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Lessons from the past: The 1929 crash - Views on News from Equitymaster
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  • Apr 8, 2009

    Lessons from the past: The 1929 crash

    In the previous article we had discussed the '1987 Crash'. A five-year 'bull' market, which started in 1982, came to an end in 1987.

    In this article we will discuss the crash in 1929 which led to severe economic collapse during the early twentieth century.

    The 1929 crash
    After World War I, during the 1920's, the American economy was fuelled by increased industrialization and new technologies. At the same time, a new concept of installment plans came into existence which gave birth to a culture of consumerism. With installment plans, American families could now afford to purchase more than ever before. America prospered in this decade and became the richest nation in the world. Aided by this spectacular growth, stocks were on a roll between 1921 and 1929; the Dow Jones Industrial Average rose six times during this period. Booming stock markets made people believe that the markets could only rise higher. Very soon this era turned into an era of intense speculation on the stock market.

    But the exuberance started fizzling out by early September of 1929 as news about failure of several banks, lower housing projects and lower steel production started making headlines. The market peaked on September 3, 1929. At this point, the Dow was up 27% from the previous year. The prices started their downhill journey from here. On October 23, 1929 fear crept in and before the closing bell rang, stock prices suddenly plummeted. This event shook the beliefs of investors in the market and panic set in. The next day, prices further plunged and 13 m shares changed hands on a single day. That was the highest daily volume in the exchange's history at that point of time. The southward journey continued on the following Monday and the Dow registered a drop of another 13%. With no respite yet in sight, on October 29 the Dow dropped another 12%. The 1929 crash set off a chain of events that plunged the US and the world into a decade-long depression.

    Economic woes further aggravated, as the government did not try to prop up aggregate demand. The Federal Reserve (FED) also did not use open market operations to keep the money supply from falling. Instead the FED raised interest rates and discouraged gold outflows after the United Kingdom abandoned the gold standard in the fall of 1931. And the FED let the private sector handle the Depression in its own fashion. This choked the economy and unemployment skyrocketed, companies incurred huge layoffs, wages plummeted and the economy went into a tailspin.

    The stock market prices are based, in a great part, on expectations. Thus, in stock markets when investors believe stock prices will increase, it increases the demand for stocks. This increased demand continues until stock prices become too high in comparison to the intrinsic value of the related corporation. These overvalued stock price result in excess supply of stocks, which in turn causes prices to fall. When a lot of investors decide to leave the market at the same time then markets plunge and little can be done to prevent the markets from falling. Thus an investor should understand the dynamics of the markets and take it in their stride. As Peter Lynch quips "You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."



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