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Stockmarkets: Lessons from the past - Views on News from Equitymaster
 
 
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  • Oct 13, 2003

    Stockmarkets: Lessons from the past

    A joke appearing in 'The Economist' goes like this, "When your neighbour loses his job it is called an economic slowdown. When you lose your job it is a recession. But, when an analyst loses his job it becomes a depression." Depression! But everything is looking great at this point of time - monsoons, economy and stock markets. Wait! We are not here to discuss this Monday morning about the 'D'-word. Rather, this month of October reminds us of the year 1929 - the year of beginning of the Great Depression. Let us peep into history and see what actually happened and what can we learn from the same.

    The Great Depression was, or is, probably the worst economic slump ever in the US and the world history. It began in the month of October 1929 and lasted for about a decade. Taking its roots in the US, this spread to almost the entire industrialized world. While there were numerous factors that played a role in bringing about a situation like this, the major causes were - greatly unequal distribution of wealth throughout the 1920's, and the rampant speculation in the US stock market. Later, these two factors combined to cause the American economy to crumple.

    The first factor, the unequal distribution of wealth, led to the vast majority of the population (who did not have enough money to satisfy their needs) buy goods on credit, hoping to pay sometimes later. This way, they postponed the problems of their present (1920's) to the future. And when that future actually arrived, those people could no longer use their wages for current consumption, because so much of their earnings went in paying for their purchases in the past.

    On the other hand, people with wealth spent heavily on luxury and investments, based on their confidence in the strength of the US economy. It is to be noted here that while investments and savings are important for an economy's well being, even they are not good at excessive levels. This greater investment led to greater productivity. However, since the rewards of excessive production were not being distributed equally, the problems of income distribution (and of overproduction) were only made worse.

    Finally, the expectations for even greater returns on these investments led to widespread market speculation. This speculation went on throughout the late 1920's. During these times, corporate earnings became of little interest, as huge profits were made due to continued rise in stock prices. Over that, one could buy stocks on margin, i.e., without the money to purchase them (same as buying a house on credit). By mid-1929, the total of outstanding brokers' loan was over US$ 7 bn, and in the next three months, this was to reach US$ 9 bn. This speculative boom in the stock market was based upon confidence. And what followed later (the huge market crash) was based on fear.

    This speculation and the consequent crash of the stock market acted as a trigger to destabilse the already fragile US economy. Luxury spending was stopped, investments slowed down, aggregate demand declined, industrial production fell, jobs were lost, defaults happened on a large scale, banks went bust. The Great Depression had finally begun.

    Now, coming back to the present times, a phenomenon of the magnitude of the Great Depression does not seem repeatable. This is for the reason that the global financial system of the present is much stronger (than that in the 1920's) to handle contingencies that may arise out of stock market speculation or economic slowdown.

    In the Indian context, while the disparity on income distribution persists, it seems to be reducing due to the emergence of the middle-class. The Indian consumer has a very important part to play in the growth of the economy. The Indian investor, on the other hand, needs to learn from the mistakes of the past and restrict giving in to temptations that rising stock markets provide. We have been witness to speculative activities taking precedence in the recent past (remember the rally in banking and steel stocks?), but over the long-term, it is only the investor (and not the speculator) who is going to come out as a winner. The only requirement now is to shun 'hot' stocks and restrict one's investments to quality companies with good managements. After all, we have a lot to learn from history, which is indeed a great teacher.

     

     

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