The stock market crash of 1929 saw the Dow Jones Industrial Average collapse 24.8% in just 6 days, making it one of the worst declines in U.S. history.
Culminating in what became known as Black Tuesday, the stock market crash of 1929 created unprecedented havoc in the economy and ultimately led to the Great Depression of the 1930s.
Millions of people lost their savings and nearly one-fourth of the workforce became unemployed. It would take almost 25 years for the stock market to return to former highs as investors shunned Wall Street and the average family focused on just getting by.
Sowing The Seeds Of The Crash
The 1920s was a period of rapid growth in prosperity for the U.S. The first half of the 1920s saw company profits soar due to rising exports to Europe, which was doing its best to rebuild after World War 1.
This led to low unemployment and made purchasing automobiles much more achievable, causing them to spread across the country. This, in turn, created more jobs and new efficiencies for the economy, further driving up the performance of the U.S. economy.
This strong tailwind contributed to sock prices climbing nearly 10 times over the decade.
As the stock market began booming, the rapid growth in prices started to attract the general population seeking to ride the wave of prosperity. It became almost a national pastime, a hobby, for both the rich and poor alike to buy stock.
With so much demand and against rapid increase in prices, people from all walks of life started to borrow from stockbrokers to finance their stock market purchases. Margin lending exploded, which is when a buyer of an asset pays only a percentage of the asset’s value and borrows the rest.
Margin lending helped propel prices ever higher and the more that prices went up, the more that credit standards were lowered. While it would have made more logical sense (and been more prudent!) to tighten lending standards, it was highly profitable for both lenders and borrowers to engage in margin lending so credit standards kept being lowered.
In many cases, positions were so leveraged that investors were buying $3 worth of stocks for only $1 of capital! With so much leverage, stocks would need to fall only one-third in order for the investor’s position to be totally wiped out. The stock market was balancing on a very delicate knife edge.
The Lead Up To The Crash
At the beginning of 1928, the Federal Reserve began to tighten monetary policy amidst concerns that banks weren’t doing enough to curb an “excessive amount of the country’s credit absorbed in speculative security loans”.
Between February 1928 and July 1928, interest rates jumped quickly from a low of 1.5% to 5.0%. The Fed’s plan was to slow the growth of speculative credit without crippling the economy. A year later in August of 1929, the Fed raised rates again to 6.0%.
This rapid rise in interest rates led to an increase in the return on holding short duration assets such as cash. So much so, it became more attractive to hold cash compared to longer duration and riskier financial assets, like real estate or stocks.
As a result, money started to flow out of the stock market and other financial assets, causing them to fall in value. Brokers, concerned by rising interest rates and falling stock prices, started to tighten margin requirements.
Where most brokers were accepting a margin of 30% just one year ago, most now raised it to about 50%.
With tightening lending standards, increasing interest rates and high stock prices, investors and lenders were near or at their maximum positions. During September of 1929, a string of bad news stories began to emerge.
From rising rates in the U.K. through to economic projections of a tight future money supply, investor’s confidence in the stock market was eroded and by mid-October, stock market prices were down 10% from their highs.
The Crash
On October 19, stock prices fell sharply. As a result, a wave of margin calls went out after the close. A margin call is when an investor needs to put up more cash or sell stocks to meet margin requirements. Since cash was hard to come by (most investors were fully invested and highly leveraged), most investors had no choice but to sell shares.
This precipitated further drops in stock prices, resulting in further margin calls. This vicious loop accelerated until its zenith on Black Tuesday which saw the Dow close down 11.7 percent, which at the time was the second worst one-day loss in history.
Over two days, the market had fallen a stunning 23 percent.
While several bear market rallies emerged, it would not be until early in 1932, amidst a near 80% drop in stock market prices from their peak, that prices would find a permanent floor and could begin to slowly grind higher.
Conclusion
The stock market crash of 1929 led to the Great Depression, causing more than a decade of suffering for many people around the globe, particularly in the U.S.
Strong economic tailwinds led to a decade of prosperity in the 1920s, resulting in stock markets being catapulted to extreme highs.
As stock markets went up, both borrowers and lenders engaged in ever riskier speculation, dropping credit standards and leveraging as much as possible.
As the Federal Reserve began to tighten monetary policy in 1928, the attractiveness of cash returns rose relative to riskier, longer-term assets. This began the process of stocks being gradually sold.
Due to everybody’s extremely leveraged positions, an increasing number of margin calls were made. This created a vicious feedback loop of investors selling stocks to meet margin requirements, which in turn pushed down stock prices, which in turn led to more margin calls being made.
It would take almost three years for the stock market to reach the bottom, followed by 25 years of slow growth before it reached its former highs.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
