October may not be the cruelest month for investors. Based on the averages, that's September. But when Wall Street stumbles at this point of the year, it does so extra hard. And that's why, in the Oct. 3 episode of Motley Fool Answers, Alison Southwick and Robert Brokamp are joined by former Fool Morgan Housel to kick off a four-part series on the history of market crashes in the United States. In this episode and segment, they discuss the big one -- the Great Depression. Did anyone at the time see it coming? And more specifically, in retrospect, can we spot what it was that stopped the music, leaving everyone to realize the party was over? Turns out, it wasn't quite as abrupt as people today think.
A full transcript follows the video.
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This video was recorded on Oct. 3, 2017.
Alison Southwick: So what actually made the bubble burst? So do we go to Black Tuesday? Because that's what I picture, right? You picture the stockbrokers jumping -- we don't literally picture them, because that's macabre.
Morgan Housel: You can if you want ...
Southwick: Is that when the bubble actually burst? On Black Tuesday?
Housel: For most of 1929, there were a lot of smart people and newspapers saying that this was getting a little out of hand, but no one said this is going to completely burst, come down, and cause a huge depression. Robert Shiller, who's a Yale economist -- we've interviewed him several times at The Motley Fool -- he has spent a bunch of time with economic historians, saying, "Find me one person in the 1920s who predicted how this was going to play out. Predicted the crash in its magnitude and the ensuing Great Depression." And he said, "No one. No one back then predicted what would happen."
Robert Brokamp: In fact, it was almost the opposite. You had people like Irving Fisher, who was the preeminent economist back then, saying in 1929 that stocks have reached what looks like a permanent plateau.
Housel: And even the pessimists would say "due for a correction." I think they called them "breaks" back then. "We're due for a break." But no one was really predicting the mayhem that came from it.
One of the things that I think is interesting back then is that a lot of the metrics that we use for sizing up the stock market today -- the P/E ratio and really basic things that you learn in Investing 101 -- didn't exist back then in people's minds. The first book that really put together how people should value stock in a rational way based on discounted earnings, which today we approximate with the P/E ratio, was a book written by Ben Graham called Security Analysis. That was written in 1934. This was years before that.
The first book that a smart finance professor put together on the theory of intrinsic value and what a company is worth based on rational accounting measures was a book written by a guy named John Burr Williams. The book was called The Theory of Investment Value, and that was 1938. This is a decade after the crash.
So if you try to put yourself back in 1929, looking at what's going on in the stock market, we didn't really have the knowledge or the metrics or the data to really understand how inflated stock prices were. We do today with the advantage of not only hindsight but a greater understanding of what stock prices should be, based on earnings and whatnot. But even back then, the smartest finance professors were really just starting to scratch the surface of how a market should be valued. People really didn't know.
Southwick: Was it a lot of gossip and whispers? Like guys chomping on cigars saying, "Hey, I've got a buddy. His boat's coming in, and it's going to take off?" No, I think the metaphor is the boat taking off.
Housel: There were two types of investors. The first was your old-school aristocratic investors who just owned stocks for a hundred years and they just cashed the dividends. That's what they were. And stocks at that point were almost indistinguishable from bonds. You didn't really care or even know what the price changes were. You just got your dividend checks every month or every quarter, and that was it. That was one side.
And then the other side was just pure casino. Had nothing to do with what the companies were doing, or what they were paying in dividends. It was just a casino going back and forth, maybe like bitcoin today, where prices go up and down, but it's not based on anything intrinsic.
Southwick: That's terrifying. All right, so, then, this doesn't last.
Southwick: Let's get to the actual bursting of the bubble.
Housel: So what's interesting, too, is that it didn't happen in one day. We talk about the Crash of 1929, but it played out over a week. And it was basically three days in October of 1929 where the market fell about 12% each day, consecutively. And so I think putting that together, rather than all happening at once, having it spread out a little bit, kind of gave investors at time time -- I don't think it was as traumatic as we would expect it to be today, because it happened slower than, say, the crash of 1987. It just kind of played out slowly.
And people were so accustomed to prosperity and rising stock prices that the 30% decline that happened in October -- was it a big deal? Of course. Did stockbrokers jump out the window? Literally, yes. There are accounts of that happening. But I think people were so shocked -- a 30% decline, in the grand scheme of things, isn't that huge. In three days it's big, but it's not that big a deal. I mean, stock prices fell 20% in the U.S. in 2011.
So there was still a pretty big sense of optimism at the time. Herbert Hoover, who was president, and Andrew Mellon, who was Secretary of Treasury, at the time made a big push in the media and newspapers to say business is sound. The fundamentals are strong. This is a temporary break, as they called it back then. We're going to pull through this. Everything is OK. And I think people bought it at the time.
And so as the months kept playing out into November and December of 1929, things stabilized and recovered a little bit. The big idea was, that was it. That was tough, but things are going to move on and keep going. There was a little bit of a rally after that, but people had absolutely no idea what was still to come.
Southwick: So what was still to come? How long are we going to suffer?
Housel: So even by mid-1930, most economists thought by looking around at what was happening that we were in a pretty bad recession, but nothing more than that. A pretty severe recession, but nothing of historic terms. It was the summer of 1930, and as we moved into 1931 the banking system started cracking, which was caused a lot by two things. One, all these investors with margin debt who were buying from banks were now defaulting on their debt that they were borrowing against. But also wheat prices and corn prices started plunging, so then farmers who had been a big driver of the economic boom in the 1920s, and had leveraged up with all kinds of debt to buy farm equipment and whatnot, were defaulting at record rates, too.
Back then, the Federal Reserve worked in a different way. They didn't bail out banks like they do today, and more importantly, the big thing was there was no FDIC insurance. If your local bank was going down, your life savings was going with it. That began the bank runs of the early 1930s, which is where things really started getting out of hand.
It peaked in 1932. There was a wave of bank failures in 1932, and the big one, actually, was a bank in Austria called Creditanstalt in Vienna. It was a huge bank in Austria. It failed overnight, and no one really saw it coming. And there have been some economists who have mapped just how it happened. After Creditanstalt failed in Vienna, then it spread to Paris, and then it spread to London, and then eventually spread to New York. It was a bank called the Knickerbocker Trust in the United States that failed in New York, and after that the curtain came down.
Southwick: Knickerbocker. That's like the most perfect name for a failing bank ...
Housel: The perfect name for a 1920s bank, right?
Southwick: You couldn't write that.
Housel: And so after the banks started failing, that's where things started getting really ugly in the United States. So now we're into, like, 1932. So we're three years after the Crash of 1929, which, I think, to me that's probably the biggest misconception of the Great Depression, is that there's the Crash of 1929 and then boom, welcome to the Great Depression!
And it wasn't. It played out, the first couple of years, played out kind of slowly, over a period of many many, years. And if you think about the 2008 financial crisis, the worst of that was really contained in literally, like, a 90-day period. It was late 2008 -- September, October, November -- and then it was pretty much over.
The Great Depression played out over three years, and that, I think, did the opposite of what the 1920s did, is that people just got accustomed to pessimism. Their hopes vanished. After you've been beaten up consistently for three years, people lose all their optimism and all their faith, and that feeds on itself. If businesses and employees and investors don't have any optimism and don't have any confidence, then it's really hard to get the economy going.
Southwick: Nothing goes up.
Housel: So the stock market bottomed in mid-1932. Unemployment and the economy bottomed in 1933, four years after the crash.