By mid-November , the Dow had declined by almost half. It didn't reach its lowest point until midway through , when it closed at The Dow didn't return to its September high until November The many bullish investors of the Roaring Twenties fueled a bubble in the stock market. The perennially rising stock prices gave consumers a sense of economic optimism, prompting them to spend money aggressively on goods like cars and telephones. They were so confident in the future that they often bought items on credit.
People in the s acquired six of every 10 automobiles and eight of every 10 radios on credit. This debt-fueled buying binge was enabled by thousands of banks and hundreds of new "installment credit" companies, which loaned money to essentially anyone who wanted it.
Foreign lenders seeking to profit from the growing U. Consumer debt as a percentage of income more than doubled during the decade. By September , total noncorporate debt in the U. At the same time that readily available credit was fueling consumer spending, the buoyant stock market gave rise to many new brokerage houses and investment trusts, which enabled the average person to buy stocks.
These amateur investors, in addition to buying stocks outright, also began opening margin accounts , which facilitate stock purchases using borrowed money. As investors increasingly used margin accounts to buy stocks that they could not afford, new money flowed rapidly into the stock market, causing stock prices to inflate. The easily available leverage was compounded many times over, with both individual investors and investment trusts acquiring assets using borrowed money.
Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. It is a truism of the investing world that markets move in cycles, with a bull market inevitably ending in a bear market downturn if not a crash. The current bull market broke records for the longest-lasting ever and for the best-performing since World War II way back in November There was a short-lived market crash, known as the Coronavirus Crash, in early It was forgotten by early April and the bull run kept rolling through the depths of a global pandemic, a volatile election season, the second impeachment of a president, and a mob invasion of the U.
Now, everyone is waiting for the next big dip. But how do you spot it before it hits? One way is by looking at the CAPE ratio, devised by the Nobel Laureate economist Robert Shiller of Yale University to measure whether a stock's price is moving up faster than the company's earnings can justify. Some use the CAPE ratio to determine whether the markets as a whole are undervalued, in which case they should go higher, or over-valued, which suggests they're headed for a crash.
It is the current price of the stock compared to its earnings per share. Investors look at two versions of it, one comparing the stock's price to its earnings over the past 12 months and a second comparing its price to its projected earnings for the next 12 months.
The higher the number, the pricier the stock looks. The lower the number, the better a buy it appears to be. It compares a stock's current price to its real earnings per share averaged over the past 10 years and adjusted for inflation. That smooths out the gyrations of the market, presumably giving a more realistic view of whether a stock is over-priced or under-valued given its real performance over time.
Tracking the number through history, you can see that the number hit a then-record 30 just before the Great Crash of , after which it fell to single digits. It climbed to a record near 45 just before the dot-com bust of before falling to By the end of , it stood at Even if it did, there are no firm trading rules for investors that can be developed from the CAPE number that can tell them precisely when to buy or when to sell.
It may prove right again. Or not. And, it should be noted that Shiller himself said in early December that stock prices "may not be as absurd as some people think. Robert Shiller, the economist behind the CAPE ratio, said in late that stock prices "may not be as absurd as some people think. According to investment manager Rob Arnott, the founder, chair, and CEO of Research Associates, this upward trajectory made sense over a period of time during which the United States progressed from being essentially an emerging market to the world's dominant economy.
That alone, he believes, could justify an increasing earnings multiple for U. In , it was about At its highest point, in , it approached As of the end of , it was While the current value of CAPE is above its long term trend line, the difference is much smaller than in , as Arnott's detailed research paper shows.
Moreover, reforms imposed in the s such as the creation of the Securities and Exchange Commission SEC and the imposition of stricter financial reporting standards, probably helped lift the CAPE by increasing confidence in the U. The quality of reported earnings today is arguably much higher than in Accordingly, the value of CAPE for may be understated, given that its denominator, reported corporate profits, could be overstated by today's standards.
Finally, there is the fact that CAPE is, after all, a look backward at 10 years of corporate earnings. These days, rightly or wrongly, investors base their choices on their expectations of profits going forward. Average cost of home insurance. How to shop for car insurance.
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These stocks were even more volatile than the publicly owned utilities. The amount of leverage both debt and preferred stock used in the utility sector may have been enormous, but we cannot tell for certain. When the large amount of leverage is combined with the inflated prices of the public utility stock, both holding company stocks, and the investment trust the problem is even more dramatic.
Although no consensus has been reached on the causes of the stock market crash, the evidence cited above suggests that it may have been that the fear of speculation helped push the stock market to the brink of collapse. The resulting decline in stock prices weakened margin positions.
When several governmental bodies indicated that public utilities in the future were not going to be able to justify their market prices, the decreases in utility stock prices resulted in margin positions being further weakened resulting in general selling. At some stage, the selling panic started and the crash resulted. What can we learn from the crash? Barsky, Robert B. Bradford DeLong. Bierman, Harold, Jr. The Great Myths of and the Lessons to be Learned.
Westport, CT: Greenwood Press, The Causes of the Stock Market Crash. Westport, CT, Greenwood Press, Committee on Banking and Currency. Washington, DeLong, J. Kendrick, John W. Productivity Trends in the United States. Princeton University Press, Moggridge, Donald. New York: Macmillan, Rappoport, Peter and Eugene N. Samuelson, Paul A.
Wigmore, Barry A. Greenwood Press, Westport, Citation: Bierman, Harold. Net Encyclopedia, edited by Robert Whaples. March 26, Please read our Copyright Information page for important copyright information.
Send email to admin eh. Newsletters To join the newsletters or submit a posting go to click here. Harold Bierman, Jr. Were Stocks Obviously Overpriced in October ? Debatable — Economic Indicators Were Strong From to the third quarter of , common stocks increased in value by percent in four years, a compound annual growth of Events Precipitating the Crash Although it can be argued that the stock market was not overvalued, there is evidence that many feared that it was overvalued — including the Federal Reserve Board and the United States Senate.
What precipitated the October crash? The market did not fall just because it was too high — as argued above it is not obvious that it was too high. The actions of the Federal Reserve, while not always wise, cannot be directly identified with the October stock market crashes in an important way. The Smoot-Hawley tariff, while looming on the horizon, was not cited by the news sources in as a factor, and was probably not important to the October market.
Business activity news in October was generally good and there were very few hints of a coming depression. Short selling and bear raids were not large enough to move the entire market. Fraud and other illegal or immoral acts were not material, despite the attention they have received.
Wednesday, October 16, On Wednesday, October 16, stock prices again declined. Monday, October 21, On Monday, October 21, the market went down again. The Times October 22 identified the causes to be margin sellers buyers on margin being forced to sell foreign money liquidating skillful short selling The same newspaper carried an article about a talk by Irving Fisher p.
Wednesday, October 23, On Wednesday, October 23 the market tumbled. An Interpretive Overview of Events and Issues My interpretation of these events is that the statement by Snowden, Chancellor of the Exchequer, indicating the presence of a speculative orgy in America is likely to have triggered the October 3 break. Contemporary Worries of Excessive Speculation During , the public was bombarded with statements of outrage by public officials regarding the speculative orgy taking place on the New York Stock Exchange.
Investment Trusts By , investment trusts were very popular with investors. Seven important types of information that are not readily available but would be of interest are: The percentage of the portfolio that was public utilities.
The extent of diversification. The percentage of the portfolios that was NYSE firms. The investment turnover. The ratio of market price to net asset value at various points in time. The amount of debt and preferred stock leverage used. Who bought the trusts and how long they held. The Public Utility Sector In addition to investment trusts, intrinsic values are usually well defined for regulated public utilities. The Public Utility Multipliers and Leverage Public utilities were a very important segment of the stock market, and even more importantly, any change in public utility stock values resulted in larger changes in equity wealth.
Conclusions and Lessons Although no consensus has been reached on the causes of the stock market crash, the evidence cited above suggests that it may have been that the fear of speculation helped push the stock market to the brink of collapse. There is a delicate balance between optimism and pessimism regarding the stock market. Statements and actions by government officials can affect the sensitivity of stock prices to events.
Call a market overpriced often enough, and investors may begin to believe it. A levered investment portfolio amplifies the swings of the stock market. Some investment securities have leverage built into them e. A series of presumably undramatic events may establish a setting for a wide price decline. A segment of the market can experience bad news and a price decline that infects the broader market. In , it seems to have been public utilities.
In , high technology firms were candidates. Interpreting events and assigning blame is unreliable if there has not been an adequate passage of time and opportunity for reflection and analysis — and is difficult even with decades of hindsight. It is difficult to predict a major market turn with any degree of reliability. It is impressive that in September , Roger Babson predicted the collapse of the stock market, but he had been predicting a collapse for many years.
Also, even Babson recommended diversification and was against complete liquidation of stock investments Financial Chronicle , September 7, , p. Even a market that is not excessively high can collapse. Both market psychology and the underlying economics are relevant.
References Barsky, Robert B. Commercial and Financial Chronicle , issues. Federal Reserve Bulletin , February, Fisher, Irving.
The Stock Market Crash and After. Galbraith, John K. The Great Crash , Boston, Houghton Mifflin, Hoover, Herbert.
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