Search for Parallels : Stock Rally: Swinging to 1929 Beat?
On Wall Street, it seems that the longer a party goes on, the more people wonder when it will end. Given the high-flying but skittish performance of the latest stock market rally, some market observers are wondering whether the rally of 1987 won’t end in the world of 1929.
As the bull market continues its show of extraordinary strength, market analysts and economists have been searching through statistics and records for parallels to the euphoric market of the late 1920s.
The search gathered some urgency on Friday, when the Dow Jones industrial average climbed 64 points by midday before taking its longest, fastest tumble ever in the following 71 minutes--a 116-point free fall that stunned investors, analysts and traders alike.
Underscored Vulnerability
Since then, the market has continued to rise, possibly because history-minded investors quickly discovered that similar wild blow-offs in the past had not immediately led to market reversals. But Friday’s activity underscored the vulnerability of the modern stock market to sudden, almost incomprehensible movement.
Few market professionals are predicting a major crash in the stock market any time soon. But that is not necessarily a comfort, because almost no one predicted the stock market crash of 1929. Anyone who expressed even faint misgivings quickly found himself buried under optimistic rebuttals by brokers, financiers and politicians who sounded eminently reasonable at the time, only to appear ludicrously irresponsible today.
For example, Irving Fisher, a Yale professor, made this famous pronouncement in September, 1929: “Stock prices have reached what looks like a permanently high plateau.”
Still, today even some leading bulls are saying that the rally has come so far, so fast, that when the inevitable bear market comes it is likely to be a long and painful one.
Downturn Predicted
“I think we have nearly a doubling of the Dow left (that is, to nearly 4,000 points),” said Robert Prechter, one of the more successful market analysts of the 1980s. Prechter, editor of the Elliott Wave Theorist newsletter in Gainesville, Ga., predicted that the downturn will come in late 1988 or early 1989 and that it will be serious.
Others agree that the end of the bull market is visible, if distantly. Some also argue that the stock market today is such a volatile, highly automated and global repository of capital that no one can predict that some unexpected development will not shock it into a major reversal.
“If we were to have a speculative blowout and crash, I think the cause would be something new and unfamiliar,” said Allen Sinai, chief economist for the investment firm of Shearson Lehman Bros. “But something could crop up. Suppose we had a minus 300-point day on the Dow? That would provoke such an exodus that if there is such a risk, something ought to be done about it.”
The rally of the 1920s carried the Dow industrial index up by 500% starting in August, 1921. It ended on Oct. 24, 1929, with a crash so shocking and, to the great mass of investors, so unexpected that to this day it has the capacity to cast a mythic shadow over the market.
Despite its obvious strength, the current bull market has not yet matched the magnitude of the ‘20s rally or of the strong post-World War II rally that ended in 1966. Since August, 1982, the start of the current bull market, the Dow has risen by about 180%.
The market of 1928-29 was characterized by excessive speculation, based on the public’s assumption that stock prices would continue to head up; the ability to buy stock on very low down payment, or margin, meaning that even a modest downturn would wipe out investors’ holdings and inspire panic selling, and a feeling of prosperity born of years of economic expansion and a receding memory of recessions past.
Rapid Innovations
Although few Jazz Age manifestations of overspeculation exist today, some analysts believe that the rapid innovations in the financial markets of the last few years may be allowing similar speculation to take place under novel guises.
“When they invented stock options (first traded in 1973) they took away some of the speculative action from the American Stock Exchange,” said William M. LeFevre, market strategist for Advest, an investment firm based in Hartford, Conn. “People who used to speculate by buying a $2 stock are now buying a $2 option.”
People who want to speculate even more have moved past stock options to stock index futures. These arcane instruments are, in essence, bets on the course of certain widely followed stock indexes over a fixed period of time.
The futures play an important role in the infamous “program trading,” the computerized process by which big investors buy and sell millions of dollars in stocks at the flick of a switch, based on whether the price of a future has moved higher or lower than the corresponding index.
The idea is to buy the future while selling representative stocks tracked by the index, or vice versa, in order to make a quick profit equivalent to the price difference between the future and the index. Because so many institutional investors tend to flick their switches in the same direction at once, programs can provoke sudden, extraordinary moves in the stock market--such as Friday’s bizarre gyrations.
Incomprehensible in 1920s
Index futures have become a significant speculative force in the stock market--one that would be incomprehensible to even the most sophisticated trader of the 1920s.
Because so many well-heeled investors trade in this market, a stock can jump in price simply by being added to an index on which a future is based. That is what happened to USAir, Sysco, and Temple Inland, which all gained more than $1 on Dec. 18. On that day, they were added to the Standard & Poor’s index of 500 industrial stocks, which is the basis of the leading stock index future. (The Dow industrial index lost 5.49 points and the S&P; 500 as a whole fell 0.78 that day.)
Futures allow investors to speculate at much lower margins than those of the 1920s, when one could buy a share of stock for as little as 10% of its market price. The balance was “borrowed” from a broker, who had the unilateral right to sell the stock if its price decline wiped out the customer’s 10% margin. These sales, or margin calls, exacerbated the steep slide in prices during and after the crash.
Today, an investor can buy a future for a tiny fraction of its market price. A single S&P; 500 futures contract, for example, has an implicit value today of $137,000 but can be purchased for a margin payment of as little as $5,000, or 3.6% (based on the latest rules of the Chicago Board of Trade, where the futures are traded).
No one knows what impact these index futures will have when the stock market enters its bear phase. Even those market professionals who argue that futures-related trading has little power to change the overall trend of the stock market agree, however, that it does exacerbate stock-market moves.
Individuals Affected
Moreover, although the futures and options markets are dominated by institutional investors, individuals are increasingly exposed to them. Such institutions as pension funds and insurance companies are really only proxies for the money of thousands of individuals. And already this year, Dreyfus Corp. has begun marketing to individuals two mutual funds aimed at trading securities, futures and options simultaneously.
Some believe that speculation in futures has a tendency to divorce stock selection from the fundamental principles of corporate quality, earnings and growth that idealists consider the cornerstones of investing. This divergence of prices from values is the essence of speculative frenzy.
“The problem with these markets is they’re not geared in the short run to fundamental values,” said James Tobin, a Nobel laureate in economics on the faculty of the Yale School of Organization and Management. “If more people paid attention to fundamentals and less to what other people are thinking, it would be a good thing.”
In many ways, some of them disturbing, the overall financial structure of the United States today resembles that of 60 years ago. In an article in December’s Atlantic Monthly, economist John Kenneth Galbraith, a leading historian of the 1929 crash, argued that the ‘80s and ‘20s have many parallels, including a “commitment to seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures.”
Incurred Huge Debts
The most popular innovation of the ‘20s was the so-called investment trust, a company organized simply to acquire shares of other companies, often paying for the shares by incurring huge amounts of debt.
That should sound familiar, because the benefit of a heavily debt-loaded balance sheet is an article of faith among today’s corporate executives and investment bankers. The problem with heavily indebted companies, however, is that they have correspondingly small cushions to protect them, should business turn down, from defaulting on their bonds and going broke, rendering their stock worthless.
Still, the search for parallels between today and yesteryear should be tempered by the fact that few conventional signals of an overheated market yet exist. Prices of American Stock Exchange and over-the-counter stocks have not been consistently outrunning those of the New York Stock Exchange, a development that would be a sign of speculative fever. Although the Amex and OTC stocks have outperformed the broad market for spells during this rally, for the most part the bull market has been concentrated among blue-chip stocks, which are less likely vehicles for speculation.
Other statistics followed by market analysts also indicate that today’s bull market, its apparent strength notwithstanding, still pales in comparison to others in the postwar period. One such measure is the market’s price/earnings multiple, or the relationship of stock prices to the most recent reports of corporate earnings. As of Wednesday, the combined price/earnings multiple of the Dow industrials was a little over 18.
‘It’s Not a Record’
“That’s at the high end, but it’s not a record,” said Advest’s LeFevre. He noted that the figure reached as high as 24 during the John F. Kennedy Administration, toward the tail end of the long postwar bull market.
Moreover, many professionals argue that not even a major stock market crash will have the devastating impact of 1929’s.
The Great Depression, argued MIT economics professor Lester Thurow, was the product less of the crash than of the ensuing collapse of the U.S. banking system. He said that a similar collapse is less likely today because of the Federal Reserve System’s ability to support a failed bank, and is less frightening to the public because of the protection of deposit insurance.
