Stock Market Crash of 1929
The boom, bust, and margin calls that welcomed the Great Depression
In short:
The stock market crash of 1929 was the most dramatic financial market crash in history, with nearly 90% of the Dow Jones Industrial Average (Dow) wiped out by the time the bottom was found. From Black Thursday (the first major selloff day) to Black Monday (another massive selloff day), these well know days within the financial industry occurred during this time. The Dow would not recover to its prior crash high until 1954, approximately two and a half decades later.
Although there are many factors that led to the crash, two major causes were a massive influx of sparsely researched individual investors that initially drove the market higher and thus fed the idea that “stocks only go up”. As a result, more and more individual investors were drawn to invest in the stock market but to also use leverage, called margin. Ultimately, these two factors accentuated the rise and collapse of the stock market during this time. Many of the events that led to the rise and collapse of the stock market during this time period led to the regulations for the securities industry. Government regulatory bodies such as the Securities and Exchange Commission (SEC) created in 1934 which still provides oversight to this day.
In-depth:
Before the Crash
With the end of World War I in 1918 as Europe was rebuilding, the United States was left in a position of being the main source for the world’s manufacturing and resources. Higher demand for American goods pushed earnings high and unemployment low, this was the dawn of the “Roaring Twenties”. For most Americans, this era was a rise in living standards, entertainment, and luxury.
Average Americans, having gotten a taste of investing with Liberty Bonds, were now more relaxed with the idea of investing in assets represent on paper. This relaxing of investing psychology among average individuals opened the opportunity for them to participate in the stock market, which, until that point was primarily only participated in by a select few. The combination of good earnings for both individuals and companies in the US, new retail investors in the stock market, and investing on margin fed the bull market throughout most of the 1920s.
Good Times End
Heading into the end of the 1920s a mix of increased tariffs by many countries and oversupply of goods caused a shift in the fundamentals of companies. Selling goods became difficult for many companies, reducing their earnings and thus share prices.
Since the market had been pushed to sky-high levels via investors with the mentality that “stocks only go up” and the backing of margin. This provided an environment in which a moderate correction would force liquidation of positions among some investors.
Margin and Liquidation
Margin is when a broker lends money to an investor to increase the size of their investment in a company/asset. For example, say an investor has $1,000 to invest and finds a company they want to invest in. This company is trading for $20/share. Without margin, the investor can only buy 50 shares, his gain if the share price rises is exactly the share price multiplied by the number of shares.
- $1,000 / $20 = 50 shares
- Increase in share price to $25, 50 shares * $25 = $1,250 or a 25% gain
However, if the investor uses margin they can borrow money to buy more shares. Today there are limits on how much an investor can borrow but in the 1920s there wasn’t. An investor may borrow 3x their principal. This makes gains and losses both bigger.
- $3,000 / $20 = 150 shares
- Increase in share price to $25, 150 shares * $25 = $3,750, subtract out amount borrowed, $1,750
- The gain after borrowed money is paid back is ~75%
But if prices fall the investment incurs losses faster.
- $3,000 / $20 = 150 shares
- Increase in share price to $15, 150 shares * $15 = $2,750, subtract out amount borrowed, $250
- The loss after borrowed money is paid back is ~(75%), this number can go very negative even larger than the original principal, ex (200%)
In an effort to keep losses from becoming bigger than the investor or brokerage firm can manage an investor may be forced to sell no matter the price or size of the loss. When many people are forced to sell at the same time this causes a selloff
As the market began to pull back margin started to work against individual investors very fast. Black Thursday became the first of many major selloffs with the Dow falling over 10% shortly after the market opened. This initial one-day massive selloff was followed by a similar scale selloff with Black Monday then Black Tuesday. At this point, the stock market was in a vicious selloff with investors getting pushed out of leveraged positions and incurring massive losses.
The losses individual investors incurred were in many cases way larger than their principal, sucking away all their life savings, homes, and businesses. The major companies of the US were worth a lot less and money everywhere became very tight.
Recovery
The United States would venture through the great depression, the dust bowl, and World War II before the stock market fully recovered. The Dow Jones Industrial Average wouldn’t return to its pre-crash high until 1954.
As a result of many of the events of the 1929 stock market crash. The securities industry would come under heavy regulation to limit the ability of the stock market to return to such an unsteady environment. Organizations such as the Securities and Exchange Commission (SEC) created in 1934 provides oversight still to this day.
Chart of 1929 stock market decline: https://www.macrotrends.net/2484/dow-jones-crash-1929-bear-market