What we learned from stock market crash
Book review of “A History of United States in Five Crashes”
Fear and greed, mostly greed, cause reckless behaviors and irrational actions. Increased complexity of financial instruments plus lack of proper regulations pushed the stock markets to crash. While it took months for the 1907 crash to unfold, it took minutes for the market to crash in 2010.
In this book review, I’m most focusing on the catalyst of the stock market crash and the main force behind it.
1907 – Panic
The first market crash in US history happened in 1907. The catalyst: San Francisco earthquake in 1906. The 8.3-magnitude earthquake on Wednesday, April 18, 1906 rocked the city and damaged gas lines. Over 27,500 or half of the city’s buildings collapsed or burned down. Market sold off sharply on the news of the quake and the massive destruction, losing more than 10% in the two weeks following the earthquake.
With houses burned down, claims of insurance piled up. London based insurers started loading gold on ships sailing west. Over $35 million gold was sent to U.S. west coast in September alone. To secure gold stock, Bank of England started to raise interest rates from 4.0% to 6.0% in less than 10 days. Higher interest rates weighed on stock market.
Behind the market panic, another financial crisis was also unfolding, caused by trust companies of America. Trust companies were new contraptions which were less regulated than banks, and were not required to reserve 25% of deposits as cash like the banks producing no income. As such, trust companies were able to pay 2 – 5% interest while most banks paid none, which allowed trust companies attract large amount of deposit.
As assets grew, trust companies started to take on risky ventures, , including bridge loans for industrial mergers and underwriting stocks and bond issuance. While trust companies were novel, insecure and untested in a crisis, their management continue to press expansion. Soon, the Knickerbocker Trust, a leading trust company behind massive oil, copper, steel and other industrial companies, was put to real stress test and would fail.
In addition to lack of reserves, much of the collateral securing trust company loans was illiquid such as lands, facilities and machinery, which couldn’t be easily sold to pay off the loans. When the underlying collateral starts to be troubled, news spread and depositors started to line up to withdraw their money. A few millions of withdrawal easily overwhelmed the trust company’s small cash reserve. Knickerbocker Trust was force to halt after paying out $8 million to depositors. Investors lost faith in Knickerbocker Trust overnight. Soon other trust companies would follow suit and quickly their liquidity started to dry up too.
As the stock market collapsed, New York Stock Exchange was threatened to close early to stop market free fall, which would obviously further fuel a crash. The trust companies and banks all turned to J.P. Morgan, the most influential figure at the time, to save the trust companies and banks, and more importantly, a crashing stock market. His summoning of $25 million commitment from banks in 15 minutes were able to save the stock exchange from being closed, and over 50 stock exchange firms from failing.
While the trust companies and stock exchange firms were saved, the Dow Jones Industrial Average lost 37.7% by December 31, 1907, by far its worst-ever annual performance until 1931.
Lessons learned: Liquidity is the life line of a bank or any lending facility like a trust company. Low cash reserve, massive loans, plus illiquidity of its collateral fueled the collapse of trust companies and faith of investors. Hence the panic of 1907 crash.
1929 – Crash
1929 crash hit many people hard, some broken mentally. Back then, when trade information such as price and number of shares was disseminated, market manipulators could trade large quantity of a stock between multiple large accounts they hold, pushing stock price higher, which was legal before 1934. That’s how people like Michael Meehan got extremely rich, until 1929 crash.
By 1929, Meehan’s brokerage firm owned eight seats on the New York Stock Exchange, altogether worth $5 million. He would trade a company named Radio Corporate of America (RCA), which was traded for $2.25 in 1921, all the way to $570 a share in 1929, as radio sent from novelty to a luxury and to a necessity.
Meehan’s story would mirror that of American stock market: growing wealthy in 1920s before suffering loss in the 1930s.
The 1914 war in Europe helped the boon in the U.S. stock market, as Europeans would buy everything American made. 1915 saw 81.7% market gain, the greatest in one year the Dow has ever enjoyed. The war eventually turned Americans into investors, as Liberty Bonds were issued in 1917 when the U.S. joined the war. Buying Liberty Bonds became a patriotic duty. By the end of war, $17 billion was sold to 20 million Americans when there was only 24 million American household.
This market boon correlates with a failed monetary policy – lower interest rates at an inflationary environment brought by the war.
At first, the New York Fed raised interest rates rapidly after the war to combat the inflation, causing market to tank 24% in 1920. Unfortunately, the NY Fed learned the wrong lesson: Instead of slowing down the pace of rate increase, it went the other way, and started a course of rate cut, from 7% in 1920 to 4% in 1922, causing the market the rally for the next five and half years, forming a gigantic economic bubble that eventually would pop in 1929.
All along, the New York Fed failed to raise its interest rates for another reason, to accommodate the Gold Standards in Europe, that is, the allow gold to flow to the central bank in England. By 1924, the Fed had cut the interest rate to 3%, the lowest it had ever set. Its hesitation or cowardice to raise interest rate by the Fed caused the stock market continued advance. As gold flows out of the U.S., money supply became scarce, causing the cost of borrowing, or call loans, skyrocketing. The spread between the fed rate and the rate of call loans became dangerously high. Call money available to stock speculators would explode, fueling a legendary stock market rally. By then the Fed had lost control of stock speculation by losing control of the money that fueled it. The end of 1928 saw 12.3% of Americans owning stocks or bonds, as there seemed little risk and much reward to investors and market would always bounce back. The confidence in the broad market indicated the levelheaded investing has gone far towards outright gambling with market speculators getting vast supply of money. Market reached its high on September 3, 1929. It would take another 25 years before regaining this level.
Eventually when the bubble started to burst in October 1929, the collateral drop started to trigger margin call, causing market to start tanking like snowballing. The Dow would lose 33.8% in 1930, 52.7% in 1931 and 23.1% in 1932. The Great Depression would follow.
History would teach us again the expanded leverage as a result of over optimism in the market would eventually plummet, leaving investors or speculators, experienced or novice at big loss. Selling at high and capturing gain along the way, setting money aside for the bad days, would be the wise investor’s winning recipe, because, as history shows, bad days would always come.