have yet another cause for sleepless nights.
The CAPE ratio, a measure of stock valuations devised by Nobel Laureate economist Robert Shiller of Yale University, is now at a higher level than it was before the Great Crash of 1929, the Financial Times reports, adding that the only time the CAPE was even higher preceded the dotcom crash of 2000-02. However, the FT notes, there are some differences between 1929 and 2018 that make the CAPE parallel less terrifying for investors.

From their previous bear market lows reached in intraday trading on March 6, 2009, through their closing values on January 12, 2018, the S&P 500 Index (SPX) has gained 318% and the Dow Jones Industrial Average (DJIA) has advanced 299%.


Regarding the CAPE valuation analysis, there are several key limitations.

Drawbacks of CAPEAccording to investment manager Rob Arnott, the founder, chairman and CEO of Research Associates, CAPE has been on an upward trend over time.
This makes sense both to him and to the FT since the U.S. as progressed from being essentially an emerging market to the world's dominant economy during the course of more than a century. As a result, both believe that an increasing earnings multiple for U.S. stocks would be justified. While the current value of CAPE is above its long term trend line, the difference is much smaller than in 1929, as Arnott's detailed research paper shows.


Moreover, as the result of 1930s reforms such as the creation of the
Securities and Exchange Commission (SEC) and tightened financial reporting standards, the quality of reported earnings today probably is much higher today than in 1929.


Accordingly, the value of CAPE for 1929 arguably is understated, given that its denominator, reported corporate profits, probably is overstated by today's standards.


The FT also points out that CAPE does not account for the level of interest rates.


When rates are low, as they are today, "discounted future earnings are higher,
and it is reasonable to pay more for stocks," the FT says. Indeed,
the FT could have added that CAPE looks backwards at 10 years of corporate earnings, whereas market valuations are, at least in theory, based on expectations of future profits.





The 1929 Crash
The Great Crash of 1929 is mostly associated with plummeting stock prices on two consecutive trading days, "Black Monday" and "Black Tuesday,"
October 28 and 29, 1929, in which the Dow fell 13% and 12%, respectively.
But this was only the most dramatic episode in a longer term bear market.
After peaking at a value of 381.17 on September 3, 1929, the Dow eventually would hit bottom on July 8, 1932, at 41.22, for a cumulative loss of 89%. It would take until November 23, 1954 – over 25 years later – for the Dow to regain its pre-crash high.




The Great Crash is generally considered to be one of the factors contributing to the onset of the Great Depression of the 1930s.

























'Unintended and Undesirable Consequences'Concerned about speculation in the stock market, the Federal Reserve "responded aggressively" with tight money policies starting in 1928, which helped to spark the Great Crash, per the Federal Reserve Bank of San Francisco (FRBSF).

Moreover, in 1929 the Fed pursued a policy of denying credit to banks that extended loans to stock speculators, according to Federal Reserve History.
"The Fed succeeded in putting a halt to the rapid increase in share prices, but in doing so it may have contributed one of the main impulses for the Great Depression," as the FRBSF Economic Letter wraps up. "Detecting and deflating financial bubbles is difficult," is a conclusion of the Fed History piece, adding that "Using monetary policy to restrain investors' exuberance may have broad, unintended, and undesirable consequences."


'Playbook' For Limiting Crash DamageBoth sources also indicate that, in the aftermath of the worst days of the crash, in October 1929, the Federal Reserve Bank of New York pursued an aggressive policy of injecting liquidity into the major New York banks.


This included open market purchases of government securities plus expedited lending to banks at a decreased discount rate.
This action was controversial at the time. Both the Federal Reserve's Board of Governors and the presidents of several other regional Federal Reserve Banks claimed that president George L. Harrison of the New York Fed has exceeded his authority. Nonetheless, this is now the accepted "playbook" for limiting the damage from stock market crashes, per Fed History.


In the aftermath of the 1987 stock market crash, the Fed under Chairman Alan Greenspan moved aggressively to increase liquidity, particularly to bolster securities firms that needed to finance large inventories of securities that they had acquired by filling the avalanche of sell orders from their clients, per a research paper from the University of Notre Dame.




In response to the financial crisis of 2008, the Fed under Chairman Ben Bernanke launched an aggressively expansionist monetary policy designed to prop up the financial system, the securities markets, and the broader economy. Hinging on massive purchases of government bonds to push interest rates near zero, this policy is frequently referred to as quantitative easing.
Greenspan, meanwhile, is among those who now warn that, by continuing this easy money policy for years after the 2008 crisis was stemmed, the Fed has created new financial asset bubbles.


(For more, see also: Stocks' Big Threat Is a Bond Collapse: Greenspan.)
Also in response to the 1987 crash, the New York Stock Exchange (NYSE) and
the Chicago Mercantile Exchange (CME) instituted so-called "circuit breakers"
that would halt trading after a large drop in prices.


These safeguards are designed to slow a wave of panicked selling,
and help the markets stabilize.


New Era, New RisksOn the other hand, computer-driven program trading, which caused rapid waves of frenzied selling in 1987, as well as later violent market downdrafts such as the "Flash Crash," has increased in speed and pervasiveness.


The upshot is that computerized trading algorithms may pose one of the biggest threats to the markets today.


(For more, see also: Could Algo Trading Cause a Bigger Crash Than 1987?)
After the experience of 1929, the Fed has been indisposed to tighten monetary policy in an attempt to deflate asset bubbles. However, as economic growth reports improve, the Fed is increasingly concerned today about keeping inflation in check. Any miscalculation that raises interest rates too high, too fast could spark a recession and send both stock and bond prices tumbling downwards.
(For more, see also: How The Fed May Kill The 2018 Stock Rally.)


Additionally, an increasingly interconnected world economy means that the spark that ignites a stock market plunge in the U.S. can be lit anywhere around the globe.
(For more, see also: 5 Global Risks That Could Hammer Stocks in 2018.)









Read more:

Why The 1929 Stock Market Crash Could Happen In 2018 | Investopedia

https://www.investopedia.com/news/1929-stock-market-crash-could-it-happen-2018/#ixzz54XefxBFm
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