TableofContents

Cover

Publishingdetails

AbouttheAuthor

ForewordbyMerrynSomersetWebb

PrefacetotheFourthEdition

Acknowledgements

Introduction

PartI.August1921

TheroadtoAugust1921:ThecourseoftheDow-1896–1921

LivingwiththeFed-Awholenewballgame(I)

Structureofthemarketin1921

Thestockmarketin1921

Thebondmarketin1921

Atthebottomwiththebear-Summer1921

Goodnewsandthebear

Pricestability&thebear

Liquidityandthebear

Thebullsandthebear

Bondsandthebear

PartII.July1932

TheroadtoJuly1932

ThecourseoftheDow-1921-29

LivingwiththeFed-Awholenewballgame(II)

ThecourseoftheDow-1929-32

Structureofthemarketin1932

Thestockmarketin1932

Thebondmarketin1932

Atthebottomwiththebear-Summer1932

Goodnewsandthebear

Pricestabilityandthebear

Liquidityandthebear

Thebullsandthebear

Bondsandthebear

Rooseveltandthebear

PartIII.June1949

TheroadtoJune1949

ThecourseoftheDow–1932-37

ThecourseoftheDow–1937-42

ThecourseoftheDow–1942-46

ThecourseoftheDow–1946-49

Structureofthemarketin1949

Thestockmarketin1949

Thebondmarketin1949

Atthebottomwiththebear–Summer1949

Goodnewsandthebear

Pricestabilityandthebear

Liquidityandthebear

Thebullsandthebear

Bondsandthebear

PartIV.August1982

TheroadtoAugust1982

ThecourseoftheDow-1949-68

ThecourseoftheDow-1968-82

Structureofthemarketin1982

Thestockmarketin1982

Thebondmarketin1982

Atthebottomwiththebear-Summer1982

Goodnewsandthebear

Pricestabilityandthebear

Liquidityandthebear

Thebullsandthebears

Bondsandthebear

Conclusions

Strategic

Tactical

Thenandnow

Bibliography

PublishingdetailsHARRIMANHOUSELTD3APennsRoadPetersfieldHampshireGU322EWGREATBRITAINTel:+44(0)1730233870Fax:+44(0)1730233880Email:enquiries@harriman-house.comWebsite:www.harriman-house.com

OriginallypublishedbyCLSABooksin2005This4theditionpublishedinGreatBritainin2016Copyright©HarrimanHouseLtd

The right of Russell Napier to be identified as the author has been asserted in accordance with theCopyright,DesignandPatentsAct1988.

ISBN:9780857195234

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ForKaren

AbouttheAuthor

ProfessorRussellNapieristheauthoroftheSolidGroundinvestmentreportandco-founderoftheinvestmentresearchportalERIC(www.eri-c.com).Russellhasworked in the investment business for 25 years and has been writing globalmacro strategy for institutional investors since 1995. Russell is founder andcourse director of the PracticalHistory of FinancialMarkets at theEdinburghBusinessSchool.Russellservesontheboardsoftwolistedcompaniesandisamember of the investment advisory committees of three fund managementcompanies.In2014hefoundedtheLibraryofMistakes,abusinessandfinancialhistorylibraryinEdinburgh.RussellhasdegreesinlawfromQueen’sUniversityBelfastandMagdaleneCollege,Cambridge,andisaFellowoftheCFASocietyoftheUKandanHonoraryProfessoratHeriot-WattUniversity.

ForewordbyMerrynSomersetWebb

RussellNapierisnotacrowdpleaser.TherearenopredictionsofDow10,000inthisbook.However,heisafabuloushistorian,educatorand,ashisintroductionstopasteditionsofthisbooksuggest,forecaster.Thelastpreface–in2009–toldusthatvaluationswerelowenoughanddeflationexaggeratedenoughthattherewasasubstantialbearmarket rallyahead.Therewas.Thequestion then–andthe one Russell asks in his new preface – is whether the huge rise in mostwesternmarketssincehasbeenmorethanarally.Was2009agreatbottomandthemarketweareallinvestingintodayaperfectlysafelong-termbullmarket?

Russell’sanswertothis?Itisnot.

It was impossible – for me at least – in 2009 to imagine the monetaryenvironment we live with now. I couldn’t imagine interest rates in the UKstayingattheirlowestlevelin300yearsfor27quartersandcounting.Icouldn’treally imagine negative interest rates or endless QE. It wasn’t immediatelyobvious that super-loose monetary policy would poison our economies withcapitalmisallocation and huge over-supply of almost everything. And I don’tthink it ever occurred to me that our central bankers would look at what isclearlyanasset-pricebubblecreatedbytheirownpoliciesandputitaboutthatthose same policies areworking just fine. Sowell, in fact, that a bitmore ofthemcan’t(surely!)doanyharm.

It was also all but impossible for most of us to imagine how all-powerfulinvestorswouldcometoseethecentralbanksasbeing.Intheyearssince2008our elected governments have effectively handed over financial crisismanagement to theirunelectedappointeesat theFed, theBankof theEnglandandtheECBandwhiletherationalwillthinkthatthisisn’treallyagoodthing(themostimportantthingtowatchinacountryshouldnotbetheminutesofitscentral bank meetings), for investors it has become a good thing. If everyeconomicsetbackisseenasanopportunityforcentralbankstointerveneagain,wecan’treallyhavebadnews.Onlyhigherassetprices.

That can’t last. It seemsobvious that themarkethasbecomemore fragile andmorevolatileasadirectresultofconstantcentralbankinterference:notethatthe

number of assets seeingmoves of four standard deviations from their normaltradingrangeshasbeenrisingsharply.Atthesametimeitishardtoimaginethatthefundamentalconditionsareinplaceforthistobealong-termbullmarket.Ifvaluationsareatthehighendoftheirhistoricalrangesbutfirmscan’tfindwaysto increase their sales and produce the profit growth those valuations suggesttheyarecapableof,howcanstockskeeprising?Andwhatofdeflation?

Russelllikestosaythatmostinvestorsarewrongtothinkofequitiesasanasset.They are instead the ‘small sliver of hope between assets and liabilities’ –somethingthatcanbewipedoutbydeflation(whichshrinksyourassetsbutnotyour liabilities) in less than the time it takes your stockbroker to explain thatvaluations aren’t high relative to bond yields and that diversified long-termportfoliosneverfail.

TheanswertoRussell’skeyquestiontoday–bearmarketrallyorbullmarket?–matters even more than it has in the other bear markets he discusses in thisbrilliant book.Obviously stockmarket crashes have always hadwider effectsthan just thoseon investorswhoholdstocks individually.But thesedays,withthedemiseofdefinedbenefitpensions,theriseofdefinedcontributionpensionsandtherapidagingofmanywesternpopulations,manymillionsmoreofuswillhave our finances and our lifestyles directly affected by the next great stockmarketbottomthanhaseverbeenthecasebefore.

This new edition is a must-read for all professionals – they will, I think, begenuinelyneglectingtheirdutytotheirclientsiftheyarenotawareofRussell’swork.ButgivenhowbusyalltoomanyofthemwillbeworryingaboutrelativeP/Es, extrapolating last year’s earnings into next andworking on their crowd-pleasingskills,Isuspectitisalsoamust-readfornon-professionalinvestorstoo.Youneed toknowwhenRussell thinks thenextgreatbottomwillbe– just incaseyourfundmanagerdoesn’t.

MerrynSomersetWebb

November2015

PrefacetotheFourthEdition

Whenthisbookwasfirstpublishedtenyearsagoitpurportedtobeapracticalguideforthoseattemptingtoinvesttheirsavingsatthebottomofanequitybearmarket. In the 2005 edition, and in the subsequent 2007 and 2009 editions,forecastsweremadeaboutthefuturedirectionoftheUSequitymarket,utilisingthe analysis of the four great bear market bottoms for US equities. So howaccurateweretheseforecastsandwhatdoesthehistoryofthefourgreatbottomssuggestaboutthefuturedirectionoftheUSequitymarket?

In the first edition of this book, published in November 2005, the followingforecast was made: ‘Before the bear market is over the DJIA [Dow JonesIndustrialAverage] is likely to declineby at least 60%’.Thedirectionprovedright but the magnitude was wrong. The DJIA rose from November 2005,peaking inOctober2007.The index thendeclined54%fromitsOctober2007peaktoitslowinMarch2009.Thiswasjust40%belowitslevelwhenthisbookwas first published in November 2005 and not the 60% decline your authorexpected.Judgedbythevaluationmeasuresrecommendedinthisbook,theUSequitymarketreachedfairvalueinMarch2009,butitwasnotascheapasonewouldhaveexpectedat agreatbearmarketbottom.Using theanalysis in thisbookonemustthenconcludethatMarch2009wasnotthebottomforthegreatbearmarketwhichhadbegunin2000.

In that first edition in2005, theconclusion stated that thedecline in theDJIAwas not imminent as ‘there has yet been no disturbance to the general pricelevel’, ‘the decline in the price of government bonds has so far beenmuted’,‘there has been no reduction in interest rates by the Fed’ and ‘there is norecession’.FromNovember2005tothepeakoftheUSequitymarketinOctober2007 inflation did rise, if not by much, but the price of the 10-year USgovernmentbonddeclinedandtheyieldrosefrom4.5%to5.3%.TheFedFundsrate, the policy interest rate set by theUS Federal reserve, rose steadily from4.0%inNovember2005to5.25%bySeptember2007.ThefirstcutintheFedFundsratecameinSeptember2007andthebusinesscyclepeakedinDecember2007.

So,asforecastinthe2005edition,thebearmarketdidcommencewheninflationandbondyieldshadrisen,theFedhadbeguntocutinterestratesandarecessionhadbegun.Thishadallhappenedbytheendof2007andaviciousbearmarketdeveloped that was not to end until March 2009. Looking back, the greatestsurprise was that the rise in inflation, bond yields and policy interest ratesnecessary to trigger therecessionandequitybearmarketwereremarkably lowby historic standards. As we were to discover in the ensuing collapse, thissensitivityofassetpricestomarginallyhigherinterestrateshadmuchtodowiththeexcessivedebtlevelswhichhadbuiltupinthesystemduringthe2001–2007economicexpansion.

The prologue to the second edition, written in July 2007, re-affirmed thepredictionthat theDJIAwoulddeclineby60%fromitsNovember2005level.Aswehaveseen,itdeclinedbyjust40%fromthatlevel.Onceagainthetriggerfor sucha correctionwas seenas a ‘disturbance to thegeneralprice level’. InJuly 2007 the preface suggested that ‘the rise in inflationwhichwill instigatesuchadeclineisnowmoreclearlyevident’.TheseinflationaryheadwindswereseentobeemanatingfromAsiaingeneralandChinainparticular.KeyreformsintheChinesebankingsystemin2005seemedtobeshiftingChinaawayfromaformofinvestment-ledeconomicgrowthtoconsumption-ledeconomicgrowth.Given the importance that massive capacity additions in China played indepressingglobal inflationfrom1994–2005, thisshift in thenatureofChinesegrowthauguredhigherinflationfortheworld.

Tothisauthor,writinginJuly2007,thatinflationwaslikelytobethetriggerforthepricedisturbancethatwouldsendUSbondyieldshigher,initiatearecessionand sendUS equity prices sharply lower.Therewas indeed a suddenburst ofinflationfromChinaandthepriceofChineseimportstotheUSroseby7%fromMarch2007toJuly2008.Thisimportedinflationcombinedwiththeriseinthepriceofcommodities,atleastpartlyduetocontinueddemandfromChina,waskey inpushingUS inflation to5.6%byJuly2008.This rise in inflation in theearly stage of the US recession may have slowed the pace of interest ratereductionsby theFederalReserveandcontributed to theseverityof the2008–2009recessionandslumpinequityprices.

Aswehaveseenabove, the rise in10-yearTreasuryyieldsand the rise in theFed Funds rate were key triggers that presaged the equity bear market andrecession that began in late 2007. Thus the rise in inflationary expectations,

which pushed these key interest rates higher, played an important role intriggering the equity bear market of 2007–2009. The rise in US inflation,forecastinthe2007editionofthisbook,didindeedcometopassbutit turnedouttobeshort-lived.ThedowndraftinUSassetpricesandeconomicactivitynotonlycrushedinflation,butdeliveredthefirstdoseofdeflationtotheUSAsince1955.Risinginflationaryexpectationsmayhavepushedinterestrateshigherandtriggered thebearmarketbut it became rapidly apparent that theproblemwasnowdeflationandnotinflation.

The key conclusion from the analysis in this book is that great equity bearmarketswilloccurasdeflation,ortherealriskofdeflation,develops.Thebookthen posits that it is as these deflationary forces lift that equity markets willbottom. The deflation necessary to reduce equities to cheap valuations didindeedarriveas thegeneralprice levelstarted todeclinesharply inSeptember2008.Atthatpoint,theDJIAcollapsed.

However,bythetimetheprefacetothe2009editionwaswrittentherewasroomforoptimism:‘Asweshallsee,thetimetobuyequitiesiswhendeflationaryriskdiminishesandriskpremiumsstarttocontract.AsIwrite,attheendof1Q09,itseems thatmarkets haveover-reacted to the risk of deflation and thus anothersignificant rally in the2000–2014greatbearmarket is the likely result.’Well,callingarallyinanequitymarketthatbottomedon9March2009isnotbad–thoughclearlythiswasnotarallyinalongbearmarketthatwouldonlybottomin2014!

Incallingforarallytheprefacetothe2009editionnotedtheimprovementsincorporate bond prices, the copper price and the price of Treasury InflationProtected Securities (TIPS) in 1Q 2009. The improvements in these keyindicators suggested the worst was over for the equity market. The prefaceconcluded, ‘The passing of the deflation risk signalled by all three indicatorsshouldbepositiveforequityprices’.Andso itproved,but thepositive impactfrom the lifting of deflation was to last much longer than your author couldforeseeinMarch2009.

Whiletheprefacetothe2009editionforesawarallythatwouldlastyears,itdidnotbelievethatUSmonetarylargessecouldlastaslongasithas:‘Theincreasein the money supply, combined with massive Treasury issuances, shouldundermine thepriceofTreasuries,butFederalReservebuying isnegatingany

suchmarketforce.HowlongittakesforthesemarketstobringdisciplinetotheUSfinancialmarketswilldeterminehowlongthebearrallywilllast.WithtruedisciplinefortheUSauthoritieslikelytobesomeyearsaway,theoddsarethatWashington will succeed in removing the deflationary risk that is depressingequity prices.’Well, with such discipline not having been dispensed even by2015, the rise in theUS equitymarket has continued. It is clear that the bearmarketwhichbeganin2000didnotbottomin2014,buthaditalreadybottomedin2009?Will2009godowninhistoryasanothergreatbearmarketbottom,orhas theDJIAyet to reachnew lows in thebearmarket that began in theyear2000?Asnotedabove,USequitiesdidnot reach the lowvaluations thathavehistoricallybeenassociatedwithgreatbearmarketbottoms.Theprefaceto the2009 edition, while forecasting a rally in equity prices, focused on two keyreasonswhy thiswas likely tobe just a rally in a longbearmarket: ‘The realdanger is in structural changes – rising consumption in China and increasingretirement in theUS– thatwillprobablybringdiscipline to theUSauthoritiesforthefirsttimesincethe1970s.’

In 2015 the inexorable pressure from these two key structural shifts hasprogressedfurtherandthedeflationaryforcesthat theywillunleasharenearer.These structural shifts augurdeflation and thus canunleash the force thatwillpush equities to valuation levels associated with the bear market bottoms of1921,1932,1949and1982.Thisnegativeimpactofdeflation,underminingfaithin the reflationary powers of central bankers after more than six years ofunconventional monetary policy, might be particularly damaging for the USequity market. More monetary solutions to deflation might seem particularlyimpotentgiven their failure togenerate inflation from2009 to2015.Themostdamagingdeflationforequitieswouldbeadeflationseeminglywithoutacure.

SohowdoesrisingconsumptioninChinaandtheriseintheretiredpopulationof theUSA increase the likelihoodofadeflationaryepisode thatwouldcreatethe fifth great bear market bottom? The key impact will be how changingconsumptionpatternsandhighersavingsrates impactonfinaldemand,aswellasonmonetarypolicyinboththeUSAandChina.

WhenonethinksoftheUnitedStateseconomyonethinksofconsumption.Theconsumer society was born in the United States with the creation of widelyavailableconsumercreditinthe1920s.TheGreatDepressionandWorldWarIIprovedtemporarysetbackstotheriseandriseoftheconsumer.Thepost-WWII

riseof theconsumer,andconsumerdebt,cametodefine theAmericanwayofgrowing.Asignificantportionofthisseeminglystructuralshiftwasdrivenbyababy-boom generation whose search for everything tomorrow, if not sooner,broughthighlevelsofconsumptionpartiallyfinancedbydebt.

If savings are frozen desire, then debt is instant gratification. The baby-boomgeneration borrowed to consume, in a decades-long pursuit of instantgratification,thewaynogenerationhaseverconsumed.Virtuallyeveryanalystnowassumesthatthisformofconsumptionisthenormalformofconsumptionfor theUnitedStates.Now, though, the baby-boomgeneration is aged 51–69,highly geared and perhaps, just perhaps, somewhat satiated. Federal Reservedata indicates that the peak percentage of households in debt have a head ofhouseholdaged45to54andfully87%ofsuchhouseholdsareindebt.Tellingly,whentheageoftheheadofhouseholdis65–74thepercentageindebthasfallento66%.Thereisafurthersteepdeclineinindebtednessthereafter.Simplyput,ifyoudon’tretireyourdebt,youdon’tgettoretire,whileanyoneseekingtoretiredebtislikelytosavemoreandspendless.

This structural shift to lower levels of consumption by the baby-boomgeneration, as they retire their debt in preparation for retirement, is a sizeableimpediment to US economic growth and inflation. It also impedes FederalReservepolicythatseekstogeneratebankcreditgrowthtostimulategrowthinmoneyandhence inflation.Thesestrongdeflationaryheadwinds,mentioned inthe 2009 preface, are now all the stronger as the baby-boomgeneration is sixyears older. If this demographic shift proves deflationary, despite six years ofunconventional monetary policy by The US Federal Reserve, then US equitypriceswillfallsharply.

TheimpactoneconomicgrowthfromthedemographicshiftintheUSalsohasmajor implications for China. China’s economic growth has primarily been aproductof adeliberatepolicyofundervaluing its exchange rate relative to theUSdollar.Thispolicyhasbeen inplacesince1994andcreatedhigh levelsofeconomicgrowthasChinaexportedthegoodsthatthebaby-boomersintheUSAandelsewheredemanded.

Thepolicycreatedgrowthbutalso inflation,and thecompetitivenessofChinahasbeenunderminedbyaparticularlyrapidriseinwagesinrecentyears.Thereare many differing measures of Chinese wages, but the best broad-based

measureofwagegrowthshowsalmosta200%growthinChinesewagessincetheendof2008.Thisriseinwagescomesasthedemandforstufffromthebaby-boomerswanes.Theimpactofthesechanges,andgrowingenergyproductionintheUS,isprofoundandtheUScurrentaccountdeficit,whichwas5.9%ofGDPin 2006, is now just 2.4% of GDP. For those countries, such as China, whomanage their currencies relative to the US dollar these smaller US currentaccountdeficits force them tochoosebetweenslowergrowthorexchange-ratedevaluation.

The2007prefacetothisbookpredictedthatthereformofthebankingsysteminChina would shift the nature of China’s growth from investment-led toconsumption-ledwithensuingglobalinflationaryimpacts.Thegrowthinwagesnotedabovehasindeedproducedsuchaninternalshift,buttheimpactonglobalinflation has beenmuchmoremuted than this author expected. Crucially, theGreatFinancialCrisisof2008–2009persuadedpolicymakersinChinathattheyneeded yet another great command-economy credit expansion. This inevitablyled to the creationof evermoreproductive capacity and thus acted todepressprices.

Thus, despite the rapid rise in Chinese wages, the price of Chinese productsimportedbytheUSisfalling.Thiscombinationofhigherwagesandincreasedproduction has come at a high price, as it has undermined Chinese corporateprofitability. Many private-sector savers in China, who have previouslyreinvested their cash flows in their businesses, are removing their funds inpursuit of better returns elsewhere. All of which means China is now in anextremely difficult position where its currency is linked to a rising USD,competitiveness is declining through higher wages, demand from its majormarketsissluggishandlocalsaversareremovingtheirfundsfromthecountry.

The most likely outcome from this combination, particularly should the USdollarcontinuetoriseontheinternationalexchanges,isthatChinawillallowitscurrency to devalue in pursuit of easiermonetary policy and higher economicgrowth.Suchamovewouldsendcheapgoods flooding into theglobal systemand, as it did after China’s 1994 devaluation, threaten the solvency of thecompaniesandcountriesthatcompetewithChina.Theabilityofthedevelopedworld central bankers to generate growth and inflation in the face of such amajordeflationary forcewillbeseverelyquestioned.Tosome,deflationmight

seemanincurablediseaseandhistorysuggeststhatthisiswhenequitieswouldbecomeverycheapindeed.

ThedeteriorationinChina’sexternalaccountswillalsoacttoincreasethecostoffinancingfortheUSprivatesector.AsChinabuysfewerTreasuries,itputsagreaterburdenuponthesavingssystemtofundtheUSgovernment.SinceChinadevalued its currency in 1994, moving into major external surplus, thepercentage of the US Treasury market owned by foreign central bankers hasrisenfrom12%ofthetotalissuancetoapeakof38%in1Q2009.Crucially,allthesepurchaseshavebeenfundedbyforeigncentralbankscreatingmoreoftheirdomesticcurrencyinreturnfortheUSdollarstheyreceivedtobuyTreasuries.These huge purchases of Treasuries by foreign central bankers, led byChina,wereessentialtokeeptheircurrenciesundervaluedrelativetotheUSdollar.

Suchpurchasescontinueduntil2014,butappear tohaveended in2015.Since2009 foreign central banks have not been alone in creating liabilities to fundtheir purchase of US Treasuries. From 1Q 2009 the US Federal Reserveincreased its holdings ofTreasuries byUS$1,985bn and also financed this viathecreationofnewmoney, this timeUSdollars, in theformofbankreserves.TheimportantimpactofallcentralbankfundingontheUSgovernmentisthatitwas funded by the creation of new liabilities by central bankers and not theliquidationof assets by savers.Thus freed from theobligation to fund theUSgovernment,saverswerefreetofundanythingelsetheywanted.Andatvariousstagesfrom1994to2015theyseemedcapableoffundingeverythingelse!

However,astheobligationtofundtheUSgovernmentfallsbackuponitssavers,therewillbefewersavingsavailable tofundtheprivatesector.Thissqueezingout of private sector funding could well manifest itself in lower share andcorporatebondpricesandthusahighercostoffundsfortheUSprivatesector.This impacton theUSwilldevelop just asChina finds itselfunable to loosenmonetarypolicyandgenerategrowthasit isforcedtocontractitscentralbankbalancesheetbysellingTreasuriestodefendtheexchangerate.Inthiswaythelower consumption growth in the US, combined with capital outflow fromChina,willresultinlowergrowthinChinaandhigherfinancingcostsandlowergrowth for the US private sector. With US inflation already at zero, thiscombinationoflowergrowthinChinaandtheUScanproducethedeflationthathashistoricallyledtomajordeclinesinequityprices.

Theanalysisinthisbooksuggeststhatthecurrenthighlevelofequityvaluation,whethermeasured by the cyclically adjustedPEor the q ratio,would indicatevery poor long-term returns for investors in US equities. These measures ofvalue suggest that, even for an investor prepared to hold for ten years, it isunlikely that the real average returns from US equities will exceed 2% perannum. This compares very unfavourably with the average long-term returnfromUSequitiesof5–6%.However,valuemeasuresalonecan tellusnothingaboutthedistributionoftheaverageannualreturnsthatmakeupthatpoorlong-termaverage.Historysuggeststhattherearelikelytobesomeverybadyearsforreturnsindeed,iflong-termreturnsarethispoor.

Thisprefaceforecasts thatoneofthoseverybadyearsisnowimminentasthedeterioration in China’s external accounts brings slower growth to China andultimately a devaluation of its exchange rate. This adjustment will beaccompaniedbyworseningcreditconditionsanddeflationintheUS.Manywillbe skeptical that these forces of deflation can be offset and thus equities arelikelytobecomeverycheap.

What follows such a deflation is likely to be highly reflationary as energisedgovernmentsact toproduce reflationwhencentralbankershave failed.Expectextrememeasures including the forgiveness of student debt, the so-called ‘QEfor the people’, de facto credit controls and exchange controls. Onlygovernments andnot central bankers candeliver suchmeasures, and theywillnot be enacted without significant political friction, particularly in the USA.Such dramaticmoves in the developedworldwould almost certainly generatehighernominalGDPgrowththatwouldbeladenwithinflation.Ultimately,thebiggestinflationaryforcemaycomefromChinawhereacentralbankcontrolledby thegovernment andunfettered from its exchange rate targetmightproduceveryhighlevelsofdomesticnominalGDPgrowth.Itisjusttooearlytotellyetbut,ifequitiesarecheap,suchforcesofreflation,thoughattendedbystructuraldeclinesintheroleofmarketforces,wouldsignalanewbullmarketforequities.

Thoseseekingtoassesswhetherequitiescanindeedbottominresponsetosuchactionswillneedtoreadthisbookagain.Itwilllikelybeadifferentworld,withmoregovernmentandastructuralriseintheimportanceofthePeople’sBankofChina. Political reactions to these major economic shifts will be particularlydifficult to predict – they always are.However, oneof thekey lessonsof thisbookisthatequitiescandiscountalmostanythingwhentheyarecheapenough.

Hopefully thisbookwillagainproveuseful in thecomingyearswhenequitiesoncemore discount toomuch bad news, as they did in 1921, 1932, 1949 and1982.

RussellNapier

November2015

Acknowledgements

Thisbookwaswritten throughafrustrationwithmoderncapitalmarket theoryand alsomost available financial history books.The first approach downplaysthestudyofhistoryandtheseconddownplaysthepracticalelementsofhistory.The aim of this book is to provide a practical history of financialmarkets. IndoingthisIhavebeeninspiredbyotherpractitionerswhohavealreadymadeacontribution in this field - Barrie Wigmore (The Crash and Its Aftermath,Securities Markets in the 1980s), Sandy Nairn (Engines That Move Markets:Technology Investing from Railroads to the Internet and Beyond), JohnLittlewood(TheStockMarket:FiftyYearsofCapitalismAtWork),MarcFaber(The Great Money Illusion and Tomorrow’s Gold) and of course GeorgeGoodmanaka‘AdamSmith’(TheMoneyGame,SuperMoney,PaperMoney).Ifthisbookturnsouttobehalfasusefulasthoseauthors’contributions,itwillnothave been a waste of two years’ effort. If this book also convinces otherpractitioners that they too can add to the literature of the practical history offinancialmarketsthenitwillhaveachieveditsgoals.

ThisbookwouldnotexistifitwerenotforGaryCoull,ExecutiveChairmanofCLSAAsia-PacificMarkets.ItwasGary’sideathatCLSAgetintothebusinessofpublishingbooksandalsohisideathatIshouldwriteone.

Itwouldnothavebeenpossibletowritethisbookwithoutaccesstoagreatdealofdata.InfindingthatdataIwassetoffintherightdirectionbyMurrayScott,whoknowshiswayaroundthedataminesbetterthananyoneIknow.Whenonedataveinappearedtobeextinguished,RichardSyllawasasureguidetoanewsourceandanew fieldof enquiry.Whenall else failedanda flight to theUSseemedessential, thestaffof theNewYorkPublicLibrarycame to the rescueandIthankthemfortheirhelpforsomeonetheyhavenevermetmanythousandsofmilesaway.Thisbookreliesparticularlyuponprimaryresearch in thebackissues of the Wall Street Journal. Reading through sixteen months of thisvenerabledailywasamammoth taskandone IprobablywouldnothaveevencontemplatedhaditnotbeenfortheservicesofProQuest(www.proquest.co.uk).The ProQuest service offers remote access to every article and advertisementpublished in theJournal since1889.While already recognised as awonderfulresource for historians, I think its usefulness to investment practitioners is not

yet fully recognised. For those who seek guidance to the investment future afully searchable database of over one hundred years of WSJ articles is awonderfulresource.

FormanyyearsnowIhavebeen involvedwithagiftedgroupof thinkersandteachers who have contributed to the Practical History of Financial Marketscourse (www.didaskoeducation.org). I owe this opportunity to learn andcontributetofinancialmarketunderstandingtothetrusteesoftheStewartIvoryFoundation, acharitywhich funds thedevelopmentand runningof this courseandmanyotherprojects.InthistaskIhavebeenveryfortunateinthatsomeofthebestmindsinfinancehaveagreedtocontributetotheproject.Ithasbeenawonderful opportunity to learn froma teamof authors and teacherswhohavecombined practical experience ofmore than two hundred years. In relation tothis book I would like to acknowledge the assistance of four of the courseauthor/teachersinparticular:MichaelOliver,GordonPepper,AndrewSmithersand Stephen Wright. Michael and Gordon have done their best to steer methrough the minefield of monetary data interpretation necessary in this book.Andrew and Stephen have been kind enough to allowme to quote from theirbook,ValuingWallStreet.Anyerrorswhichmayappearinthesepagesonthesubjectofqratiosormoneyarethoseofthestudentratherthantheteacher.Forthosewhoalsowish to learnfromthe teacherspleasecomeandjoinuson thePracticalHistoryofFinancialMarketscourse,buyacopyofValuingWallStreetorGordonPepper’sTheLiquidityTheoryofAssetPrices.

Ihope thisbook isnowdigestible to theaverage reader. Itwasnotalwaysso.Even hardened investment professionals, such asmy friend PJKing, found itveryhardgoing.PJ,inthebluntbutkindwayperhapsuniquetomenofCountyCork, made very clear what should be changed. Of course, coming from theother end of Ireland, I did not agree easily to all of this. This is where theAntipodeans come in. Editors Tim Cribb and Simon Harris beat down myramblingproseintosomethingwhichhopefullyisnowdigestibleforall.WithouttheconsiderableeffortsofTimandSimonIwouldprobablystillbewritingandfindingmoresubjectswhichsimplyhadtobecovered.Iamneitherqualifiedbyaptitude or spirit to be an editor and I admire their skill and fortitude whenconfrontedwithsuchastubbornauthor.

InjustabouteverybookIhaveeverread,theauthoracknowledgesthesupportof their immediate family. Only if you have written a book can you really

understandwhy this issonecessary. Iwould like to thankmywifeSheilaandmy sons Rory and Dylan for putting up withmy long absences and frequentboring discursions on times long past. In particular I would like to thankmyparentsfortheirguidanceandsupportovermanydecades.Thankstomyfatherwho,asitwastoturnout,hadalreadytaughtmemostofwhatIneededtoknowabout business in his butcher’s shop in Belfast. Thanks to my mother, whotaughtmethattherearemanythingsinlifemuchmoreimportantthanbusiness.

IntroductionBeforebeginningaHunt,itiswisetoasksomeonewhatyouarelookingforbeforeyoubeginlookingforit.

Pooh'sLittleInstructionBookbyJoanPowers,inspiredbyA.A.Milne.

Asaflyfisherman,IhaveoccasionallyfoundmyselfdeepinthewoodsofNorthAmerica.Thisiswherethebearslive.AsanUlsterman,myexperiencehasnotbeenindodgingbearsandIhavesoughttheadviceoftheexpertsonwhattodoshouldoneappearon the riverbank.TheUSNationalParksServicehasbeenparticularlyhelpful.

Make asmuchnoise as possible to scare it away.Yell.Bangpots together. Ifthere’ssomeonewithyou,standtogethertopresentamoreintimidatingfigure.Allofthismightpreventyournamejoiningthelistof56peoplesofarkilledinbearattacksinNorthAmericaoverthepasttwodecades.

Thisbookisaboutwhattodoshouldyouspotabearofadifferentkind,butoneno lessdangerous. It is a fieldguide for the financial bear,which can shred aportfolio and seriously damage your wealth. And this type of bear is amuchgreaterthreattomostindividualsthananythingfoundinthewild.

There are some84million shareholdersofUSequities alone [1] , andmillionsuponmillionsmorearoundtheglobe,whosefinancialfuturescouldbedestroyedor seriously damaged by one of these bears, which are not nearly as easy torecognise as amemberof theurisidae family in thewoodsofNorthAmerica.Evenifyoucanrecognisethisbear,makingalotofnoiseorstandingtoughwithfriendswon’tscareitaway,thoughyoumayfeelalotbetter.

Thisisagoodtimetolookatthefinancialbear.ThelargedeclineinthepriceofUSequities that erupted inMarch2000peteredout in late2002.Was this theendof thebearmarket?Informedcommentatorsaredividedontheissue,evenbytheautumnof2005whenequitypricesremainwellabovetheirlows.Didanewbullmarketbegin in2002,or is it justabounce ina longerbearmarket?Therearefewmoreimportantquestionstobeansweredinmodernfinanceandthisbook,bylookingatallthepreviousmajorbearmarketsthathavefollowedonfromperiodsofextremeovervaluation,offersananswertothatquestion.We

remain in a bearmarket.Whenwill it end?Howmuch lowerwill themarkethave to go? What events will help you determine when the market hasbottomed?Theanswersareinthisbook.

Aswitheverythinginlife-except,perhaps,waterinyourwadersinthemiddleofaparticularlycoldstream-thereisanupsidetoabearmarket.AccordingtoProfessorJeremySiegel’sanalysisoftotalrealreturnssince1802,allaninvestorneeds do is hold for 17 years, and they will never lose money in the stockmarket. If you sit it out and ignore market prices, history suggests that insometime less than 17 years the bear will simply go away, leaving your realpurchasing power undamaged.When it comes to investment in equities, it isindeedtruethateverythingcomestohewhowaits.Ifyouhavethattimehorizon,youdon’tneedafinancialfieldguide.

Few investors are sanguine enough to ignoremarketmovements for 17 years.Indeed,NewYorkStockExchange (NYSE)statistics for the firsthalfof2005show theaverageholdingperiodof the84millionstockowners in theUSwasjust12months(theaverageholdingperiodfrom1900-2002wasjust18months).Inthe20thCentury,therealannualreturnonUSequitieswasnegativefor35ofthose100years.Ineightofthoseyears,thenegativereturnexceeded20%.So,theaverageinvestorwilllikelyencounterabearmarketeverythreeyearsorso,andevery13yearsthebearwillbeparticularlymean.

Granted that much of the volume on the NYSE is created by hedge fundmanagers and operatorswith near 20/20 short-term foresight, let’s assume theaverageinvestorismorepatientthanthestatisticssuggestandworksonatimehorizon of ten years. This, of course, is wishful thinking as NYSE averageturnoverratesshowonlyoneyearinthepasthundredwheretheaverageinvestorhada timehorizonof thisduration.However ifweassumea ten-yearholdingperiod,thatstillmakesabearencountersomewhatlikely.Fornineoftheyearsofthepastcentury,subsequentten-yeartotalrealreturnsfromUSequitieswerenegative. This is frequent enough, even for an investor with a ten-year timehorizon,tofacetheriskofcommittingcapitalintheonedudyearin11.Andbigbears tend to linger. Periods of rising prices, before a further fall, are notuncommon in long bear markets. A financial field guide helps to avoidmistakingariseinpricesfortheonsetofanewbullmarket.

As youwill discover, it seems highly likely that the rise in US equity pricessince October 2002 has been just such a false dawn. That’s importantinformation,evenifyouhaveaten-yeartimehorizon.

Bears, however, can be beautiful in theirway, and an alternative title for thisbookmighthavebeenHowILearnedtoStopWorryingandLovetheBear.Bearmarketsmeanlowerprices.Consumersdon’tobjecttolowerpricesandneithershouldinvestorsiftheyarebuyingratherthanselling.Avoidingbearspreserveswealth, but buying cheap in a bear market, given the positive real long-termreturns fromequities, is evenmoreprofitable.This fieldguide to the financialbearfocusesontheverylucrativeperiodsinhistorywhenequitypriceshadbeenpushedwellbelowfairvalueandreboundwasimminent.

AsUS baseball legendYogi Berra once said, ‘You can observe a lot just bywatching’.Bywatchingthefinancialbears,wecanobservethepointatwhichanumber of potential factors come together to signal the market can only getbetter. Those factors include low valuations, improved earnings, improvingliquidity, falling bond yields, and changes in how themarket is perceived bythosewhoplayit.Theaimofthisguideistohelprecognisefactorsthathave,inthe past, proven to be good markers to the future, and those that have beenmisleading.Albert Einstein once said the secret of his successwas to ask therightquestions,andkeepgoinguntilhegottheanswer.Infinancialmarketsjustasking the right questions can be incredibly difficult. This book, by studyingfinancialhistory,offers thequestions toaskwhenconfrontedbythebear.YouhaveanadvantageoverEinstein.Thebeautyoffinanceoverphysicsisthatyoudon’tneedtoprovidetherightanswers,justbetteranswersthanmosteveryoneelse. Hopefully, this guide will help you on the way to finding those betteranswers.

Usingfinancialhistoryasatooltounderstandtheanatomyofthebearmarketiscontentious,andHenryFordwasright inawaytosay that ‘history ismoreorless bunk’. Fordwas talking about “tradition”, a form of extrapolation that isinherentlydangerousforanyinvestor.Amanofcapitaltrappedinamindsetofbehaving the same way as his forebears would probably still be clutching anequity portfolio rigid with the scrip of the Anglo-American Brush LightCompany (the patent holder of the arc-light made redundant by the work ofEdison)andTheLocomobileCompany(itssteamcarlostitsone-thirdshareoftheUSautomobilemarket).Unfortunately,Ford’s aphorismbecame imbedded

in the academic approach to financial markets in 1952 when Harry M.Markowitz published his paper ‘Portfolio Selection’. [2] This paper began anassault by academia on the value of history to investors.Markowitz assumedmarketswereefficient,andhecametosomeclearconclusionsaboutthebenefitsofbuildingadiversifiedportfolioof stocks.Thisdallianceof sciencewith theconcept of efficiency in relation to financialmarkets soon became a courtshipandmarriageintheformofthe“efficientmarkethypothesis”.

The birth of this theorywas, formany, proof that historywas indeed “bunk”.Whatvalue,theyasked,cantherebeinstudyingthehistoryoffinancialmarketsif the stock market efficiently and immediately reflected all availableinformation? Wasn’t history simply an accumulation of all available pastinformation? By the 1970s, the belief that market prices already reflect allavailableinformationhadgainedWallStreet’sendorsement.AsPeterBernsteinputsit:

Had it not been for the crash of 1974, few financial practitionerswould havepaidattentiontotheideasthathadbeenstirringinivorytowersforsometwentyyears.Butwhenitturnedoutthatimprovisedstrategiestobeatthemarketservedonly to jeopardize theirclients’ interests,practitioners realized that theyhad tochange their ways. Reluctantly they began to show interest in converting theabstract ideasof theacademics intomethods tocontrol riskand tostaunch thelosses their clients were suffering. This was the motivating force of therevolutionthatshapedthenewWallStreet.[3]

ThenewWallStreetcametoreplacetheold.Theacolytesofefficiencycreatedashrinetomathematicalmodellingofriskandreturn,allbasedontheassumptionof efficiency. As is the wont of all new sects, iconoclasts damned themethodologyof theirpredecessorsasbarbaric.However,evenas thisnewsectbecame the orthodoxy, there were incidents that struck at its core beliefs. In1987, thenewWallStreetcreatedaderivativeproduct thatoffered investorsatype of portfolio insurance. It failed to deliver, exacerbating the stockmarketcrashofthatyear.

ThenewWallStreetmayhavecreatedproductsforthemanagementofrisk,butit couldnot eradicate the riskof humangreed and stupidity, as the citizensofCalifornia’s Orange County and the shareholders of Gibson Greetings

discovered.[4]In1998,theacolytesclosesttotheshrinefeltthetremorsasLongTermCapitalManagement,perhapstheultimatecreationofthenewWallStreet,imploded. Picking through thewreckage, therewas evidence in the boomandbust of 1995 to 2002 that the new Wall Street was no more successful inprotectingclients’intereststhanthefailed“improvisedstrategies”of1974.

Whateverthetruthsinherentintheascendantorthodoxy,wasitreallysowisetodiscardthelessonsofthosewhohadgonebefore?Theeventsof1995to2002indicate that some synthesis of oldWall Street thinking and newWall Streetideas could create a more relevant and useful approach for financialpractitioners.Andthatbringsusbacktothevalueoffinancialhistory.

Therecentexpansionandbustingofyetanotherstockmarketbubblemaybeagoodenoughreasontosuggestthereismoreinheavenandearththanisdreamedof in the philosophy of efficiency. There is also another reason. In 2002, thebehavioural psychologist Daniel Kahneman, alongwith Vernon I. Smith, wasawarded the Nobel Prize in economics for ‘having integrated insights frompsychological research into economic science, especially concerning humanjudgementanddecision-makingunderuncertainty’.[5]

TheNobelCommitteebelievedKahnemanhadelucidatedsomeoftheerrorsinhumanjudgementthateradicatethesuretyofefficiency.Ironically,Kahneman’sfirstpublishedarticleontheconceptappearedin1974, justasWallStreetwascoming to embrace market efficiency. The Nobel Committee had previouslyhonoured the acolytes of efficiency - Harry Markowitz, Merton Miller andWilliamSharpein1990,andMyronScholesandRobertMertonin1997.Itnowrecognises a psychologist who questions whether human judgement, even inaggregate,lendsitselftoefficiency.

If there is a legitimate role for the study of human judgement and decision-makingunderuncertainty,thenfinancialhistoryisredeemed.Whatisfinancialhistoryifnotsuchastudy?Thebehaviouralistschoolofpsychology,aroundfornearly a century, is basedonobserving reactions to selected stimuli.Financialhistory looks at market prices, which are a reflection of the behaviour ofthousandsofparticipantstocertainstimuli.Inbehaviouraleconomics,historyisa useful tool for observing how financialmarketswork, rather than theorisingabouthowtheyshouldwork.

Such historical studies have not yet lent themselves to the comforts ofempiricism. This, in itself,may be enough of a reason formany to reject theapproach.However,theinabilitytotranslateallunderstandingintobinarycodedoes not necessarily denude it of value and insight. If psychology is a softscience,thenusingfinancialhistorytoassesshumandecision-makingintimesofuncertainty is softer still. For those who accept that human judgement anddecision-making cannot be divined by equations, financialmarket history is aguidetounderstandingthefuture.

Theparticularvalue in financialmarkethistorycomesfromits insight into theoperationofhumanjudgementunderuncertainty,inparticularitsexaminationofcontemporaneousopinion.Whileanyhistorianisliabletohindsightbias,afocusoncontemporarycommentsandreactionsatleastreducestherisksofprojectingone’sownorderonthings.Asahistoricalsource,newspapersofferanefficientdailycollationofeventsand,inthefinancialpress,withafocusonthemarkets,thishasbeenthebestpracticalrepositoryofcontemporaryopinionfor thepastcentury ormore. The boom in press coverage of the stockmarket dates fromaround the birth of the railway, when the emerging middle classes foundinvesting in the new technology almost irresistible. If we focus on thisparticularlyrichveinofinformation,wefindalargelyreliablesourcethatdatesbacktoaround1850.

To discover what the bottom of past bear markets looked like, and how theinvestor was reacting, I analysed some 70,000 articles from theWall StreetJournal written in the two months either side of the four great bear marketbottoms.Ireportmyfindingsinthesepages.Myaimistoprovideasaccurateapicture as possible of a bear-market bottombased on contemporary comment.This is where any understanding of human decision-making in times of pastinvestmentuncertaintymustbegin.Thepagesof theWSJ takeus close to theprimarysourcesonwhatwashappeningatthetimeand,atvariouspointsinthebook,thereaderwillbeimmersedinthiscontemporarycoverageofeventsandtheapproachesthathaveworkedinassessingwhenthebearisabouttobecomethebull.What also emerges is anunderstandingof how similar the great fourbear-market bottoms were, in turn leading us to a set of signals to guideinvestmentstrategy.

Inthisbook,Ifocusonthehistoryofbearmarkets.Suchperiodshaveimportantpractical implications for today’s investor, but seem to be the chaptermissing

from most books on financial history. Booms and bust make for attractiveanalyses,butwhatof themoment thebust endsand theboombegins.Pickingthat point must surely minimise losses and optimise profit. But which of themanybearmarketsinthemanyfinancialjurisdictionsoccurringsince1850willleadustotherightconclusions?Lookingforthebestavailablefinancialmarketcoverage and the largest financialmarket,we are drawn to theUnited States,ratherthantheUnitedKingdom.So,whichoftheUSbearmarketswilltellthemostcompletestory?Thosebearmarketbottomsthatwerefollowedbythebestsubsequent returns have the advantage of at least suggesting practicalramifications from the exercise. Whatever subjectivity there may be indiscussingwhethermarketsarebelowfairvalue,thesubsequentsuperiorreturnsfromtheselowsarethebestobjectiveindicatorthatvaluedidexist.

AndrewSmithersandStephenWrightpublishedabookin2000calledValuingWallStreet,inwhichtheauthorscalculatethebestyearsinthe20thCenturytohave invested in equities. They defined a measure of “hindsight value”,calculated by taking the average of 40 discrete periods of subsequent returnsoverone-to-40years.Bytakingtheaverageofreturnsover40differentholdingperiods, “hindsightvalue”would represent the rangeofholdingperiodsof theverydifferinginvestorswhohaveboughtequitiesinanygivenyear.ThisstudyshowedthebestthreeyearstobuyUSequitieswere1920,1932and1948.TheseyearsdonotnecessarilycoincidewiththeperiodwhentheDowJonesIndustrialIndex (DJIA) reached its low. This difference is mainly because the returncalculationsaredoneusingyear-endlevels,andtheequitymarkethasahabitofnotnecessarilybeingatitslowon31December.Whenadjustmentismadeforintra-year movement, the three best times to invest in US equities emerge asAugust1921,July1932andJune1949.

“Hindsightvalue”canonlybecalculatedforthoseyearswherethereisatleastasubsequent40yearsofreturns.Subjectivitydoesplayapartinleadingustothefourth period for analysis in this book, but there are good reasons to believe1982willprovetobeoneofthefourbestyearstohaveinvestedinUSequities.Itiscertainlyinthetopfour,23yearsdownthetrack.

Asequitiesproducedthebestreturnsafterthesefourperiods,wecanstatewiththebenefitofhindsightthatequitieswereattheircheapestin1921,1932,1949and1982.This is ameasureof valueonlyobservable some40years after theeventand,thus,oflimitedimmediateuse.Forthepurposesofthisbook,weneed

areliablemeasureofvalueavailabletoinvestorsfacingthemarketonaday-to-daybasis.Therearemanycompetingvaluationmetrics,butfortunatelyAndrewSmithers and StephenWright narrowed the field to just two. InValuingWallStreet, they subject the most common valuation measures to various tests,importantly the reliability of those measures relative to subsequent returns asindicated by “hindsight value”.Whatwe find is thereweremeasures of valueavailabletoinvestorsatthetimethatshowedequitiestobeverycheapin1921,1932,1949and1982.WhileacceptingtheusefulnessofthecyclicallyadjustedPE-thechosenmeasureofvalueofYale’sRobertShiller-SmithersandWrightfoundthattheqratiohasbeenaparticularlyaccurateindicatorofsuperiorfuturereturns.Givenitsusefulness,atleastoverthelongterm,wewillusetheqratiotoassesshowequityvaluationshavealteredoverdifferentperiods.

Theqratioiseffectivelyameasureofthestock-marketvaluationofacompanyrelativetothereplacementvalueofitsassets.Inthisbook,astatementsuchas‘equitiesweretradingbelowfairvalue’simplymeanstheprevailingqratiowasbelowthegeometricmeanof theratio.Thefourperiodswestudyin thisbookare the only occasions when equities were at more than a 70% discount toreplacement value. The role of this book is to explain the forces that reducedpricestosuchlevels,andidentifythefactorspushingthembacktoreplacementvalueandbeyond.

To tell the story of the four-month period around the four great bear marketbottoms,wecannotignorethebiggerpicture.Tounderstandtheforcespushingequitypricesbacktowardsfairvalue,onemustunderstandthefearsthatdrovethem to suchdiscounts to fairvalue.That excursion,often throughdecadesofinvestment history, is a book in itself andmuch has had to be omitted in theinterestofbrevity.InPartI,thebackstorycanbefoundundertheheading‘TheroadtoAugust1921’-asimilarheadingisusedtosetupthesubsequentthreeperiodsunderdiscussion.Itisalsonecessarytoprovideabriefdescriptionofthestructure of the financial markets in each of the periods studied. There areimportantstructuraldifferencesineachperiodthatneedtobeborneinmindbyinvestors seeking to apply the lessons of history to today’s markets. Forexample,majorfinancialinstitutionswerenotlistedontheNYSEinthefirstofthe periods we examine. A brief overview can be found under the heading‘Structureofthemarkets’.Havingsketchedthecauseofthemarketdeclineanditscontemporarystructure,wethenfocusonthefactorssignallingtheendofthe

bearmarket, under theheading ‘At thebottomwith thebear’.Examinationofthe behaviour of the fixed-interestmarkets - a book in itself - focuses on thesalienteventsdirectlyaffectingequityprices.

Readerswillalsonoticethatextendedattentionispaidtotheeventsof1929-32.This is because there are important differencesbetween thisgreat bearmarketandtheotherthreeanalysedinthisbook.Itisalsobecause1929-32isoftenheldup as being typical of a bear market; and events of that period often colouropinions about what a bear market looks like. It is therefore useful to spendsometimewiththisbear,ifonlytounderstandmoreabouthowuniqueitwasinfinancialhistory.

This book is aimed at both the professional investor and those wanting toexercise their own judgement inmaking the best financial provisions for theirfuture. Throughout the book are boxes to help the lay investor seeking tounderstand the complexities that professionals sometimes neglect to explain.Still, there is likely to be jargon that has gone unexplained. A useful aid inunderstandingthisjargonistheexcellentonlineencyclopaediaattheEconomicHistoryServiceswebsiteatwww.eh.net.

Sectionsoftexthavebeenboldedtoguidethereaderwithconclusionsthatmaybedrawnfromeventsastheyarediscussed,buildingtowardsasetofuniversalconclusions about bear-market bottoms, their identification and strategies tooptimiseprofit.

Throughout this book are epigraphs from some of the 20thCentury’s greatestwriters. They were living amid enormous economic turbulence and financialuncertaintyandtheirworkaroundthetimeofouranalysisallowsustoholdthemirror of literature to the events we examine. The central characters in thesenovelsmadepropitiousfinancialdecisionsjustasthestockmarketwasreachingitsbottom.F.ScottFitzgeraldhadNickCarrawaygiveuphisjobonWallStreetin 1922, following Gatsby’s death, and return toWisconsin.Whether he washappythereweshallneverknowbutheheadedeast justas thegreatestequitybullmarketinUShistorybegan.ForJamesT.Farrell,poorStudsLoniganhadan evenworse fate.He flunghis nest egg into themarket in1931, just as theworstportionofthefinancialcollapsebegan.Beforetheequitymarketbottomedin July 1932, Studswas dead. In the late 1940s,RobertHolton had to decidewhethertotakeariskandheadofftoItalywithamarriedwoman,ortoplayit

safe and stayonWallStreet.GoreVidal decidedHolton should staybehind -andoutsidethepageshewouldnodoubthavebenefitedhandsomelyfromoneofthelongestbullmarketsinthehistoryofAmerica.Thisisnottosayhewouldn’trather have been in Italy. Holton appears to have been the only one of thesecharacterstohavemadeafinanciallyastutedecision.ForJohnUpdike’sHarry‘Rabbit’Angstrom,gold,intheformofkrugerrands,wasthebestinvestmentforhisfuture.Hisfatefulpurchasealmostcoincidedwithgold’sall-timehigh.

Can it be coincidence that the four years covered in this book - 1921, 1932,1949,1982-alsomarkmomentouschangeinAmericansociety.Therewasthebirth of the consumer society (1921), the birth of big government (1932), thebirth of themilitary-industrial complex (1949) and the rebirth of freemarkets(1982).Eachof the fictionalcharacters in thisbookstruggleswithaparticularsocietaltransition,allthewhilewrestlingwiththeimpactofthatchangeontheirfinancialfuture.

Ihadlunchwithamanwhohascomeacrossquiteafewbearsinhistime,polarexplorer andmountaineer DavidHempleman-Adams. I asked himwhat to dowhenconfrontedwithabearandhisadvicewasbrief:‘Shootthebastard.’Gunsoffernoprotectionfromthefinancialbear.Thisbook,Ihope,makesitafairerfight.

Endnotes1NewYorkStockExchangeFactbook.[returntotext]

2JournalofFinanceVol.III,No.1(March)[returntotext]

3PeterBernstein,CapitalIdeas:TheImprobableOriginsofModernWallStreet[returntotext]

4Bothsetsof investorswoundupnursinghuge financial loses,havingmisunderstood the financial risksinherentinderivativeproducts.[returntotext]

5PressreleasefromRoyalSwedishAcademyofSciences,9October2002[returntotext]

PartI.August1921‘Iwouldn’tasktoomuchofher,’Iventured.‘Youcan’trepeatthepast.’

‘Can’trepeatthepast?’hecriedincredulously.‘Whyofcourseyoucan!’

FScottFitzgerald,TheGreatGatsbyDespitetheboominUSstockmarketsduringtheearlyyearsofWWI,byAugust1921theDowJones&Co.IndexofIndustrialshareswasbacktoitslevelof22yearsago.Investorswhohadshunnedthisdangerousnewsectorofthemarkethadfaredevenworsewiththeirbluechiprailroadsharesbackat1881prices.Butnowwasawonderfultimetobuy,withequitiestradingata70%discounttothereplacementvalueoftheirassets.BySeptember1929,equitieswereclosetoa100%premiumtotheirreplacementvalueandtheDJIAhadrisenalmostfivefold.Thiswasthegreatestbullmarketinthealmost140-yearhistoryoftheNewYorkStockExchange.Whatchangedin1921,andhowcouldinvestorshaveanticipatedthebottomofthemarkettoprofitfromtheRoaringTwenties?

TheroadtoAugust1921:ThecourseoftheDow-1896–1921

ItwastheendofsummerinlowerManhattanwhentheairwasrippedasunderby a thunderous explosion outside the offices of JP Morgan & Co on WallStreet. The area went dark and a huge cloud of smoke swathed the financialcentreofAmerica.Brokers at theNewYorkStockExchange ran to avoid theflying glass.Windows shattered up to half amile away.The death tollwouldreach40andthedatewas16September1920.Ithasneverbeendeterminedwhoplanted the bomb. The press and public used one of Wall Street’s favouriteanalytical tools in assessing the situation: extrapolation. InApril 1920, bombshadbeenmailedto18prominentpeopleknownintheirpoliticstobeanti-labour.Itwasassumed theWallStreetbombwasalsoa“red”attack, this timeon thecentre ofUS, and increasinglyworld, capitalism. The bombwas not the onlydisturbanceonWallStreet-aviciousbearmarketwasalsowreakinghavoc.

Bear markets are the field of study of this book. This is not due to anypredilection of the author to chronicle the more depressing periods of ourinvestmenthistory,quitethereverse.Buyingat thebottomisthegoal,perhapsonlyadream,ofeveryinvestor.Thisbookisthusanidentificationguidetothoseseekingtoestablishthatperiodwhenthebearturnsintothebull.Thisisthemostprofitable timeto invest inequities,and thesummerof1921wasprobably themost profitable time in the history of Wall Street. To create such anidentification guide it is important to, paraphrasing the estimableMrsBeeton,‘firstcatchyourbear’,butdefiningabearmarketisnoteasy,eventoday,withtheS&P500 and theDow Jones IndustrialAverage (DJIA) sometimes tellingquite different stories. In 1921, it was far more complicated as there was noindexrepresentativeofthewholemarket.Togaugemarketmovements,onehadtowatchtwodistinctsectors:theDow,Jones&Co20IndustrialStockAverage,andtheDow,Jones&Co20RailroadStockAverage.

The development of the two separate stock indices by Charles Dow tells thestoryofthedevelopmentofthestockmarketitselfasitheadeddowntheroadtothebearmarketof1919-21.In1896,industrialsharesalesaccountedfor48%ofvolume on theNYSE, comparedwith 52% of volume for the railroad stocks.Therewasanextremely lowlevelofmarketactivity ingeneral - reflected ina

41%declineinthepriceofNYSEmembershipsoverthepreviousdecade-andinrailroadsharesinparticular,asthemarketrecoveredfromthepanicof1893-95.

JPMorgan’samalgamationofbankruptanddistressedrailroads in thewakeofthecrisisof1893-95panicbreathednewlifeintothatmoribundsector.Mergermaniafollowedsoonafterthelaunchoftheindustrialsindex,andthenumberofbusinessmergersintheUnitedStatesrosefrom69in1897tomorethan1,200in1899.Thepositiveimpactfromsuchmergerswasgreatestfortherailroadsector,whereprofitabilityhadbeencrushedbyexcess capacity.Amerger-drivenbullmarket in railroad shares drove up the railroad index from 1896 to 1902, farsurpassing the rise in the industrials index, where excess capacity had notpreviously been as damaging to profitability. Dow’s creation of an industrialaverage in 1896 marked the highpoint of interest in the industrial stocks andtheirshareoftotalmarketturnoverdidnotriseabovethe1896levelagainuntil1911.

TheDow Jones Industrial Average (DJIA) was first published inMay1896andwascalculatedbyaveragingthesharepricesof12componentcompanies.CharlesDowcreatedhisoriginalindexin1884,atwhichtimeit was dominated by railroad shares. The need for a second index forindustrials was evident by 1896, indicating the growing importance toinvestorsofthe“smokestack”companies.InOctober1916,thenumberofstocks in the index was expanded to 20, and in October 1928 to thecurrent 30. The index continues to be weighted by price rather thanmarket capitalisation. References throughout this book to “the market”refertotheDJIA.Throughoutthefourperiodscovered,investorslookedtotheDJIAastheirguidetowhatthemarketwasdoing.Inanalysingtheinvestor’sperceptionofthemarket,wealsofocusontheDJIA.Sometimesit is necessary to refer to another index, the S&PComposite Index, butsuchdivergenceisconfinedtovaluationandearnings,wherethedataisofsuperiorqualitytothatavailablefortheDJIA.

The highpoint for activity in railroad stocks ended with the assassination ofWilliamMcKinleyin1901andtheascendancyofTheodoreRoosevelt.Thenewpresidentwaslesssympathetictothenumerouscombinesofbusinessesformed

aslegaltrustsandactedtocontrolpricinginmanyindustries.Thetrust-bustingactivitiesofthenewadministrationhitthematurerailroadbusinesswithgreaterferocitythanthegrowingindustrialsector.By1911,theindustrialsector’sshareoftotalturnoverbreachedthe1896leveland,forthefirsttime,exceededactivityinrailroadstocks.Activityand interest inbothassetclasseswere thenroughlyequaluntilthestartofWorldWarI,whenadramaticdivergenceinactivityandpricesdeveloped.

FIGURE1.RAILROAD/INDUSTRIALSMARKETSHARE(%)1895-1921

Source:NewYorkStockExchange

Investorsseekingtosurviveandprofitinthe1919-21bearmarketweredealingwithamarketwhichhadbeenstructurallytransformedbyWWI.Bytheendofthewar,industrialsaccountedformorethan80%ofNYSEvolumeandmostoftherailroadshadbeennationalised.Thewaralsoproducedadisturbancetothegeneral price level,whichwas to lead directly to the bearmarket of 1919-21.Market reaction to the assassination ofArchdukeFranzFerdinand on 28 June1914 had been relatively calm. However, on 25 July, Austria and Germanyrefused to attend a conference of the sixGreat Powers (Russia,GreatBritain,France,Austria-Hungary, Italy andGermany).Theapparent inevitabilityof anoutright war heightened the prospects for a mass selling of stocks. Investors

feared a heavy outflow of gold from the US, a debtor nation, to finance aEuropean war and an ensuing tightening of domestic liquidity. On 28 July,AustriadeclaredwaronSerbia,andthestockexchangesofMontreal,Toronto,and Madrid closed, followed the next day by Vienna, Budapest, Brussels,Antwerp,Rome andBerlin.On 31 July, the London exchange closed and theNYSEwasleftwithlittlechoicebuttofollowsuitratherthanbefacedwiththeprospect of having to absorb huge forces of liquidation fromglobal investors.TheDJIAstoodat71.42andtherailroadaverageat89.41.

Withcertainrestrictionsontrading,themarketreopenedon12December1914,a Saturday. On theMonday, theWall Street Journal published the first DowJones averages for more than four months. The railroad average had risen to90.21.Theindustrialsaverage,however,ended12Decemberat54,down32%from the 30 July level.The industrials average bottomed just below that levelwithindaysbeforeamajorbullmarketthatlastedthrough1915.Insteadofthefearedcapitaloutflow,fundspouredinto theUSas thewarringnationsboughtnecessarymaterialsfromtheneutralindustrialpowerhouse.

FIGURE2.DOWJONESINDUSTRIALAVERAGE–INCEPTIONTO1921BEARMARKETBOTTOM

Source:DowJones&Co.

Aswellas improving liquidity, industrial stockpricesbenefited fromboomingprofits. It is important to stress the incrediblemagnitudeof theprofitboom inthatperiod.Innominaltermsprofitsdidnotexceedthe1916leveluntil1949.Inreal terms, itwasnotuntilDecember1955 that1916earningswere exceeded,and thereafter therewerenumeroussubsequentdeclines topre-1916 levels.AslateasJanuary1992,S&PCompositerealearningswerebelowthe1916level.Indeed,whenrealearningsbottomedinMarch2002,theywerejust4.7%abovethe1916 level.Not surprisingly in this environment investorsquickly came tofavour industrial stocks referred to as “war brides” - those accruing hugewarorders from Europe. Following this major bull market, railroad and industrialstockstradedlargelysidewaysthrough1916,beforeamajordownturninpricesin1917onthegrowinglikelihoodoftheUSenteringthewarandanearlypeace.Further contributing to the 1917 bear market was government intervention tocontrol commodity prices, the failure of the railroads to secure rate increasesfromtheInterstateCommerceCommission(ICC),risingcosts,theintroductionofanexcessprofitstaxandincreasedgovernmentdebtissues.

As the stalematedwar inEurope turned to attrition, the industrial and railroadindexes traded sideways through1918. Itwasnotuntil after thewar, in1919,that the industrials enjoyed another bull market, reaching an all-time high inNovember1919.ThevastdiscrepancyinperformanceofthetwosectorsduringandimmediatelyafterWWIresultedfrommanyfactors,butthenationalisationof the railroads at noon on 28December 1917was clearly a key factor. Thiseffectivelyconvertedrailroadequityintobonds,withthegovernmentpayingthestockownersafixeddividendbasedontheaverageearningsoftheircompaniespriortonationalisation.

Withreturnstorailroadstockholdersthusconstrained, investorfocusshiftedtoindustrial stocks, where companies were benefiting from the wartime boom.When the industrials’ bullmarket peaked in 1919, turnover in railroad sharesaccounted for just 13.8% of the total trading volume. But investors in stockscontinued to focus onboth indexes through1919-21.Many investors believedthedeclineinrailroadstockswasatemporaryphenomenonthatwoulddisappearwith the end of nationalisation in March 1920. By 1921, investors were stilllooking to the railroadand industrial indices in assessing the scaleof thebearmarket,eventhoughvolumeintheindustrialssectornowfarsurpassedactivityintherailroads.

LivingwiththeFed-Awholenewballgame(I)

Itwouldbeeasy,anddangerous,toassumethatmarketsworkedin1921astheydotoday.Beforelookingat thestockmarketindetailfortheperiodofJunetoOctober- twomonthseithersideoftheAugustbottom-it isworthpausingtoconsider key institutional differences in theworkings of the financialmarketsthenagainstnow.Inparticular,insettingthescenefortheeventsoflatesummer1921, it is important to consider the emergence of an unknown new factor inmarkets-theFederalReserveSystem,establishedin1914.

This system consisted of the Federal Reserve Board and 12 Federal ReserveBanks.TheReserveBankswerefreetodeterminediscountratesbut,accordingto the legislation, suchdecisionswere ‘subject to reviewanddeterminationofthe Federal Reserve Board’. However, no such review and determinationwasgiventotheFederalReserveBoardwhenitcametotheopenmarketoperationsoftheFederalReserveBanks.Therewas,thus,thepossibilityofahighdegreeofautonomy for theFederalReserveBankswithin the system.Thisautonomyled,intheearlyyearsofthesystem,totheFederalReserveBankofNewYork,operatingasitdidinthefinancialcapitalofAmerica,becomingakeydriverofthesystem’smonetarypolicy.

Thedecentralisedstructureofthesystemcomplicatedthebusinessofforecastingfuture policy and also led to conflictswithin the system itself,whichwere tohaveimportantconsequencesinthenottoodistantfuture.Thedramaticimpactofthecreationofthisinstitutionatthetimemightbeunderstoodbythemoderninvestor ifone imagined the impacton investmentdecisions if thesystemwasabolishedtomorrow.

The creationof a central bank altered theoperationof amonetarymechanismthathadbeenfamiliartoUSinvestorssincethepost-CivilWarresumptionofthegold standard in 1879. The Federal Reserve System created an element ofuncertaintyforinvestors.Itwasdifficulttoknowhowthisextra,humanelementwouldwork.Indeed,therehadbeenalong-heldbelief,summedupbythereportof theBullionCommittee to theBritishHouse ofCommons in 1810, that theintroductionofanyhumanelementinthemonetaryprocesscouldbedangerous.

Themostdetailedknowledgeoftheactualtradeofthecountry,combined with the profound Science in all the principles ofMoney and circulation, would not enable any man or set ofmentoadjust,andkeepalwaysadjusted,therightproportionofcirculatingmediuminacountrytothewantsoftrade.[6]

TheUSdidnothaveanofficialcentralbank-PresidentAndrewJacksonvetoedtherenewalofthecharteroftheSecondBankoftheUnitedStatesin1832.

Just how the new system would interact with the gold standard to influenceliquidity, interest rates and financialmarketswas difficult to predict, given itsmandate:

Toprovide for the establishment ofFederal reservebanks, tofurnish an elastic currency, to afford means of rediscountingcommercialpaper,toestablishamoreeffectivesupervisionofbankingintheUnitedStates,andforotherpurposes.[7]

Such a step was believed necessary because, twice in the recent past, theinability to ‘furnishanelasticcurrency’hadbrought theUnitedStatesclose tobankruptcy.InFebruary1895,onlyaloanfromJPMorganandtheRothschildshadpreventedtheexhaustionoftheUSgovernmentgoldreserveandtheendofthe gold standard. In 1907, JP Morgan again brokered a deal to prevent thebankruptcyofkeyfinancialinstitutionsandsavedthefinancialsystem.Despitesignificantpoliticalopposition,Wilson’sDemocratsenactedthelegislationthatcreatedtheFederalReserveSystemandthe“elasticcurrency”thatwassupposedtoremovefromprivatehandstheroleofdefactolenderoflastresort.

The gold standard was amonetary system, under which gold coin waslegaltenderandbanknotescouldberedeemedforgoldatafixedprice.Many countries adopted this monetary system, each declaring a fixedpriceingoldfortheirdomesticcurrency.Aseachnationalcurrencywasredeemable for a fixed amount of gold, the value of each currencywaseffectivelyfixedrelativetoeachother.Thishadimportantimplicationsforthesupplyofmoneyintheeconomy,andeconomicactivityandprices.IftheUS, for instance,ranabalanceofpaymentssurplus, therewouldbemore buyers than sellers of US dollars. In that situation, more dollarswould have to be created to retain the fixed rate of exchange. Asufficiently large increase in theamountofdollarswould likelyproducehigher economic activity, but also higher prices. Higher prices wouldeventuallyerodeUScompetitivenessandthebalanceofpaymentswouldeventuallymoveintodeficit.Inasituationwherethereweremoresellersthanbuyersofthecurrency,theprocesswouldbereversed.AfterWWIavariationof thegoldstandardwas introducedinwhichsomeauthoritieswouldholdothercurrencies,whichthemselveswereredeemableforgold,as part of their reserves. This systemwas known as the gold exchangestandard.

Inpractice,theFederalReserveSystemfurnishedelasticitybycreatingFederalReserve banknotes and accepting commercial bank deposits with the Fed assatisfyinglegalreserverequirements.TheFedcreatedthesetwotypesofmoneybyreceiptofgold, rediscountingofeligiblepaper,discountingofforeign tradeacceptances, and open market purchases of government securities, banker’sacceptances and bills of exchange. This ability to create money based onrediscounting bank assets was known as the real bills criterion. The difficultquestionforinvestorstoanswerwashowsuchanelasticcurrencywouldoperatewhilethecountryalsoadheredtothegoldstandard?Theapparentconflictisthatthegoldstandarddictatesthestockofmoneynecessarytobalanceinternationalpayments while the real bills doctrine does not limit the quantity of money.MiltonFriedmanandAnnaJacobsonSchwarzarguedthatthiscontradictionwas‘moreapparentthanreal’.

While the gold standard determines the longer-termmovementsinthetotalstockofmoney,itleavesmuchleeway

inshorter-runmovements.Goldreservesand the internationalcapital market provide cushions for temporary imbalances.More important, the gold standard does not determine thedivision of the total stock of money between currency anddeposits, whereas the real bills criterion was linked to thisdivision.[8]

Thecrisesof1895and1907wereexacerbatedby thepublic’sshift frombankdeposits tocash.Thus, thenewlegislationwasaimedatcreatingasystemthatwould allow such a shift to occur without producing bank failures or therestriction of cash payments by banks. The elastic currency could be rapidlyexpanded in such situations and banks could rapidly access currency bydiscountingtheirassetswiththenewreservebank.

Intheory,aninvestorshouldexpectthattheFedwouldoperateonlytoalleviateany rush to currency thatwould imperil the banking system.The problem forthoseallocatingcapitalwasthat,inpractice,somethingverydifferentoccurred.From the creation of the Federal Reserve System in November 1914 to June1920 the “elastic” money was stretched and the stock of money more thandoubled.Tocomplicatematters further for investors, theFed’s role inmoney-creationwasinconsistentandunpredictable.

FIGURE3.SOURCESOFCHANGEINHIGH-POWEREDMONEY

Source:FriedmanAndSchwartz

High-poweredmoney(alsoknownasthemonetarybase)isatermforacombination of all the forms ofmoney, overwhich theFederalReservehasalmostcompletecontrol.Itisknownashigh-poweredmoneybecausesmallchangesproducemuchlargerimpactsonthetotalamountofmoneyintheeconomy.Byimpactingthetotalamountofmoneyintheeconomy,changes in high-powered money can have major impacts on economicactivityandinflation.PriortothecreationoftheFederalReserveSystemthe key determinant of change to high-powered money had been goldinflows and outflows under the operation of the gold standard. Thismechanismcontinuedto impact thegrowthofhigh-poweredmoneyafterthe creation of the Fed, but the Fed could also act independently toinfluence high-powered money. Over the years, equity investors havewatched theperformanceofhigh-poweredmoneyasa leading indicatoroffuturetrendsintheeconomy,inflationandthestockmarket.

AswecanseefromFigure3,theFederalReserveSystemplayedonlyaminorrole inmoney-creationprior toUS entry into thewar.The initial surge in thegrowthof high-poweredmoneywasdue to amajor gold inflowas belligerentgovernments purchased goods, liquidated investments and borrowed money.ThisprocessproducedaturnaroundintheUSinternationalinvestmentposition.Adeficitof$3.7billionin1914becameasurplusofsimilarsizeby1919.Atthisstage in its history, the Fed could only rediscount selected commercial bankassets tocreateFederalReservemoney. Ithadaccumulated fewassets, sohadnone to sell to “sterilise” an increase in high-powered money caused by theaccumulation of gold. Inmore simple terms, the Fed could stretch the elasticcurrencyinitsearlyyearsbut,untilithadbeenfirststretched,itcouldnotbeaninstrument formonetary tightening.For the investor, theFedSystemhad littleimpact on liquidity adjustment and its consequent influence on stock marketpricesfromthesystem’screationuntiltheUSenteredthewarin1917.

US entry into the war created a clear monetary shift. The country now soldgoods to itsalliesonUSgovernmentcredit rather than in return forgold.TheflowofgoldtotheUSceased.Inthisperiodtheincreaseinthemonetarygoldstock now played a negligible role in the increase in high-poweredmoney.AsecondmonetarychangeduetotheUSentryintothewarwasthegovernment’sneed to finance the military. Although taxes rose, revenue was insufficient.

Money creation through the central bank now played a role in enabling thegovernment to raise financedomestically. Investorsnowhad tounderstand therole of the elastic currency in propping up government finances rather thanpreventing the liquidity crises for which it had been designed. How “elastic”wouldbethenewcurrencyinthissituationand,assumingtheUSwonthewar,what would be the magnitude of its subsequent contraction? Investors whoanswered these two questions correctly would make the optimal investmentdecisionsof1917-21.

Entry into the war produced a dramatic stretch in the elastic currency. Fedmoney accounted for 21% of high-powered money in April 1917, but byNovember 1918 this had risen to 59%. The member banks of the FederalReserveSystemaccomplishedthisbylendingtotheircustomersforthepurchaseofgovernmentbondsandthenrediscountingtheseloansatoneofthe12ReserveBanks.After1917,theFedclearlyutiliseditsnewpowersto‘furnishanelasticcurrency’, not to alleviate or prevent amoney panic, but to assist governmentwar financing. WWI was the first major conflict to be fought by the UnitedStatessinceitsCivilWar.Onthatoccasion,itwasnecessarytosuspendthegoldstandard.On this occasion, the newly introduced currency elasticity permittedthecountrytoremainonthegoldstandard.ForUSinvestorsin1917,the“elasticcurrency” kept money easy during a period of war and the gold standard inplace. Investors who expected a suspension of the gold standard or itsmaintenance with associated tight money had failed to understand how thecreation of the Federal Reserve System had changed the operation of themonetarysystem.

It was to be expected that the cessation of hostilities would depress the highlevels of war demand, and bring about economic contraction. Just such aneconomicdeclinebegan inAugust1918,evenbefore theArmistice.Butwhilemanyexpectedaprolongeddecline,thecontractionhadrunitscoursebyMarch1919.Thepublicshiftedtoholdinglesscashthanithadinthewarperiod,andmoredeposits.Thisreturnofhigh-poweredmoneyintothecommercialbankingsystemhelpedtostabilisemonetarygrowth.JustasimportantweretheactionsoftheFedBoard,whichkept interest rates low through1919andata significantdiscounttomarketrates.Thisfurtherencouragedmemberbankstoborrowfromthesystemandincreaselending.TheFedjustifieditsactionasnecessarytofundthegovernment’sfloatingdebtandtopreventaslideinthepriceofgovernment

bonds, now a key asset and source of collateral to the banking system. InperformingthissupportoperationtheFedstretchedtheelasticcurrencyasmuchinthispostwarperiodasduringtheconflict(seeFigure3).

AlthoughtherewassignificantdebatewithintheFedandtheTreasury,thebeliefwas that somehow the system could distinguish “legitimate” borrowing from“speculative”duringthisperiodofartificiallylowrates.Thiswasnot thecase,and a speculative bull market in industrial equities and commodities ragedthrough 1919. It had long been a basic principle of investment that wartimeinflationwouldbefollowedbypostwardeflationduetotheoperationofthegoldstandard.However,nowthereverseoccurredastheFedstretchedtheelasticityof the currency even further to assist the government with its fundingrequirements.Investorsplayingbytheoldrulesmissedthebullmarketinstocksandcommoditiesin1919.

Itwasinthispostwarperiodthatinvestorsseriouslymisreadhowthemonetarysystem would operate. The ability or willingness of the Fed to exercise thepowerofelasticitywassubsequentlymisconstruedduetoitsactivitiesin1919.Many assumed the Fed’s willingness to stretch the elastic currency hadsufficiently circumvented the operation of the gold standard to prevent anyfuturedramatic rise in interest rates.TheFed,whichprovided thesystemwithnocreditpriortoNovember1914,wasprovidingaround$3billionbytheendof1919,asumequivalenttoalmost4%ofGDP.WithFedcreditrisingfromabaseofzero,itwasnotsurprisingthatsomeinvestorscouldbelievethatmuchhigherlevelsofelasticitycouldbepermitted.Inthisnewenvironment,itwasbelievedthat borrowing funds for speculation in rising asset priceswas a lot less riskythan it had been before the birth of the Federal Reserve System. It was thismisjudgementbyinvestorsthatled,afterthestockmarketpartyof1919,tothemorepainfulhangoverof1920–21.

Whathadapparentlybeenforgottenwasthestatutorylimittotheelasticityofthecurrency,whichwasrapidlybeingreached.The legislationrequired theFed toholdgoldreservesof40%againstnotes,and35%legaltenderreservesagainstnetdeposits.Internally,theFederalReservehadestablisheditsownminimumof40%totalreservesagainstnetdepositsandnoteliability.Withgoldleavingthecountry and the commercial banks encouraged to lend by sub-market ratesprovided by the Fed, a decline in the reserve ratio ensued. Having alreadydeclined significantly during the war, the ratio fell from 48.1% in December

1918to42.7%inJanuary1920.TheFedwatchedthedeclinewithoutaction,butin the first quarter of 1920, therewas room formanoeuvre as the governmentbegantoretirefederaldebt.

The key reason for continuing to stretch the elastic currency was now gone.While the statutory power existed to suspend the reserve requirement andcontinue the stretching, the performance of themoneymarketwas suggestingearlyin1919thatnosuspensionwasexpected.Tightness in themoneymarketwasalreadyevident,withcallmoneyratesat15%byJune1919,risingto30%byNovember.TheFedmadeitsfirstmovetopreventthecontinuingdeclineofthereserveratioinNovember/December1919byraisingthediscountrate-mostbanks increasing the discount rate to 4.75% in that period, with all banksincreasing the rate to 6.0% by January/February 1920. Thewillingness of theFed to stretch the elasticity of the currency to its limit played a role in thepostwarbullmarketinindustrialstocks.ThereactionforcedbythedeclineintheFed’s reserve ratio towards its statutory limit was to play amajor role in theensuingbearmarket.

Aswellasaheavyfocusonthenewmonetaryinstitution,investorsin1921paidparticular attention to alterations in the general price level.While inflation isregularlyatopicofdiscussionintoday’sfinancialpress,therewasafargreaterfocusin1921.Thisfocusforinvestorsonpriceswasdictatedbytheoperationofthegoldstandardanditsimpactonthepricesofsecurities.Undertheoperationofthegoldstandard,bearmarketsinstockswerenormallyassociatedwithalossof competitiveness, deterioration in the external accounts, tightening liquidity,economiccontractionandadeclineinthegeneralpricelevel.

FIGURE4.FEDERALRESERVEBANKOFNEWYORKDISCOUNTRATE–1914–24

Source:FederalReserve,BankingandMoneyStatistics

A question for any investor in assessing the end of this process was whetherdomestic prices had become competitive relative to prices of key tradingpartners.Ifthiswasthecase,theprocesscouldreverse,withimprovingexternalaccounts, easier liquidity, and economic expansion all acting to produce animprovementinequityprices.Judgingwhenthedeflation,begunin1920,wouldbecompletewasparticularlydifficultduetothescaleofpriorpriceadjustments;fromJune1914 toMay1920,wholesaleprices in theUS rose147%. JudginghowcompetitivetheUSwasaftersuchinflationwasfurthercomplicatedbythehigh wartime inflation of its key trading partners, which were operating withflexibleexchangerates.

In the immediate postwar era, declines in the French franc,mark and sterlingagainsttheUSdollarproducedmaterialcapitalflowsintothesejurisdictionsasforeigninvestorsbetonareturnofthesecurrenciestothegoldstandardattheirpre-warlevels.However,suchconfidenceincreasinglyevaporatedandaslideinexchangeratesbeganin1919.Fromthebeginningof1919tothestartof1921,the franc and themarkhad fallenbymore than60%and sterling almost 30%against the dollar. There had also been very high levels of inflation in othernationsanditwasthusnotcleartowhatextentpricesintheUSwouldhavetodeflatetoproduceabalanceintheexternalaccountsunderthegoldstandard.

Judging how large this adjustment would need to be was the key tounderstanding how tight liquidity would be and howmuch economic activitywould be depressed. As the bull market in industrial shares lasted untilNovember 1919, there were those who believed no such adjustment wasnecessary.Theywerewrong.

How did an investor in the postwar era assess the level of domestic pricesdictatedby theoperationof thegoldstandard?Itwasnotsurprising thatmanywereconfusedduetothescaleofthedislocationtotheglobaleconomycausedbyWWI.ThemagnitudeofpriceriseshadbeenthelargestwitnessedintheUSsince theCivilWar and nobody knew exactly how the relatively newFederalReserve System would influence price determination. Prices had been risingbeforetheUSenteredthewar,andonemighthaveexpectedthat,withtheFedlargelyinactiveuntilApril1917,thegoldstandardwouldhaveactedtorestrainprices in that period. This was not the case as gold poured into the US (seeFigure5)andthestockofhigh-poweredmoneyincreased.

FIGURE5.YEAR-ENDGOLDSTOCKHELDBYUSTREASURY,ANNUALNEWIMPORTOFGOLD

Source:USBureauOfTheCensus

Innormalcircumstances,theinevitableboosttoliquiditywouldhaveresultedinrising prices, undermining US competitiveness and leading to a deflationaryoutflow of gold. However, in wartime such adjustments do not occur sosmoothly.Tosomeextent,thedemandformunitionsandmaterialwouldalwaysbe less price-sensitive than the demand for foodstuffs and other material

demandsofpeace.ThiswouldacttokeepdemandforUSgoodshigherthanitwouldotherwisebe.

Adeflationarymonetarystrainshouldhavedevelopedinthosecountrieslosinggold, resulting in their greater competitiveness, thus acting to bring gold backacrosstheAtlantic.TherewereobviousnewsecurityissueswhichdiscouragedcapitalistsfrombringinggoldbacktoEurope.Also,duringthewar,thedomesticscarcity of goods in Europe drove up prices despite the monetary drainillustrating how war production interrupted the normal operation of the goldstandard. The price differentialwith theUSwas not big enough to produce adramaticchangeinthecurrentaccountsituationanddrawgoldbacktoEuropein these extremecircumstances.Despite adhering to thegold standard, theUSwitnessed significant inflation before it entered thewar (see Figure 6). In thepostwarera,investorshadtoponderhow“sticky”thisgoldwouldbe.Howlongwould Europe take to rebuild and truly threaten US industry and nationalcompetitiveness?Would peace dictate the return of gold to Europe or wouldsocialchaos,evidentinRussiaandGermany,keepforeigngoldintheUS?Evenanalysing the future for general prices based purely on the gold standardwasfraught with difficulty, further complicated by the Fed’s actions fromMarch1917toNov1919.

FIGURE6.RISEINWHOLESALEPRICESINTHREEPERIODSOFJUNE1914–MAY1920

Source:FriedmanAndSchwartzAMonetaryHistoryoftheUnitedStates,1867–1960

In ponderingwhatwould happen to the flow of gold and how elastic the Fedwouldallowthecurrencytobecome,investorsalsohadtoassessthedegreeofpermanence in the growth of theUS economy and corporate earnings.Unlessonecouldassessthenormalpeacetimelevelofprofitabilityoflistedcompanieshowcouldonevaluethem?Evenwiththebenefitofhindsight,itisnoteasyto

accuratelyquantifyhowmuchgrowthintheUSeconomyfrom1914-19wasrealandhowmuchduetoinflation.Onecanrefertomonetaryandpriceadjustmentsintheperiodwithahighdegreeofcertainty,butthealterationinthesizeoftheeconomy is subject to greater uncertainty. The first published gross domesticproduct(GDP)statisticspreparedbytheUSDepartmentofCommercerelateto1929. Prior to 1929, there are only estimates by economic historians of thegrowthintheUSeconomy.

FIGURE7.ANNUALPERCENTAGECHANGEINGDP

Source:NathanBalkeandRobertGordon,TheEstimationofPre-warGNP:MethodologyandNewEvidence.NBERWorkingPapers2674

Whilerealeconomicgrowthhadbeenstrongfromtheendof1914totheendof1919,muchofthatgrowthisaccountedforbytheboomyearof1916,whenthewarinEuropewasdemandinggreaterresourcesandneutralUShelpedprovidethem.Real growthof the economy in 1916 accounts for 70%of the total realgrowth in the five years 1915 to 1919. So apart from the difficult issue ofassessing the necessary contraction in the elastic currency thewartime periodalso produced a significant problem in correctly valuing equities. In assessingthevaluationofstocksinthepostwarperiod,investorsneededanswerstosomekey questions.Was the boom of 1916 a permanent surge in the US share ofworldtrade,andthusapermanentprofitboostforUScorporations?Ifthe1916boomwasunique, thendidn’tpeaceauguramajorcontractioninprofitability?Couldonevaluestocksinrelationtotheirwartimeprofitabilityorwasthepre-warlevelofprofitabilitythecorrectbasisforvaluation?

Even ifonecameto theconclusion that therealgrowth in theeconomywasapermanentfixture,thewartimereadjustmentstillheldrisksforinvestors.Whiletheeconomywasclearly larger inreal terms than ithadbeenprior to thewar,thewartimeinflationstillneededtobesqueezedfromthesystem.Whatscaleofdeflationwouldbenecessary?WhatdamagewouldsuchdeflationinflictontheUS financial system? Howwould the Federal Reserve’s ability to provide anelastic currency influence the price adjustment and financial system stability?There were clearly fears that the whole 147% rise in wholesale prices mighthave to be squeezed out of the system, and such a level of deflation wouldproducesevereeconomichardship,particularlyfor thosewhohadborrowed topurchasegoodsatsuchsubstantiallyhigherprices.TheFed’sactionsNovember1918 to late 1919 suggested it would stretch the currency to its extreme toprevent adjustment of such magnitude. Certainly, that was how it seemed toinvestors until the discount rate was raised in November 1919. It looked likesomedeflationwouldindeedbenecessary,buthowmuchandhowlongwouldittake?

Whileinvestorscouldexpectpostwardeflation,thiswouldnotnecessarilybethecase.Therewereothernations,admittedlyfreefromtheconstraintsofthegoldstandard, which sought a different way out of the postwar malaise. Investorswereawarethattherewasanotherway,andinthesummerof1921theydebatedwhether Germany, Russia, Poland, Hungary and Austria were correct inpursuing this alternative approach. In these jurisdictions, where there was nolonger any legal anchor to gold, the authorities printedmoneywith a view tostimulatingeconomicgrowthandemploymentandpreventingdeflation.

Thispolicyworked,atleastinitially,butasFigure8shows,thegoldbackingofcurrencies fell dramatically in the process. Postwar deflation was avoided inGermany,wherewholesale price inflation in 1921was 29%, a contrast to the24%deflationinFrance,26%pricedeclineintheUKand11%dropintheUS.In Germany, not only did prices rise, the economy did not enter a recession.Therewasevenastock-marketboom:

…insofarastheinflationledtorealexchangeratedepreciation,on balance it stimulated exports, employment, andproduction…Investorshadanincentivetoprotecttheirsavingsby drawing down their bank accounts. They should havepurchasedclaimsonfirmsinapositiontopassalongtherisein

pricestotheircustomersandhencetopaydividendsthatkeptpace with inflation…Real share prices rose until the end of1921.[9]

FIGURE8.GOLD-TO-NOTECOVERAGERATIOS

Source:WallStreetJournal,2July1921

FromMarchtoAugustof1921,theFrankfurterZeitungstockaverageincreased40%.Indeed, theBerlinStockExchangesuspendedtrading inearlySeptember1921asspeculationwasproducingvolumesitsmemberscouldnothandle.On9September 1921 theWSJ suggested the decline in the value of themarkwasproducingthebullmarket:

Early in July paper marks began to show such a tendencytowarddepreciationthattheinvestingclassesinGermanytookalarm and there was a mad rush to invest their paper inindustrialandothersecuritiesbeforecurrencydroppedfurther.

While the prospect of hyperinflationary disaster was becoming increasinglyevident, there were still foreign investors who were optimistic. The Germangovernmentestimatedinmid-1921thatasmuchas$1billionworthofGerman

bank notes and bondsmight have been held by investors outside the country.This accumulation had occurred during a period when the mark’s value hadfallen from US8¢ to US1¢. But the pages of the WSJ had only the mostdepressingoutlookforGermanyanditscurrency,andevenGermanswereawareofthelikelyconsequencesofthismonetarypolicy.WhentheheadoftheBritishdelegation to theBrusselsConference remarked thatGermanywas headed fortheabyss,ananonymousGermanbankerwasquotedasreplying.

‘WedonotcareabouttheadviceoftheBritish.Theyareonlythinkingof themselves. Perhapswe are headed for the abyss,butthenwewilldragFrancedownwithus,andthatmeansthebankruptcyofallEurope.’[10]

FIGURE9.GERMANWHOLESALEPRICEINDEX1918–1923

Source:B.R.Mitchell,EuropeanHistoricalStatistics1750–1970

The German experience, as shown in Figure 9, was the most extreme, withmonthlyprice inflationpeaking at just over threemillionpercent. In theotherjurisdictions, events were not quite as dramatic, but the peakmonthly rate ofinflationreached213%inRussia,275%inPoland,134%inAustriaand98%inHungary.Whathadappearedapositivepolicyforinvestorsin1921,comparedwiththedeflationarypoliciespursuedelsewhere,ledtoanalmostcompletelossofcapital.

ItisimportanttorememberthatUSinvestorsattemptingtoassesswhentheUSpricelevelwouldstabilisehadtoconsiderGermany’sinflationarypolicies.Forsometimethepolicyworked.Itsrealexchangeratedeclinedandittookmarketshare innumerousproducts. If thatcontinued,andRussia,Poland,Austriaand

Hungarycouldfollowasimilarpath,theeconomicadjustmentintheUSmightbemuchlargerthananyonewouldnormallyexpect.Withoutthegoldstandard,calculationsastowhenpricesandtheeconomywouldbottomwereconsiderablymorecomplicated.

Endnotes6Report from the select committeeof theHouseofCommonson thehighpriceofgoldbullion (1810).[returntotext]

7PreambletotheFederalReserveAct1913[returntotext]

8Milton Friedman andAnna Jacobson Schwartz,AMonetaryHistory of theUnited States, 1867–1960[returntotext]

9Eichgreen,GoldenFetters:TheGoldStandardandtheGreatDepression1919–1939[returntotext]

10WallStreetJournal,3October1921[returntotext]

Structureofthemarketin1921Upinthecity,Itriedforawhiletolistthequotationsonaninterminableamountofstock,thenIfellasleepinmyswivel-chair.Justbeforenoonthephonewokeme,andIstartedupwithsweatbreakingoutonmyforehead.

FScottFitzgerald,TheGreatGatsby

Thestockmarketin1921

Thestockmarketin1921wasnottheusualdomainoftheinstitutionalinvestor.Such investors did exist, but common stocks were still regarded as of aspeculativenatureandtheinstitutionalinvestorwasmuchmoreinterestedinthebondmarket.Figure10showsthestockmarketcompositionon30July1921fortheNewYorkStockExchange.

FIGURE10.STOCKMARKETCOMPOSITION30JULY1921

Source:WallStreetJournal,1August1921.Note:Manycompanieshadmorethanoneissue.

While the number of companies with NYSE-listed securities was just 382,compared tomore than2,500 today, therewasstillabroadrangeof industriesavailable to investors. The key sectors were railroads, steels and oils. Theissuance of stock in 1921 provides some indication of contemporary investorinterest.Railroadsaccountedforlessthan1%ofthenewstockissuedinthefirsteightmonthsof1921,with thebalance sharedequallybetweenpublicutilitiesand the industrial sector. One new growth business was rapidly gainingimportance-theautosector.Otherkeygrowthbusinesseswererubber,boostedby the boom in the auto industry, and cigarettes, as consumers were shifted

towards manufactured sticks and away from more traditional forms of loosetobacco.

Railroads:USrailwaysecuritieshadbeenavailabletoinvestorssinceMohawk& Hudson Railroad joined the NYSE in 1830. From a very early stage, thebusiness had been plagued by excessive competition, but despite numerousbankruptcies in the 19thCentury, investors had a choice of numerous railwaystocks, such as: Atchison Topeka& Santa Fe, Baltimore andOhio, CanadianPacific,Chesapeake andOhio,NewYorkCentral SouthernPacific andUnionPacific.

Steel:TheindustrywasstilldominatedbyUSSteel,puttogetherbyJPMorganthrough the purchase of Carnegie Steel and other operations. The workingcapital of US Steel was almost double that of the other 12 listed companiescombined.By1921,capacityutilisationinUSsteelmillshadfallento20%.

Automobiles:FordwasproducingabouthalftheautosintheUS,butitdidnotlistuntil1956.Otherdominantplayers,suchasGeneralMotors,wereavailableon the market, as were stocks such as Studebaker, Pierce Arrow, Willys-Overland,RepublicMotorsandMaxwellMotors.

Oils:The sectorwas dominated by elements of the former StandardOil trustwhich accounted for thirteen listed companies such as Standard Oil ofCalifornia, Standard Oil of New Jersey and Standard Oil of Ohio. Themuchsmallerindependentsectorhadseenawartimeboomandhadaparticularfocuson Mexico. Companies such as Associated Oil, Cosden Oil, Houston Oil,InvincibleOil,MexicanPetroleum,PacificOilandSinclairOilwerespeculativefavourites.

Rubber: Rubber companies had been doing good business since Goodyear’sinvention of vulcanisation made the material more practical for clothing andotheruses.However,itwasthearrivalofthemotorcarthatproducedaboomforthefourlistedrubbercompanies,amongthemGoodrichBFandUSRubber.

Mining:TherehadbeenaboominminingduringWWIandcoppermininginparticular had been amajor beneficiary. The postwar collapse in price took aheavytoll,withthecopperpricefallingbacktothe1911level.By1921,copperwasbackto12¢apoundcomparedto15.5¢apoundithadaveragedintheeight

yearspriortothewar.Notuntilthemid-1950sdidthecopperpriceexceedthe1916 level. By 1921, only eight of the leading US copper mines were stillproducing. The mining stocks listed on the NYSE included the likes ofAnaconda,HomestakeandDome.

Retail: The original listed retail stocks had been mail-order companies, butchain stores and department stores had also become large enough to gainlistings. The key retails stocks to choose from included Sears-Roebuck,Woolworth’s,MontgomeryWard,MayDepartmentStores.

Sugar: There had been a bull market in sugar during and after the war.However,likeothercommodities,the1920-21recessionbadlyhurtthepriceofsugar.Refinedsugarhadreached26¢apound in1920butbysummer1921 itwas just 5.5¢ a pound. This financial disaster resulted in National City Bankbecoming, through the seizure of collateral on bad loans, one of the biggestsugarproducersinCuba.ProductionofsugarwasconcentratedinCuba,whereoutputhaddoubledover theprevious sixyears andaccounted forone-thirdofthe national economy.The listed companieswere involved in both productionandrefiningofsugar -GuantanamoSugar,CubaCaneSugar,AmericanSugarRefiningCo.

Tobacco: The tobacco business was undergoing major change since thedismantling of the American Tobacco trust and the dramatic growth of thecigarette business. Among key tobacco investments of the daywere LorillardandLiggett&Myers.

Others: Outside the main sectors was a collection of companies involved innumerousemergingbusinesses, fromthemanufactureofsubmarines tomakersofasphaltroofing.Manyofthecompaniesarestillactivelytraded,insectorsthathave gained considerable importance -AmericanExpress,AT&T,CocaCola,Eastman Kodak, General Electric, National Biscuit Company (Nabisco), OtisElevatorsandWestinghouse.

FIGURE11.RAILS,PREFERREDSHARESANDTHEBROADINDEXRELATIVETOTHEDJIA

Source:NBERandwww.econ.yale.edu/~shiller/data.htm

When the bearmarket came, investors fared best by accepting the guaranteedreturnsprovidedby thegovernment.Thenationalisedrailroadshadcompletelyfailedtoparticipateinthepostwarboomincommoditypricesandonthestockmarket.Investorscouldseelittleupsideininvestmentswithdividendspeggedathistoriclevelsbygovernmentfiat.Ofcourse,whentheeconomytookadiveinthe 1920-21 recession, the stability of guaranteed dividends from thegovernment had its benefits. As Figure 11 shows, the decline in the railroadsindex from the1919marketpeak to thebottom inAugust1921wasonlyhalfthat of the decline in theDJIA. It also shows how the broad S&PCompositeIndex and preferred shares performed far better than the then-20 componentstocksoftheDJIA.

NotallthemajorcorporationswerelistedontheNYSE.Thecurbmarket,whichuntil28June1921tookplaceliterallyonthesidewalkatBroadStreet,wasthehome of some companies that were to become global success stories in theirrespective industries.Literallyon thestreetwere the likesofBritishAmericanTobacco,Gillette,PhilipMorrisandRadioCorporationofAmerica(RCA).

Many companies have faded somewhat from history, even if, in many cases,theiroperationscontinue.In1921, investorskeentobackthesurvivingWrightbrother,Orville,hadtheopportunitytodosobybuyingtheWrightAeronauticalCo, which the brothers had founded together. The company focused on aero-

enginesanddespiteamergerwithCurtissin1929,wasbasicallyoutoftheaerobusiness by the end of the 1950s. In 1921, the outlook for the Savage ArmsCompanywaslookingupastheirlever-actionriflehadbeenendorsedbyChiefLameBearin1919.Today’sinvestorsmighthavebeeninterestedinbuyingthestock of theNationalAcmeCo; unfortunately the companyproducedwhat itschairman described as “labour-saving machinery” and not the ingeniousproductslaterinsuchgreatdemandbyWileECoyote.ThenameGuantanamo,linkedwithasugarcompanyin1921,hasverydifferentassociationstoday.

Thebondmarketin1921‘Young Parke’s in trouble,’ he said rapidly. ‘They picked him up when he handed the bonds over thecounter.TheygotacircularfromNewYorkgiving’emthenumbersjustfiveminutesbefore.Whatd’youknowaboutthat,hey?Younevercantellinthesehicktowns.’

FScottFitzgerald,TheGreatGatsby

A key factor producing the 1919-21 bear market in equities was theintensificationofthelongbearmarketinbonds.By1921,investorsinbondshadbeen subject to a prolonged bear market which had begun in 1899. Theredemptionyieldsongovernmentsecuritiesduringthe1899-1921perioddonotprovideanaccuratereflectionofreturnstoinvestors.Federaldebtwasinshortsupplyin1900-16,astheratioofFederaldebtoutstandingtoGDPaveragedjust4.2%.Aswell as limited supply, demandwas artificially raised by legislationpermittingnationalbankstoissuebanknotessecuredbygovernmentbonds-in1913,80%ofthe$965milliongovernmentdebtwassecurityforbanknotes.

Theartificial constrainingofyieldsand restrictionof liquidityonFederaldebtforcedinvestors to lookatmoreliquidandhigher-yieldingdebtsecurities.Theprime investment medium for investors in 1899-1916 was thus the corporatebond. Thismarketwas almost 20-times larger than the entireUS governmentbondmarket. The chart below shows the rise in average redemption yield oftheseinstrumentsfor1900-21.

FIGURE12.AVERAGEYIELDOFUSPRIMECORPORATEBONDS

Source:SidneyHomerandRichardSylla,AHistoryofInterestRates

Figure12revealstheslow-burningbearmarketincorporatebondsfrom1899to1916 and the dramatic jump in yields from 1917-20. The Federal ReserveSystemkeptinterestrateslowin1914-18,butthisdidnotpreventasignificantdecline in bond prices after the US entered WWI in 1917. The 23.6% pricedecline of prime corporate bonds from Jan 1917 toMay 1920made upmorethanhalfofthetotaldeclinefor1899-1920.Thisthree-yearperiodwastheworstbearmarketinbondssincethestartoftheCivilWar.

TheUSbondmarket changeddramaticallywithUSentry into thewar. In theaftermath,federaldebtdominatedthepublicdebtmarkets.USFederaldebtrosefrom 2.7% ofGDP in 1916 to 32.9% in 1921.Relative toGDP, thiswas thelargestlevelofdebtinthecountry’shistory,edgingoutthe31.0%levelreachedin1866,whichwasthefinanciallegacyoftheCivilWar.TheFederaldebthadgonefrombeingan illiquid,structurallyover-priced instrument in1916, to themostliquidandmostwidely-heldinstrumentin1918.By1920thefederaldebthadballoonedto$24.3billionnowsurpassinginsizethe$18.0billioncorporatebondmarket.Itisestimatedtherewere18millionsubscriberstothefourLibertyBond issues of 1917-18 which is impressive when one considers that thepopulationoftheUnitedStateswasjustover100millionatthetime.

FIGURE13.USFEDERALDEBTASPERCENTAGEOFGDP1792–1921

Source:USBureauoftheCensus

Growth in thedebtmarket through the issuanceofLibertyBondsandVictoryLoansbroughtmillionsofnewinvestorsintothefinancialmarkets.LibertyBondissuesaccounted for71%ofFederaldebtoutstanding in1921and thepostwarVictoryLoanstookupafurther16%ofthetotal.While thefirstLibertyBondwas issued to yield 3.5%, financing becamemore difficult and the fourthwasissued to yield 4.25%. Peace did not bring any respite for bond investors asinflationaccelerated in theshortpostwareconomicboom. In the1920-21bearmarketinbonds,almost80%oftheoriginalholdersofLibertyBondssoldout.

AveragedailyturnoverforbondsontheNYSEinthesummerof1921wasabout$10 million, compared with $36 million for stocks. Investor focus switchedbetweenFederal andother issues,butFederaldebtalwaysaccounted formorethan half, and sometimes as much as two-thirds of turnover. As the smallestLibertyBondandVictoryLoanissueswerefor$3.8billioneach,itwasrarefortrading in any corporate bond to exceed the volume of any one of thesegovernment issues. Other active bonds included Burlington, UnitedKingdom,Cuba Cane Sugar, Pennsylvania Rail Road, French Republic and WesternUnion.

Apart from Federal debt, the other bonds traded on the New York StockExchangeweredefined as “miscellaneous” and subdivided into three sectors -

industrials, rails, and government and city (the only non-foreign issuer in thegovernmentandcitysectorwasNewYorkCity).

FIGURE14.MISCELLANEOUSBONDS31AUGUST1921

Source:WallStreetJournal

Ofcourse,thereweremanybondswhichwerenotlistedontheNYSEandweretraded off-market by various dealers. Already by 1920much of the corporatebondbusinesswasshiftingawayfromtheNYSE.AsFigure15shows,thebondmarketintotalin1920hadover6,000issuesmorethantentimesthenumberofstockstradedontheNYSE.

FIGURE15.USCORPORATEBONDSOUTSTANDINGDECEMBER1920

Source:BraddockHickman,StatisticalMeasuresofCorporateBondFinancingSince1900

The increasing number of foreign sovereign issues listed in NewYorkwas aclearsignofhowtheUShad,particularlyduringthewar,cometorivaltheUKasaglobal financialcentre. InAugust1921, thebondsofArgentina,Belgium,Brazil, Canada, Chile, Cuba, Denmark, Dominica, France, Japan, Mexico,

Norway,Sweden,Switzerland, theUKandUruguay tradedon theNYSE.Thetransitional nature of global financial supremacy is evident in the fact that,althoughJapan,CityofTokyo,CityofZurichandArgentinahadNYSE-listedbonds,theyweredenominatedinsterling.However,thelargestsingleissueandthelargestcombinedissuerofforeignbondswastheUKitself.LiquidationofitsUSinvestmentshadnotbeeninitselfsufficienttofinancethewar,and,by1921,the face value of its sovereign bonds listed on the NYSE had risen to $450million.ThejunksovereignissueofthedaywasMexico.Theprice,inthelow30s, reflected that Mexico had been in default since 1914. In 1921 ImperialRussian Government bonds, unlikely to be redeemed unless there was arestoration of themonarchy in Russia,were trading at around 20 on the curbmarket.

Atthebottomwiththebear-Summer1921ButtherewasJordanbesideme,who,unlikeDaisy,wastoowiseevertocarrywell-forgottendreamsfromagetoage.

FScottFitzgerald,TheGreatGatsby

Inmajorbearmarkets,equitiesarereducedto lowvaluations.However,asweshall see, this movement to extreme undervaluation is only partly due to thisfinaldown-draftinprices.Akeyelementofthemovetoundervaluationisalsoaprolongedperiodof time, prior to the bearmarket itself,when the advance instockpriceshasfailedtokeeppacewitheconomicandearningsgrowth.Asweshallsee,theimprovementinstockvaluations,evenpriortothebearmarket,hasbeenafeatureofallthebearmarketbottomsintheUSwiththeexceptionofthe1929-32episode.TheDJIA’sprogressfromitsinceptiontoitslowon24August1921tellsmuchofthestoryofhowthediscrepancyinstockpricesandearningshadreducedvaluationsevenpriortotheeruptionofthebearmarket(seeFigure16).

FIGURE16.DOW,JONESANDCO-INDUSTRIALAVERAGE(1896–1921)

Source:DowJones&Co.

Source:DowJones&Co.

On24August1921,theDJIAclosedat63.9,alevelfirstreachedon27January1899.Essentially, the industrials indexhadgonenowhere in twodecades.Butthis sideways movement in stocks contrasted sharply with the US economy.Figure17tellsofamazinggrowth.NominalGDPincreasedby383%,realGDPby 88%. Much related to expanding population, yet real GDP per capitaincreased33%intheperiod.Listedcompanies,however,wereinthebestsectorsto benefit. Figure 17 shows steel production rising more than four-fold andrailroad track in operation increasing 148%. A number of listed companiesparticipated in the exponential growth of the automobile business. Listedcompaniesrepresentedothergrowthindustries,suchascigarettes,electricityandtelephones.

FIGURE17.CHANGESINTHEUSFROM1899TOEND1920[PopulationtoIronOreProduction]

FIGURE17CTD.CHANGESINTHEUSFROM1899TOEND1920[OccupieddwellingunitstoMilitarypersonelonactiveduty]

Source:USBureauOfTheCensus,andBalkeandGordon.AdjustedwithadditionoIinternationalfactorincomefromDepartmentofCommerce.Note:Blanksdenoteverylargepercentageincreases.

The narrowness of theDJIA cannot be blamed formisrepresenting the actualreturns fromstocksover theperiod.Thisbook focuses, asdid investors at thetime,ontheDJIAasameasureofgeneralstockmarketperformance.Butwithhindsightwe can compare the performance of this narrow indexwith amuchbroader index published by Alfred Cowles in 1938. Cowles was a privateinvestorwhowassodisgruntledbytheinvestmentadvicehereceivedfromso-called experts that he spent a significant portion of his life proving theirincompetence.Oneelementofthisquestwasthecreationofabroaderindextomeasurestockpriceperformance.Thisbroadindexwasbasedon

…whatwouldhavehappenedtoan investor’sfunds ifhehadboughtatthebeginningof1871allstocksquotedontheNewYork Stock Exchange, allocating his purchases among theindividual issues in proportion to their total monetary value,

and each month up to 1938 had by the same criterionredistributedhisholdingsamongallquotedstocks.[11]

Thisbroaderindextooshowslittleprogressinthepriceofequitiesintheperiod1899-1920,andevenputsthebroadmarketinAugust1921atasimilarleveltothatofJune1881.

Cowles’ index has been maintained and as the Standard & Poor’sComposite Index (S&P 500) has become an increasingly importantmeasure of US stock price performance. As this index has detailedearningsanddividenddatabackto1871itisoftenreferredtointhisbookwhen issues relating toearningsandvaluationsarediscussed.HoweverindiscussingmarketmovementsthefocusisontheDJIAwhichobviouslydominatedinvestorperceptionsandpressheadlinespriortothecreationof theS&PCompositeIndexandcontinuedtodosoevenuptothebearmarketof1982.

Ingeneral,onemightaccountforthisdiscrepancybetweentheexpansionoftheeconomyandthestagnationofstockpricesfrom1881-1921asanindicationthatcorporateearningsgrowthhaddisappointed.Cowles’1938studyshowsearningsper share for thewholemarket declined 34% in the 40 years from1881 until1921, thoughearnings thatyearwereverydepressed.Figure18providessomeofthelowandhighpointsforearningspershare.

FIGURE18.S&PCOMPOSITEINDEX(1871=100)–PEAKSANDTROUGHSFROMINCEPTION

Source:RobertShiller,MarketVolatility

So what constitutes the normal level of earnings to be utilised in computingearnings growth over the period? If we use 1916 earnings, then the markets’earningsgrowthoverthe40yearswas250%.Ifweuse1921earnings,thentherewasacontractioninearningsof34%.Taking1921earningsasnormal,thePEinJanuary1921was24.5x,butif1916earningswereconsiderednormal,thenthePEwas4.6x.Economicgrowthin1916wasanexceptional16.1%inrealtermsandinvestorswereclearlyscepticalthatthiswasarepresentativeyeartojudgeprofitability.With thebenefitofhindsight investorshadevery reason todoubtas,apartfrom1929,thislevelofearningswasnottobesurpasseduntil1947.Ifoneutiliseshindsight todeclare thatnormalisedearnings in1921werearoundtheaverageof1922-26,whentheeconomyhadrecovered,thentheJanuary1921PEwas7x.

Listedsectorearningshadstillonlyincreased130%from1881.Inthesameperiod,nominalGDPintheUSgrew732%andrealGDP435%.So,whileaccepting the possibility of misrepresenting normalised earnings in thisvolatile period, it is still clear the earnings of listed companies hadsignificantlylaggedthegeneralgrowthintheeconomyfrom1881-1921.

AsimplewayofshowingthislagistocompareanindexofnominalGDPandtheS&PCompositeIndexearningsfromasimilarstartdatein1871.Figure19showsthegrowthdifferentialbetweentheeconomyandthereportedearningsoflisted companies. In this remarkable period of growth for the US economyshareholdersclearlyfailedtobenefittotheextentonewouldhaveexpected.Thefailureofcorporateearningsgrowthtokeeppacewithgrowthintheeconomyisonekey reasonwhyequitieshaddisappointed investors evenprior to thebearmarketof1919-21.

Another reason for the apparent stagnation in share prices was the decline invaluationsover theperiod.Using the1922-26averageasnormalisedearnings,themarketPEhaddeclinedto7xbyJanuary1921.ThedeclineinthePEfromveryhighlevelsisevidentinFigure20.

FIGURE19.S&PCOMPOSITEINDEXEARNINGS(1871=100)ASARATIOOFUSNOMINALGDP

Source:www.econ.yale.edu/~shiller/data.htm.BalkeandGordon,TheEstimationofPre-warGNP:MethodologyandNewEvidence.NBERWorkingPapers2674

FIGURE20.PEOFS&PCOMPOSITEINDEX(CYCLICALLYADJUSTEDEARNINGS)1881-1921

Source:www.econ.yale.edu/~shiller/data.htm.

Even despite the depressed level of 1921 earnings, which suggested a PE of25.2xinDecember1921,therewasampleevidencethatstockswerecheap.Themostdramaticdemonstrationofthediscrepancybetweencorporateperformanceand share price performance is provided by the growth in cumulative retainedearnings.From1915to1920theaverageretainedearningspershareofthelistedindustrial sector was $48, which was the same as the average price of anindustrial share in 1921. The situation was described in the WSJ on 19Septemberbyananonymousbanker:

…the capitalisation of scores of concerns today is sellingbelow working capital. In the case of many companies thesharesaresellingforlessthanthevalueoftheplants.Thereareshares of copper mines that are selling below what it wouldcost to equip these respectivemines…The shares of a largenumberof industrialcorporationsaresellingatone-third theirrespectiveintrinsicvalues.

Investorschosetoignoresuchearningspower.Theriseinthegovernmentdebtfrom$1.1billionin1915to$24billionprobablyplayedaroleinsqueezingoutthefundsavailableforthepurchaseofstocksanddistractinginvestors.

FIGURE21.S&PCOMPOSITESTOCKPRICEINDEXFROMINCEPTIONTOAUGUST1921

Source:www.econ.yale.edu/~shiller/data.htm

With theS&PCompositeunchangedfrom1881 to1921(Figure22), investorssecured no capital return over the period. Of course investors did receivedividends.

While reinvested dividends did exceed returns from investing in primecommercial paper, the difference over the 40-year period was small; a stockinvestorobtainedonlyamarginallyhigherreturnthananinvestorinthehighestquality fixed-interest securities.This stagnation in sharepricesoccurredas thereportedearningsgrowthof the listedsectorsignificantly laggedthegrowthoftheeconomy,andasthevaluationplacedonearningsalmosthalved.Paymentsof dividends failed to adequately compensate investors for these poor capitalreturns.

FIGURE22.DIVIDENDYIELDOFS&PCOMPOSITE,YIELDON4-6MTHCOMMERCIALPAPER

Source:RobertShiller,MarketVolatility

By 1921, the q ratio suggested equities were very cheap. As the replacementvalueofassetsisonlyavailablefromyear-end,allannualqratiosaremeasured

asofDecember inanygivenyear.Thepeakreadingfor theqratio in thefirstquarterofthe20thCenturywas1.12xinDecember1905,whichwasalsowhenthemarketpeaked.Atyear-end1921,theqratiowasjust0.35x.TherehadbeenasignificantmarketrallyfromAugusttoDecember1921,whichsuggeststheqratioinAugustwaslessthat0.3xandmayhavebeenaslowas0.28x.Equitieswere trading at more than a 70% discount to the replacement value of theirassets.

FIGURE23.DOWJONESINDUSTRIALAVERAGE–1919-21

Source:DowJones&Co.

EquitieshadbecomecheapbyAugust1921,butitwasasituationthathadbeendevelopingforalongtime–arguablyfor40years,andat leastsincethebearmarketof1907.

GoodnewsandthebearItwasthehourofaprofoundhumanchange,andexcitementwasgeneratingintheair.

FScottFitzgerald,TheGreatGatsby

Therearemanyassertions trottedoutby investorsduringbearmarkets -nevercatch a falling knife, nobody rings a bell at the bottom of the market, etc.However,perhapsthemostcommonadviceisthatoneshouldbuystockswhenallthenewsisbad;andthatthebestindicatorofthisdelugeisthepressoftheday.Butaninvestoractingonthisadviceandnotbuyingequitiesatthebottomon24August1921,oranytimein1921,wouldhavemissedthebullmarketofthe“RoaringTwenties”.

TheWall Street Journal in the summer of 1921 was teeming with news andwell-informedopinionthattheeconomiccontractionandwithitthebearmarketin stocks was ending. Not just the editorials expressed such opinions, butbusinessmen and even politicians were accurately predicting the end of thepostwaradjustment.Thisgeneraloptimism,reflectedinthefollowingnotesfromtheWSJtwomonthseithersideoftheDJIAbottomon24August1921,refutestheoldmarketadagethatinvestorsshouldkeeptheirpowderdryuntilthereisnogoodnewsatall.

25June:Steelmakersaretakingamorecheerfulviewofthesituation.Theyrealisethatconsumerswilleventuallyhavetobuysteelproductsandthatanimprovementinoperationisnotfaroff.

27June:FederalReserveBulletin,finaledition,declaresthatwithoutwaitingforimprovementintheexportandgeneralforeigntradesituation,domesticbusinesshasbeguntoshowaturnforthebetterinseverallines.

27June:‘ThewonderfulimprovementbeingmadeinconditionofFederalReservebanksundoubtedlyforecastscheapermoney,andIbelieveweshallsoonhave5%ratesoncommercialpaper.’[CommentsbyControlleroftheCurrency,DRCrissinger.]

27June:‘Wehavehitthebottomandwhenpricesbegintoriseslightlypeoplewilljumpatopportunitiestobuy.WhenindustriesthroughtheFederalReservebankscanobtainsufficientfundsatreasonableinterestratestoexpand,foreigntradeandforeignloanswillautomaticallybetakencareofbybusinessmenthemselves’[HarryFSinclair(founderofSinclairConsolidatedOilCorp.).]

30June:‘Belatedliquidationinsuchcommoditiesasmineraloil,sugar,paper,andthelikeisallowedtooutweighinimportancetheaccumulated

evidencesofstabilisationatlowerlevelsofsuchthingsascopper,cotton,wool,silk,hidesandgrain.’

1July:‘WithproductiveprospectsfavourableandpricesinsomelinesapparentlyreachingaconditionofgreaterstabilitytheoutlookfortheAutumntradeappearsreasonablyencouraging.’[FederalReserveBoardBusinessReview.]

1July:Manybankersbelieveaveragecommoditypricesarenowatornearbottom.

11July:‘Wearealreadyenteringtheaccumulationperiodbetweenabearandabullmarket,duringwhichtimeaspecialrecognitionisbestowedonthosecompaniesalreadydefinitelyontheupwardpath.’[JSBacheofJSBache&Co.]

12July:‘Meanwhilewiseinvestorswillcontinuetomakeprofitsbybuyingatthebottomofthelongswingsandsellingatthetop.Wearenowat,orverycloseto,thebottomofoneofthoselongswingsandinvestorswhobuylong-termbondsorinvestmentstocksnowshouldhaveahandsomeprofitinthenextfewyears.’

14July:Businesshasturnedthecornerofdepression.ThisistheviewexpressedbySecretaryHooverinhisBostonspeech.Othermen,prominentinbusinessorpoliticallife,haverecentlyexpressedthesameopinion.Amongthefundamentalconditionsofrecovery,thewagereadjustmentsnowgoingonareofgreatimportance…Decreasedpurchasingpowerofthefarmershadmuchtodowiththestagnationinindustry.Pricescannotrunallatoncetoarelativelevelbutthegapsarebeingclosedupandabushelofwheathasagreaterexchangevaluethanatthefirstoftheyear.

15July:ManyleadingcommissionhousesaretellingtheircustomersthatthedullnesswillprobablycontinueintoSeptember.Butthestockmarketdiscountsachangeforthebetterorworseatleastsixmonthsaheadandif,asmanybelieve,businesscanbeexpectedtopickupbyNovemberorDecemberitismorethanlikelythatWallStreetwillbegintodiscountitverysoon.

18July:Thereissomeimprovementthroughoutthecountryinmotorsales.Ford,StudebakerandDodgearerunningnearlyfullwhilea

numberofothermanufacturerswhohavebeenoperatingonmoderateschedulesreportnoticeableimprovementinsalesduringthepasttendayswhichismakingincreasedoperationsnecessary.

27July:Whenthecropsareontheirwaytothemarketandwhencertainimportantfinancingiscompleted,thenperhapsthepublicwillbegintorecognizethatimprovementhasbegun,andthatdepressionisendingandwiththatrecognitionwillcomeabetterfeelingwhichofitselfwillstimulateindustryandbusiness.

1August:Altogethertradesentimentwasmoreoptimisticanditisnowgenerallybelievedthatthebottomofthedepressionhasbeenreachedalthoughreallygoodbusinessisnotexpectedforsometimetocome.TwoencouragingfactorsinthepastweekweretheUnitedStatesSteelCorporation’squarterlyearningsstatementwhichwasabout$10,000,000betterthanhadbeenexpectedgenerally,andthestatementfromtheBethlehemSteelCorporationthatthesixmonths’dividendsonthecommonstockshadbeenfullyearned.

1August:JudgeGarydoesnotqualifyanopinionwhichhefirstvoicedsometimeago,forhesaysthatsometimeinthefutureprobablynotdistantthereistocome‘thebiggestbusinessthiscountryhaseverwitnessed.’[JudgeGary,chairmanofUSSteel]

1August:‘Consumersdemandasreflectedinthevolumesofretailtrade(withdueallowanceforpricedeclines),continuesasgoodasorbetterthanatthistimelastyear.Theimprovedconditionnotedduringthepastmonthortwoasaffectingtextiles,bootsandshoes,andotherlinesofbusinessproducingimmediatelyconsumablecommodities,havebeenmaintained.Probablythemosthopefulfeatureintheoutlookis,however,thecontinuingprospectofexcellentfoodcropreturns.’[FederalReserveBoardreviewofgeneralconditionsforJuly.]

1August:Thelistofcommoditiesthatforsolongatimeresisteddeflationisbecominglessandless.Withthegradualpassingawayoftheperiodofpriceuncertaintyagreatobstacletothemakingofforwardcommitmentsisbeingremoved.Stocksarebeingrundownandcrucialtothisistheincreasedpurchasingpowerofthefarmingcommunities.’

1August:‘Assuranceisnowdoublysurethatwehavereachedthebottomofthebusinessdepression.Onecanfeelit,sotospeakunderfoot.

ThelastmonthhasbroughtaverymarkedchangenotonlyinsecuritymarketsbutinthewholeoutlookforAmericanindustryandbusiness.Seeminglyagainstthetide,bankclearingsandrailroadtraffichavebeenincreasingandtherehavebeensignsoffirmerpricesinmanystaplecommodities.’[Blodget&Colettertoclients.]

2August:NationalBankoftheRepublicofChicagostatesthatitispossibletoseeevidenceofthebeginningofimprovement.Priceuncertaintyhasbeenthemostpotentcauseofthedryingupofforwardbusinessandnowconstitutestheprincipaldeterrenttoreduceindustrialoperations.Yetthere’sevidencethatthedownwardswingofpricesisnearingitsendandcommoditiesarereachingalevelonwhichforwardcommitmentsmaybeundertakensafely…Thelongdeadlockinthetradeoffarmingcommunitiesisnearinganend.Theearlyandheavymarketingofwheathasbroughtaboutadecidedchangeinsentiment.Astimulationofruraltrademusthaveabeneficialeffectonindustryinallpartsofthecountry.

3August:Throughoutthecountryfactoryownersareputtinginrepairswhichleadsmechanicalgoodsofficialstobelievethataresumptionofindustryisexpectedinthenearfuture.

3August:Steelpricesarenearingbottom.Themoderateimprovementinordersoverthelastweekortwomaybetheforerunnerofagradualimprovementtowardnormal.

3August:Therevivalintheleatherbusinessisnothingshortofremarkable.Insteadofoperating20%and30%ofcapacityastheydidonlysixmonthsago,someoftheplantsoftheAmericanHideandLeatherCo.arenowrunningdoubleshifts.

5August:Manybrokeragehousesareadvisingthepurchaseofstocksonthetheorythatthetendencywillbeupwardfortheremainderoftheyear.

9August:‘ForthebenefitofthosewhoareinclinedtoindulgeingloomIwanttosaythatwehaveenteredthecyclesofrecovery.Oneofthebestsymptomsofrecoveryistheeasierratesformoney.’[BenjaminStrongGovernoroftheFederalReserveBankofNewYork.]

24August:DJIAbottoms.

25August:Businessconditionsreflectmoreclearlythanamonthago

theimprovementthenunderway,thoughitwasthen,asnow,somewhatobscuredbytheusualmid-Summerdullness.Theincreasedavailabilityofcreditandthemarkeddeclineswhichhavetakenplaceinmoneyratesinthelastsixmonthsareamongthesurestevidencesthatthebettermentisfoundedonimprovedfundamentalconditions.

29August:Resumptionofoperationsbysomeofthehigh-gradepapermillsonabroadscale,fromvarioussectionsofthecountry.

1September:Evidenceisaccumulatingthatamoreoptimisticfeelingisdevelopinginmostsections.ManybankersintheruraldistrictsexpressastonishmentatthepessimismthatprevailsinWallStreet.Itislikelythatthesituationwillbecomestillbetterwhentheeffectsoftheharvesthavebeenfullyfelt,overtheterritoryunderdiscussion.Thereisabetterfeeling.Mostpeoplehavemadetheirlandingandrealizewheretheyare.

13September:Bettertimesareaheadbasedonthesefacts-Recentdevelopmentincottonwhichhasreleasedlargesumsofmoney.Increasedrailwaytonnage.Governmentreadinessandabilitytohelpbusiness.Aidtothecottonandlivestockindustriesgreatlyacceleratedtheirrecovery,andhelpedthewholeagriculturalbusiness.Depletionofstocksinalmostalllinesofbusiness.

22September:Thegreatestprosperityeverisjustaroundthecorner,SecretaryofLaborDavisdeclared.`itwillnotbeareturntonormal,butasweepbeyondthattothehighestpitchofgoodtimes,’Davissaid.`IcanseethegreatesteraofprosperitytheUnitedStateshaseverknownnearathand.Weareonthevergeofit.’

23September:‘Allhistoryshowsthatperiodsofprosperityanddepressioncomeincycles,therotationbeingaboutasfollows;(1)Prosperity,(2)liquidation,(3)stagnationand(4)revival.Atthepresenttimetheprocessofliquidationiswelladvanced…Whentheperiodofrevivaldoesdefinitelysetin,tobefollowedbyaneweraofprosperity,letusrememberthatthegreaterthewaveofprosperityandthemoreunrestrainedtheexpansionandthespeculationaccompanyingit,thesharperwillbethedepressionthatwillfollow.If,however,thelessonsofthepasttwoyearsareremembered,thenextperiodofprosperitywillbeoflongerduration,thananywehavehadbeforeandthesubsequentreactionwillbefarlesssevere.’[WPGHardingGovernoroftheFederal

ReserveBoardatthe‘Made-inCarolinas’ExpositionatCharlotteNC.]

2October:TheFederalReserveboard’sreviewofbusinessandfinancialconditionsthroughoutthetwelveFederalReserveDistricts,isthemosthopefulinmorethanayear.

2October:‘Thetroughofthebusinessdepressionhas,veryclearlybeenpassed.ThevolumeofmanufacturehalteditsabruptdeclineinFebruary;pricesofimportantcommoditiessuchascopper,tin,lead,rubberandcotton,haverecoveredafteralongperiodofweakness,andoflateunemploymentingeneralhasslightlydecreased.Thesefactsdonotmeanthatbusinessisnotdepressed,butratherthatwearerisingoutofthetroughandbeginninganupwardswing…IfconditionsinEuropeweremorenearlynormal,andtherewerenopossibilityofarailroadstrikeintheUnitedStates,wecouldconfidentlycountuponthecontinuedimprovement.’[HarvardUniversityCommitteeonEconomicsResearch.]

5October:Itiswelltosaythatthereisnothinginourdomesticsituationnorintheinternationalsituationthatcansustainapessimisticoutlook,oradespondentviewthattheworldhassunkintopermanentdepression.Gradualinfluencespreventingtherestorationofstableconditionsaredisappearingaspricesmovetowardstabilityonanequitablebasis…Thefullpurchasingpowerthatisnecessaryprerequisiteofnormalprosperityisbeingrecoveredsteadilyassocialandpoliticalconditionsabroadimprove.[JohnSDrumoftheAmericanBanker’sAssociationaddressatthe47thAnnualConvention.]

5October:Idlecarsareregardedasaninfalliblebarometerofbusiness,andthetrendoverthelastfewweekshascertainlyreflectedanimprovementincommerceandindustry.Thereareplentyofcarsandlocomotivesatthemomenttohandlethebusinessofthecountrywhichisona50%basis.Ajumpto75%ofnormalwouldcallforeverycartohandlefreightconsignedtotherailroads.Normalbusinessconditionswouldmeanacarfamine.

5October:CaptainRobertDollararrivedThursdayaboardhisownlinetheRobertDollarfromShanghaiafterasix-monthtripthroughtheOrient.‘FromobservationsIamfirmlyconvincedthatthatbottomofbusinessdepressionhasbeenreachedthroughouttheworldandbusinessconditionsaregraduallybecomingbetter.’

21October:Todaythereisadefiniteturningofthetideinthebusinessandindustrialactivitiesofthecountry.Thisupwardswingofthebusinesspendulumisclearlydefinedtothosewhocanreadtheeconomicsignsofthetimes.[PersonalmessageofVicePresidentCoolidgereadtotheBostonChamberofCommerce.]

Waitingforanabsenceofgoodnewsbeforebuyingstockswouldnothavebeenwise.Ofcourse,1921wasnotthebottomofanynormalbearmarket.Stockshadreachedadegreeofundervaluationthatwouldonlybewitnessedthreetimesinthe20thCentury.If1921wasextreme,itstillsuggeststhatinperiodsofextremeundervaluation,whichare theperiodswhenevery investorwould like to enterthemarket,oneshouldnotbe looking for theabsenceofgoodnews to triggerinvestment.

Indeed, the 1921 example suggests the reverse is true; that, in periods ofundervaluation, investorsmaywell ignore signsof aneconomic recoverywithpositiveimplicationsforcorporateearningsandcontinuetosell.Indeed,in1921,theimprovementintheeconomycoincidedwiththeimprovementintheequitymarket.TheNationalBureauofEconomicResearch(NBER)referencedateforthebottomoftheeconomiccontractionisJuly1921andtheDJIAbottomedinAugust.

The bottom of this bearmarketwasmemorable for the failure of investors toreacttogoodnews.OnecanonlyadmiretheprescienceofJudgeGary,chairmanofUSSteel,andJamesDavis,SecretaryofLabor,whoaccuratelyforecastariseto new levels of prosperity. Unfortunately, the prophetic words of WilliamHardingoftheFederalReserveBoardweresubsequentlyforgotten.

[If]thelessonsofthepasttwoyearsareremembered,thenextperiod of prosperity will be of longer duration than any wehave had before, and the subsequent reactionwill be far lesssevere.[12]

Pricestability&thebear

A phrase began to beat in my ears with a sort of heady excitement: ‘There are only the pursued, thepursuing,thebusy,andthetired.’

FScottFitzgerald,TheGreatGatsby

FScottFitzgerald,TheGreatGatsby

In the summer of 1921 bullish forecasts by the WSJ, businessmen andgovernment officials proved accurate. So what was the secret of success forthosewhoproclaimedthebottomofthebusinesscycleandtheendofthebearmarketinstocks.Onerecurringpieceofevidencecitedbythesecommentatorsauguredwellfortheendofthebusinesscontraction-theincreasingstabilityofprices.Someoftheirmorebullishdeclarationswere:

‘Theaccumulatedevidencesofstabilisationat lower levelsofsuchthingsascopper,cotton,wool,silk,hidesandgrain.’

‘Pricesinsomelinesapparentlyreachingaconditionofgreaterstability.’

‘Pricescannotrunallatoncetoarelativelevelbutthegapsarebeingclosedup.’

‘There have been signs of firmer prices in many staplecommodities.’

‘Thedownwardswingofpricesisnearingitsendandthatoneby one commodities are reaching a level on which forwardcommitmentsmaybeundertakenwithsafety.’

‘With the gradual passing away of the period of priceuncertainty a great obstacle to the making of forwardcommitmentsisbeingremoved.’

‘Prices of important commodities such as copper, tin, lead,rubber and cotton, have recovered after a long period ofweakness.’

‘Gradual influences preventing the restoration of stableconditionsaredisappearingaspricesmovetowardstabilityonanequitablebasis.’

Adjustmentinpricelevelsisaprerequisiteforanyinvestorallocatingcapitalina jurisdiction operating a gold standard. During the contraction phase of the

businesscycle,thegoldstandardmechanismoperatedtoreducedomesticpricesuntil an improvement in competitiveness produced an improvement in theexternal accounts, a flow of gold back into the US and finally an easing ofliquidity.Investorswhocouldseeevidencethatpriceswerestabilisingbelievedthemechanismhadworkedtoreducepricestosuchalevelthateasingliquidityand economic improvementwould follow.Aswe have already seen assessingthe correct price level was complicated in 1921 by numerous factors. Whilemany could theorise on what level of deflation would be necessary, pricestabilisation provided practical evidence that the adjustment process was overand economic recovery could begin. For these reasons, evidence of pricestabilitywas seized upon as signifying the end of the 1919-21 bearmarket instocks.

When one considers the large range of opinions expressed by numerouscommentatorsinthesummerof1921,themostaccurateforecastsoftheendofthebearmarketcamefromthosewhofocusedonthechangeinthetrendinprices.

Themoderninvestorwillbesurprisednotjustbythemagnitudeofthenecessarydeflation,butbythefactthatthefinancialsystemcopedsowellwhencomparedwith the impact of post-1929 deflation. While popular memory associatesdeflationwiththe1930s,thebiggestannualpostwardeflationoccurredin1921.ThiswasnotjustaUSphenomenon.In1921,nineofthemajoreconomiesoftheworld suffered their worst annual deflation recorded in the 20th Century:Australia,Canada,France,TheNetherlands,SouthAfrica,Sweden,Switzerland,theUnitedKingdomandtheUnitedStates.Thiswas largelydue toareturn topeace-timeconditionsandtheprospectofareturntopeacetimeprices.TheUS,Switzerland, Sweden, TheNetherlands andCanada had recorded their highestlevelofinflationinthecenturyduringWWI.Aspricescontinuedtodeclinein1921,investorswonderedwhetherthedeflationwouldhavetotakepricesbacktopre-warlevelsorwhethersomeintermediatelevelwouldsuffice.Thepaceoftheadjustmentanditsmagnitudewerefrightening.

ThiswasveryprobablythesharpestdeclineinpricesinUShistory.Labourwasnotimmune-thepriceofunskilledlabourfellfrom60¢anhouratitspeaktoaslowas25¢bythesummerof1921.Figure24showshowdifficultitmusthavebeenfortheinvestortoguessin1920howlargeadeflationwasnecessitatedbytheoperationofthegoldstandard.Asitturnedout,pricesdidnothavetodeflate

to1913averages, althoughsome,notablycorn, cottonandhides,did just this.The increasing evidence of price stabilisation in the summer of 1921 was initselfasignificantpieceofevidencethatthebusinessdownturnwasending.Buthowcouldstockinvestorsbesurethestabilisationofpricesaroundthesummerof1921wasnotjustatemporaryhiatusbeforepricescontinuedthecorrectionto1913levels?

The one factor that seems to have convinced commentators that thestabilisationofpricesrepresented thebottomwas theresponseofdemandto lower prices. In particular, the increasingly important automobileindustry had seen demand improving from early summer in response topricecuts.Similarresponseswereevidentinotherindustries.

FIGURE24.DECLINEINPRICES1920-21ANDINFLATIONFROM1913T0LOWESTLEVELSOF1921

Source:USBureauofLabor

TheWSJ reported on 9 July 1921 thatwhen phonograph companies, facing a“buyersstrike”,reducedpricesbyathirdtherewasaconsiderablestimulationofsalesinhigh-pricedmodels.

Themoral seems to be that the public has the power and thewilltobuywhenitcangetabargain.

Evidenceofincreaseddemandwasliftingconfidencethatfuturepriceswouldbestableorrising.AstheWSJcommentedon1August,‘withthegradualpassingaway of the period of price uncertainty a great obstacle to making forwardcommitments isbeing removed’. In thesameedition, therewasevidence fromthe real world to confirm the theory. The WSJ reported that ‘operators andmiddlemen’inthecoalbusinesswererefusingtoacceptcurrentspotpricesforSeptemberdeliveryas theybelievedpricesmight rise.A further indicatorwastheimprovementinsupplydynamics.

Advance in the price of iron, first noted last week in theChicago district, then spreading to Buffalo and since topracticallyallpartsofthecountry.Itfollowslogicallyfromthefact that producers have for some time been selling ironconsiderablybelowcost,aprocesswhichcannotbecontinuedindefinitely, and from the fact that stocksof ironhave at lastreducedtowhereitisimpossibletomakeimmediateshipmentonmanyofthegradesdesired.[13]

Asmoreandmorecommoditypricesstabilisedandfirmed,investorsgrewmoreconfidentthelistwouldgrow.[14]

In such fashion, confidence in price stability spread and the bottom of thebusinesscyclearrived.Eventhoseinvestorswhohadseenthedeflationcominghad not necessarily been able to protect themselves. One broker expecting apostwardeflationbought$15,000ofdiamondsin1918.However,by1921eventhe pawnshops would only lend him 10% of the purchase price and he wasforcedtosellfor$6,000.Eventhegirls’bestfriendhadfailedasastoreofvalueinadeflationaryperiod.Withsuchshiftsinvalue,itwasnotsurprisingareturntopricestabilitywasgreetedwithsuchexcitementinthesummerof1921.

LiquidityandthebearIboughtadozenvolumesonbankingandcreditandinvestmentsecurities,andtheystoodonmyshelf inredandgold likenewmoney fromthemint,promising tounfold theshiningsecrets thatonlyMidasandMorganandMaecenasknew.

FScottFitzgerald,TheGreatGatsby

Thewarhadproducedamajorshiftinwealthbetweentheleadingnationsoftheworld.By1921,theUSheldonethirdoftheworld’smonetarygoldsupply.Thisgold, along with Federal Reserve money, were the dominant components ofhigh-poweredmoney.Withsuchawarchestflowingin,itseemedonlyamatterof timebeforeaverysignificant increase in themoneystockandcreditwouldfollow. Some pundits believed that forecasting this turn in the money/creditcycle would be the key to predicting better economic conditions and a betterstockmarket.While the forecasts of an economic recovery in theWSJ in thesummerof1921focusedprimarilyontheimportanceofpricestability,therewasalsofrequentmentionoftheprospectofeasiermoney:

‘The wonderful improvement being made in condition ofFederalReservebanksundoubtedlyforecastscheapermoney.’[DRCrissinger,ComptrolleroftheCurrency.]

‘WhenindustriesthroughtheFederalReservebankscanobtainsufficient fundsat reasonable interest rates toexpand, foreigntradeandforeign loanswillautomaticallybe takencareofbybusiness men themselves.’ [Harry Sinclair, Controller ofSinclairOil.]

‘Oneof thebest symptomsof recovery is the easier rates formoney.’ [Benjamin Strong, Governor the Federal ReserveBankofNewYork.]

The increased availability of credit and the marked declineswhichhave takenplace inmoney rates in the last sixmonthsareamongthesurestevidences that thebetterment is foundedonimprovedfundamentalconditions.

Clearly contemporary commentators thought it was important to focus on themonetarysituationbuthoweasywasittoseetheturningpointthatwouldresultin a turnaround in the business cycle and the equity market? In theory, amonetaryexpansionresults inpricestabilisation,but inpractice leadsand lagscreated problems for investors. There was certainly a marked discrepancybetweenthebehaviourofthepriceindicesandoutstandingbankcreditin1920-

21. TheNBERdates the peak of the economic expansion as January 1920. Itappearsselectedpricedeclineswerethefirstwarningsignsfor investorsratherthan any decline in credit associated with the rising discount rate inNovember/December1919.

The prices of certain articles, notably in the textile industry,begantodeclineasearlyasFebruaryandMarchof1920,andthegeneralpricelevelasreflectedintheDepartmentofLaborindexdidnotbegintofalluntilthreemonthslater.Thevolumeof credit, however, remained high throughout the summer of1920 and did not reach its maximum the country over untilOctober,somefivemonthslaterthanthegeneralmaximumforprices.Uptothepresent,whentheDepartmentofLaborpriceindex is 46% below maximum and this bank’s basiccommodity index is 58% below maximum, the loans ofnationalbanksthroughoutthecountryarelessthan14%belowmaximum.[15]

Commercial-bankloanbookshadincreased18%year-on-yearinthesecondhalfof1919,andtheyear-on-yearincreasewasstill8%inthefirsthalfof1920.Therapidriseinthediscountrate-from4%inNovember1919to7%inJune1920,alevelnotsurpasseduntil1973-tooksometimetoaffectthebanks.Thecreditcontractionwasclearlynotofthesamemagnitudeasthegeneralpricedeflation.Didthismeanfurthercreditcontractionanddeflationwouldfollow,orthatthelink between credit and the general price levelwas not as direct as believed?Whatevertherelationshipbetweencreditandthegeneralpricelevel,itwasnotadirectrelationshipthatcouldbeeasilyinterpreted.

Monetary policy is formulated and implemented by the Board ofGovernorsoftheFederalReserveSystem(priorto1935theMembersofthe Federal Reserve Board) and the Federal OpenMarkets Committee(prior to 1935 the OpenMarket Investment Committee for the FederalReserveSystem).Bycontrollingthecostandavailabilityofbankreservesthe Federal Reserve System impacts the supply ofmoney, interest ratesand credit availability. In impacting these monetary factors, the Fedhopes to steer the economy to producea combinationof high economicgrowthandlowinflation.Havingdetermineditsmonetarytarget,in2005a level for theFed funds interest rate,changes in thebankreservesarethemechanismthroughwhichthetargetismet.InvestorsregularlyassesschangesintheFed’sbalancesheetfortheimpactonbankreservesand,thus, monetary policy in general. Under the gold standard, the gold-exchangestandardandtheBrettonWoodsagreementsofJuly1944,therewerevaryingdegreesofrestraintplacedontheFedby theneedtokeepthe dollar stable on the international exchanges. Since the 1970s, theFederal Reserve has been subject to no such fetters. Over the yearsinvestors have sought to assess whether monetary policy was loose,leading to potentially higher growth, but also higher inflation, or tight,leadingtopotentiallylowergrowthandlowerinflation.

Akeydeterminantinassessinghowmuchfurthersuchacontractionwouldhaveto progresswas the Fed’swillingness to reverse the contraction in the elasticmoney begun in themiddle of 1920. TheWSJ explains how the study of theFederal Reserve System balance sheet in general, and the reserve ratio inparticular,wasthekeyinassessingthecreditcycle:

TheReserveratio itself is themost important indicator…TheFederalReservelawrequiresFederalReservebankstocarryagold reserve of 40% against Federal Reserve notes in actualcirculation and 35% cash against net deposits. When thecombined ratio declined to about 40% it was clear thatexpansionofcreditscouldonlybecontinuedbyhugeimportsofgold….They[bankers]begantocontractloans.Thiscausedalowerlevelofprices.Lowerpricesinfluencetheflowofgoldto this country, which improved the reserve ratio. As prices

declined and the volume of business contracted there was asmallerdemand forFederalReservenotes,whichpermittedarapid retirement of those notes, and, resulted in a furtherimprovementinthecombinedratio.Theratiohavingimprovedslightlyover30pointsfromtherecordlow,thereis,ofcourse,anenormousvolumeofunusedcashinbanks.[16]

TheWSJ goes on to explain how this excess cash usually first seeks higherinterestratesinbondsandhowlowerbondyieldsleadtoanimprovementinthestockmarket.Itsoundsstraightforward,butjusthoweasywasitforinvestorstopredict each stage of this cycle, considering theWSJ’s view that the ‘reserveratioitselfisthemostimportantindicator’?

The first sign of preparedness to ease occurred with a reduction in thediscountrate inMay1921,whenthereserveratiohadrisento56.4%,thehighest level sinceAugust1918.Thiscut inofficial interestratesoccurredjust threemonthsbefore the equitymarketbottomed.TheDJIAdeclined20%intheinterveningperiod.

Itisunclearhowanyinvestorwouldhavebeenabletoforeseeacontractionofsuch magnitude in the elastic currency before the Fed considered providingrediscountfacilitiesatlowerratesofinterest.FederalReserveBoardmeetingsatthe time were assessing the appropriate degree of deflation for the economywhen determining policy. In particular, discussionsmake it clear that the Fedpostponedanyreductionininterestratesuntiltherehadbeenareductioninwagerates, which the governors deemed necessary. This clearly suggests that theFederal Reserve Board was not steering monetary policy with regard to thedegree of stretch in the elastic currency, but rather in relation to whatadjustmentsitthoughtnecessaryinthepricelevel.Inthatenvironment,investorslooking at the Fed’s balance sheet for signs of easier monetary policy weremisdirected. The Fed was not setting its course by the compass of its ownbalance sheet but was actively judging the appropriate monetary conditionsnecessary for the economy. The elastic currency invented to prevent financialcollapse, had been used in 1917-19 to finance the government and now wasbeing used to manage the economy. This element of subjectivity in FeddecisionsmadeitverydangeroustoassessfuturemonetaryconditionspurelyonthecurrentconditionoftheFed’sbalancesheet.

Those commentators who cited improvements in the condition of the FederalReserveSystemasanindicationthatthingswouldimprovewere,tosomeextent,right, but it would have been almost impossible to judge the level ofimprovementneeded to trigger recovery in theeconomyand thestockmarket.Therewasasimilarproblemifthefocuswasonmarketratesofinterest.Therehadbeenanimprovementinmarket interestrates longbeforethestockmarketreached its lowon 25August 1921. In June 1920, the call-money rate rangedfrom10%to14%,andaccordingtotheComptrolleroftheCurrencyatthetime,some rates as high as 30% had been reported. Market rates of interest haddeclined significantly from 1920 to 1921 without halting the bear market inequities(seeFigure25).

FIGURE25.KEYINTERESTRATESON31AUGUST1920AND31AUGUST1921

Source:FederalReserve,BankingandMonetaryStatistics

Therehadbeena steadydecline inmarket rates since June1921and theWSJwas reporting ‘a liberal supply’ofcallmoneyat5.0% inAugust1921.By28July,call rateswereat lowsnotseensinceNovember1919,andstill thestockmarket declined. It is probably axiomatic to say that, at some level, thesereductions would produce an economic recovery, but there is little in theeconomicrecordtoindicatehowinvestorswouldhaveestimatedthestimulatorylevel.Basedonthisanalysisitwasthoseinvestorswhofocusedonalterationsinthegeneralprice levelwhowerebetter able togauge the turningpoint for theeconomyandthemarket.WhilethefirstsignsofpricestabilitydidcoincidewithrecoverythecontractionoftheFed’sbalancesheetcontinuedforyearsaftertherecoveryhadbegunandmarketinterestrateshadbeendeclininglongbeforethestockmarketbottomed.

There is more to liquidity analysis than just analysing changes in the Fed’sbalance sheet. Though such changes have a direct impact on high-poweredmoney, it isonlya smallpartof the totalmoney supply inanyeconomy.Thegrowth in broader measures of money can differ significantly from trends inhigh-poweredmoney in the short term. If “liquidity analysis” focuses on thiswider variable, do we find any better indications of the bottom of the bearmarket? There is a major discrepancy between the signals from M2 growth,dependinguponwhetheroneislookingatanominalorinflation-adjustedseries.Thenominalseriesshowsnoimprovementuntil themiddleof1922,wellafterthebottomof thebearmarket inequities.However,amarked improvement inthe inflation adjusted series is evident in April-May of 1921 when a further20+%decline in theDJIAwas still tooccur.Thus theremayhavebeen someusefulindicationsfromthegrowthofinflation-adjustedM2intheperiod,but,aswith following the first decline in the discount rate, it signalled a buy inMaybeforethefinaldown-legintheDJIA.

IfFedbalance-sheetchangeshavebeendifficulttoreadandbroadmeasuresofmoneymisleading,whataboutcreditgrowthasanindicatorofbetter timesforthe economy and the stock market? Commercial-bank lending continued toexpandlongafterthedeclineineconomicactivityhadbegun.Itwasalsomanymonths after the economy and stock market had bottomed before total loansbegan to expand.Monthly data is not available, but the annual data shows adecreaseintotalloansof5.5%fromJune1921toJune1922.Overthatperiod,the economy was expanding at almost 7% in real terms, and the DJIA rosealmost 36%.Watching credit-growth numbers would not have been useful intryingtofindthebottomofthisparticularbearmarket.

While an analysis of themonetary situation seems to throw little light on theabilityof investors topredict thebottomof theequitymarket, itdoes raiseaninteresting structural issue. How did the US financial system weather thisdeflationarystorm,whenasimilarstormfrom1929-33wipedoutbanksholdingone-tenthof totalUSdeposits?(Wediscuss this issue indetail inPart II.)Thepublic accepted that the commercial banking system could take the strain in1920-21 and increased their deposits; but such faith was lacking in 1929-33.Looking at thebalance sheet ofChaseNational, the fourth-largest bank in theUS,on30June1920,itisnotdifficulttoseewhythepublichadsuchfaith.

FIGURE26.CHASENATIONALBANK’SBALANCESHEETON30

FIGURE26.CHASENATIONALBANK’SBALANCESHEETON30JUNE1920

Source:WallStreetJournal

TheUScommercialbankingsystemwas inahighly liquidpositiongoing intothe1919-21deflation.Longaccustomedtodeflationaryperiodsnecessitatedbythe gold standard, it had built balance sheets to cope. This high degree ofliquidity, and perhaps the creation of the Federal Reserve System itself,convincedthepublicthebankingsystemwassafe.In1921,theywereright.

ThebullsandthebearThereisnoconfusionliketheconfusionofasimplemind,andaswedroveawayTomwasfeelingthehotwhipsofpanic.

FScottFitzgerald,TheGreatGatsby

Theanalysissofarsuggestssavvyinvestorsin1921werecorrectlyforecastingaturnaround in the equity market by focusing on mounting evidence of pricestability.Suchafocusseemsintellectuallysound,giventheoperationofthegoldstandard, and it worked. Another approach with intellectual appeal was tomonitorthebalancesheetoftheFederalReserveSystem.Evenwiththebenefitof hindsight, such an approach seems to have been highly subjective and lessreliablethanafocusonpricestability.

Ofcourse,noteverymarketoperatorlooksatthingsinthesamewayandsuchdetachedanalysisisnotalwayspossiblewhenoneisinthegripofthebearonadailybasis.Togetabetterideaoflifeintheinvestmenttrencheswenowfocusoninvestorcommentandreactioninthetwomonthsbeforeandafterthemarketbottom on 24August 1921. In following the day-by-day progress of the bearmarketfrom25June1921toitsnadiron24Augustandthroughthetwomonthsfollowing,oneseeshowthosewrestlingthebearassessedthesituation.

FIGURE27.BOTTOMOFTHEBEARMARKET–THEDJIAJUNE1921TOOCTOBER1921

Source:DowJones&Co.

Notes from the pages of the Wall Street Journal indicate the factorscontemporary opinion believed to be important in calling the bottom of themarketinthesummerof1921:

25June:Theconsensusisthatthemarketisnowactingasthoughitwantedtogoup.Easymoneyhasbroughtaboutconsiderableshiftingfromthebeartothebull-marketside.

28June:(Those)whoacknowledgetherehasbeennosignofbusinessimprovementasyetdonotfavoursellingstocksshortaroundcurrent

levels.Theysayitisunreasonabletocomparestocksnowpurelyontheirearningsfiguresof1921.Itisthebalancesheetthatisevenmoreimportantintimeslikethese.

29June:Thebearishfraternitywerebolder.Thesetradershavemadesubstantialprofitsduringthelongandpainfulperiodofliquidationandtheyhavereachedthestagewheretheyrefusetoregardanydevelopmentasconstructive…Thereisnodisputingthatconfidenceinthebusinessfutureisgrowingstrongerdaily.Pessimismisslowlygivingwaytooptimism,adevelopmentthestockmarketwillreflectinduetime.Themarketgiveseveryindicationthattheurgentliquidationisover.Itisanarrowmarketbothways,butoneverydrivebythebearssupportseemstobeinevidence.

6July:Dullestdayoftheyear.ThegenerallistheldupwelldespitethepressureonMexicanPetroleum.Thereisstillabigshortinterestinthemarket.

7July:FailureofthegenerallisttogodownonTuesdayduringtheviolentbreakinMexicanPetroleumservedasawarningtothebearcrowd.Itprovedconclusivelythatthelistwassooversoldthattheshortinterestwasservingasacushiontoanygeneraldecline…ageneralcoveringmovementsetinandbeforethedaywasoverthelargestrecoveryofanysingledaythisyearwasrecorded.

13July:Therankandfileofthetradersarestillbearishanddespitetherun-upinpriceslastweektherehasbeennoappreciablediminishingoftheshortinterest.

13July:‘Stocksmorerecentlydonotappeartobeinplentifulsupplyforlendingpurposesand,inotherwords,thetechnicalsituationwouldindicatethatsomeconstructivedevelopmentsmighteasilybereflectedinhigherquotationsforthebetterclassofshares.’[Hornblower&Weekslettertoclients.]

13July:Ithasbeennoticeableforsometimethatwhenthegenerallistsellsoff,copperstocksholdfirm.

13July:BrokerholdingsofUSSteelhadbeenashighas58%atDecember1916butinvestorstookmorestockandbrokersheldjust23%atendJune1921.

15July:Tradersonthefloorarestillfindingitdifficulttomakeanymoney.Infactitwassaidyesterdaymorningmanyofthefloormenarenotcomingintotownatallandwillnotuntilthemarketshowssomesignsofrealactivity.

18July:Dullestmarketinthreeyears…Veryfewoftheusuallyactivetradersappearedinthefinancialdistrict.Weareinatypicalsummermarket,withnoincentivetodoanything.Itisacknowledgedthatthebigmoneyhasalreadybeenmadeontheshortsideofthemarket,andasyetthereisnothinginbusinessconditionstomaketradersgolongofstocks…Thereisabsolutelynopublicparticipationinthemarket.

19July:Mostbrokeragehousesareadvisingtheircustomerstokeepoutofthemarketuntilitbecomesmoreactive.

20July:Industrialpreferredstocksarebeingofferedatpricessomeofwhicharebargains.Eventhebest,well-seasonedissueswithalongdividendrecordareofferedatpricestoyield7%to10%,whilemoneymaybehadaround6%…Theomissionofthelastquarterlypreferreddividendsbyfiveimportantcompaniesmayhavebeenacontributorycausetotheyieldingofhighergradeissuesinsympathy.

21July:Themarketbecameextremelydullonthedecline,whichthebullsconsideredafavourablesign.

22July:Tradingsmallestinanyfive-hoursessionsofarin1921.Loweringofrediscountratedidnotstimulateanyinterest.Thereisabigshortinterestinthesteelstocksandsomeofthebigoperatorsaremoreinclinedtocovershortstocksonbadnewsthantoputoutnewshortlines.Premiumshavebeenremovedfromthespeculativestocksintheloancrowdandsomestocksareloaningflat.

28July:LowestcallratesinceNovember1919.‘Itisaprofessionalmarketofcontrolledfluctuation…Theobviousseldomhappensinaprofessionalmarketatthetimewhenexpected.’[Hornblower&Weekslettertoclients.]

29July:Peopleinapositiontoknowcharacterizedthebreakintheequipmentgroupasentirelyduetoabearraidbythesameintereststhathavestagedotheraffairsofthesortduringthelastfewmonths.

1August:AmericanTelephone$90millionstockofferingwasvery

successful.ThisfollowsabigloanforBurlingtonandtheFrenchgovernment.

1August:Brokeragesbareofcustomers.

2August:MotorsfailedtorespondtothewonderfulnewsfromStudebaker.(Businessforthesecondquarterwasgreaterby50%thanthepreviousrecordquarter)

2August:BearDrivesatFruit(UnitedFruitCo.)uncoverlittlerealstock,foritisnosecretthatinterestsconversantwiththecompany’soutlookhavebeenbuyingthesharesonalldips.

3August:Brokersloanslowestinabouteightyears.Inthepasttwoyearstheseloanshavecontracted$1.25mto$500,000.ThepeakwasreachedonJuly31st1919.Atthepeakofthe1919marketthedailycallmarketvolumewasaround$45mbuttodayitisaround$15mto$10m.

5August:Riseinrailroadstockshasbeengoingforwardfornearlysixweekswithslightinterveningsetbacks.Whereasinpreviousspurtsintherailsthelower-pricedshareswerefavourites,ithasbeennotablethatthefeaturesofthepresentadvancewerehigh-pricedandinvestmentrailroadshares.

5August:Thereareonly900,000sharesofSteelcommonheldbyWallStreet,comparedwithover2,500,000sharesheldafewyearsago.

9August:Thereisnobodyofsmallinvestorswhoprovidemarketsupportinthedarkesthour.IfbrokersdependedonthatkindofbusinesstheExchangemightproperlycloseorconvertitselfintoamovingpicturetheatre.

10August:‘Itisafacthoweverthatmycompanyhasmorepotentialbuyersonhandtodaybothininvestmentandspeculativeaccountsthanatanytimesince1914.Ihaveclientswhoarestrainingattheleashtobuystocks,andIamholdingthembymainforce.’[Quotefromanonymousbroker.]

11August:Therewasnolet-upinthesellingforspeculativeaccount.TheywerehelpedbythepassingoftheAmericanSugardividendwhichdrovethisstocktoanewlowfortheyear.

18August:Premiumsonanumberofissuesdemonstratedthattherehad

beenlittleperceptiblereductionintheextentoftheshortinterest.

19August:Overthepasttwodayscertainissuesthathavebeenunderpressurehavehadacomeback,regardedbymanyasanattemptonthepartoftheshortstocovertheircommitments.Asanexample,PierceArrowcommonissellingoutoflinewiththepreferred,butnotwithstandingthis,thecommonhasheldarounditspresentpriceforthelastseveralweeks.

20August:Absorptionofstocksandbondsforinvestmentisreachinglargerproportionsthanonewouldimagine.Thereisverylittlebuyingforaquickturn.Majorityofthebuyerssaytheyarepickingupstocksforapullofayearortworealizingtheyarecheap.Thesestocksarebeingpaidfor.Thisisaperiodofinvestmentaccumulation.

23August:Liquidationinanumberofstocksseemstobeover.Proofofthisisfoundinthefactthattransactionsarefewandfarbetween.Thisisparticularlytrueofthecopperissues.

24August:DJIAbottoms.

25August:‘Sofarastheaveragesareconcernedtheyarefarfromencouragingtothebull,buttheydonotyetjointlyindicateadefiniteresumptionofthemainbearmovement.’[WilliamPeterHamilton’sDowTheoryAnalysis.]

25August:InternationalPapercommonsellingat$39.50severalmonthsaftertheissuanceofanannualreportshowing$53ashareavailableforcommon,isastockmarketdevelopmentwithoutprecedent…AmericanInternationalhassolddownto253/8andtheliquidatingvalueofthesecuritiesitholdsare$50.

27August:Urgentshortcoveringbybearoperatorsfrightenedbythetechnicallystrongpositionofthemarketaswellassomesubstantialbuyingorders,causedavigorousrallyinvirtuallyallstockswhichcontinuedwellintotheafternoon.

28August:BearsTrapped…Themarkethadreachedthatstagewhereatechnicalrallywascertain.Thelistofstockscommandingapremiumintheloancrowdwasthelongestsincethepresentbearmarketstartedtwoyearsago…Therallythatstartedbeforetheendofthefirsthourwasthebestinthelastthreemonths…Thebearrumorswhichhavepermeated

WallStreetforthepastmonthandwhichculminatedThursdayinthefalsereportaboutthedeferringofdividendbytheMexicanPetroleumCo.havearousedtheconstructiveelementintheStreet;anditisreportedthatlargefinancialinterestshavecombinedtoforcetheprominentshortstocovertheirlinesandalsotogivewarningthatthecampaignofuntruthhasbeencarriedbeyondunbearablelimits.

29August:BearAttackFails…Manycompanieshavemorecashthanatanytimeintheirhistory.

30August:HousesbullishonGEtelltheirfriendsthattheinsidersintendgivingtheshortsareallesson,andthatthestockwillbeputmuchhigher.

31August:ShortsDrivenIn…Thedroppingoftherateofcallmoneyto4.5%,thelowestrateinnearlyamonth,causedaconsiderableuneasinessintheranksofthebearcrowd.

1September:Therewasacontinuationoftheupturninstocksstillcontainingalargeshortinterest.ThetotalofsixstockscommandingapremiumcompareswithfifteenstocksloaningatapremiumlastThursday,justbeforethepresentupturninpricesgotunderway.

2September:Withtheshortinteresteliminatedthereisnownoonetobuystocks.

3September:DemonstrationAgainstShorts…AdditionalencouragementisgivenbyWallStreet’schangeofattitudetowardthenewsoftheday.Insteadofstressingbearishfactors-astateofmindwhichgrewchronicduringsummermonths-tradersaretendingtolookonthebrighterside.

7September:‘ItistimetheAmericanbusinessmanrealisedthatthedownwardtrendinbusinesshasbeenreachedandtheindustriesinthecountry,ingeneral,haveseentheendofthereadjustmentperiod.Duringtheperiodofinflation,largenumbersofbusinessmenfounditnecessarytoexpandtheirbusinessinordertotakecareofthetremendousquantityofworkcomingtheirway,withtheresultthatwhentheperiodofdeflationhadstarted,theyfoundthemselveswithlargequantitiesofhighpricedrawmaterialsandfinishedproductsonhandwhichbecamepracticallyunsaleableatanythingliketheircost.Aboutthattimegreat

crywentoutfromtheAmericanpublicagainsttheexcessivepricesofeverythingandtheinevitablehappened-a“buyer’s”strikeoccurred.Inorderthatthislargeaccumulationofstockinhandmightbedisposedof,itwascontinuallyofferedatlowprices-fromtimetotime,andgraduallyatthedifferentlevels,thesegoodshavebeenliquidated.Atthepresenttime,insteadofhavinglargeaccumulatedlinesofgoodsonhand,thereisactuallyashortageinmanychannels…Inordertopartlybringaboutthisstateofliquidation,theproducersofmanymaterialsvoluntarilycutdowntheiroutputmillswereclosedcompletelyorrunningonveryshorttime.ButduringthisperiodtheexcessiveamountofproductionwasgraduallybeingusedupandoncetheAmericanpublicrealizesthatprosperityisagainaheadofthemandthattheAdministrationhasbeendoingthingsalongaconstructivelineandwillcontinuetodoso,therewillbeascramblebyeveryonetopurchasewhattheyneedatthepresentprevailinglowprices.Oncethatbuyingstarts-withproductionatsub-normallevels,itisboundtoturnthewholetideandpriceswilladvanceagain-and,advancingpricesalwaysbringprosperitythroughoutthecountry.’[JesseLivermore.]

7September:Thenumberofstocksreducedtoloaningatapremiumistwo.

10September:Itmightbesaidthatabearpanicexistedbeforetheendoftheday.ThelastoftheWaldorfcrowd,whichhadbeenpersistentlybearishonthemarket,wasdrivenin.

12September:Duringthecurrentweekthousandsofsharesofthebetterclassofindustrialandrailroadstockshavebeenabsorbedbylargeinterestswhoareconvincedthat,withtheinevitablereactions,thetendencyofbusinessaswellassecuritymarkets,willbeupward…Theadvancethisweekisundoubtedlyduetoanimprovementingeneralbusinessconditions…ThebearcrowdhasbeengivenoneoftheworstbeatingsinthehistoryofWallStreet…Manybrokeragehouseswhoadvisedprofittakingarenowconvincedbytheactionofthemarketthattheriseisanythingbutaflurryengineeredbyprofessionaloperators.

14September:‘Astothesecuritymarket,thecapitalizationsofmanyconcernsaretodaysellingbelownetcurrentassetsovercurrentliabilities.Thesharesofmanycorporationsaresellingatone-thirdof

theirrespectivebookvalues.Securitypriceslikethesearetooattractivetoexistforanygreatlengthoftime.Alreadywehearthatthetextile,shoeandmanyotherindustriesarerapidlygettingbacktonormal.’[WilliamBoyceThompson,miningentrepreneurandformerdirectoroftheFederalReserveBankofNewYork.]

14September:Outsideofahandfulofstocks,howevertherewaslittleinterestshowninthemarketanditwasevidentthattherecentrisehadnotencouragedpublicparticipation.

16September:Alreadythefloatingsupplyhasbeenreducedanditmaywellbethatinsixmonths’timeweshallbesayingthattherearenotenoughstockstogoaround.Greatpricemovementsalwaysoverrunthemselvesandthisistrueofbullandbearmarketsalike.Whentestedindustrialpropertiesshowabookvaluefarinexcessoftheircommonstockatthemarketprice,ignoringtheirearningcapacityaltogether,wemayatleastsaythatthesuperiorsafetyoftax-exemptmunicipalbondshasblindedtheinvestortoequitieswhichmaywellmakethetaxesseemsmall.

22September:Mostofthem[rumours]concernawellknownstockmarketoperatorandaprominentindustrialleader.Thesetwomenareunderstoodtohavebeenlargelyresponsiblefortheadvancethatstartedamonthagoandlastedfornearlythreeweeks.Nowitissaidthattherehasbeenafallingoutbetweenthetwoandtheirfriendsaremakingallsortsofchargesofdouble-crossing,sellingoutofthepool,andotherchargesoflikecharacter.Fromtheactionofthemarketitcertainlyappearsthatsomethinghasgonewrongontheinsidebecauseitisthepoolstocksthatarehavingtheseverestreactions.[ThisisareferencetoJessieLivermore]

23September:Anumberofhousesarguestocksareasalebecausethepublicrefusestocomeintothemarket.Itistraditionalthatanupwardmovementinstocksisnotstartedbythepublic.Themarketforthelasttwoyearshasreactedsharplyaftereachrise,andsellingstocksonbulgeshasbecomeahabit.Therecentrisedidnothavethesamecharacteristicsaspreviousadvances.Thestrengthofsecuritiesoverthefirsthalfofthemonthfollowedtheconvictionofthelargestbankersandfinanciersthatthebottomofthedepressionhadbeenreached.Theyhavebeenthe

largestbuyersofstocks.Professionaloperationshavebeeninevidenceincertainissues,buttherealreasonfortheupwardtrendhasbeengoodbuyingforalongpull….Therealsourceofstockmarketsupportiscomingfromthelargebanksandimportantfinancialinterests.Theyturnedbullishonthemarketmorethantwoweeksagoandhavebeenbuyersofthegoodstocks.Thesellersconsistofhousesthatsoldoutandarenowworkingalowerlevel.

26September:‘Wefeeltheprincipalthingtobearinmindisthatthegreatestnecessityintheearlystagesofabullmarketispatiencebecausethereisnoquestioninanyone’smind,apparently,astowherepriceswillbesellingayearfromnowbutasusualthemarketoftodaykeepswould-bepurchasersinconstantdoubtandtheywillnotbuystockswhentheyaredullandunattractive,butonlywhentheyareactiveandmadetolookveryattractiveforsellingpurposes.’[Hornblower&Weekslettertoclients.]

4October:Itcannotbetoooftensaidthatthestockmarketreflectsabsolutelyalleverybodyknowsaboutthebusinessofthecountry.Whenthemarketistakenbysurprisethereispanicandhistoryrecordshowseldomitistakenbysurprise.[EditoroftheWSJ,WilliamPeterHamilton.]

4October:Itisaneasymattertoputastockuponashortinterest,butdifficulttoholditaftertheshortinteresthasbeeneliminated.

4October:ManyrecriminationshavebeenhurledatJesseLivermoreforthehaltingoftherecentadvanceinthemarketdueprimarilytotheinabilityofthegeneralpublictolookuponaprofessionaltraderasanythingbutapirateandadestroyerofvalues.RatherthanhalttheadvanceLivermoredidallhecouldtokeepitgoing.HeandGeorgeJ.Whelan,thetobaccomagnate,weretheprimemoversinthemanipulation.Thepubicwastotallyabsentandrefusedtocomein.[Duringtheupswing,thetwomenhadfallenoutregardingwhichstockshouldbeusedtoleadtheadvance].

5October:Marketmanipulatorswantthepublicwhentheyarereadytodistributestockanddonotwantthepublicinupontheirgroundfloorplans.Thereforewhenpublicationismaderespectingfinancialplans,thewholematterisoftenheldupindefinitelyorsetasidetobebrought

forwardonanentirelynewbasis.TheoperatorswhohadputthemarketupretiredandthequestionisstillunsettledastowhetherasamarketleaderMexicanPetroleum,tobaccostocks,orrailroadsharesshouldhavetherightofway.Butalltheleadersagreethestockmarkethasbeenliquidatedoutandthatthereisonlyonewayforittogoandthatisup.Buthowimmediately,orinwhattime,nobodycanagree.

5October:TwobearfactorswhichcannotbeignoredarethebankruptcyofGermanyandAmerica’srailroads.

7October:Themarkethasbeenpermittedtotakeitsowncourseforthepasttwoweeksandspeculativeauthoritiesdeclareithasactedwell.Developmentshaveindicatedthatitwillbenodifficultmattertomoveithigher…Brokerloanshaveincreasedverylittle.

10October:AccordingtothePujoCommitteeonly14%ofalltradingisdonebytheso-calledpublic.Willtheother86%waituponthepublic’spleasure?Thetruthofthematteristhatthe‘public’whosepresenceseemssoessentialtothesuccessofmarketventuresisveryactiveinthebondmarketanditspurchasingisputtingLibertybondstonewhighsdaily.

12October:Ascopper,steel,petroleumandotherpricestendupwardandmoneyratesdownward…thenextmovewillbeup.Itisevidentfromthecharacteroftransactionsthatthereisnoactualliquidation…alsothatthebigprofessionalsaredoingnothingontheshortside.

24October:Bearishoperators,whohadsteadfastlyrefusedtobelievethatthepricemovementwascapableofasustainedrise,werebadlypunishedintheupwarddriveandtheirhastyattempttoextricatethemselvesfromadisastrouspositiongavefurtherimpetustotheadvance.

For those in the trenches from June to August 1921, the watch phrase wasclearly‘knowyourenemy’.Oneofthereasonscitedforbecomingmorepositiveonthestockmarketisthatthebearshave‘reachedthatstagewheretheyrefuseto regard any development as constructive’, even in a periodwhen therewasample good news emerging. The emergence of buying interest on every“drive” by the bears provided further evidence their day in the sun wasending.Inparticular,on19August,justpriortothemarketbottom,itwasnoted

that some common issueswere selling out of linewith preferred counterparts.Thiswastakenasasignthatsomeshortswerebeingforcedtocovertheirshortpositions in the common, creating themisalignment.The general emphasis onbadnewswasnotedasapositivesignjusttwodaysbeforethemarketbottomed:

Bear tips are now quite the thing, and any one who evenintimates thatastockmaygoup is lookedonwithsuspicion.Suchaconditionusuallymarkstheendofabearmarket.[17]

Justafewdayslater,ananonymousbankerpointedoutnotjusttheproliferationofpessimismbuttheabundanceoflies:

‘I listen to a hundred confidences a day and recently theexaggerations I have heard frommen in allwalks of life areappalling. I have even kept stillwhenmenwhispered reportson things of which they knew nothing, obviously wickedreportswhichwereentirelyincorrect.BadnewsmaytravelfastbutfakenewshasthewingsofMercury,thatIknow,andoutofapossible100 reportsofdisasterand tribulation I listen toweekly, perhaps one has an iota of truth in it and that one isneverasblackasitseems.’[18]

Notallcompaniesacceptedtheproliferationof“fakenews”lyingdown.EdwardL Doheny of Mexican Petroleum succeeded in having newsletter writer WCMooreindictedonchargesofcriminallibelonthebasisofacommentinoneofhisinvestmentnewsletters.

Aswe have already seen a flow of good news had been developing for sometimeandhadpreviouslybeen ignored. Induecourse,a turn in themarketwasapparentwheninvestorfocusswitchedfromthebadnewsflowtothegoodnewsflow.Apartfromthesesubjectivecriteria,itisclearfromtheextractsabovethat,investorsalsolookedcloselyatlendingactivity.Whenthesupplyofstocksforlendingwas decreasing and thus the cost of borrowing stocks rising, thiswasevidencetheshortswererunningoutofammunition.Itmayhavebeencoincidence, but the very bottom of themarket occurredwhen the number ofstocksbeinglentatapremiumpeaked.Itwasbelieved,rightly,thatthiswasanindication the activityof the shortswaspeaking and their activities todepressstockswerelikelytowanefromsuchhighlevels.

In1921, longbeforeinstitutional investorscametodominatethestockmarket,another part of knowing your enemy was to assess the general ownership ofstocks.Historyhadshownthat,insignificantbullmarkets,theconcentrationofownershipofstocksshiftedtoWallStreet.ThebellwetherstockatthetimeforassessingsuchshiftswasUSSteel,whichhadbeen the largest listedcompanysince its creation in 1901.Brokers’ holdings ofUSSteel reached 58%by thepeakofthestockmarketboomof1916andbytheendofJune1921hadfallento23%.Thegeneralpublichadtakenuptheslackandinvestorswatchedthetotalnumber of shareholders of US Steel as another indication of when the bearmarketinstockswouldend.Thereasoningwasthatmain-streetinvestorswouldseekthehavenofUSSteelintimesofdifficulty.WhenthenumberholdingUSSteelreachedhistoricallyhighlevels,itwastakentorepresentanexpressionofextremeconservatismamongthepublic.

Peaks in the number of holders of US Steel had always previously coincidedwith nadirs of public participation in themarket. This defensive positionwasonlylikelytoreducefromsuchhighlevels,resultinginagreatercommitmenttothe stockmarket in general. In the course of the 1919-21bearmarket,AT&Tcame to be just as important asUSSteel as a bellwether - and the number ofholdersofitsstockactuallyexceededUSSteel.

ThehighnumberofshareholdersinUSSteelandAT&Tinthesummerof1921wasonceagainagoodindicatorthattheequitymarketwasreachingitslows.Ofcourse the public’s conservative investment stance would only be slowlyreversed. While some investors did watch odd-lot activity for a signal of aturnaround in themarket, itwasnotwidelyexpected thegeneralpublicwouldlead thebuyingat thebottomof themarket.Thekeybuyers looked for at thebottom were the “big constructive interests”. These were the men of wealthwhomonewould normally associatewith significant ownership of stocks andwho had been largely absent from the market for some years. Their publicpronouncements suggest they were driven by considerations of value, but aneasing of the wartime surtax - taxing stock market gains - was also aconsideration. In 1921, it was these buyers who began to put a floor undercertainstocksandsqueezethebears,sendingthemarketsharplyhigher.

Thebullsof1921 focusedon thevalue insharesandkey technical factorswhich suggested that market prices would recover. There was littlediscussiononthe immediateearningsoutlook.Whilethemarketbottomed

inAugust1921reportedearningshadafurther37%todeclinebeforetheyreached bottom in December 1921. An earnings recovery significantlylaggedtherecoveryinthestockmarket.

Aswell as a focus on the activities of keyplayers, investors in 1921watchedgeneralbehaviourinthemarket.Theirbullishnesswasnotjustbecausevolumeswerelow,butthatasignificantproportionofalltheactivityonthemarketwasmadeupbyshortingactivity.Whentheshortsweredominant,andmanybrokersdid not bother to come to their offices, thiswas a signpositive interest in themarketwaslikelytoincrease.Adeclineinbrokerloanstohistoricallylowlevelsalso indicated interest in themarket had probably reached its low.Amarketdecliningonparticularlylowvolumewasthoughttobeparticularlybullish.This opinion is in conflict with a modern adage which states that bearmarketswillendwithanactofcapitulation involvinga finalslumpinthemarket onheavyvolume.AsFigure 28 shows this is not the case and thefinal decline of themarket in 1921was attendedby low rather thanhighvolume.Presumably this lowvolume reflects a disinterest in stockswhichaugurswellforstockpricesinthefuturewhereinterestandaccumulationincrease.AriseinvolumesafterthefirstreboundintheDJIAsuggeststhatthepricerisemaybesustainable.

FIGURE28.DJIAANDTWO-WEEKMOVINGAVERAGENYSESTOCKVOLUMES

Source:NYSEandDowJones&Co.

It is worth dealing specifically with the comments of Jesse Livermore andWilliamPeterHamiltoninthesummerof1921.Livermorehadbeenrecognisedformanyyearsasoneofthemostsuccessfuloperatorsinthemarkets.By1900hewas already banned from the “bucket shops” ofNewYork andBoston forbeingtoosuccessful.In1907,hemademorethan$3millioninonedayshortingduring the stockmarket crash.Livermore switched from thebears to thebullsalmostexactlyat thebottomofthe1921bearmarket.HisbullishcommentstotheWSJreportedon7September1921forecastingthat‘thewholetideofpriceswilladvanceagainandadvancingpricesalwaysbringprosperitythroughoutthecountry’werepartofanoperation to talk-up themarket. In justifyingwhy thebear market in stocks was over, Livermore focused on the very low level ofinventoryinthesystemandtheimpactthiswaslikelytohaveinproducingpricestability.Inhisopinion,thislowlevelofinventorywouldpreventfurtherpricedeclines,spurbuyingactivityandadvanceprices.

FromHamilton’seditorialsintheWallStreetJournalinthesummerof1921,itis clear his reading of the two averages (theDJIA and theDow Jones&Co.Railroad index) that he accurately called the bottom of the 1921 bearmarketutilisingtheDowTheory.

TheDowTheoryhasbeenelaboratedatgreatlengthovertheyearsafterbeing first expounded in a piecemeal fashion byCharlesH.Dow in his‘ReviewandOutlook’editorial,whichbeganintheWSJinApril1899.

Downever formalisedhis theory.The firstattempt todosowasbyS.A.Nelson,whopublished‘Dow’sTheory’inhis1903publicationTheABCofStockSpeculation.WilliamPeterHamiltonhadjoinedtheWSJin1899and had worked with Dow before Dow’s death aged 51 in 1902. Aseditorial-page editor for the WSJ Hamilton often wrote about Dow’stheoryand its implications for thecurrentstockmarketsituationandhehadplentytosayinthesummerof1921.In1922HamiltongavehisownexplanationofCharlesDow’stheoryintheStockMarketBarometer.

Dow’s theory is fundamentally simple. He showed that there are,simultaneously, three movements in progress in the stock market. Themajor is the primary movement… It will be shown that thus primarymovement tends to runoveraperiodofat leastayearand isgenerallymuchlonger.Coincidentwithit,orinthecourseofit,isDow’ssecondarymovement, represented by sharp rallies in a primary bear market andsharpreactionsinaprimarybullmarket…Concurrentlywiththeprimaryand secondarymovement of themarket, and constant throughout, thereobviouslywas,asDowpointedout,theunderlyingfluctuationfromdaytoday…Dow’s theory inpracticedevelopsmany implications. ‘Oneof thebest testedof themis that the twoaveragescorroborateeachother,andthat there is never a primarymovement, rarely a secondarymovement,wheretheydonotagree’,Hamiltonsaid.[19]

Bondsandthebear

Aprolongedbearmarketinbondshadbeenunderwaysince1899andescalatedduringtheperiodofpostwarinflation.Strictlyspeaking,theUScorporatebondandFederaldebtmarketshadbottomedinMay1920.TheDowJonesindexof40 corporation bonds posted its lowest reading of 57.29 in thatmonth beforecommencinga rise.By the followingJune, the indexhadgivenupmostof itsgainstobottomat57.75.Althoughstill0.8%abovetheMay1920low,theJune

1921bottomwasthebeginningofasharprise inpricesandabullmarket thatdidnotenduntil1946.

Gains in theLibertyBondmarket in1920provedmoredurable.AsFigure29shows,LibertyBondprices,unlikethepricesofcorporatebonds,didnotretestthe lowsofMay1920.However,pricegains in the thirteenmonths fromMay1920toJune1921wereroughlyequaltothesamegainsmadeinthefivemonthsfromJunetoOctoberof1921.

FIGURE29.LIBERTYBONDPRICES

Source:WallStreetJournal,7October1921

ThebottomfortheLibertyBondmarketwasclearlyMay1920,butaswiththecorporatebondmarket,therealpickupforthe25-yearbullmarketthatfollowed began in the summer of 1921. While Liberty Bond prices didbenefitfromthedeflationunderwaythroughout1920andmostof1921,thecorporate bond market traded sideways. In the summer of 1921,improvement in the bond market preceded that of stocks. Liberty Bondprices bottomed in the first week of June and the corporate bond indexbottomed in the finalweekofJune.TheDJIAwasnot tobottomuntil 24August.

TheDowJonesCompositeIndexofCorporationBondscomprisedfourdifferentsectors: highest-grade rails, second-grade rails, public utility bonds andindustrialbonds.Theindustrialbondswerethelasttobottom,whichatthetimewas attributed to the fact that many industrial corporations omitted or cut

dividends in the summerof1921,while thedividendoutlook forother sectorswasmorestable.

FIGURE30.DOW,JONES&COINDEXOFRAILWAY,UTILITYANDINDUSTRIALBONDS

Source:FederalReserve,BankingandMonetaryStatistics

At this time, the outlook for bond and equity investors in the railroads wasinextricably linked with politics. The key financial issue for both parties waswhetherthegovernmentwouldpaycompensationforitsunderinvestmentduringthe period of nationalisation, and if so, how much it would be? The earlyimprovement in the railroad bondmarketwas due to a combination of better-than-expectedearningsresults in thesummerof1921,butalsoprogressonthepoliticalfront.AsFigure31shows,therallyinkeybondissueswasunderway,asthedeclineofthestockmarketcontinuedintoAugust.

As Figure 31 shows, the bond market recovery was across-the-board, withparticularlygoodgainstobehadinhigh-yieldingpaperandamongthesecond-grade rails and foreign-government issues.Thematurity of the high-grade railpaper is significantly longer than other sectors and this reflects awillingness,whichwaned from1900, for investors toaccept long-datedpaper in return forhigher yields. (One non-callable railroad bond issued prior to this change in

investment fashionhadamaturityof2862.)LibertyBondyields for8August1921areshowninFigure32.

Thepatternforthebondmarket,atthisstage,wasforgovernmentbondstoleadthe recovery, followed about threeweeks later by the corporate bondmarket.Due to continued economic woes, the industrial sector was the last of thecorporate bond sectors to see an improvement. Particularly important for thecorporatebondmarketwasevidencethatdeflationhadrunitscourse.Deflationhadcreatedhavoc in thecorporatebondmarketas issuerswere lumberedwithnumerous fixed costs, including bond interest payments, at a timewhen saleswere contracting. Corporate bonds were thus particularly sensitive to anyevidencedeflationwasending.Moresothanforequities,thevariablethatbondinvestorswatchedwhenseekingtoidentifythebottomofthebondmarketwasthetrendindeflation.

FIGURE31.KEYBONDSFROMLOWS(ENDJUNE1921)TO8AUGUST1921,YIELDON8AUGUST

FIGURE31CTD.KEYBONDSFROMLOWS(ENDJUNE1921)TO8AUGUST1921,YIELDON8AUGUST

Source:WallStreetJournal,9August1921

FIGURE32.YIELDTOMATURITYOFLIBERTYBONDSANDVICTORYNOTES(8AUGUST1921)

Source:WallStreetJournal

AstheWSJregularlypointedoutinthesummerof1921,manycorporatebondsrepresented excellent investment opportunities when call money could beborrowedforaslittleas4.5%.Aswiththeequitymarket,therewasnogeneraldespairat thebottomof thismarket,butaclamourofopinionbackedbygood

newsthat itwasthetimetobuy.Inthesummerof1921thelackof interest insuchoptimisticadvicecoincidedwiththebottomofthebearmarketratherthananygeneralcrescendoofpessimism.

The bullish dynamic for bonds was evident in the pages of theWall StreetJournal. Inparticular, thecommercialbankswerebecoming increasingly largebuyersofgovernmentbonds,as thedemandforcredit ‘forexpansionpurposeshasalmostceased’(WSJ,27June).Thelowcostofcredit,withcallmoneyratesaround 5%, made the purchase of corporate bonds particularly attractive as‘reasonablysafebondsareavailableatyieldsrangingfrom8%(WSJshouldbetakingadvantageoftheopportunity,and‘severalbankinghouseswhichmakeaspecialty in dealing on bonds are advising their clients to exchange holdingswhichmatureinthenextfewyearsforlong-termbonds’(WSJ,23July).

The key reason for investor nervousness on this obvious trade was thecontinuingnegativeimpactofdeflationoncorporatebalancesheets.So,aswiththeequitymarket, the stabilisationofprices reduced the risks to investors andthus encouragedmore people to borrow short at around5%and to buybondswithconsiderablyhigheryields.Interestingly,therailroadbondswerealreadyatsix-monthhighsasthemorespeculativeissueswerestillsearchingforabottom.A key difference for railroads is that pricing in this industrywasmuchmorecertainand,aslateas1920,theInterstateCommerceCommissionhadapproveda40%riseinfreightratesanda20%riseinpassengerrates.Itisnoticeablethatthesebondswereabletoseeaturnaroundmuchmorequicklythanthosesectorsreliant onmarket forces to produce price stabilisation.With prices stabilisingandgrowingover-subscriptionsforUSandforeigngovernmentbondissues,alltheindicationsweretherethatthecorporatebondmarketwasabouttobottom.

USequities tradedbelow fair value from1917 to 1926.Howwasaninvestortoknowthat1921wastheopportunemomenttoinvest?Aswehaveseen,therewasacombinationofsignalsinthesummerof1921suggestingitwastimetobuy:improvingdemandatlowerpricesforselectedgoods,particularlyautos;commoditypricestabilisation;improvingeconomicnewsbeingignored by the market; rising volumes on a strong stockmarket;fallingvolumesonaweakstockmarket;arisingshortinterest;afinalfallinequitypricesonlowvolumes;reductionsinFedcontrolledinterestrates;arallyinthegovernmentbond

market;arallyinthecorporatebondmarket;positivesignalsfrom the Dow Theory. This is the checklist of features oneneeds to focuson ifone seeks thebottomof thebearmarket.Thebadnewswasthatthenextbearmarketwasverydifferent,andmoreviciousinitsnature.Thegoodnewswasmostofthesignalswereagainflashinggreenatthebottomofthemarket.

Endnotes11AlfredCowles&Associates,1938CommonStockIndexes[returntotext]

12WallStreetJournal,23September1921[returntotext]

13WallStreetJournal,18August1921[returntotext]

14WallStreetJournal,11October1921[returntotext]

15NewYorkFederalReserveBankreport,August1921[returntotext]

16WallStreetJournal,12December1921[returntotext]

17WallStreetJournal,19August1921[returntotext]

18WallStreetJournal,27August1921[returntotext]

19WilliamPeterHamilton,TheStockMarketBarometer[returntotext]

PartII.July1932‘Mort,thewholeshootingmatchpuzzlesme,’Studssaid,sippingcoffee.‘Idon’tunderstandit.Iguesstherewasadepressionrightafterthewar,butIdidn’tpaymuchattentiontoit.

‘Itwasn’tanywheresnearasfrightfulasthisone.’

JamesT.Farrell,JudgementDay

TheroadtoJuly1932leadsthroughthemostfamousbull-and-bearmarketsinthe history of American stocks. From 63.9 on 24August 1921, theDJIA rosealmost500%to381.2on3September1929.Fromthere,itplunged89%beforebottomingoutat41.22on8July1932.Thesedramaticpriceadjustmentsalonewould probably account for the fascination with this period of US history.However,aswellasthesheerdramaofwildpriceoscillation,thestockmarketmappedanirrevocablechangeinUSsociety.

TheroadtoJuly1932Andwhenhisinvestmentsrose,he’dsell,bankhisoriginalcapital,usetheprofitstoplayonotherstocks.Alltheseyearshe’dbeensodumbhehadn’tthoughtofmakingmoneythisway.Otherguyshadcleanedupdoingit,andhehadbeenjusttoodumbtoknowit.

JamesT.Farrell,JudgementDay

Thecommercialballyhooofthe1920swasthestageinAmericandevelopmentwhen consumerism finally triumphed over almost everything that had gonebefore. And, asWilliam Leach observes, Charles Cooley, pioneer founder ofmodernsociology,‘worriedaboutthistrend’.

‘Pecuniary values,’ he wrote in 1912, were not ‘natural’ or‘normal’;theywerethehistoricaloutgrowthofaneweconomyand culture and ‘by nomeans the work of the whole peopleacting homogenously’. In the past, values had taken their‘characterfrom…thechurch’,nowtheywerederivingitfrom‘business and consumption’. Increasingly the worth ofeverything -evenbeauty, friendship, religion, themoral life -wasbeingdeterminedbywhatitcouldbringinthemarket.[20]

ThewordsofF.ScottFitzgeraldfromTheGreatGatsbyquotedinPartIofthisbook relate to the summer of 1922 andwere so “of their time” because theyperfectly illustrated the “new worth” of everything. The seal on thetransformation of America was the publication of advertising man BruceBarton’sbookTheManNobodyKnowsin1924.Bartonwrotethat:

Some day… someone will write a book about Jesus. Everybusinessman will read it and send it to his partners and hissalesmen. For it will tell the story of the founder ofmodernbusiness.

The previous values ofAmericawere transmutingwith little subtlety into theconsumer society. If there is one story from the newspapers of 1932 thatillustratesthechangeinAmerican’sconceptofworthoverthisperioditisfromtheWallStreetJournalof14May.

StateBankCommissionerArthurGuyhasadvertisedforsaleatpublic auction June 6 a cemetery on Memorial Drive at theMaidencityline.Itcontains44gravesandwillbesoldforthebenefit of the depositors of the defunct Highland Trust Co.,recently taken over by the bank commissioner. The trustcompanyheldamortgageonthecemetery.

In1918,Americahonoureditsdead,inthe1920stheymortgagedthem,andbythe1930sforeclosedon them.Givensuchadramaticchange, it isperhapsnotsurprising that this period of stock-market history has attracted so muchattention,entwinedasitiswiththetransformationofacountry.However,unduefocusonthisoneperiodhascreatedamisleadingimpressionofbearmarkets.Asweshallseethroughthecourseofthisbooktherearekeyfactorsthatmake1929-32 unlike the other three major bear markets of the 20th Century.Whileoftencitedas theclassicexampleofabearmarket, itmaybemoretheexceptionthantheruleandthushavemisledgenerationsofinvestors.

ThecourseoftheDow-1921-29

Although theDJIA bottomed inAugust 1921 at 63.9, it was quite some timebeforethegreatbullmarketdeveloped.AslateasJuly1924,theindexwasstillbelow100,andwasbelowitsNovember1919highaslateasApril1925.Bytheendof1924, earningsper share in thebroadmarketwere just above the1919level. One could categorise 1921-24 as a return to pre-recession profit andvaluation.Thisreturnto“normalcy”,awordfavouredbyWarrenHardinginhisrunforthepresidencyin1920,wasveryprofitableforinvestors.ByApril1925,themarkethadrisen87%fromtheAugust1921low,withanaveragedividendyieldsince1921of6.4%.Thiswas,however,justthebeginning.AnnualvolumefiguresfortheNYSEsuggestrapidlygrowinginterestinstocksfrom1925.

FIGURE33.DOWJONESINDUSTRIALAVERAGE–1AUGUST1921TO3SEPTEMBER1929

Source:DowJones&Co.

Eventheinsiders,thosewhoboughtandsoldseatsontheNYSE,didnotbegintoshowanythingbutnormalenthusiasmforthemarketoutlookuntil1925(seeFigure35).

FIGURE34.VOLUMEONTHENYSE–1922-29

Source:NewYorkTimes

Interest in themarketwasalreadygrowing,but thevictoryofCalvinCoolidgeand the Republicans in the November 1924 presidential election is generally

seen as the catalyst for an even greater belief in the positive outlook for USbusiness. Although the decision of the voters was never in doubt, investorsbegan to realise what another four years of Republican administration couldmean for the stock market. Specifically, the Republicans had already proventhemselves reluctantenforcersofanti-trust legislation,only the latest ina longhistoryofinactionbeingthecessationofanti-trustactionagainsttheAluminiumCompanyofAmerica.AndrewMellon,SecretaryoftheTreasuryandoneoftherichest men in America, had already delivered tax cuts and a significantreduction in government spending and more of the same was promised. ForthoseinanydoubtaboutCoolidge’sintentions,hemadehimselfcrystalclearinhisinauguraladdresson4March1925:

Thecollectionofanytaxes,whicharenotabsolutelyrequired,whichdonotbeyondreasonabledoubtcontributetothepublicwelfare,isonlyaspeciesoflegalisedlarceny.

Whathappenedafterthe1924electionwassingledoutforspecialmentionwhentheWSJcelebratedits50thanniversaryon27June1932.

Not for many years had Wall Street witnessed such asensationaladvanceinsecuritypricesastookplaceinthefinaltwo months of the year following the election of PresidentCalvinCoolidge.Notonlymillion-sharedays,buttwo-millionshare days became common and the advances in prices dayafter day were spectacular and sensational, representingspeculativeaswellasinvestmentdemand.

Whiletheelectionprovidedacatalystforthebullmarketinlate1924,itwasnottheunderlyingcauseof thegreatest upswing in themarket’shistory.With thebenefitofhindsight,onecan tracemanycauses.However, the twokey factorswhicharecommoninallmajorbullmarkets,atechnologicalbreakthroughandtheincreasedavailabilityofcredit,wereveryevidentinthegreatbullmarketofthe1920s.

FIGURE35.PRICEOFASEATONTHENYSE–1920-27

Source:NewYorkStockExchange

The great technological breakthrough for the 1920s was rapidly increasingaccess toa technologyfirstoffered to theAmericanconsumeron4September1882-electricity.Growthintheuseofelectricpowerwasslow,withonly8.0%of dwellings wired up by 1907. By 1921, 37.8% of US dwellings wereconnected.By1929,67.9%ofhomeshadelectricity.Againstthatbackdrop,thepercentageoffactorymachinerypoweredbyelectricityrosefrom32%in1919to49%in1929.Salesofcommercialelectricalequipment in1929were146%higherthanin1921.By1929,theUSproducedmoreelectricpowerthantherestoftheworldcombined.Thedramaticgrowthofthisindustryproducedthreekeystimulants for abullmarket in equities - a surge inproductivity, a dampeningeffectoninflation,andaleapindemandfornewelectricalproducts.

The electrification of America boosted productivity and corporate earnings,providingonefundamentalreasonfortheriseinstockpricesduringthe1920s.Realgrossprivatedomesticproductpermanhourincreased19%from1921to1929.Eachunitofcapitaladdedbybusinessin1929was23%moreproductivethanithadbeenin1921.CorporateAmericatookanincreasinglylargeshareofthe national wealth during the decade. Data compiled by the CowlesCommission shows earnings per share for what was to become the S&PCompositeIndexrising455%from1921to1929.Grantedthat1921wasayearofverydepressedearnings,butevenmeasuredfromtherecoveryyearof1923earnings per share for the market increased 64% to 1929. The technology ofelectricity helped boost corporate profits. Perhaps even more importantly, the

growthinproductivitywasacrucialelementinreducinginflationarypressure.Itisoftenthoughtthattheexuberanceofthe1920smusthavebeenassociatedwithrisinginflation.Ifanythingdeflationarytendenciesweremoreevident.

We have seen that 1919-21was a period of gross deflation.More surprising,however,isthatmostpricesintheUSin1929werebelow1921levels.

FIGURE36.PRICEINDICES–1921AND1929

Source:USBureauoftheCensus.

Despitethesurgeindemandinthe1920s,supplywaseasilyabletokeeppace,thusdampeninginflation.MuchofthevastbulkofincreasedsupplycamefromwithintheUSandwasdrivenbyelectrificationandensuingproductivitygains.Foodprices rose from the very low levels of 1921, but remained significantlybelow price levels of WWI. Most everything else fell in price. Anothertechnological change,growth in theuseof themotorcar,playedakey role inkeepingfoodpricesdown.In1900,one thirdofcrop landof theUSproducedfodder for horses. Thiswas increasingly turned over to producing food ratherthan feed asUShorse numbers dwindled.OnUS farms alone therewere fivemillion fewer horses in 1929 than in 1921. To electrification,we can add theimpactofmassproductionoftheautomobileongrowingcorporateprofits,lowinflation and low interest rates. That combination alone would have beensufficientforabullmarketinequities,butthetechnologicaldevelopmentsalsoproducedasurgeindemand.

Theincreasingnumberofhouseholdswithelectricitymeantabiggermarketfordomesticelectricalappliances.Thedollarvalueofsalesofelectricalhouseholdappliances, even during this period of quiescent prices, increased 189% from

1921to1929.Themostnotablegrowthproductwastheradio,withsalesrisingalmost30-fold.Electrificationincreaseddemandfornumerousitemspreviouslyconsidered luxuries - phonographs, washing machines, sewing machines,vacuumcleanersandthe1919inventiononceconsideredtheultimateinluxury-theelectricrefrigerator.New“growth”businessessprangup,andinvestorsonlysawblue-skypotential.Onethingwasmissing,however,andthatwasthehardcashneededby theAmericanconsumer tobuyall theseproductsproducedbyUS“growth”companies.

Asuddenexpansionofconsumercreditwasacrucialfeatureof the1920sbullmarket.Consumercredit in theUSwas,until then,basedon instalment loans,which had been available in the US since at least 1807, though largely theprovinceoffurnitureretailers.Instalmentcreditwaspopularisedfromthe1850sby the Singer Sewing Machine Company, and half the furniture retailers ofBostonwereofferinginstalmentplansby1899.Still,instalmentcreditwasseenasratherworkingclass,andthisformofcreditwasanathematoothersectorsofsociety.AnnaSchwarzandMiltonFriedman, in theirMonetaryHistoryof theUnitedStates1867-1960,observedthatwhileinstalmentcreditwasavailable,itwas“hardlyknown”in1914.Thekeypsychologicalchangecamein1919,whenGeneralMotorsAcceptanceCorporationopeneditsdoors.Inordertobuyanewand expensive consumer durable, themotor car, even themiddle classes tookinstalmentcredit.Itssocialacceptabilityslowlyincreasedandwasextendedtoarangeofconsumerdurables.

Thepercentageofhouseholdsbuyingcarsoninstalmentrosefrom4.9%in1919to15.2%in1929.Writingin1927,WilburPlummershowedhowtheinstalmentcreditplanhadbeenendorsedbymostsectionsofsociety:

Itwasfoundthatfortypercentofthefamiliescanvassedinthepoorerpartoftownboughtontheinstalmentbasis;twenty-fivepercentofthosecanvassedinthemiddleclasssectionsoftownbought in this manner; and five per cent of the well-to-dofamiliesusedthesystem.[21]

Instalment credit was most concentrated in the new goods made practical byincreasingelectrification.

Credit sales rose rapidly during the 1920s, especially in thefield of consumer durables.By 1927, 15 per cent of all suchgoods - some $6 billion in value - were bought throughinstalmentcontracts.Over85percentofallfurnituresales,80percentofphonographs,75percentofwashingmachines,andmore than half the sales of radios, pianos, sewingmachines,vacuumcleanersandrefrigeratorsweremadethisway.[22]

WhenNationalCityBank,thelargestbankintheUS,enteredthepersonal-creditbusiness in 1928, buying consumer goods on credit received a furtherendorsement.

Clearly,suchleveragecouldprovidenumerousbenefitsinanyeconomicupturn,but it also increased the risks of greater-than-normal levels of default in theevent of economic decline.The rapid development of instalment credit duringthe1920swasextremelysignificant,astheoverallmonetarysituationcouldnotbe described as particularly lax. The development of the instalment creditindustryintheUSatthattimeshowshow,eveninwhatseemtobeperiodsofmonetarymoderation,newcreditchannelscanappearofferingcreditwherenonepreviouslyhadbeenavailable.Bullmarketsinconsumptioninkeyareascanbefuelledbysuchdevelopments,evenatatimewhenoverallcreditgrowthremainswithinnormalboundaries.

LivingwiththeFed-Awholenewballgame(II)‘Allright,kidme.ButI’mnosucker.I’mkickingoutmytwelve-fiftyashareandwhenIcollectonit,I’llbecollectingfiftybucksashare.AndthenPat,comeroundandaskmehowaboutsomerealestateoutonthelake,’Ikesaid.

JamesT.Farrell,JudgementDay

As this great technological displacement fed into the general prosperity of theUS,whatwastheFederalReservedoing?CouldinvestorsexpecttheFedtonowonlyutilisetheelasticcurrencyinthelenderoflastresortroleasenvisionedbytheoriginal legislation?Investorswere todiscover that theFed, invigoratedbyitsroleineconomicmanagementfrom1914-21,wouldcontinuetointervenetoreducethepredictabilityoftheoperationofthegoldstandard.Fedactivityhadnotbeen just anunavoidableconsequenceof thewarand itsaftermathbut the

birthofanewpermanentlyactiveandunpredictablevariableforinvestors.Inthetwenties an inflow of gold was dictating an easy monetary policy, but mostmembers of the FederalReserveBoard believed something had to be done tocurb the speculation associated with easier money. A tight monetary policyimposedbytheFedwouldreducethesizeofthecurrentaccountdeficitdictatedby the gold standard alone and thus prevent gold and liquidity moving toAmerica’s trading partners. The longer this halt in the flowof gold, themoredifficult it would be to accomplish reconstruction of the international goldstandard.Thesedualobjectives,tocurbspeculationandalsotoensureadequategold flows to trading partners,would complicate policy responses in 1927-29,when speculative activity reached ever-higher levels. Once again the Boardbelievedtherewereexceptionalcircumstancesthatwarrantedmanagementoftheelastic currency and not the unfettered operation of the gold standard. Onceagain,as ithaddonefrom1917-21, thiswas tosignificantlycomplicate thingsforinvestors.

Therewasgoodreasonfor theFedtobeconcernedaboutpermittingexcessiveeconomicgrowthinthepostwarperiod.TheFedwasconcernedthatgoldwouldbenaturallyredistributed,as thegoldstandardwasreconstructed,anditwouldbedangerous topermit thecreationof credit structures in theUSbasedon itspermanency.ThishesitancytopermitalargeamountofcredittobebuiltonthemonetarygoldstockisunderstandablewhenonelooksatthescaleoftheflowofgoldtotheUS.SinceWWI,theUShadbeensittingonamonetarypowderkegandthesupplyof“gunpowder”increasedmateriallyinthefirsthalfofthe1920s.

FIGURE37.MONETARYGOLDHELDBYCENTRALBANKS/TREASURIES(%OFWORLDTOTAL)

Source:TimothyGreen,CentralBankGoldReserve.

In 1921, only the United States and five other countries (Cuba, Nicaragua,Panama, Philippines and Salvador) remained on the gold standard. It wasexpected that, when the postwar economic adjustments had been completed,mostcountrieswouldwishtoreturn.Choosinganexchangerateforthereturntothe gold standard would be a political decision, and if politicians in othercountrieschosetodeliberatelyundervaluetheircurrencies,thenmajoroutflowsof gold from theUS could be expected.TheFed had contingency plans for adramatic gold outflow. From 1923 to 1929, it intervened to sterilise goldinflows, acting to dampen the growth in high-powered money, the totalmonetarystockandthereforegrowthofcreditandtheeconomy.If theUShadbeen operating without the Federal Reserve System, then money would havebeen considerably easier in the 1920s. However, as the decade wore on, theexpected dramatic gold outflow failed to materialise, possibly due to warreparationsandrepaymentofwardebt.AsHughBancroft,PresidentoftheWallStreetJournalandhusbandofitsowner,argued:

The reparations and war-debt settlements set up a new andarbitraryforce,not responsive to thenormaloperationsof thelawofdemandandsupply,whichremorselesslydrained$500millionayearfromtherestoftheworld…Finally,whenmorethan 70% of the world’s stock of monetary gold had been

concentrated in the United States and France, there wasn’tenough gold left in the rest of the world to sustainconfidence…[23]

By the end of 1924, seven countries had returned to the gold standard and afurther11didsoin1925,bywhichtimetheUSauthoritiesheld43.2%ofworldgold reserves. Fully 48 countries had returned to the gold standard by 1929.However, only after 1925 did the US share of gold reserves begin to slowlydeclineassomecountries,notablyFrance,chosetoundervaluetheircurrencies.While France undervalued its currency, a not surprising political decision, theBritishdecidedtoreturntothegoldstandardataratewhichclearlyovervaluedsterling.ThenetimpactwasthattherewasnodramaticdraininUSreserves,andit canbeargued thatby sterilising thegold inflowand reducingmonetaryandeconomicgrowth, theFed restrained the amount of gold thatwould otherwisehavelefttheUSbecauseofbalanceofpaymentsdeterioration.IftheFedhadnotpursued a sterilisation policy, one can only surmise that the US would haveundergoneaboom-bust scenariomuchearlier in thedecade - and it isunclearwhether itwouldhavebeenquiteon the samescaleas theboom-bust thatdidensue.TheFed’smonetary restraintwas ratcheted up from1928onwards andthemoneystockatthepeakoftheeconomyinAugust1929wasactuallylowerthanithadbeen16monthsearlier.SotheFed’sactivitiescannotbesaidtohaveadded to the speculative frenzy of the 1920s. The figures for credit growthduringthedecadedonotindicatetoolooseamonetarypolicy.

FIGURE38.ALLBANKS’GROWTHINTOTALASSETS,LOANSANDINVESTMENTS($M)

Source:FederalReserve,BankingandMonetaryStatistics

Thecredit-growthfiguresinFigure38needtobeviewedfromtheperspectiveofa 42%growth in nominalGDP from1921 to 1929, againstwhichbank creditgrowthdoesnotnecessarilysuggestexcess.Ithasbeenargued,byJ.K.Galbraithamongothers,thattheFedshouldhaveadoptedaneventightermonetarypolicybut this would have had dire consequences for the reconstruction of theinternational gold standard. Could the US economy really have remainedunaffectedbytheeconomicchaosiftherestoftheworldhasbeenforcedagainfromthegoldstandard?Perhapsthefailuretocontracttheelasticcurrencyevenfurther was driven by international considerations but they were internationalconsiderationswhichhadverydirectconsequencesforAmerica.TheFeddidactto constrainmonetary growth and during the 1920s had considerable success.Onecouldarguethatsuchconstraint,whichrestrictedtheflowofgoldtothosecountriesindesperateneedofgold,wasakeyfactorincreatingtheinternationalcrisis thatwas to hitAmerica inSeptember 1929.Clearly, thiswas a difficultbalancingactfortheFedtogetright.

There is little evidence of any general excessive easing in monetary policyduring the period. As well as the sterilisation policy, the Fed, as in thecommodity boom of 1919, attempted direct restraint in areas of speculativeactivity,andinthesecondhalfofthe20sthecapitalofspeculativeactivitywasWallStreet.

As early as 1925, just as the real bull market was getting underway, somemembersoftheFedwereconvincedthattoomuchcreditwasbeingchannelledtowards “speculative” rather than “productive” purposes. It became clear thatWallStreet inparticularwas increasinglyattracting these so-called speculativeloans.WhatcouldtheFeddoaboutit?Themethodsuggestedbythemajorityofthe Board to tackle this “abuse” of the system was to refuse rediscountingprivileges to those member banks judged to be making excessive loans onsecurities. It was not entirely clear whether the Federal Reserve banks couldlegally do this. A split developed within the Federal Reserve Board amongstthosewhofavouredsuch“direct”pressuretotargetspeculativeloansandthosewho believed a rise in the discount rate was the more appropriate response.Althoughdebatecontinued,theneedforactionbecamemoreapparentby1928asthebullmarketinstocksshowednosignsofabating.

FIGURE39.BROKERS’LOANSBYSOURCE–1927-29($M)

Source:FederalReserve,BankingandMonetaryStatistics

Figure 39 shows how credit was being sucked in from across the country tofinance the purchase of stocks. By the end of 1929, loans in theUS bankingsystem totalled$41.9billion.Total loans tobrokers in1929, fromall sources,were thus the equivalentof20%of totalbank loansoutstanding.TheFedhaddrawnupa listof100memberbanks itconsideredtobefinancingspeculationandshouldbesubjectedto“direct”pressure.Thiscouldperhapshaveworkedto

reducetheamountofbankcreditbeingdirectedtowardsWallStreet,butitwasunlikely toprevent therushofcredit fromothersources.ThetotalvalueofallstocksandbondslistedontheNYSErosefrom$27billionattheendof1924to$89 billion by the end of October 1929. During that period, loans fromNewYork banks to brokers barely increased, and loans from outside banks werelowerinOctober1929thantheyhadbeeninJune1925.AsFigure39shows,theflowofcreditforstockspeculationwascomingfromnon-banks.Thesourceofthe“speculative”loansrushingtowardsWallStreetwasnotthebankingsystem,soitisnotclearhow“direct”pressureonmemberbanksadvocatedbytheFedwas going to work to reduce speculation. Indeed, there is ample anecdotalevidencethatfundswereflowinginfromaroundtheglobetofinancethelendingboomonWallStreet.NotuntilFebruary1928didtheFederalReserveBankofNewYork implement thefirst rise in interest rates, recognition inpart that theattempttotargetspeculativelendinghadfailed.

TheNewYorkFed’sdiscountraterosefrom3.5%inFebruary1928to6.0%byAugust 1929. However, as Figure 39 shows, the growth of loans to brokersacceleratedduringthatperiod.Theriseinthediscountrateflowedintothecallmarketandcall-moneyratesrosefrom4.24%inJanuary1928to9.23%inJuly1929.TherewasasmallpanicinthestockmarketinMarch1929ascall-moneyratesbrieflyexceeded20%,thoughasratescamebackdownbelow10%itwasbusiness as usual. Loans to brokers continued to grow and the stock marketcontinued to rise. The apparent large rise in interest rates was too small toprevent more borrowing and speculation in an environment where excessivecapitalgainswereassumedtobenormal.ByJuly1929camethefirstsignstherise in interest rateswasaffecting theeconomy,even if itwasnot interruptingtheupwardsurgeofthestockmarket.Iftheriseininterestratesworkedtocurbspeculation, the evidence is that it did so by reducing economic activity,threatening corporate earnings growth and undermining the fundamental valueof stocks. By September and October, the actions of the Fed were curbingspeculationbecausetheywerecurbingoveralleconomicactivity.

Investors might have originally expected the Fed would be a quiescentorganisation ready to act as lender of last resort when necessary. It had beenactive since its inception primarily due to the national emergency of war.However, it becameclear in the1920s that it believed it hadan active role inmonetarypolicy.Fed-watchinghadbeenborn,and in1928-29 itwasclear the

policyoftheFedwastoendthespeculativefrenzyinWallStreet.Ittookoverayear, but the sledgehammer needed to crack the nut of speculative activity onWallStreetsignificantlydamagedtheeconomyintheprocess.

ThecourseoftheDow-1929-32It’sgoddamntoughwhenapoormansavesalittlemoneyandthinksthathe’sgotsomethingputasideforhisoldage,andthenthebankgoesbust.It’sgoddamnrotten.AndIsupposethecrookedbankerswhostoleallthemoneywillgofree.

JamesT.Farrell,JudgementDay

Sowhatbroughtthepartytoanend?SignsofslowingintheUSeconomywereevident by the early summer of 1929. In June, the indices of industrial andfactoryproductionpeaked,andyear-on-yeargrowthofmotorvehicleproductionwasslowing.TheNBERreferencedateforthepeakoftheeconomicexpansionisAugust1929.Aslowdownhadbeenunderwayforsometimeinotherpartsofthe world. In Australia and the Netherlands, economic deterioration began asearlyas1927,andby1928GermanyandBrazilhadslumped.Argentina,CanadaandPolandfollowedinthefirsthalfof1929.

Throughouttheboomperiodofthe1920s,theUSranacurrentaccountsurplus,andthefailureofthecountrywith43%oftheworld’sofficialgoldreservestorun a current account deficit restricted growth opportunities in other countriesreturning to the gold standard. Higher US economic growth would havenaturallyledtoanoutflowofgoldandeasingmonetaryconditionsoverseas,butthisdidnotoccur.FurthercomplicatingtheissuewasthatWallStreetactedasamagnet for capital, whether for direct investment in securities or lending atsometimesdouble-digitinterestratestoinvestorsforthepurchaseofsecurities.Thiscapital,undermorenormalcircumstances,mayhavefounditswaytootherjurisdictions, easing liquidity conditions. The slowdown in capital outflowbecameparticularlypronouncedin1929whenprivatecapitaloutflowsfromtheUnitedStatesfell42%fromtheaveragelevelof1927-28.

Thosecountriesseekingtomaintainacommitmenttothegoldstandardhadnoalternativebuttopursuedeflationarypoliciesintheabsenceofanyimprovementofthecurrentaccountwhentheiraccesstoforeigncapitalbecamerestricted.TheviolentgyrationsonWallStreetinSeptemberandOctober1929mayhavebeen

partly a belated realisation that the rest of the world was being forced intodeflationbytryingtoadheretothegoldstandard.As1929progresseditbecameclearerthat,ifthegoldstandardwasmaintained,theUSfacedlowerexportsduetoforeigndeflationarypolicies,andifthegoldstandardbrokethencompetitivedevaluations threatened a similar disruption. Overseas economic deteriorationmayhavebeenindicatingthepossibilityofaneconomicdeteriorationintheUS,whichwasbecomingapparenttoinvestorsbySeptemberandOctoberof1929.[24]

TheDJIApeakedon3September1929andhadfallen32%by28October,theeveofwhatwouldbeknownas‘thedaythebubbleburst’.WhateverfactorwascausingtheliquidationofstockswasalreadyinplaywellbeforethatfinalmadweekofOctober.AsSeptemberworeon,evidencethatthenewglobalmonetarysystemwasunderseverepressurebecameclearer.On26September,theBankofEngland raised itsdiscount rate from5.5%to6.5%.Thiswas in response toadrain in gold and took interest rates to the highest level in eight years. PhilipSnowden, the Chancellor of the Exchequer, said the action was necessary topreventthedrainofcapitaltothat‘orgyofspeculation3,000milesaway’ [25] .Theinterest-ratedifferentialbetweentheUSandtheUKchangeddramatically,alsodrivenbyadecline in thecallmoney rate from10%to5% inNewYorkduringthefirsttwoweeksofOctober.Thedemandforloansforthepurchaseofsecuritieswasdryingupandthepriceofsuchloanswasdeclining.Withsterlingstrengthening, it was becoming increasingly likely a gold drain from the USwouldoccur.ThetimingoftheBankofEngland’sincreaseininterestratesthushelpedunsettleinvestorsintheUS.

Other events in late September and early October further tested the nerve ofinvestors. On 30 September, the UK business empire of Clarence Hatrycollapsed.Hatry,whohadbeentryingtoconsolidatetheUKsteelindustry,wasforging scrip to raise more finance. The stock market grew suspicious of theincreased supply of shares in the market and the stock prices of Hatry’snumerous interests went into free fall. The banks, seeing the value of theirsecurity shrink, restricted credit and the game was up for Hatry. The suddencollapseofamajorbusinessenterprisecreatedconcernaboutthefoundationsatother businesses.A further blow to confidence came on 11Octoberwhen theMassachusetts Department of Public Utilities refused permission to BostonEdisonfora4:1stocksplit,andaccompaniedthedecisionwithastatementthat

‘no one, in our judgement…on the basis of its earnings,would find it to hisadvantage tobuy it’.ThecoverofTimemagazine indicated thehigh levelsofpublic interest in business and investment; on 28October it featured SwedishfinancierIvarKreugerandon4NovembertheChicagoutilitiesmagnateSamuelInsull. By 1932, Kreuger had committed suicide after his business empirecollapsed and Insull was fighting extradition from Greece on charges ofembezzlementandmailfraud.

Whatever triggered thedecline in themarket, there is general agreement as towhy it was of such significant magnitude - the unwinding of many of theexcessesof thebullmarket. In particular, any fall in thepriceof equitieswaslikelytobeexacerbatedwhenleverageovertheseassetshadreachedsuchhighlevels.

Publicparticipationinthemarkethadrisendramatically.Bestestimatessuggestthat half a million Americans owned securities prior to WWI. By 1929, thenumberhadrisentoasmanyas20million.Itisunlikelyallthesesmallinvestorswereconversantinthebasicprinciplesofequityvaluation.Wheninterestinthestockmarketbegantowane,thedownsideforpriceswaslikelytobelargerthaninperiodsoflesspublicenthusiasm.Theunwindingofpublicparticipationtookitstoll,asdidtheunwindingofthepositionsofsomeoftheinvestmentvehiclescreatedtoattractfundsofsmallinvestors.Whileitissafetoassumethepublicwasuneducatedinthewaysofthemarketsinthe1920s,thesamecouldalsobesaidformost“professional”investors.AsHughBullockopinedin1932:

InvestmentmanagementinGreatBritainisaprofession.Thereare approximately 200,000 seasoned,marketable securities intheworld. It takesspecialists to find thebest.We inAmericaaresomewhatnewtothebusiness.ButIbelieveyouwillseeaclassofmengrowupwhoareashonest andableas those inBritain.[26]

Bullock’s commentsweremade in light of the often negligent and sometimesfraudulent activities of the professional managers of investment trusts in theperiod.Although the investment-trust business had been playing an increasingroleintheLondonStockExchangesince1868,by1920therewereatmost40investment trusts in the US, and they were of negligible importance. Then,between 1927 and 1930, 700 investment trusts and investment holding

companies were created to take advantage of the public’s demand forinvestment-management expertise. In 1929 alone, 265 new investment trustswereformedwith$3billionincapitalsubscribed.InSeptemberofthatyear,halfof the $1.2 billion share capital raised through theNYSEwas for investment-trustcompanies.Atthepeakofthemarketthissectoraccountedforatleast$8billion of market capitalisation. While many of these trusts were reputableinvestment vehicles, others indulged in dubious practices - the purchase ofilliquid stock, buying shares from the company’s own directors, manipulatingtheprice of holdings, using funds to buy failed issues fromconnectedparties,excessive gearing, stock-bonus allocations to managers, and extremeconcentration of investments. Given the nature and extent of Wall Street’smisallocationofcapitalintheeconomicupswing,itwasnottoosurprisingthatsignificant capital destructionwould follow. That the inevitable destruction ofcapitalwouldbefollowedbyaglobaldepressionwashardertoforesee.

Fromitspeakon3September1929,themarketfell48%by13November.Theinitialdecline toaroundmid-Octoberwasrelativelymild,butfrom10Octoberto13NovembertheDowJonesIndustrialAveragefell44%.AlthoughthepaceoftheOctoberdeclinewasunprecedented,thescalewasnotexceptional(Figure40).

FIGURE40.20THCENTURYBEARMARKETSINTHEUSUPTO1929–DECLINESINTHEDJIA

Source:DowJones&Co.

While thedecline inpriceshadbeenunusually rapid, therewassoonevidencethe recoverymight alsooccurmorequickly thanusual.By17April1930, themarket had recovered 52% of the decline and was back where it was at thebeginningof1929.Themarketwasnowjust23%belowitshighof3September

1929.Themagnitudeofthedeclinehadnotbeenabnormalandthereboundhadbeenmore rapid thannormal.While thesuddennessof thedecline inprices inOctober1929playssomeroleinthehistoricallegacyof“TheGreatCrash”,itiseventsafterApril1930thatareprimarilyresponsibleforthisperiodoffinancial-market history looming so large in the psyche of investors today. Investorsunfortunate enough to believe themarket recoverywas on a firm footing andwhoboughtequitieson17April1930sawtheDJIAdiveagain,losing86%ofitsvaluebeforeitbottomedinJuly1932.ThusthemostdramaticlandscapeontheroadtoJuly1932cameafterApril1930.

Ifthereisonekeydifferencebetweenother20thCenturybearmarketsandwhathappenedin1929-32,itisthecollapseofthebankingsystem.Bankcollapseandfearofbankcollapsehadcertainlyplayeda role inpreviousbearmarkets andrecessions. The panic of 1907 involved numerous bank and trust companyfailures,and thatexperience leddirectly to thecreationof theFederalReserveSystem. In 1916-17 and again in 1919-21, the new system seemed towork incontaining the scourge of bank collapses, in even the most trying economicconditions. The ability of the Federal Reserve System to ‘furnish an elasticcurrency’seemedtowork,preventingmoneypanicandmassbankclosure.AsFigure41indicates,whatultimatelyturnedthis“ordinary”bearmarketintothegreateststockmarketcrashinUShistorywerethebankingcrises.

FIGURE41.BEARMARKET1929-32–EACHPHASEANDITSCONTRIBUTIONTODJIADECLINE

Source:DowJones&Co.

Compare the stuttered decline of the stock market with events in the widereconomy. Figure 42 uses available monthly and quarterly data to map theprogressoftherecession.

FIGURE42.PROGRESSOFECONOMICDECLINE–ENDJUNE1929(INDEX=100)TOJUNE1934

Source:USBureauoftheCensus.

Figure 42 maps the 1929-33 recession and shows that, by mid-1930, the USeconomyhadnotbeengreatlyaffectedbythestockmarketcrasheightmonthsbefore.Inthe12monthsfromJune1929,theeconomycontractedby1.8%andtheconsumerpriceindexfell0.9%.Thepaceofdeclinewasconsiderablymorerapidinfactorypayrolls,thewholesalepriceindexanddepartmentstoresales.Intheoveralleconomy,thepaceacceleratedmarkedlyinthesecondhalfof1930,influencedbythefirstbankingcrisis,whicheruptedinOctoberofthatyear.Thefirst half of 1931 saw the onlymarginal recovery in the economy during the

1929-32contractionasGNPandrealdepartment-storesalesbothincreased.Thisrecovery was thrown off track by the second banking crisis, apparentdomestically in March 1931 and intensified by the banking crisis in Europe,whichhittheheadlinesinearlyMay.

Intermsofthecourseoftherecession,asmeasuredbyGNPinconstantdollars,only35%ofwhatwastobethetotalcontractionhadoccurredbytheendofJune1931. The real break from the normal pattern of the business cycle was theimpact of the secondbanking crisis and growing concern about exchange ratestability,which from June 1931 toDecember 1932 accounted for almost two-thirds of the total economic contraction. This tale of economic decline has aclear relationshipwith the decline in the stockmarket.ByFebruary 1931, themarket’s decline had been larger than that of 1907 and 1919-21, but notmateriallyso.Allthedreadfulnewexperiencestobevisitedoninvestorscameafterthefirsthalfof1931-upuntilthen,theeconomiccontractionandthebearmarkethadbeen“normal”.

Bankfailureshadbeenrunningathighlevelsthroughoutthe1920s,withmanyyearsseeingagreatervalueofdepositsaffectedbysuspensionthaninthesevererecessionaryyearof1921.

Thehighlevelofbankfailuresduringthe1920swastheresultofhardtimesinthe farming sector and increased competitive pressures due to bankamalgamations. However, even by those high standards of failure, somethingclearly different was underway in the final quarter of 1930. By the end ofOctober1930, the total valueofdeposits affectedbybank suspensions for theyear was $287 million. The Federal Reserve did not seem perturbed by thebusiness contraction at that stage and, despite reducing the discount rate, hadbeenreducingcredittomemberbanksthroughouttheperiod.BasedonthedataavailablebyJune,onewouldhaveexpectedthetotalvalueofdepositsaffectedbysuspensiontohavebeenlessthan$350millionfortheyear-ahighlevelbyhistorical standards, but theUSeconomyhadnot beenunduly affectedby the$260millionofdepositshitbybanksuspension in1926.However,NovemberandDecemberof1930produced$550millionworthofdepositstiedupin608banksuspensions,puttingthelevelofdamagetothefinancialsystemonawholenewscale.Even in the fourthquarterof1930most failedbankswere those inagriculturalareas,alreadyweakenedbythehardshipsofthe1920s.

FIGURE43.TOTALCOMMERCIALBANKSUSPENSIONSBYTOTALDEPOSITS($M)

Source:FederalReserve,BankingandMonetaryStatistics

Crucially, one of the banks to fail in this periodwas the Bank of the UnitedStates,amemberoftheFederalReserveSystem.ItwasthelargestbankfailureinUShistory.Thiswasnocountrybankandits400,000depositorswereheavilyconcentrated in New York City. When they lost their money, depositorselsewhere began to perceive material risk. From mid-September to mid-December 1930, the Dow Jones Industrial Average crashed through theNovember1929low,declining36%.

Publicbehaviourchanged,asdid thebehaviourof thebanks.UpuntilOctober1930, publicwillingness to hold bank deposits actually continued to increase.This increase in the ratioof deposits to currencyheldby theAmericanpubliccontinued a trend which had been evident throughout the 1920s. By October1930, the deposit-currency ratiowas at a newhigh, indicating an unparalleleddegree of faith in the banking system just as the first banking crisis arrived.Therewasnowamajorriskthatevenifthepublicdecidedtoreduceitslevelofdeposits to historically “normal” levels, a major monetary contraction wouldensue. FromOctober 1930, such awithdrawal of deposits began, but perhapsnone could have anticipated the contraction in the deposit-currency ratio thatensued,from11.5inOctober1930tojust4.4inMarch1933.Beforethepublic’s

withdrawalofitsmoneywasover,thedeposit-currencyratiowouldbereducedtolevelsnotseensincetheendofthe19thCentury.Giventheoperationofthefractional reserve banking system,where banks had tomaintain cash balancesmuch smaller than their deposit base, this drain of cash from the banks had averynegativeimpact.Inthisperiodthebanksneededtoreducedepositsby$14in order to make $1 available for the public to hold as currency. The hugemonetaryimpactofsuchdepositflightandtheinability,orunwillingness,oftheFederalReservetocounteractit,isthekeyreasonwhytheUSrecessionof1930developedintothedepressionof1931-32.

Totaldeposits in theUSbanking systemdeclined from$59,828million at theendofJune1930to$58,092millionbytheendoftheyear.Thisinitialdeclinewasmodest but it kick-started a processwhich, combinedwithFed inactivity,resulted in very negative impacts for bank balance sheets. The banks reactednormallytodepositflightbyseekingmoreliquidassetsfortheirbalancesheets.Thishada significant impact,as thebanks tended to shift theirholdingsawayfromcorporatebondsandintogovernmentsecurities.PricesofcorporatebondshadbeenrisingslowlysincethestockmarketcrashofOctober1929.However,with the onset of the banking crisis ofOctober 1930, prices began to decline.Whileslowatfirst, thiswasthebeginningofanewpricetrendthatwouldnotrun its course until the summer of 1932. It exacerbated problems for bankersgoinginto1931astheywereforcedtomarktheseliquidinvestmentstomarket.

Thereweresomesignsofeconomicstability inearly1931,but thisresultedinonly amodest rally in the equitymarket.During the banking crisis, theDJIAreachedalowof157.5on16December1930.By24February1931,ithadrisen23%andwasjust2.2%belowthelowofNovember1929.Evenatthisstage,themagnitudeofthedeclineintheindexwasonlymarginallyinexcessofthe1907and 1919-21 bear markets. It was now that the second bank crisis hit. Aninvestor committing funds to equities on24February1931, almost 16monthsaftertheOctober1929crash,wouldwitnessa79%dropintheDJIAinthenext17 months. It was this period of decline that marked out the bear market asclearlydifferentfromanythingbefore.

Prior to the first banking crisis, long-and short-term interest rates had beendeclining,ashadyieldsonBaa-ratedbonds.However,ayieldspreadthenbegantoopen,basedonthequalityofcorporatecredits.Bankssearchingforliquidityweredumpinglowerqualitybondsforgovernmentsecurities.Withtheonsetof

anotherfloodofbanksuspensionsinMarch1931,thebanksagainstrengthenedtheirreservepositions.BankfailuresincreasedrapidlyinMarchandconfidencewas further undermined in May when Austria’s largest private bank, Credit-Anstalt,failed.TheAustrianauthoritiesrespondedwithnumerousmeasures,oneofwhichwasexchangecontrols, freezingforeignbankbalances inAustria.AsCredit-Anstalt had a controlling interest in Hungary’s biggest bank, a run ondeposits began there in mid-May. The panic spread to Germany. Theintroduction of exchange controls in Austria had created concern amongdepositors inGermanbanks that thebalance sheet of their institutionsmaybeundermined.AsmorethanhalfofallGermanbankdepositswereownedbynon-Germans,alossofconfidencebytheseinvestorshadveryseriousinternationalconsequences. There was a full-scale banking crisis in Germany by July andexchange controls followed. As US bank deposits in Austria, Hungary andGermany were frozen, the stability of US bank balance sheets were furtherundermined.ThisfurtherquestionmarkoverUSbankbalancesheetspromptedthe American public to hold even greater cash balances at the expense ofdeposits.Totaldepositsofallbanksdeclinedfrom$58,092millioninDecember1930to$56,092millioninJune1931,then$49,509millionbyDecember1931.TheUSbankingsystemheld less indeposits inDecember1931 than ithad inDecember1924.Thebankswereforcedtoagainadjusttheirassetportfoliosandcorporatebondsweredumpedwithpricessinkingfurther.

The US was now beset by its second banking crisis in less than a year. Thecountry’sleadingexpertshadconfidentlypredictedtheFederalReserveSystemwould prevent such events. In the Saturday Evening Post of 14 April 1928,SecretaryoftheTreasuryAndrewMellondeclaredtheretobe:

…nolongeranyfearonthepartofthebanksorthebusinesscommunity that some sudden and temporary business crisismay develop and precipitate a financial panic such as visitedthecountry informeryears…Weareno longer thevictimsofthe vagaries of the business cycles. The Federal ReserveSystem is the antidote for money contraction and creditshortage.[27]

The Federal Reserve System offered no such antidote. Those investors whoremained committed to equities expecting the re-extension of the elastic

currency must have watched in amazement as nothing was done. The Fedreducedthediscountrateasrecessionandthendepressiondeveloped,buttherewasnoattempttoincreasecredittomemberbanks,evenasthepublicwithdrewdeposits from thebankingsystemandcommercialbanksdumpedbonds in thescrambleforliquidity.In1921,oneofthekeyquestionsforinvestorswashowfarFedcreditwouldshrinkfromitspeaklevelsofaround$3.5billionin1919.Few could have foreseen the contraction continuing until mid-1924, when itstoodjustbelow$1billion.Insummer1931,Fedcreditoutstandingwasagainvery close to that lowof 1924.The economyexpandeddramatically over thatperiodandtherewasclearlyamplescopetoextendthe“elasticcurrency”fromthese very low levels.However if, asAndrewMellon had asserted, the Fed’sabilitytoextendcredittothesystemwastheantidote,thenthedoctorsfailedtoadminister it. Not until late in the summer of 1931 did the Fed begin anymaterialpurchaseofbillsandcommencetoextendcredittomemberbanks.Bythatstage,however,thepublic’sfaithinthebankingsystemhadslumped,withthedeposit-currencyratiobelow9.0fromitspeakof11.5inOctober1930.Asthebankingsystemshooktoitsfoundations,anewstageofthemonetarycrisisemergedas theUSmonetarygoldstock,atanall timehighofmore than$4.7billionaslateasAugust1931,begantodrainaway.

The damaging gold drain from theUS began in September 1931 as investorswere shocked by the devaluation of sterling. Eight other countries quicklyfollowedsuit,andafurtherfourjumpedshipinOctober.Foreigninvestorshad,throughouttheworseningeconomicproblems,decliningstockmarketandbankcrisesintheUS,maintainedtheirfaithinthegoldvalueoftheUSdollar.FromSeptember1929 toAugust 1931,USgold stocks increased15%,with37%ofthe increase coming inMayand Juneof1931asEurope’sownbankingcrisissent capital fleeing for the “safehaven”of theUS.Britain’sdesertionofgoldchangedthingsdramaticallyandtheUSgoldstocksdeclined15%fromAugusttoOctober1931,erasingthetotalinflowsince1929.InvestorsarguedthatiftheUKcouldabandonthegoldstandard,therewasarisktheUSwouldfollow.

Thecombinationof adrainongold reservesandcurrencywithdrawals furtherexacerbated pressure on the commercial banking system, which wascompounded by rising interest rates. The Federal Reserve acted as the goldstandarddictated,raisingthediscountratefrom1.5%to3.5%inOctoberwithaviewtohaltingthedrainofgoldfromthecountry.Commercialbanksonceagain

rushedtodumpassetsinthescrambleforliquidity.Now,forthefirsttimeintherecession, even the price of government securities declined. Investors whoexpectedthatgovernmentbondswouldprovidenominalreturnsinadeflationaryperiodwerenowinforamajorsurprise.Withbanksforcedtoreducethevalueof their government-bondholdings, balance sheet conditions furtherworsened.In the six-month period of August 1931 to January 1932, 1,860 banks withdepositsof$1,449millionsuspendedoperations- thesameamountofdepositsaffectedbybanksuspensionsintheentire1921-29period.Thesecondbankingcrisiswas of amuchmore serious nature than the first and, though operatingfrom lower levelsof theDJIA, accounted for32%of the entiredeclineof themarketfromSeptember1929toJuly1932.

By 5 October 1931, the Dow had declined 77% from its peak in September1929. Even the pessimistic investor may have considered that this scale ofdeclinewas sufficient to augur the endof anybearmarket.Someof the signswere indeedpositive as theHoover administrationwas finally spurred to try anew approach to the crisis. In October 1931, the National Credit Corporationwas launched, aimed at extending loans to banks against assets deemedunacceptableassecurityforcreditbytheFederalReserveSystem.InFebruary1932, the Republican administration created the Reconstruction FinanceCorporationtoprovideloanstobanksandrailroads.By26February,theFederalReserve Board was sufficiently relaxed about gold outflow to reduce thediscountrateby50basispointsto3%.On17February,theGlass-SteagallActwaspassed,permittinggovernmentbonds toserveascollateralagainstFederalReserve bank notes, thus removing a technical bar to the creation of greaterliquidity by the Federal Reserve System. The DJIAwasmarginally higher inMarch1932thanithadbeeninOctober1931.InvestorswhothoughttheworstwasoverandboughtinattheMarch1932highweretolose54%oftheirfundsbeforethemarketbottomedinJuly.

Thefinalblowtothemarket,whichaccountsforaquarteroftheentirebearrun,wasprimarilyduetoareneweddrainongoldfromtheUS.FromMarch1932totheendofJuly,USgoldreservesdeclinedafurther12%.Atthetime,theWallStreet Journal attributed the outflow to the growing number of bills beforeCongress seeking to increase government spending. The burgeoning fiscaldeficit, it argued, convinced foreigners thatUSadherence to thegold standardwas under threat. However, it is more likely the Federal Reserve’s move to

large-scaleopen-marketpurchasesofgovernmentsecuritiescausedforeignerstotake fright. Still, there was a heady cocktail of reasons for foreigners to beselling US dollars in early 1932. Barry Eichengreen argues that devaluationselsewherethreatenedtoerodeAmerica’scurrentaccountsurplus.

ThegreaterthepressureontheFederalReserveBoardtoadoptreflationary initiatives, the greater the risk of dollardevaluation. The continued rise of American unemploymentonly intensified that pressure. With 1932 an election year,Congress was sure to exhort the Fed to respond moreaggressively. Speculators consequently liquidated their dollardeposits,andcentralbanksconvertedtheirdollarreservesintoAmericangold.[28]

ThereisnodoubttheFed’slaunchofasignificantopenmarketoperationatthislate stage was prompted by the fear of direct political involvement in themonetary sphere. George Harrison, governor of the Federal Reserve Bank ofNewYork, told theexecutivecommitteeofhisdirectors that ‘theonlyway toforestall somesortof radical financial legislationbyCongress, is togo furtherandfasterwithourownprogram’. [29]Investorshadgoodreason toworry thatpoliticians,byinclinationpronetoinflationarypolicies,werenowinthedriver’sseat instead of the central bankers, doyens of sound money. These investorsargued thatFedactionsnowshowed that reflation, andnot soundmoney,wasthe target. The change in policy was particularly alarming to foreign centralbanksholdingUSdollarsintheirreservesunderthegoldexchangestandard.Ifthisnewpolicyalignmentcontinued,thenitwasevenmoreprobablethattheUSwouldabandonthegoldstandard.ForeignersbegantowithdrawbalancesfromtheUSandmanyonWallStreetbelieveddevaluationofthedollarwaslikelybythe summer. The Fed’s belated conversion to reflationary policy, rather thanencouraging investors, produced a final panic on Wall Street. Against thisbackground of increasingly likely devaluation and continued economicdeterioration, thebearmarket inequitiescontinued.TheDJIA,assailedby thecrash of October 1929, the first banking crisis of October 1930, the secondbankingcrisisof1931andthegolddrainof1932,wasabouttohitbottom.

Endnotes

20WilliamLeach,LandofDesire:Merchants,PowerandtheRiseofaNewAmericanCulture[returntotext]

21WilliamPlumer,SocialandEconomicConsequencesofBuyingontheInstalmentPlan1927[returntotext]

22RobertSobel,TheGreatBullMarket-WallStreetinthe1920s[returntotext]

23WallStreetJournal,1August1932[returntotext]

24BarryEichengreen,GoldenFetters:TheGoldStandardAndTheGreatDepression,(1919-1939)[returntotext]

25AddresstoLabourPartyConference,Brighton,3October1929[returntotext]

26HughBullock,‘NewInvestmentTrustFormHeldNeedofFinancialLife’(NewYorkEveningPost4January1932)[returntotext]

27QuotedinHaroldB.ClevelandandThomasF.Huertas,Citibank1812-1970[returntotext]

28BarryEichengreen,opcit[returntotext]

29PrivatenotesofGeorgeL.Harrison(GovernoroftheReserveBankofNewYork),QuotedinFriedmanandSchwartz.[returntotext]

Structureofthemarketin1932‘It’s this way, Joe. Now, what gave us good times? The automobile industry. Why? Because it wassomethingnewtodevelop.Now,whatdoweneednowtobringbackbetter times?Somethingelse that’snew,todevelop.Well,that’stheidea,see.ThisoutfitI’mwithhasgotsomethingnew.Anelectricshaver.’

JamesT.Farrell,JudgementDay

Thestockmarketin1932

Between each of the four periods covered in this book there were markedchanges in the structure of the stock market. The intervening bull marketsbrought forth numerous new issues and new technologies, resulting in theemergence of new industries. While the 1921-32 period is the shortest gapbetweenbearmarketbottoms itwasstill accompaniedbysignificant structuralchange in the stockmarket. Thereweremanymore securities for investors tochoosefromin1932comparedto1921.Evenfollowingthedarkestdaysofthecrash and depression therewere 1,278NYSE-listed stocks at the end of 1932compared with just 691 at the end of 1921. In contradiction of popularmythology themarket remainedactive.For1932as awhole, 32%of the totalshares listedweretradedcomparedto59%in1921.Despite thisdeclinein theturnoverrate,425millionsharesweretradedin1932comparedto173millionin1921.The turnoverratedeclined,despite larger tradingvolumesbecause listedsharesontheNYSEhadincreased349%overtheperiod.

AsthestockmarketreacheditslowsinthelastdaysofJune1932,theaverageweeklyvolumewasjust3,047,183shares.Astheaveragestockpriceon1Julywas$11.89, thevalueof theweeklyaverage turnoveron theNYSEwas$36.2million.Inunderstandingthestructureofthemarketitisimportanttorememberthepreferredsharewasstillanimportantassetclassin1932,accountingfor19%of themarketvalueofcommonandpreferredstock listedon theNYSE.On1July1932,therewere808commonstockslistedonthemarketand445preferredstocks, and there was a significant business arbitraging the common andpreferred stocks of the same issuer. On average through 1932, 50% of listedcompanieshadboth commonandpreferred issuesoutstanding.Although therewere1,253listedsharesinthesummerof1932,onatypicalday’stradingtherewouldbeactivityinperhapsaround500issues.InSeptember1929,themarket

valueofcommonandpreferredstocksreached$90billion.Theensuingdeclinein value from 1929 to 1932 almost exactly mirrored the decline in averagemarketcapitalisation-betweenSeptember1929andJune1932,as thenumberof total common and preferred stock issues only declined from 1,280 inSeptember1929to1,262inJuly1932.

In August 1929, the last period of normal trading prior to the slump, dailyaveragevolumewas3,677,053shares.Astheaveragepeakmonthlysharepricewas$89.13,dailyvolumewasaround$328millionbeforethesubsequentpanicof September and October sent volumes to abnormally high levels. Thus the89%declineintheDJIAinthe1929-32bearmarkethastobeseenagainsta5%declineinthenumberoflistedsecuritiesanda98%declineinthevalueofdailytradingvolume.

Theseheadlinefiguresareoftenusedtoshowthatby1932thestockmarketwasinactiveandshunnedby investors.However thefact is that32%ofallNYSE-listed shareswere traded in 1932 and therewere almost twice asmany listedcompaniestochoosefromin1932comparedto1921.TheDJIAmayhavefallenby89%fromitspeak,butthetotalmarketcapitalisationofNYSE-listedstockswasjust40%belowthelevelreachedbytheendof1924,whenthefirstreliablemarket capitalisation data became available. While a 32% turnover of listedcompaniesmayhavebeenlowbyhistoricstandards,itwastoprovetobehigherthananylevelachievedfrom1937to1979.

Inunderstandingthestructureofthemarketin1932,itisimportanttorealisethemajorchangeswhichhadoccurredinAmericanindustryovertheperiod.Figure44 and Figure 45 show themarket value of all the NYSE-listed sectors on 1September 1929 and 1 July 1932. Perhaps the most surprising thing is thatrailroadsstillcomprisedthelargestsectorofthemarketinSeptember1929.Thislarge weighting occurred despite the fact that the industrial sector hadoutperformed railroads by 86% from the lows ofAugust 1921 to the peak ofSeptember1929.

Althoughthebullmarketofthe1920sisoftenassociatedwiththeboominautosand radios, the three largest sectors of the market - railroads, petroleum andchemicals-accountedfor31%oftotalmarketcapitalisationatthemarketzenithin September 1929. The communications sector, which included the mightyAT&T,wasnotableforbecominganincreasinglyimportantsectorofthemarket

eventhoughcomprisedofjustahandfulofcompanies.EveninSeptember1929,thefinancialsector,comprisedlargelyofinvestmenttrusts,waslessthan2.5%of total market capitalisation. As late as 1920, US Steel had been the largestlistedcompanyinAmericaandpartofakeysectorofthestockmarket,butby1929theentiresteelsectorwasjustthe10thlargestbymarketvalue.

FIGURE44.MARKETVALUESEPTEMBER1929[RAILROAD&EQUIPMENTSTOFOREIGNCOMPANIES-CANADA&CUBA]

FIGURE44CTD.MARKETVALUESEPTEMBER1929[TOBACCOTOTOTAL]

Source:WallStreetJournal,September1929

It was during the 1929-32 bear market that the railroad sector finally lost itscrown as the largest sector of themarket. By July 1932, it accounted for just8.7% of total market capitalisation. Just two decades earlier, it enjoyed morethan50%ofNYSEturnover.ThelargestsectorofthemarketinJune1932waspetroleum, although utility operating and holding companies, when groupedtogether, were the dominant sector accounting for 15% of total marketcapitalisation.Another sector to suffer amaterialdecline in importanceduringthe bear market was autos and accessories. The auto industry suffered theDepressionfarmorethanthesafesectorsoffoods,tobacco,communicationsandutilities.Therewasalsoadegreeofconcentrationduringtheperiod,withthe10largest sectors accounting for 77% of market capitalisation in 1932, up from71% in1929.By1932 the stockmarketwasdominatedby theutility, oil andcommunications sectors which together accounted for 37% of total marketcapitalisation.

FIGURE45.MARKETVALUEJULY1932(TENLARGESTSECTORSINBOLD)[RAILROAD&EQUIPMENTSTOFOREIGNCOMPANIES-CANADA&CUBA]

FIGURE45CTD.MARKETVALUEJULY1932[TENLARGESTSECTORSINBOLD)[TOBACCOTOTOTAL]

Source:WallStreetJournal,July1932

Theextent towhich the change in the structureof themarket is due to share-priceperformanceratherthancorporateactivitycanonlybeassessedfromJune1926,whendetailedsectorperformancedatafirstbecameavailable.Wecannotseetheimpactofsectorpriceperformancethroughoutthe1921-29bullmarket,butwecanview1926-29,themostexuberantperiodofthe“RoaringTwenties”.

The 1920s bull market is often associated with the performance of the autosector or Radio Corporation of America (RCA) stock, but the real stars werechemicalsandelectricalequipment.TheelectrificationofAmericanhouseholdsandbusinessesacceleratedduringthedecade,creatingboomconditionsfor theelectricalequipmentmanufacturers.Theelectrificationbusinessalsoboostedtheperformanceofutilitystocks,assistedbysomedubiousfinancialengineeringinthesector.Inthebustthatfollowed,manyoftheutilityholdingcompaniesfailedand their CEOs - the likes of William Foshay, head of a Minneapolis basedholdingcompany,andSamuelInsull,headofMiddleWestUtilities-endeduponcriminalcharges.

FIGURE46.KEYSECTORPERFORMANCE–JUNE1926TOSEPTEMBER1929

Source:KennethR.French,‘IndustryPortfolioData’.Note:Totalreturnwithdividendsreinvested.

The chemical industry benefited from the general economic boom, but by the1920sinvestorswerebecomingincreasinglyexcitedaboutprospectsforthenewpetrochemicalindustry.Cellophanehadbeencommerciallyavailablesince1919,but when Du Pont added a waterproof coating to the product in 1927, itsusefulnessincreaseddramatically.Asthe1920sprogressed,syntheticmethanoland synthetic nitrates went into commercial production. Investors could seedevelopment of petrochemicals as a path to huge growth in the production ofsyntheticrawmaterials.Otherbreakthroughs-neoprene,Perspex,polytheneandnylon-werenottocomeuntil theearly1930s.However,themereprospectofcommercial success frompetrochemicalproductshelpedboost thesharepricesofchemicalcompaniesinthesecondhalfofthe1920s.

The financials sector also performed well - this was driven by the mania forinvestment-trustshares.Withmanytrustsrisingtosignificantpremiumstotheirassetvalues,andapplyinggearingtoboosttheirreturns,itisnotsurprisingthesectorproducedgoodreturnsinabullmarket.

The commodity sectors,which had led the lastmajor bullmarket of 1917-19,lagged during the 1920s. This was a period when inflation in general was inabeyance and the prices for many commodities actually declined. Those whostuckwithoilsharesthroughthe1919-21bearmarketwerenottoberewarded-oilwasoneoftheworstperformingsectorsinthe1920s.

The scale of the declines shown in Figure 47 has to be considered against abackgroundofa33%declineinthewholesalepriceindexoverthesameperiod.Aswellasthisoff-settingpositive,mostcompaniesmanagedtomaintainsomeformofdividendpayment throughout theperiod.CowlesFoundationdata, thebroadest dividend data available for the market, shows a 48% decline individendpaymentsfrom1929to1932.

Figure47.KEYSECTORPERFORMANCE–SEPTEMBER1929TOJUNE1932

Source:KennethR.French,‘IndustryPortfolioData’.Note:Totalreturnwithdividendsreinvested.

Seeminglydefensivesectorsofthemarketsuchasutilityandfoodstocksofferedlittle protection for investors. Thiswas partly due to the over-valuation of allstocks by September 1929 but also due to the scale of the recession which

produced volume declines in basics such as electricity and packaged foods.Packagedfoodwasarelativelynewgrowthconceptinthenineteentwentiesandthus there was ample room for demand declines. By 1932 85% of the breadconsumedinAmericawasbakedathome.Thetobaccosectorwastheonlyplacetohidefrom1929-1932asvolumesincreased,rawmaterialpricescollapsedandsellingpricesheldup.

Thebondmarketin1932WhatdoesFatherMoylansay?Hetellswhatthebankersaredoing.LoaningAmericanmoneytoEurope.IftheyhadkeptAmericanmoneyinAmericawhereitbelongs,therewouldn’tbeanydepression.

JamesT.Farrell,JudgementDay

On1 June1932, therewere1,587bond issues aggregating$52,193millionofparvaluewithamarketvalueof$36,856millionlistedontheNYSE.Basedonmarketvalue,theNYSE-listedbondmarketwascomposedofthefollowingkeysectors:

FIGURE48.COMPOSITIONOFNYSE-LISTEDBONDMARKET1JUNE1932

Source:WallStreetJournal,11July1932

GovernmentsecuritiesmadeupthebulkofNYSE-listedbonds,thoughthiswasaccountedforbyjust11issues.Theaveragedailyvolumeinthebondmarketinthisperiodwasaround$10million,ofwhichsome40%wasinUSgovernmentsecurities.The totaldaily tradingvalueof theother1,576 issueswasabout$6million.InMay1932,themonthbeforethebondrallybegan,thetotalturnover

inbondsontheNYSEwas$169million,thelowestMaytotalsince1918.Bondshad not dropped as dramatically as stocks. As the total value of NYSE-listedbondswas$46,741millionon1September1929, thevalueof themarkethaddeclinedjust21%overthecourseoftheequitybearmarket.

This relatively small decline in total market value and number of issues is,however, deceptive as the period saw steady prices forUS government bondsand falling prices for other classifications. On 1 September 1929, there were1,543 non-US government bond issues with an approximate market value of$33,809millionandby1June1932thishadbeenreducedto$21,927millionof1,574issues.Thesteepdeclineinpriceswasaproductofageneraldeteriorationincorporatebalancesheetswroughtbydeflation.Whilemanycorporatebalancesheets were in dire straits, it was also true that many had been significantlystrengthened through the longeconomiccontraction.AmericanSuperpower, in1932 a utility company and not a geo-political entity, was described as a“speculativeissue”despitepossessingabalancesheetwhichtodayseemshighlyconservative.

While obviously a speculative issue, American Superpowercommon shares carry with them a certain appeal for thebusiness man who is prepared to go without return on hiscommitmentforwhatmayprovetobeanextendedperiod.Thecompany has no funded debt, and at the end of 1931 had inexcessof$26,650,000ofUnitedStatesgovernment securitiesalone.[30]

Evencompaniesmaking suchbalance sheet adjustmentshad seen thevalueoftheir bonds hurt by the economic deterioration. Figure 49, which shows theyieldsofkeysectorsinSeptember1929andJune1932,providessomeguidanceastotheshiftinthebondmarketovertheperiod.

Figure49.BONDYIELDSFORKEYCLASSESOFBONDSSEPTEMBER1929ANDJUNE1932

Source:FederalReserve,BankingandMonetaryStatistics

The moderate decline in the market value of bonds outstanding was becausegovernmentbondpriceswerelargelyunchangedovertheperiod.TheTreasury’sthreebond issuesof$2.2billion in1931, its first in threeyears,alsobolsteredthe totalmarketvalueofbonds.Onewouldhaveexpectedagovernmentbondrally in deflationary times,which iswhat happened, at least initially.Thebullmarket in government securities lasted from September 1929 to the secondbanking crisis in June 1931, when the yield reached 3.13%. With the addeddevaluation panic of late 1931, even the price of government bonds declined.However, thenetsituationwasthat thepriceofgovernmentbondswaslargelyunchangedfromSeptember1929toJune1932.

It was very different for other classes of bonds. Initially, while the recessionremained of normal dimensions, bond prices rallied. FromSeptember 1929 tothe peak of the rally in September 1930, industrial bond yields fell 33 basispoints.HoweverinSeptember1930,everythingchanged-withthefirstbankingcrisis, industrial bond prices fell dramatically. Industrial bond prices werealreadybelowSeptember1929levelsbyasearlyasDecember1930.

ThisgeneralpatternofarallyfromSeptember1929toSeptember1930andthena dramatic sell-off was also true for railroad and utility bonds. The rally incompany bond prices for 11 months after the October stock market crash isanotherfactorsuggestingthecrashitselfmaynothaveplayedaslargearoleintheensuingdepressionasispopularlybelieved.

FIGURE50.USGOVERNMENTYIELDSMONTHLY–JANUARY1929-JANUARY1933

Source:FederalReserve,BankingandMonetaryStatistics

FIGURE51.YIELDONBAACORPORATEBONDS–JANUARY1929-JANUARY1933

Source:FederalReserve,BankingandMonetaryStatistics

While bond prices may have been declining they were significantlyoutperforming equities and, even as the stock market bottomed, investment

managerscontinuedahighcommitmenttobonds.TheWallStreetJournalof11July1932carriedsuchregularnewsitemsas:

Anderson&Cromwell,managersofFidelityFund,Inc.reportthaton June30 theportfoliowas investedas follows:Bonds,65%;stocks,28.6%;cash,accrualsetc.,6.4%.

Separatementionmust bemadeof foreigngovernment bonds. Itmay surprisemostmoderninvestors that themarketvalueof thesebondsoutstrippedthatofdomestic commercial concerns in June1932.Although thereweremanymoredomestic corporate bonds listed on theNYSE, foreign governments tended tohavemuch larger issues. During the 1920s, when Britainwas still recoveringfrom thewar, theUS became the key provider of global capital to theworld.That rise in importancewas signifiedbyadramatic increase in thenumberofforeigngovernmentsraisingcapitalon theNYSE.At theendofJanuary1926,therewere116foreigngovernmentissueslistedontheNYSE,withacombinedmarketvalueof$3,024million.BythepeakoftheequitymarketinSeptember1929, there were 202 such issues with a combined market value of $16,012million,comprisingone-thirdofthetotalvalueofallbondslistedontheNYSE.Apart from the debt securities of major nations such as the UK, France andCanada, a US investor could add to his bond portfolio Bavaria, Bolivia,Bordeaux, Brisbane, Budapest, Costa Rica, Cuba, Haiti, Nuremberg, Oslo,Panama,Rotterdam,Warsaw,ViennaorYokohama.By1June1932,themarketvalue ofNYSE-listed foreign government bonds had declined to just $11,242million,a30%dropfromtheSeptember1929level,withasmallincreaseinthenumberofissuesto214.Aselectionof1929highand1932lowpricesprovidessomeindicationoftherangeofreturns.

AsFigure52shows,deflationwroughthavocwith thepriceofmostsovereigncredits. Governments initially tried to live up to commitments to the goldstandard and repay US-dollar debt. However, the internal deflation thisdemanded became politically unpalatable as unemployment rose and financialsystemscollapsedornearedcollapse.By1932,thoughtheUSremainedonthegold standard, a long list of others had been forced to devalue - Bolivia,Bulgaria,Canada,Czechoslovakia,Denmark,Egypt,Estonia,Finland,Germany,Greece, Hungary, India, Japan, Mexico, New Zealand, Nicaragua, Norway,Portugal,Salvador,Sweden,UnitedKingdom,Venezuela,Yugoslavia.

FIGURE52.FOREIGNGOVERNMENTBONDSLISTEDONNYSE–3SEPT1929PRICES,1932LOW

Source:WallStreetJournal

Notsurprisingly,theabilityofcountriesdevaluingagainstgoldandthedollartorepay US-dollar debt was significantly diminished. The best-performingsovereign credit during the period was the Republic of France which, havingjoined the gold standard with an undervalued currency in 1928, was able tomaintain its commitment to gold until 1936.Of course, the end of the link togolddidnotnecessarily leadtoacollapseinthepriceofsovereigncredit.TheUK and Canada had left the gold standard by 1932, but were pursuing

sufficientlysoundmonetarypoliciesthatbondpricestradedhigherthanthoseofItaly,whichwasnottoabandonthegoldstandarduntil1936.

Endnote30WallStreetJournal.9June1932[returntotext]

Atthebottomwiththebear-Summer1932InmyrecentvisittotheWhiteHouse,Ifoundthissamehopeprevailinginofficialcircles,andIconcludedthatwhatweallmustdoistogetbehindourpresidentandpushupward,tothenextperiodofprosperity.

JamesT.Farrell,JudgementDay

The investment trenches were deep and muddy in the summer of 1932. Butbeforewegetintothetacticsofthetrenches,weneedtotakeastrategiclookatthatbattlefieldinvestorscall“thelongterm”.

There are many ways 1932 stands out from other major bear-marketbottomsofthe20thCentury.Themost importantdifferenceisthepaceatwhichequitiesmovedfromovervaluedtoundervalued.

As we have already seen, stocks had become very cheap in 1921, primarilybecause equity prices had been moving sideways while the economy andcorporate earnings had been growing. At its peak, before the 1919-21 bearmarket, the DJIA reached 119.6.While the US economy had boomed in theprevioustwodecadestheDJIAwasnotmuchhigherthanthe100.5reachedinNovember1909orthe102.7levelreachedasearlyasJanuary1906.However,thingswereverydifferentontheeveofthe1929-32bearmarket-theDowhadreached381.2on3September1929,anincreaseofalmost500%fromthe1921low.Therewasnoslowreturnofvaluetoequities,butacrashthatwastoturnovervaluedequitiesintoundervaluedequitiesinlessthanthreeyears.

Wehave already traced the growth of theUS economyover a 20-year periodafterwhichtheDJIAendedvirtuallyunchangedin1921.Thatcomparisonwasuseful in showing the huge stridesmade by theUS economy at a timewhenequity prices were volatile but effectively going nowhere. Things were verydifferent in 1929 following a prolongedbullmarket in equities,with theDowpeakingalmost220%abovethepreviousbullmarketpeakofNovember1919.Withsuchadramaticriseinthepriceofequities,therecanbenocasefor1929-32 as being just the final down leg that exacerbated an undervaluation of themarket. Fromvery low levels the valuation of equities rose and rose over thecourse of the 1920s. Then dramatically, in the late 1920s and into the early1930s, equities went from overvalued to undervalued. As we shall see, this

dramaticvaluationshiftisinstarkcontrasttotheslowburning,downwarddriftin valuations and then final slump that we see in all the other bear marketsconsideredinthisbook.Becausethe1929-32bearmarketloomssolargeintheinvestment psyche, we still assume this is the model for all bear markets.However, this bear market is very much the exception in terms of thedevelopmentofrealvalueforinvestorsinthestockmarket.

A key driver for the bullmarket in equities during the 1920swas that finallyequityinvestorsbegantofullyparticipateinthegrowthoftheUSeconomy.ThenumbersinFigure53showthepaceofeconomicdevelopmentfromtheendofthebearmarketin1921totheendofthebullmarketin1929.

FIGURE53.ECONOMICCHANGESINTHEUSFROM1920TOEND1929[POPULATIONTOCRUDEOILPRODUCTION]

FIGURE53CTD.ECONOMICCHANGESINTHEUSFROM1920TOEND1929[VALUEOFNEWBUILDINGPERMITSMILITARYPERSONNELONACTIVEJOURNAL]

Source:USBureauoftheCensus

HeadlineGDPfiguresprovidesignificantinsightintotheimportantdeflationarytrendinthe1920s.Measuredinrealterms,GDPincreased43%overtheperiod,whilenominalGDPgrowthwas20%.Thebulkofthisdeflationoccurredinthecommoditypricecollapseof1921,buttheGDPdeflatorwasmarginallylowerin1929thanitwasevenattheendof1921.AsFigure53shows,economicgrowth,perhapswith the exceptionof the farming sector,wasparticularlyhighduringthe decade. However, none of the economic indicators covered in Figure 53grew as fast as the stock market over the same period. This was in markedcontrasttopreviousdecadeswhen,aswehavealreadyseen,aneconomicboomdid not result in higher equity prices. So what explains this suddentransformationoftherelationshipbetweenbroadeconomicgrowthandthepriceofequities?Didcorporateearningsgrowthoutstripgrowthintheeconomyandthus justify the almost 500% rise in the Dow Jones Industrial Average fromAugust 1921 to September 1929? To what extent where the high returns forinvestorsjustaproductofhighervaluationsforequities?

Thebestdataavailableonearningsgrowthovertheperiodis thatcompiledbytheCowlesFoundation.Inquantifyingprofitgrowthinthe1920s,pickingastart

datehasamajorimpactontheoutcome,duetothecollapseinprofitsin1921.Figure 54 provides the series of earnings from 1916-29 and indicates thevolatilityofearningsovertheperiod.

FIGURE54.EARNINGSOFS&PCOMPOSITESTOCKPRICEINDEX(INDEX,1929=100)

Source:RobertJ.Shiller,MarketVolatility

The data shows the difficulty in assessing the level of profit growth of listedcompaniesduringthe1920s.Itisclearthehugewar-profityearof1916andthedeflationary year of 1921 are not good starting points for launching anycomparisonwith1929.Inordertocopewithsuchproblemsthroughoutthisbookwe refer to the cyclically adjusted earnings as providing the best guide to theunderlyingearningspoweroflistedcompanies.Thechosencyclicaladjustmentis to compute a ten-year rolling average earnings figure as recommended byProfessorRobertShiller inhisbookIrrationalExuberance.However,even thisapproachtocalculatingnormalearningsiscomplicatedinthisparticularperioddue to the exceptionally high levels of profit earned from 1915-17. Thesewartimeprofits inflateeventen-yearaveragefiguresfor1921andindicate thatcyclicallyadjustedearnings increased just11%from1921 to1929.Asimpler,but clearlymore subjective, way of estimating profit growth is to look at thegrowth in earnings following the economy’s recovery from recession in 1922and 1923 to the peak of themarket in 1929. Utilising this approach, and the

numbersinFigure54, it isagoodruleof thumbtosaythat theprofitof listedcompaniesdoubledduring thegreatbullmarketof the1920s. Importantly, the1920-29 period, when reported earnings grew faster than economic growth,stands in marked contrast to 1871-1921, when the reverse was the case. Ingeneral terms, the economy expanded 43% over 1920-29, while earningsdoubled.However,thestockmarketrose220%aboveitsprevioushighestlevelandalmostfivetimesaboveitsAugust1921low.The1920sauguredanewerafor equities. Reported earnings growth finally lived up to and exceededeconomicgrowth,andagainstthatbackground,perhapsnotsurprisingly,equityvaluations rose. Finally some evidence arose that shareholders would directlyparticipateintheeconomicemergenceofAmericaandthisalonecouldbegintojustifysignificantlyhighervaluationsforequities.

Thisgrowing faith in investorparticipation in economicgrowthpushedequityvaluations to extreme levels. As elsewhere in this book, we assess equityvaluationwithreference to thecyclicallyadjustedPEand theqratio.Utilisingtheten-yearaveragerollingearningsfiguretomakethecyclicaladjustment,thePEoftheS&PCompositeIndexrosefrom7.4xinAugust1921topeakat31.6xinSeptember1929.TheaveragecyclicallyadjustedPEhadbeenjust15.3xfromJanuary1881toSeptember1929,andthepreviouspeaklevelhadbeen26.5xinJune1901.

Clearlytherewassomethinginequityvaluationsin1929tosuggestthata“newera” for future earnings growth had developed. The q ratio shows similarextremesofvaluationby1929.Thedataisonlyavailableforyear-endandasthestockmarkethadalreadydeclinedsignificantlyby31December1929,thedatadoesnotregistertheSeptemberpeakfortheratio.However,evenutilisingyear-enddata,theratiowasstill20%abovetheprevioushighrecordedin1905and80%abovethe1900-29average.

On the eve of the 1929-32 bear market, equities were very expensive, amarkedcontrasttothesituationin1919.

FIGURE55.S&PCOMPOSITEPE(CYCLICALLYADJUSTEDEARNINGS)

Source:www.econ.yale.edu/~shiller/data.htm

The idea behind the q ratio is basically very simple. It compares twodifferent estimates of the valueofUS companies.The first iswhatWallStreetsaysthecompaniesareworthandthesecondistheirfundamentalvalue. For the stock market as a whole, fundamental value is what itwouldcosttodaytoreplacealltheassetsofallquotedcompanies.Theirvalueiswhatitwouldcosttocreatethem,ifwehadtostartfromscratchanddo it again.To calculate their fundamental value,weneed toworkouthowmuchthiscostwouldbe.Theirtotalvalueisthusthemeasureofwhatthecompaniesareworthintermsoftheirassets,bothphysicalandfinancial,minus their liabilities.Thisestimate isnormallyreferred toasnetworth. To find q,we compare the networth of the corporate sectorwith the total value that the stockmarketputsoncorporate shares.Theratiobetweenthetwoisq.

–FromAndrewSmithers&StephenWright,ValuingWallStreet

When themarket peaked in November 1919, on the eve of the 1919-21 bearmarket, the cyclically adjusted PEwas just 10.6x, 33% below the 1881-1919average.AsweshallseeinPartsIIIandIV,the1919-21experience,ofaslowdecline in valuations ending with a dramatic slump, is more common than a

rapidmovementfromovervaluedtoundervalued.Popularmemorysees1929-32 as the typical bear market, when a rapid decline in price produces amovetoundervaluation.Tosomeextentthishasresultedinaruleofthumbthatequitiesbecomecheapafterasignificantdeclineinprice.Theevidencefrom1921and,asweshallsee,1949and1982,isthatthisisnotnecessarilythe case. The 1921 instance is more typical when the move fromovervaluation to undervaluation took well over a decade. Bear markets,where three-year price declines make overvalued equities cheap, are theexceptionandnottherule.

ThecontractioninvaluationsfromSeptember1929toJuly1932wasonlypartofthestory.The1929-32bearmarketsawtheDJIAfall89%,andacollapseinearningsplayedanimportantrole.TheS&PCompositeIndexearningsdeclined68% from September 1929 to July 1932. The contraction in valuation anddecline in earnings together reduced the DJIA to 41.2 on 8 July 1932, justmarginallyabovethe40.9levelon26May1896whentheindexwaslaunched.Inrealterms,reportedearningsoftheS&PCompositeIndexinJuly1932werebelow those reported inOctober 1873 and in nominal termswere back to thelevelofDecember1880.

Thisdeclineinearningssurpassedthescaleofdeclineineconomicactivity.Innominal terms, GDP returned to around its 1917 level and in real terms toaround its 1922 level, representing contractions of 43% and 26% respectivelyfrom 1929. The strategic picture of the 1929-32 bear market is of a marketfalling from near-historical peak valuations combined with a contraction inearningsthatsignificantlysurpassedthescaleoftheeconomiccontraction.Themost importantcomponentof thestrategicpicture for the investoron the frontlineinthesummerof1932waswhetherthestockmarketwasnowtradingbelow“fairvalue”.

With earnings of listed companies reduced to 1880 levels by the summer of1932, it is clearlynot enough to assess thedegreeof “value” in themarket inrelationtothoseearnings.Atissuewasthecorrectlevelofnormalisedearnings,and assessing this was increasingly difficult by 1932. It was argued by someinvestorsthattheleft-wingpoliciesofaRooseveltadministrationwouldresultina structural reduction in corporate profitability. As early as May 1932, evenbefore his nomination as the Democrat candidate, Franklin D. Roosevelt wasstatingthat,inthefuture,capitalmustbecontentwithsmallerreturnsrelativeto

labour.Maybepast levelsofprofitabilitycouldnowprovidenoguidanceas tothefuture.Didthe68%declineinmarketearningspresagethisneweraoflowerprofitability?

Thisconfusionastothelevelofunderlyingearningsaccountsfor thedramaticdifferencesinvaluationparametersaroundthebearmarketbottomofJuly1932.

Despitereportedearningsbeingbackto1880levels,themarketcapitalisedeventhatlevelofearningsatonly10.2xinJuly1932,a26%discounttothe1871-1932monthlyPEaverage.

However,within12monthsthemarketwastovaluecorporateearningsat26.3xcurrentearnings,aPElevelonlypreviouslysurpassedinonemonth(December1894)andnot tobeseenagainuntilMarch1998.Thisstill standsas themostdramaticrecordedchangeinmarketPEina12-monthperiodandisaccountedforbytheriseoftheindexanda13%declineinearningsfromthebottomofthemarketinJuly1932.

ThedramaticsurgeinthePEratioin1933isoftentakentoindicatethatequitieswereexpensive-notso,theywereverycheap.ItisuntruethatthePEindicatedthemarketwasexpensiveat10.2inJuly1932,asthemarketwascapitalisinganearnings level first achieved in 1881. Only the most dyed-in-the-woolRepublicancouldbelievethat the“NewDeal”hadreducedtheearningspowerof US corporations to such a permanently low level. The headline PE didbecomeaverymisleading indicatorofvalueby1933as itneared itshistoricalhigh,butthebullmarketunderwayinequitiesstillhadaverylongwaytorun.Onreportedearnings, thePEsuggestedequitieswerearound26%undervaluedin July 1932, relative to the long-term average PE. On any form of adjustedearnings,theyweretradingevenfurtherbelowfairvalue.

Calculated using 10-year rolling-average earnings, themarket PE in July1932 was almost 70% below its 1881-1932 average. The q ratio was alsoindicating equities were very cheap. At the bottom of themarket in July1932,theqratiohadprobablyfallenbelow0.3x.AsinAugust1921,equitieswerenowtradingatmorethana70%discounttothereplacementvalueoftheirassets.

Thegoodnews, then, for the entrenched investor in the summerof1932,wasthatequitieswereverycheapunlessonebelieved thatRooseveltwas intentondestroyingcapitalism inAmerica.Thebadnewswas that, using the cyclicallyadjusted PE as a measure of value, equities had been below their long-termaveragevaluationsincethemiddleof1931.SincethentheDJIAhaddeclinedbyalmost70%.

Stocks also crashed through all previously accepted limits imposed byconsiderationsofbookvalue.Helpfully,theWallStreetJournalprovidedatablecomparing price-to-book and price-to-working capital ratios for 21 of the 30DowJonesIndustrialAveragestockson18May1932,withcomparisonto thelowpricesof1921.

FIGURE56.KEYDJIAMEMBERS–PRICETOBOOKANDPRICETOWORKINGCAPITAL

Source:WallStreetJournal,19May1932.Note:The1932and1921lowpricesforthe21stocksareshowninpercentagesofbookvalue,excludingintangibles,andofequitiesinworkingcapital,afterdeductingfullparvalueofallpriorobligations.

On a simple average, the numbers in Figure 56 show the 21 industrial stocksreachingaprice-to-bookratioof0.66xcompared to0.82xat the1921 low.Ofcourse,18Maywasnot thebottom for themarket and theDJIAwas to fall afurther22%beforehittingbottom,bywhichtimetheprice-to-bookratiooftheindustrialsmarketwasaround0.52x.

Investorswhobelievedthe1921lowof0.82xwouldmarkthebottomfortheprice-to-bookratioin1932witnessedafurther27%declineinthepriceofequities.

Thisshiftininvestorperceptionsofwhatconstitutedvaluemaywellhavebeenareactiontothedoubtfulvalueaccordedstocksatthetopofthemarket.

During the roaring days of the bull market, lack of fullinformation about a company gave its securities a certain‘mystery’value.Thelongdepressionhasdoneagreatdeal toeliminate‘mystery’valuefromconsiderationoftheworthofasecurity.[31]

Inthelatesummerof1929investorshadplacedapremiumon“mystery”,butbythesummerof1932theywoulddemanda50%discountonhardassets.

Goodnewsandthebear

‘Iknow,allright.Itellyou,Iknowtimesisgoingtogetbetter,andI’mnotjustguessing.’

‘SendatelegramtoHooverabouthimandlethiminonthesecret,’Studssaid.

JamesT.Farrell,JudgementDay

Bythesummerof1932,faithinthewholefinancialsystemhadcollapsedalongwith thestockmarket.Therewereprobably few laughswhenCharlieChaplin,on returning from a world tour, remarked to the press: ‘I am reputedly acomedian,butafterseeingthefinancialconditionsoftheworldIhavedecidedIamasmuchaneconomistasfinanciersarecomedians.’[32]

As if to sumup the generalmood, aWall Street Journal headline of 12May1932stated‘InspirationShutsDown’.ThestoryreferredtotheclosureofamineinArizonabyInspirationCopper,ratherthanthegeneralmalaiseinthecountry.There were still those awaiting the cyclical economic rebound, though it wastaking a long time to materialise. Since 1854, the average duration of aneconomicdeclinefrompeakto troughhadbeenjust20months.ByJuly1932,thecountrywasinits35thmonthofeconomicdecline.The1921bottomfortheequity market coincided with the bottoming of the economy - the NBERreferencedateofJuly1921confirms this.However, thingsarenotasclearcutfor 1932. TheNBER reference date for the bottom of the recession isMarch1933. Itwouldappear that theequitymarketbottomedninemonthsbefore theeconomy.

Therewasaneconomicrecoverywhichbeganinthesummerof1932,butitwasknockedoffcoursebyathirdbankingcrisis,thistimefollowingtheelectionofRooseveltaspresidentinNovember.Theeconomiccontractionassociatedwiththis third crisis reduced economic activity to even lower levels than thosewitnessedinthesummerof1932-just.Indeed,afuturechairmanoftheFederalReserve,ArthurBurns, inabookco-authoredwithWesleyMitchell,describedthese two periods, summer 1932 and March 1933, as representing a “doublebottom”fortheeconomy.[33]

LABEL57.DOWJONESINDUSTRIALAVERAGE–MAY-SEPTEMBER1932

Source:DowJones&Co.

Thestockmarkettechnicallyledtherecoveryintheeconomy,butitisalmostastrue to say that the market bottom coincided with this first bottom of theeconomy.

For those in the investment trenches in the summerof1932, it is important torememberthatthelightseeminglypeepingovertheparapetprovedtobeafalsedawn.TheeconomicrecoveryhadpeteredoutbyNovember1932andbyMarch1933 it was pretty much back where it had started in June 1932. The thirdbankingcrisisdidnot,however,returntheDJIAtoitsJuly1932low.Theindexrose 94% from 8 July 1932 to 7 September 1932 and, by 27 February 1933,whenithititslowforthatyear,itwasstill22%abovethebear-marketbottomof8July1932.Itisstilldebatablewhethertheequitymarketled,orcoincidedwith,the recovery in theeconomy. It is clear, though, that confidence in themarketneveragainsubsidedtothelevelsregisteredinJuly1932.

InPartI,weheardasymphonyofgoodnewsin1921fromnumeroussourcesasthe stockmarket reached the bottomof the bearmarket, but investors seemeddeterminedtofocusonthenegative.Thingsweredifferentin1932.BythatJuly,the stock market had declined 89%, there had been two banking crises,wholesale prices had fallen 40%, and industrial production had halved. Thesurprise collapse of banks and the ensuing consequences were beyond the

experienceofmostinvestors.Eventhegreatbearmarketof1907andthefailureof theKnickerbockerTrustCompanyhadnotdamaged investorson thisscale.(On 21 October 1907, the National Bank of Commerce refused to honourcheques of Knickerbocker Trust, sparking runs on nearly every trust in NewYork.)[34]ItisperhapsunsurprisingthatbyJuly1932,34monthsintotheworstbearmarketandeconomiccontractioninlivingmemory,therewaslittleleftbywayofoptimism.Whereasin1921thenewspaperswerefilledwithlargelygoodnews,in1932goodnewswasmuchthinnerontheground.

It should be stressed, however, that even at the darkest hour for Americancapitalism,noteverypieceofnewswasbadandnoteverycommentatorbearish.

Throughoutthisbookwefocusonthetwo-monthperiodeithersideofthebearmarket bottom in an attempt to get a contemporaneous view of the market.Popularmythologyhasitthatthereisnogoodnewsaroundatthebottomofthemarket.Ifeversuchanassertionwaslikelytobetrue,thenonewouldexpectittobesoasinvestorsbattledagainsttheGreatDepression.However,therewasanamplesupplyofpositiveeconomicnewsinthepagesoftheWallStreetJournalinthesummerof1932:

9May:AnupturninnewpassengerautosalesinexcessofanormalseasonalgaininApril.Reportsathandfromsevenstatesshowanincreaseof36%overMarch.TheaveragegainfromMarchtoAprilintheprecedingsevenyearswas30.5%.

10May:TheNorfolkplantoftheFordMotorCo.wasinoperationonaSaturdayforthefirsttimeinfouryears.

16May:Aprilconstructioncontracttotalsforthe37stateseastoftheRockyMountainsshowedan8%gainoverMarchincontrasttoalossof9%betweenthecorrespondingtwomonthsof1931.InpublicworkstheAprilgainoverMarchwas93%.

16May:Thosepeopleabletoaffordanewcar,butwhohavenotbeenbuying,arenowcomingintothemarket.

16May:GradualindustrialimprovementnotedinvariouspartsofNewHampshire.

17May:Buildingpermitsin568citiesandtownsoftheUnitedStates

duringAprilshowedagainof19.7%overtheMarchfigure,ascomparedwithanormalseasonalexpecteddecreaseof3.3%.TheApriltotalhoweverwas30%belowthatforApril1931.

21May:Increasedemploymentreportedineightofthe16majorindustrialgroups.

22May:ThegradualsteppingupofFordoutputishavingamarkedeffectinseveralquarters.

24May:WilliamGuggenheim,NewYorkcapitalist,inclassreunionspeechatUniversityofPennsylvaniastates:“Alittlelightthatbringswithitarayofhopeisemergingfromtheindustrialchaosandgloom.Weareapproachingthecompletionoftheadjustmentsthatwerenecessary.”

24May:StutzMotorCarCo.hasmanynewordersonhandandwillbeginoperatingona6-dayweeklyscheduleeffectiveimmediately.

25May:Inventoriesareatalowebbandanydemandofimportancewouldfindshelvesbareofstocks.

30May:H.A.Scandrett,presidentofSt.Paul,saidagriculturalconditionsintheroad’sterritorywereneverbetterandthatiftheycontinuedsotherewouldbeanearlymovementofgraintraffic.

11June:ChevroletSalesCurveRising.

13June:Detroit-GeneralBusinessReflectsContinuedPickupinAutomobileSales

15June:Nearexhaustionofconsumersuppliespointstowardpossibleearlytrendupwardofpricesandrecoveryofbusiness,accordingtoP.A.O’ConnellofBoston,presidentofNationalRetailDryGoodsAssociation,speakingatorganization’sannualconventioninPittsburgh.

17June:TheheadofoneoftheleadingwholesalehardwarehousesinToledodeclaredthattherehadbeenanoticeablepickuprecentlyindemandfromlocaldealers,whowerebuildingupinventories.Hedeclaredthatsimilarupswingsindemandfromthesamesourceshadprecededupturnsingeneralbusinessafterpreviousperiodsofintensedepression.Hewasinclinedtoregardtheturnasmostsignificant.

18June:Afteranunprofitablefirstquarter,businessoftheCaterpillarTractorCo.turnedforthebetterinAprilwiththeresultthatnetforthemonthofMayaggregated$73,826equivalentto4centsashare

20June:Employmentdecreased3.2%,inMayandpayrolltotals3.9%,ascomparedwithApril.Ofthe16groupsofemployment,decreasesinbothemploymentandearningswereshownin10.Theautoindustryreportedanincreaseof1.5%inemploymentandagainof13.5%inpayrolls.

21June:Fisher’sindexofcommoditypricesslippedtoanothernewlow,butthewholesalepriceindexoftheNationalFertilizerAssociationrecordedthefirstgainintwomonthsrisingto60from59.6.Agreaternumberofcommoditypricesadvancedthanforanyweekduringthelastseveralmonths.Includedonthelistofcommoditiesthatshowedadvancedpriceswerecotton,burlap,lard,flour,sugar,corn,wheat,cattle,hogs,tinandgasoline.

25June:PresentindicationsarethatbothretailandwholesaledistributionofseasonalmerchandiseisimprovingintheChicagomarketarea.

3July:Theupwardtendwhichwasbegunaweekagoincommoditypricescontinuedduringthepastweek,accordingtoProfessorIrvingFisher’sweeklyindexforwholesalecommoditypricesinthiscountry.FortheweekendedJuly1,indexrose0.1to59.6,whichcompareswiththerecordlowof59.3establishedonJune17.ThismarksatleastatemporarybreakintheprolongeddropintheindexwhichcontinuedfromlastMarchwithoutinterruption.

6July:Danbury’shatindustry,dormantsincetheshort-lived‘Eugenie’hatboom,awokesuddenlytoday,withtwoofthelargestfactoriesswingingintocapacityoperation.

6July:BeliefthatbottomofbusinessdepressionhasbeenreachedisexpressedbyCharlesEdison,sonofThomasA.EdisonandheadofEdisonIndustries,Inc.,followinghisreturnfromsixweekstourofUnitedStates.

7July:WholesalePriceIndexoftheNationalFertilizerAssociationadvancedforathirdconsecutiveweek.

7July:Asinof&Sons,Inc.,ChicopeeMass.,woollenclothingmanufacturers,whoseplanthasbeenclosedsinceMay1,announceworktoberesumedonfullschedulethisweek,givingemploymenttoabout750people.

8July:NewHighForSugar.

8July:DJIAbottoms.

9July:WorldcommoditymarketsrespondedtothereparationsagreementreachedatLausannebyaquickeningofoutsideinterestandbyfairlysharppricemark-upsinseveralofthem,ledbyhogsandsugar,bothofwhichwentintonewhighgroundonthecurrentmovement.

11July:Banksuspensionsforthepastweekdroppedto24from41theweekprevious,theAmericanBankerreports.

14July:CropconditionsinterritoryofChicago&NorthWesternRy.showrecordpromiseandtheseasonispracticallyfarenoughadvancedthattheonly‘if’appearstobeinprices,accordingtoHenryW.Beyers,Vice-Presidentinchargeoftraffic.

14July:Theadvanceinhidepricesinthepasttendays,up35%fromthelowsreachedashortwhileago,shouldprovebeneficialtoU.S.LeatherCo..

16July:HooverCutsOwnPay20%AndCabinetMembers15%.

21July:Advancefrom40to50centsabarrelforcementintheMiddleWestisthefirstpriceincreaseofconsequencessince1929.InMaylastyearthefinalcutoccurred,bringingpricestothelowestlevelin15years.

21July:Althoughtheradiobusinessisgoingthroughitsquietestperiodoftheyear,manydealershavebeensurprisedattheirvolumeofsales.

22July:“Economiccrisesinthepastcenturyhaveallendedwithafirmingofcommodityandbondprices.Bothoftheseindicationsarevisibletoday.”Barnet,Fuerst&Co..

26July:Morethan15,000idleNewEnglandershavebeenrecalledtotheirjobsorgivennewjobsasresultofabusinessspurtduringthepastfewweeks,asurveyreveals.

1August:Travellingrepresentativesoftheautomobilemanufacturers,

whohavefirsthandknowledgeofconditionsineverysectionofthecountry,havefoundbusinessgenerallyfirmingupandthepublicinamoreoptimisticframeofmind.

1August:Steelpricesareholdingbetterthanatanytimesincethedepressionstarted.

1August:Cocksureconclusionsconcerningthenearfuturearenotunlikelytoproveembarrassing.Buttheyareunnecessaryatthepresentstageofaffairs;whatismore,theywouldbefarlesspracticalusethanthedefinitelyobservablesignsthatultimaterecoveryisontheway.

2August:Surplustransportation,asrepresentedbyusedcarstocks,isbeingrapidlyconsumed.DuringJunestocksofusedcarsintheUnitedStateswerereducedby10%andduringthefirst20daysofJulybyanadditional16%.

2August:Willys-OverlandsteppedupitsJulyproductionschedule20%abovethatoriginallyplannedasresultofdemandforthenewstreamlineseries…comparedwiththefirsthalfofJulylastyear,thegainthisyearwas23%.

3August:AlthoughbusinessactivitycontinuedtorecededuringJune,andintheearlypartofJuly,severalrecentconstructivedevelopmentshavecontributedtoanimprovementinsentiment,thesurveyofcurrentbusiness,publishedbyDepartmentofCommerce,says.

3August:Manyfavourablefactorshaveappearedintradeandgeneralbusinessduringthelastfewmonths,accordingtothemonthlyreportoftheFederalReserveBankofDallas.

3August:Shelvesarebare,manufacturer,middlemenandretailerssayanyturnforthebetterintradewouldturnareplacementbusinessintoananxiousdemandwhichmightinmanyindustriesbedifficulttofill.

3August:Bradstreet’scommodityindexofwholesalepricesscoreditssecondconsecutivemonthlyadvanceonAugust1st.Itincreased1.0%.Inallpreviousbusinesscycles,Bradstreet’sfindsthatthefirstimprovementoccurredintheverysensitiverawmaterialsandthengradually,thebettermentbecamemoregeneral,affectingsemi-finishedandthenfinishedarticles.Thisseemstobethepresentcourseofcommodityprices.

6August:RoyD.Chapin,newSecretaryofCommerce,saysthereisnodoubt“depressionhasrunitscourse”andthat“thejobnowistounleashthebuyingpower”.

8August:Dispatchesfromindustrialcentres,whilefurnishingtestimonytothedullnessofindustrygenerally,detailedhighhopes.

8August:LondonEconomistexpressesbeliefthatUnitedStateshaspassedcrisisfindingthatcreditexpansionpolicyhasbeenbeneficialandthatpublicpsychologyhasbecomesteadier.

9August:Chicago-OperatorsoftheleadingStateStreet,neighbourhoodandoutlyingdrygoodsstoreshereareunanimousinexpressingconvictionthattheirbusinessisshowingfundamentalimprovement…Pricesofleadinglinesaredevelopingstillfurther.

13August:St.Louis-Apronouncedspurtinordersfordrygoodsduringthepastfewdays,withunitvolumeexceedingthatbookedforanysimilarperiodsofarthisyearandcomparingfavourablywithsalesayearago.

15August:Themotorindustryisfeelingthefirsteffectsoftheimprovedsentimentwhichpervadesbusiness.Retailsaleshavebeenstimulatedandbuyinginteresthasbecomemoreactive.Interestisbeingrevivedinthehigherpricedcars,andincreasedsalesarebeingreported.

17August:ThereisadistinctlybrighteroutlookinAmericangroceryindustry,saysPaulS.Willis,presidentofAssociatedGroceryManufacturers,whofindspublicisturningtoqualityratherthanlow-costgoods.

19August:F.A.Merrick,presidentoftheWestinghouseElectric&ManufacturingCo.,says“Thenaturalforcesofrecuperationhavebeguntooperate,anditisgratifyingthatevidencesoftheirworkingarebecomingincreasinglyapparent.Theappreciationofpricesofcommoditiesandsecuritiesandtheupturninbusinessofthesmallerunitsmustprecedethefullnormalfunctioningofthebusinessworldasawhole.”

19August:“Steadyimprovementinbusinesssentimentinalllinesisbeingreflectedstronglyinabroaderbuyingmovement.Theoutlookisbrighterthanatanytimeinthelastsixmonths,andforsomebranchesof

activitybetterthanatanytimeinthelasttwoyears.”-Dun’sReview.

19August:Whiletheadvanceinwholesalepriceshascontinuedformorethantwomonths,retailpriceshavebeenlagging,butmustofnecessitysoonbeginageneralriseifthewholesalepricelevelsaremaintained.

20August:“Withinthelasttwoweeksunmistakableindicationsofatrendupwardhavemadetheirappearance….For18monthswehavepurposelyrefrainedfrommakingpredictions.Nowwefeelthereisatangiblebasisuponwhichtobecomedefinitelyoptimistic.”A.Vanderzee,generalsalesmanagerofDodgeBrs.Corp.

22August:Theweeklysteeltradereviewsweremoreencouragingintone.Whileoperationsforthemostrecentweekareuponly1%therearedefinitesignsofanincreaseindemand,particularlyforlightsteel.

22August:Arenewalofconfidence,increasedactivity,togetherwithadecidedlyimprovedsentiment,wasevidentinmanylinesoftradeduringthepastweekinChicago.

22August:ImprovementingeneralbusinessisindicatedinreportsofseveralDetroitmanufacturingconcerns.

22August:USEmploymentServicestatesJulysawthefirstreallynoticeableexpansioninindustrialactivitythathasoccurredsofarthisyear.

23August:Recentcommoditypriceincreasescaughtmanyretailmerchants‘short’andsentthemscramblingtoreplenishinventoriesthathadbeencuttothelimit.

29August:OneofthebestrecognizedsignsofbettertimesisthefactthatprosperityishittingNewEnglandfirst,saidW.L.Hinds,vice-presidentoftheCrouse-HindsCo.,electricalmanufacturers.“Becauseofthecharacterofitsindustry,NewEnglandalwaysleadsthewayoutofanationalbusinessslump.”

29August:Insomelines,particularlytherayonandtextileindustries,therehasbeenamarkedchangeforthebetter.

29August:Respondingtotheimprovedtoneofgeneralbusiness,trucksaleshavebeguntopickup,particularlyinlighter-weightlines.Itis

normalforthetruckbranchofthemotorindustrytofeelthefirsteffectsofarecoveryingeneralbusiness.Duetohardusagereplacementdemandrisesfirst.

30August:Iowa’sbusinessmoralehasstrengthenedwiththesteadyriseinhogprices.Hogpricesmadetheir17thconsecutiveadvanceyesterday.

2September:InquiriesreceivedbyChicagoAssociationofCommerceforproductsmadeinthatdistrictincreasedmorethan35%inthepastthreeweeks.

3September:Themostsignificanttrendofconsumerbuyingthusfarinfalllinesistheratherclearlydefinedpreferenceforbettergoods.Thishasbroughtwithitastepping-upofindustrialoperations,andmanyfactorieswhichhadbeenidleformonthsagainareturningtheirwheelsinanticipationofaswellingtideofpurchasingderivedfromtheabsolutenecessityofreplacingworn-outarticlesofevery-dayserviceandaventuringforthofidlefundsinsearchofpracticalbuyingopportunities.

5September:LondonEconomist,editedbySirWalterLayton,seespossibilityofsubstantialeconomicrecoveryinUnitedStates“asresultofexistingnaturalforcesbackedbythestimulusofcontrolledinflationnowbeingapplied.”

Newsreportsalonedonotprovidetheevidencethatitwastimetobuyequities.But,readingbackthroughthem,anyinvestormustreconsiderwhetherallnewsmustbebadbeforethemarketcanhitbottom.Eveninthedarkestdaysof1932-whenthingsweresobadPresidentHooverresistedpaycutsforsoldiersincasehe needed them to quell a revolution - therewas still ample good news to befound.

As in 1921, the investor’s ability to ignore good news, rather than thepredominance of bad news, characterised the end of the bear market in1932.

Inboth1921and1932,themotorindustrywasinthevanguardofrecoveryandnews of improvement fromNewEnglandwas particularly noticeable. In bothperiods, evidence of the pickup in demand, against a background of fallingprices,becamenoticeablefirstinhigher-quality,higher-pricedgoods.However,themoststrikingsimilarityinthetwoperiodsisthatapositivechainofevents

beganonceevidenceofpricestabilityreturnedtothecommoditymarkets.It isthese price trends, evident from the headlines of the day, which provided themostaccurateindicatorthatthebearmarketinequitieswascomingtoanend.

Pricestabilityandthebear‘Look,Bill,atthatgorgeousblackcrepe.It’sonlytwelvedollars.Clothesaredirtcheapnow.’

JamesT.Farrell,JudgementDay

Signsofpricestability,asin1921,coincidedwiththebottomofthebearmarketin1932.Asin1921,growingstabilityinselectedcommoditypricesbroadenedtoincludemorecommoditiesandfinallyreachedthewholesalepriceindex.

Wediscussed inPart I the importanceofpriceadjustments to theoperationofthe business cycle in a gold-standard regime. Stability in commodity pricesseemstohaveplayedaroleevenwhen,in1932asin1921,theUSwasoneofthefewnationsstilloperatingagoldstandard.Whatevercomplicationsthefreefloatofothercurrenciesbroughttoassessingtheoutlookforthegoldstandard,thestabilityofcommoditypricesstillseemstohavebeenimportantindefiningwhentheeconomiccyclewasnearingbottom.At thefirstsignofanupturn incommodityandwholesalepriceindicesinthelongbearmarketfromSeptember1929,theequitymarketstabilisedandmovedhigher.

FIGURE58.USWHOLESALEPRICES–SEPTEMBER1929TOSEPTEMBER1933

Source:NationalBureauofEconomicResearch

ThekeydifferencebetweenJuly1932andAugust1921isthattheimprovementinwholesalepricesthatdevelopedin1932wasnotsustained.EconomicgrowthbegantostallaroundNovemberof1932,andbyMarch1933economicactivitywas probably just below the July 1932 level. A similar trendwas evident forwholesale prices, the difference being that prices clearly fell below their July1932lows.ThewholesalepriceindexoftheBureauofLaborreachedits1932low in June,butbyFebruary1933, followinga rally that ended inNovember,theindexwas6.6%belowtheJune1932level.Howeverevenattheir1933lowsequity prices remained 20% higher than the levels reached in July 1932. Asustainable advance in wholesale prices began in February 1933 and thiscoincidedwiththemostdramaticperiodofappreciationintheequitybullmarketwhichwastolastuntil1937.

The lesson for the investor from 1921 and 1932 is that increasing stability incommodityandwholesalepricesisanimportantindicatorthatthebottomofthestockmarket isclose. In1921, thesign thatsuchstabilitywassustainablewasthe unwillingness of producers to sell their products forward, and that thecountrywasoperatingwithverylowinventorylevels.Asthequotationsabovefrom the WSJ illustrate, similar considerations were noted in the summer of1932.On15May1932, theWallStreet Journal listed amuch larger rangeoffactors at play, under the headline ‘Anti-Deflation Forces Spread’, indicatingcommoditypriceswouldstabilise.Thefactorswere:

FederalReservepurchasesofgovernmentsecurities.

ExcessivelylowreturnoncapitalinNewYork.

AprobablecutinNewYorkrediscountrateinnearfuture.

WillingnessofBankofEnglandtocooperate.

SuccessivereductionsofBankofEnglandrateto2½%from6%.

Accumulationof£13,500,000goldbyBritishTreasurysinceMarch.

PilingupofidlecapitalinParis,andinSwitzerlandandother“neutral”countries.

Suspensionofthegoldstandardandcurrencydepreciationinascoreofcountries.

ContinuedgoldflowfromIndia.

As in 1921, itwas easier towatch for these signs of improvement rather thanpickaprice level inadvanceatwhichtheadjustmentprocessmustbeover. In1921, many predicted deflation would have to carry prices back to pre-warlevels.Thisdidnotoccur,andpricesandtheequitymarketbottomedwellbeforesuch an adjustment. Similarly in 1932, it was almost impossible to judge inadvanceatwhat level thepriceadjustmentwascomplete.Thewholesalepriceindexsankbelowthe1921cyclicallow,belowthe1913pre-warlevel,andkeptfallinguntil it reached the1907 level.Within thisaveragemeasureofdecline,someproducershadtocopewithevenmoreseriousadjustments.InearlyJune1932,Procter&GamblecutthepriceofIvorysoaptoits1879launchprice.Thepriceofsugarwasbacktoits1895level,andcopper,leadandzinchit50-yearlows.Thingswereevenworseinthecottonmarket,whichbottomedaroundits1848level. [35]Inthisenvironmentwatchingforkeysignsofpricestabilisationwas much easier than forecasting the “correct” price at which the wheels ofcommercewouldbeginagaintoturn.

Signs that such deflation was ending in summer 1932 proved a very bullishindicator for the equity market. As usual, some commentators were moreprescientthanothers.JohnD.Rockefeller,whohadthegoodfortunetobebornon8 July, sounded suitablyupbeat inhis announcement to thenation releasedthesamedayasthestockmarketbottomed.‘Thesearethedayswhenmanyarediscouraged,’hesaid.

In the 93 years ofmy life, depressions have come and gone.Prosperityhasalwaysreturned,andwillagain.Andnowonmybirthday, I desire to reaffirm my belief in the fundamentalprinciples upon which this country was founded - liberty,unselfishdevotiontothecommongood,andbeliefinGod.[36]

HeurgedAmericansto‘recognizewithhumilityourmistakesofextravagance,selfishness and indifference, let us, with faith in God, in ourselves and inhumanity, go forward, courageously resolved to play our part worthily inbuildingabetterworld’.Measuredintoday’sterms,Rockefellerhadamassedafortune in excess of $200 billion, larger than Bill Gates and Warren Buffetcombined.NodoubttheAmericanpeoplewereamusedtohearthat‘devotiontothecommongood’wasoneofthekeyprinciplesthatwouldbringthemthroughhard times.Maybe they remembered the exhortations of the then 90-year-oldRockefellerinastatementissuedonWednesday30October1929.

Believingthatfundamentalconditionsofthecountryaresoundandthatthereisnothinginthebusinesssituationtowarrantthedestructionofvaluesthathastakenplace…mysonandIhaveforsomedaysbeenpurchasingsoundcommonstocks.[37]

LiquidityandthebearIfhekeptitathomehemightberobbed.Ifhesockeditinabank,thebankmightgounder.Ifheboughtstock,themarketmightcrash.Christ,whatagoofyworlditwasbecoming.

JamesT.Farrell,JudgementDay

Investorslookingtofindtheendofequitybearmarketsoftenlookforsignsfromtheactionsof theFederalReserveandimprovementsinliquidity.InPartI,wesawjusthowdifficultitwastoforecastthegyrationsinthenewelasticcurrency.Assessingchangesinliquidityisdifficultenough,evenwiththepredictabilityofthe operation of the gold standard, but the liquidity forecasting business hadbeensignificantlycomplicatedwith thebirthof theFederalReserveSystemin1914. In 1918-20 the elastic currencywas expandedwell beyondwhat almostanyone had predicted as the Federal Reserve Board sought to support thegovernment’s war financing activities. Unfortunately for Fed watchers the

contractionoftheelasticcurrencycontinuedlongafterthestockmarketandtheeconomyhadbottomedinthesummerof1921.

ThoseawaitingstabilityinFedcreditoutstandingtoindicatebetterliquidityandabetterstockmarketwerestillwaitinginthemiddleof1924,threeyearsaftertheequitymarkethadbottomed.Thepast inabilityofmarket commentators toforecastFedactivitiesandtheirimpactonliquiditymayaccountforthelackofpositive commentson liquidity in thepress in the summerof1932.Of all thepositive comments from the WSJ noted above on the outlook for the USeconomyonlyLondon’sEconomistmentioned improvement in liquidity as animportant factor. [38] The general lack of enthusiasm for easier liquidity as astock market indicator is particularly interesting when one considers the FedbeganamaterialinjectionofliquidityintothefinancialsysteminApril1932justpriortotheequitymarketbottom.

TheWSJtriedtoexplaintoitsreadershowtheFed’snewpolicywassupposedtoworkwiththeFederalReservebuyinggovernmentbondsandissuingchecksforthepurpose.

Thechecksgivenforthebondswillbedepositedinbanksandthence pass back to theReserve banks, either in payment forpast rediscounts or for credit in the reserve accounts of thememberbanks,wherethecreditwillserveasthereservebaseforapossibleexpansionofmemberbankloansorinvestmentsinatleast10timesthevolume.[39]

This all sounds straightforward and was presumably why Secretary of theTreasuryAndrewMellonbelievedtheFederalReserveSystemwastheantidotetothebusinesscycle.HoweverhowcouldonepredictwhentheFedwouldapplythe antidote? Those invested in equities and relying on the provision of theantidotetocurethedepressionhadlostmostoftheircapitalbyearly1932.Therehad been a longstanding argument within the Fed as to the impact of puttingmoneyintocirculationviapurchaseofgovernmentsecuritiesorbills.Famously,theFederalReserveBankofNewYorkplungedintothemarketinlateOctober1929,buying$160millionofgovernmentsecuritiesdespiteonlyhavingexplicitauthorisation from theFederalReserveBoard forpurchasesup to$25million.TheBoard strongly disapproved of the action and therewas a general feeling

that such actions would delay necessary liquidation and promote speculation.TheNewYorkFed continued to lobby for a stretchingof the elastic currencyfrom November 1929 right through to the run on the dollar caused by thedevaluation of sterling in September 1931.However the persuasive powers ofthe New York institution had been dented by the death in 1928 of its long-servingGovernorBenjaminStrong.TheFederalReserveBoardignoredthecallsfrom New York for the administering of Andrew Mellon’s antidote. So aninvestorseekingtofindthe liquidity turnaroundin1929-32wouldhavehadtobeprivytothisdebateandhaverealisedthattheBoardwouldbevictoriousovertheNewYorkFed.

TheFederalReserveSystemhadbeencreatedtorescuethecountryfromjustthetype of national financial emergency which was now developing. Theinstitution’s relative inaction, given its general activism since its creation in1914,wasaparticularlydifficult factor tounderstandand forecast in1929-32.The Board continued to hold the upper hand over the New York Bank, andFederal Reserve credit outstanding showed no sign of increasing until latesummer1931.ThenfromAugust1931toOctober1931,totalbillsandsecuritiesheld by the Federal Reserve banks rose from $930million to $2,062million.However, this policy soon came to an enforced end on the devaluation ofsterling. Even the Federal Reserve Bank of New York accepted that theexpansiveopenmarketpolicycouldnotnowcontinueasadrainongold fromthe US developed. Not until January 1932 was the New York Bank againpushing theBoard to launchaprogrammeofopen-marketpurchases. InApril,the Board did again authorise a major purchase of securities, a move largelyattributedtofearofCongresstakinglegislativeactionratherthananyacceptancethat the New York Fed’s arguments were correct. The role of Congress inforcing the Fed’s change of policy is further suggested by the fact that theexpansionofFedcreditessentiallyceasedwhenCongressadjournedon16July.

FIGURE59.PEAKSANDTROUGHSOFBILLS,SECURITIESDISCOUNTEDBYFEDERALRESERVE

Source:FederalReserve,BankingandMonetaryStatistics

Figure 59 shows the inactivity of the Fed in providing liquidity to the systemuntil July 1931. But the equity market did not respond to the injection ofliquidity from August to October 1931, presumably as these open-marketpurchasescoincidedwithaworseningoftheinternationalpositionandsterling’sdeparture fromthegoldstandard.When theFed triedasimilarpolicy inApril1932, investorswere sceptical given themarket’s failure to react positively inthe fall.Another reasonwas that theFed’s actions served tomerelyoffset theimpactofthegoldoutflow.TheFed’sactionsalsocoincidedwithamajorseriesofbank failures inChicago,whichproduced furtherwithdrawalsof cash fromthebankingsystem.From8Juneto6July,currencyincirculationhadincreasedby$32millionasthepublicwithdrewfurthersumsfromthebankingsystem.Itseems the introductionof a2¢ taxon chequesmayalsohaveplayed a role inpersuadingthepublictoholdevermorecashinsteadofdeposits.Thenewpolicyofopen-marketpurchases,eventotheextentthatitoffsetthesenegativefactors,wasnotasuccess.Thepolicywasaccuratelyjudgedtobedrivenbyshort-termpolitical expediency and commercial bankers were cautious in using the newfunds.

ItisnowclearlyapparentthatbanksarenotwillingtousethesurplusfundsbeingputattheirdisposalbytheFederalReserveuntiltheyhaveaclearerideaoftaxesandthebudget.[40]

Bankers rushed to defend their inaction. A report from the Guaranty TrustCompany on 1 June explained that the banks would be happy to makemorecommercial loans and to extend lines of credit to deserving businesses andpredictedthatthiswouldhappenwhendomesticconsumptionpickedup.

A resumption of normal purchasing by the public will bequickly followed by an expansion of bank loans. The lattermustfollow,butcannotprecede,suchaction.

This reasoningmayhavebeencorrect.TheWSJ reportedon16 Juneeven thepawnbrokerswereflushwithliquidity.

NewYorkCitypawnbrokersreportsharpdropinbusinessdueto reluctance of people to incur indebtedness under currentconditionsand todepreciatedvalueofpledgedarticles.Muchoftheirmoneyislyingidle.

ByJune1932,theincreaseinthereservesofFed’smemberbankswashalftheamount lost since the second banking crisis started. The improved financialconditionofthecommercialbankshadnonoticeableimpactontheirwillingnesstoextendloans,andthiswasrecognisedveryrapidlybythemarketasindicating‘very clearly a continuance of drastic deflation, despite the Federal Reserve’spolicyofcontrolledcreditexpansion’.[41]

Thisinstantassessmentofthecreditpolicyprovedcorrect.Someweeksshowedanimprovementandcausedsomeexcitement,butonamonthlybasisthedeclinein loans continued until April 1933. The transmission mechanism had failed.However, something did happen at exactly this stage of the depression ascommoditypricesbegantoriseandtheeconomybegantorecover.

It is clearly difficult to link this response by commodity prices directly to theopen-marketpurchasesof theFederalReserve,giventhat thoseactionsdidnotsucceed in producing credit creation. However, there may have been indirecteffectsanditisnotablethattheamountofcurrencyheldbythepublicpeakedinJuly1932,andthedeposit-currencyratioimprovedmarginallyfortherestoftheyear. Willingness to maintain deposit levels showed improved faith in thebanking system, perhaps because of the Fed’s action to create liquidity. Thelessening of public fear may have helped to stabilise commodity prices andproduceeconomic recovery in the summerof1932.Whether itdid, the lessonfor investorswas the high danger inherent in calling the bottom of the equitymarketbasedsolelyontheFed’smovetoeaseliquidity.Onecanspeculatethatthe Fed’s action played an indirect role in stabilising commodity prices and

boosting economic activity but there is no evidence that it had the expecteddirectimpactontheeconomybyboostingcreditcreation.

For an investor to bet that the Fed’s new policy would work by indirectlyproducing a stabilisation in consumer sentiment and feeding through to aneconomicrecoverywouldhavebeenariskyonetomake,giventheabsenceofsuch a response to a similar policy pursued from August to October 1931.EnteringtheequitymarketwhentheFedfirstadoptedsuchapolicy,inAugust1931,wouldhavemeantexposuretoafurther69%declineintheDJIA.Perhapsthe brave investor, unperturbed,would have committed to themarket inApril1932when thesecondmaterialopen-marketpurchasedrivewas launched.Butfrom April to July that investor would have lost one-third of the investment.Thosewhocommitted fundswhen theFed’sopen-market operations indicatedeasierliquiditywerebadlyburnedfromAugust1931toJuly1932.

InPartI,weanalysedthechangesinbroadmoneygrowthandcreditgrowthinthe search for indicators of a bearmarket bottom. The search yielded little in1921 and, if anything, produced an even smaller harvest in 1932. Itwas1935before total loans of the US commercial banking system bottomed and creditgrowth resumed.A focusonbroadmoney-supplygrowthalso fails topoint toanytriggerpointforbuyingequitiesinJuly1932.Ifjudgedineithernominalorreal terms, it would not be until the end of the first quarter of 1933 that animprovementinbroadmoneycouldbesaidtohavebeenunderway.

Perhaps thiswas just not the time to expectmonetary analysis to have all theanswers.Howcouldoneanalysemonetarystatisticstoassesstheturnaroundinapsychologicalmalaise inwhich the very use ofmoney itselfwas in question?The loss of faith is illustrated by the situation in South Carolina, where millworkers agreed to accept cloth inpayment for an extraweek’swork amonth.Merchantsandfarmersinthevicinityagreed‘insofaraspossible’toacceptthecloth inpayment forgoods. [42]Andacross thecivilizedworld,desire forgoldhadneverbeenstronger.

Ifwemayjudgebythe‘premium’beingpaid-infrancsbeitnoted!-ofcloseupon25%uponcurbtransactionsinAmericandouble-eagles in Paris - and, where coin is not available, onsliversofgoldcutfrombullion.[43]

In such extreme situations, crunching monetary statistics in the search forevidenceoffinancialstabilityisprobablynotthebestuseofone’stime.

ThebullsandthebearHethoughtofhowhisstockwasnowdowntoten,andhehadtomakeuphismindwhethertoholditorsell.Adropfromtwothousandtoeighthundreddollars,andIkeDuganhadsaidfluctuations.ThatbastardwasgoingtohavefluctuationsthenexttimehemetStudsLonigan.

JamesT.Farrell,JudgementDay

In 1932, as in 1921, thereweremanyprognostications on the direction of theequitymarket.In1932,asin1921,thoseinvestorswhoadvancedthetheorythatreturningpricestabilitywouldmarktheturningpointofthemarketwereprovencorrect. As in 1921, trying to judge the bottom of the equity market usingliquidityanalysiswasfraughtwithproblems.Intheinvestmenttrenches,though,there are often perhapsmore tactical than strategicwaysof assessinghow thebattle is proceeding and there are numerous comparisons between 1921 and1932.

FIGURE60.DOWJONESINDUSTRIALAVERGAGE–8MAYTO8OCTOBER1932

Source:DowJones&Co.

Source:DowJones&Co.

The following notes from the Wall Street Journal show the view from theinvestmenttrenchesinthesummerof1932.

9May:Theabsenceofmomentumofupswingshadbeenduetounusuallysmallshortinginterestandlackofinducementforimportantbuying.

9May:Sharpestupwardmovementinmonths.Hoover’spleatobalancethebudgetwasthecause.

12May:Itissignificant,inreviewingmarketsoverthepastmonth,thatwhenvolumeoftradinghasbeenabovetheaverage,priceshavebeenrising,whereasdeclines,forthemostpart,havebeenaccomplishedonasmallvolumeoftradingwhichhasshownnodispositiontoincreaseaslowerlevelshavebeenreached.

13May:Ifthegovernment’sprogram,asfinallyoutlined,contemplatesadefinitepolicyofembarkingoninflation,ariseinstockpricesundoubtedlywoulddevelop.

17May:ActionbytheSenateDemocraticleaderswelcome-joiningRepublicanstourgespeedyenactmentofthetaxbilltouchedoffalaterally.

21May:OvernightannouncementoftheformationofacommitteeoftwelvebankersandindustrialiststoaidinputtingtoworkthehugestoreoffundsbeingpouredintothemarketbytheFederalReserveSystems’creditexpansionpolicyinjectedanewelementofhopeintothesecuritiesmarketyesterday.Justwhatthenewlyformedcommittee’sprogramwillberemainedindoubt,buyanyeffectfromitsendeavoursmightwellbefirstreflectedinthebondmarket.Whileotherdevelopmentsmaygiveatemporaryfilliptothesecuritiesmarkets,itishardtoseehowanyralliescanmakeheadwayuntilWashingtonnewsismoreconstructive.

25May:Weakestwerethefoodcompanyandthetobaccoshares,whichsofarhaveheldupthebestinthelongdecline.Inmanyquarters,weaknessintheseissueswasattributedtothesellingofstockswhichhadheldupthebesttoprotectaccountshardhitbyweaknessinothersecurities.Newlowsinthefoodgroupwerenumerous.

26May:Thesharpincreaseinvolumeyesterdayindicatedthatthemarketmightbeapproachingaclimax.

27May:AT&Tintonewlowground.

28May:Theapathyofanextremelydullpre-holidaystockmarketwasshakenbya60%reductionintheGeneralElectricquarterlydividend.

28May:Interestinstockmarketwaspracticallynon-existentinthemorning.

2June:Reportsofaformationofanewstabilizationcorporation.TheFederalReserve’spolicyofcontrolledcreditexpansionhaspermittedthepilingupofahugeamountofexcessreservesbymostimportantbankinginstitutions.Someofthesereserves,atleast,willbeputtoworkthroughpurchasesofdebenturesoftheproposedcorporation,accordingtoindications.Stocksscoredabruptralliesearlyinyesterday’ssession,stimulatedbytheSenate’sfinalpassageofthetaxbill.Iftheproposedeconomymeasureisputthroughabalancebudgetshouldresult.SinceMarch8,theDow-Jonesaveragesofindustrial,railroadandutilitystockshaveshrunkfromaround50%tomorethan60%.Theverydepthofthedeclineseemstoindicatethatthemarketissomewherenearaturn.

6June:Therecoveryhasbeensimilartoanumberofotherswiftreversalsinthemarketsduringthelongdeflationinsecurityprices.Eachofitspredecessorshasbroughtthehopethatadefiniteturningpointhasbeenreached,onlytohavehopesdashedbythesubsequentreaction.

11June:Instocksthedaysawanumberofstrikingadvances,buttheyweremostlyattheexpenseofanovercrowdedandnervousshortinterest,whichwasevidentlyimpressedbywhathappenedtotheunfortunategroupinAuburn.Startingoutwithanovernightgainofabout5points,Auburnpushedsteadilyahead,andatonetimewasupover20points.Otherstockswithalargeshortinterestshowedabruptupswings,particularlyJ.J.Case,ColumbiaCarbonandInternationalBusinessMachine.

11June:Notalltheday’snewswasfavourablebutthemarketpaidlittleattentiontothebad.

13June:OnbalanceEuropeappearstobebuyingAmericansecuritiesinthelocalmarketthuscheckingthesteadywaveofliquidationfrom

overseaswhichwasacontributingfactorintheweakmarketNewYorkexperiencedoverthepastseveralweeks.

15June:Stockpricesgenerallywerehigher,andattimesthemarketgaveclearindicationsofadispositiontoturndefinitelystrong.

Strengthofthedollarincomparisontoforeigncurrenciesgaveimpetustotheforwardmovementinstockpriceswhichprevailedmuchofthesession.

16June:Considerablesignificanceattachedtomannerinwhichthemarketactedduringtheday.Tradingvolumesubsidedduringperiodsofreaction,andincreasedwhenstocksmovedahead.Inaddition,thefactthattheleadingstocksgavethebestperformance,andgaveevidenceofconcertedbuying,wasconsiderednoteworthy.

17June:Streettakingitscuefromthebondmarketthesedaysasthetradingelementrealizesthatwithoutanadvanceinbonds,permanentimprovementinstockscanhardlybeanticipated.

21June:Tradingfelltoapproximately400,000sharesforthefullfive-hoursession,thelowestforanyfulldaystradingsinceJune21924.Monday’s400,000sharescontrastwith16,410,000therecordonOctober29,1929whenstocksbrokebadly.Onthatdaytheturnoverinoneissue-GeneralMotorscommon-amountedto971,300shares(therecordforanindividualissue)ortwicethetotalvolumeonMonday.

23June:Thoughnewlowsweresetinsomeoftheleaders,therestofthelistwassteadyinthefaceofthesedeclines.

24June:Pressurefromliquidationagainwasevidentinindividualissues,notablyAmericanCan,whichstruckanewlowlevelduringthesession,andAmericanTelephone.Thelatterhoveredwithinafractionofitspreviouslowbutrecoveredsubstantiallyintheafternoonandmarkedupafairgainfortheday.

25June:Thedeflationinstockprices,andthatisamildwordforit,hascarriedpricesdowntoalevelwherebetterthan50%ofthestockstradedinaresellingforunder$10ashare.InThursday’strading,transactionstookplacein422issues.Ofthisnumber226soldat$10ashareorless…notasinglecommonstocksoldat$100orbetter.

28June:Thebreakthroughoftheindustrialaveragewasdistinctlydisquieting.Alone,itisnotaconclusivesignal,butifitisconfirmedbytherails,undertheDowtheoryitclearlyindicatesthatthelongdeflationisnotover.[Dow-JonesIndustrialsbreaksMaylow].

29June:ThestockofGeneralFoodswasnotdisturbedbythereductionindividendpaymentsto50centsquarterlyagainst75centspreviously.Newlows-USSteel,Coca-Cola,GeneralMotors,NationalBiscuit,Sears-Roebuck,UnionPacificandAT&T.

30June:Duringtheday,theDemocraticconclaveinChicagoofferedverylittleinthewayofnewstoaffectthesecuritiesmarkets…DispatchesfromLausanneservedtoconfirmtheimpression,includedintheovernightnews,thattheconferencewasnearacompletebreakdown,withouthavingmadeanycontributiontoasolutionofthepressingEuropeaneconomicproblems.

2July:Suchstocksasrepresentequitiesinsoundcompaniespossessedofcurrentfinancialstrengthandfundamentallygoodoperatingprospects,withafairmodicumofearningpowerevenunderpresentconditions,mayberegardedasdistinctlyattractiveforthelongpullatpresentmarketprices.Followingisabrieflistofstocksofthetypewehaveinmind:AmericanTelephone&Telegraph,ConsolidatedGas,UnitedGasImprovement,PacificGas&Electric,Chesapeake&Ohio,AmericanTobaccoB,UnitedStatesTobacco,Procter&Gamble,AmericanHomeProducts,ContinentalCan,E.I.duPontdeNemours,WilliamWrigleyJr.,AmericanChicle,Borden,CornProducts.

3July:OnJune27ththeindustrialsclosedat42.93morethanapointbelowthepreviousbottomof44.74setonMay31st.TostudentsoftheDowTheory,thebreakthroughintheindustrialsaveragewasawarning,butnotaclearsignal,becauseconfirmationfromtherailswaslackingandhasbeenlackingsincethattime.Therailaveragesetalowof14.10onJune1.OnJune27itfellto13.76,onlyfractionallybelowthepreviousbottom,andsofarhasnotgoneafullpointundertheJune1low…Therehavebeenveryclearsignsofresistancetosellingpressureintherails.EveninthefaceofthedistressinglypoorearningsstatementsforthemonthofMay,therailshaveheld.Theevidenceofsupportintherailroadlistandtheabilityoftheaveragetoholdonlyslightlyunderthe

resistancepointaresignificanttothestudentoftheaverages.

8July:[DJIAbottoms]

11July:WhileWallStreetgenerallycontinuestopaymoreattentiontofearsofpossibleadversenewsthantoconcreteactionswhichhavetremendouspotentialitiesforlong-termimprovement,therehasbeeninvestmentbuying,bothhereandabroad.

11July:Severalleadingstocksbrokethroughtheirpreviouslowlevelslateintheweek,includingAmericanTelephone,CocaCola,EastmanKodak,UnionPacific,PublicServiceofN.J.,InternationalShoeandInternationalBusinessMachine.

11July:CommonstockofCocaColahasbeensubjecttoconsiderableshortselling…thisselling,whichhasbeenbytraderswhobelievethatthereturnofbeerofahigheralcoholiccontentthan½of1%israpidlybecomingaprobability.RobertW.Woodruff,PresidentofCocaColapointedoutthatinMontreal,wherethesaleofalcoholicbeverageshasbeenpermittedforsometime,salesofCocaColaaremorethendoublethepercapitasalesoftheUnitedStates.

12July:ShareholdersofRCAnumbered103,851onDecember31,1931.AyearagoonJune30thetotalwas93,000andonthesamedateof1928therewere25,000stockholders.

12July:NotwithstandingthefactthatatthecloseofthemarketonTuesday,July5,alloftheDow-Jonesaverageswerewithinhalfapointorsoofthelowsfortheyearandforthedepression,alonglistofstocksandbondslistedontheNewYorkStockExchangeatthattimeshowedadvancesof50%ormorefromthelowpricesoftheyear.[Listshows67stocks50%ormoreabovetheir1932lowsthedaythemarketbottomedon8July.]

14July:TheAnglo-FrenchaccordagreeingtoaunitedfrontonpoliticalandfinancialmattersaffectingthewelfareofEurope,wasthechiefmatterofinterest.ForeignbuyingofAmericanstockshasbeeninsomewhatlargervolumeinthepastfewdaysaccordingtosomesources…Foraperiodofmonths,fromearlyMarchuntillateJune,foreigntradinginthemarket,exceptforoccasionalshortselling,wasrelativelynegligible.

15July:Theactionofstocksinthefaceofquiteanumberofunfavourabledevelopments,wasparticularlyencouraging.Unquestionably,thehopeofnearbyadjournmentofCongress,whichmightprovideastimulusforarally,remainedtheprimefactorintheupswing.[Congressadjournednextday].

20July:Interimscomingtohand.TheStreetisresigningitselftothefactthatmostofthemwillnotofferpleasantreadingbutontheotherhanditisobviousthatthesecuritiesofmostofthecompaniesreportinghavelongsincediscountedthisfact.

22July:AtThursday’sclosingpriceAluminiumCo.Stockwas80%aboveitslowpointthisyearof$22ashareandGulfwas39%higherthanitslowof$22.TheDow-Jonesindustrialaveragehasrisen13%fromthe1932low.

22July:TherewasshortcoveringinAT&T.ReportsofsuchcompaniesasAT&T,Auburn,duPont,Nash,NationalBiscuit,OtisElevator,UnionOilofCaliforniaandUnitedFruit,showingthatnoneofthesecompaniesearneditsdividendrequirementsfortheperiodareamongthoseshareswhichhaveralliedinthelastdayortwosomesubstantially.

25July:IT&Tholdersnumber100,745.OnDecember311929therewere53,594.InthefirstannualreportofthecompanyasofDecember31,1921,thenumberofstockholderswasgivenas846.

25July:Volumefelloffmateriallyonthedeclinesandthemarketmanagedtoconsolidateitsrecentgainswithoutyieldingappreciableground.

25July:Theimportanceoftherecentadvanceinbondsisbeginningtomakeitselffeltinstocks.Inmanycasesbondsareinmarginalaccountsforcollateralpurposesandanysharpriseinbondsgivessuchaccountsgreaterbuyingpower.

26July:Duringperiodsofhesitancywhenpricesdippedoffslightlyactivitywassharplycurtailed.Volumepickedupsharplyaspricesworkedhigher.TheactionofthemarketwasinsharpcontrasttothelongperiodofdeclinefromearlyMarchtoearlyJune,whenvolumedrieduponanyrecoveries,andincreasedduringperiodsofweakness.

26July:Althoughscepticshaveheldthatthecurrentpriceadvanceis

largelyprofessionalandthereforenottobetakentooseriously,therehas,nevertheless,beenasubstantialamountofbuyingbythosewhoreasonthattheirfavouritestocksarecheaponcurrentearningsevenifthereisnoprospectofanyimmediatebusinessimprovement.

30July:TrendlinefromSeptember1929finallybroken,providinginouropinionconclusivetechnicalevidencethatthemajorbearmovementhasdefinitelybeensucceedednotbyaminorrecoverybutbyabullswing.

1August:Thereactionafterthesharpupturn,lookedforinmanyquartershasnotmaterialized,andstockshavepushedsteadilyahead,absorbingprofit-takingandliquidationinfairlyeasyfashion.

Immediatecauseforthebreakoftheexchangeswasfoundintherushofbearstocovertheiropenshortpositionstakeninforwarddollarexchangeduringtheflightfromthedollarlastspring.Thesepositionsforthemostpartwereneverclosedinexpectationsoffurtherunfavourabledevelopmentsinthiscountry…PreviouslyconvincedthattheUnitedStateswasheadedforeconomicchaos,thesightofrisingsecuritypricesbroughtconvictionthattheUnitedStatesafterallfurnishedthebestopportunityforcapitalinvestmentandappreciation.

5August:InspiteofevidencethatmanyintheStreetcontinuedtofighttheadvanceandthatbothshortsellingandprofit-takingwereinthemarketthroughoutthesession,pricesinmostinstancesattainednewhighsinthemostactivemarketsinceOctober,1931.

6August:Whilepriceseasedduringtheafternoon,itwasapparentthatsubstantialresistancewasbeingencounteredonthedecline,andtherewasnoevidenceofanymajorextensionofthereaction.

8August:TheStreetbelievestheshortpositioninmanystocksisstillaslargeasitwasamonthagoabeliefwhichtheExchange’sfiguresontheshortinterestasofAugusttendstobearout.

9August:AllcapitalsofEuropehaveprobablydonemoretradinginoursecuritiesinthepastweekthaninoverayearandcertainlymorebuyingthatatanytimesincethe1929crash.

12August:Inthefaceofthelargestmonth’spercentageadvanceintheaggregatesecurityvaluessincethedepressionstarted,totalknown

securityloansdeclined$112,000,000inJulytothelowestlevelonrecord.Totalknownsecurityloanshavenowdeclined$8,518,000,000sincethepeakof$13,205,000,000wasreachedonSeptember30,1929.

13August:Thestockmarketisignoringthepoorbusinessfiguresthathavebeencomingoutandpayingmoreattentiontoanyindiceswhichpointtoanupturninthefall…Foralongtimethemarketreactedimmediatelytounfavourablenewsanddidnotdiscountprospectsofcheerierdevelopments.

16August:ThemarketpracticallyignoredthereductionintheduPontcommondividendto50centsquarterlyfrom75cents.

Sofarevidenceofanyimportantchangeinbusinessislacking,butbondandrawmaterialcommoditypriceshaveshownstrengthoveraperiodofroughlytwomonths.

16August:RevivalofBritishinterestinWallStreetdatesfromtheannouncementofthewarloanconversionofferandtheadjournmentofCongress.ItisbelievedherethatLondonledthewayinWallStreet’supswingaboutamonthago.ALondonbroker’scircularpublishedonJuly26setouttwolistsof15bluechipAmericanandBritishindustrialcommonshareswhichshowedanaverageyieldontheAmericansharesof10.4%.

17August:AseatontheNYSEchangedhandsat$150,000up25%fromtheprecedingsaleandcomparingwiththelowfortheyearof$68,000.

Theseweredarkdaysindeedinthesummerof1932,buttherewerestillplentyofbullsabout.Onekeychangeevidentinthecommentsabove,however,wasthat the market in general, and specific securities in particular, stoppedpostingnegativepricereactionswhenbadnewswasannounced.Duringthisperiodwhenthemarketseemedsostunnedasnottorespondtogoodorbadnewsasubtleshiftbegantodevelop.

Although the general market was still declining, apparently ignoring theincreasinggoodnews, selectedstockshadalreadybegun to rise in response tospecific good news. The day the market bottomed on 8 July, 67 issues weretradingmore than50%above theirearlier1932 lows. In thedogdaysofearly

summer1932,itwascommonforlessthan450issuestotrade,sothemovementofthesestockscancertainlybeconsideredmaterial.NoneofthesestockswereDowconstituents,anditisdifficulttocharacterisethem.However,onecommontrait is that theywould benefit from higher commodity prices in general, andsugarpricesinparticular.Perhapstheabilityofsuchanumberofstockstorallypriortothebottomofthemarketaveragesprovidesevidencethatbuyingpowerwasbuilding.

Oneof the featuressingledout in the finaldaysof thebearmarketbyvariouscommentatorswastheweaknessinAT&T.Thiswasthewidestheldstockinthemarket and major one-day declines were enough in themselves to makeheadlines.Theabilityofeventhisstocktohitsuch“airpockets”wasperhapsasignthatsmall investorswhohadstuckwith themarketwerenowthrowinginthetowel.DidthesemajordeclinesinAT&Tsignifythatthelastbullhadturnedbear?It isalsonoticeablethatwhileamaterialnumberofselectedstockswererallyingsignificantlythroughthelastdaysofthebearmarket,therewasamajorcollapseinthe“safe”tobaccoandfoodssectors.Theaverageweightedpriceoffoodstocks fell23.2% inMayand the tobaccosectordeclinedby21.3%.Theaveragemonthlypricedeclineforthesesectorsduringthe33monthsofthebearmarkethadbeen3.4%and1.3%respectively.However,thecollapseinpriceofthese“safe”sectorscannot,inisolation,betakenasafoolproofindicatorthatthemarketisreachingitsbottom.InSeptember1930,thefoodsectorsawa27.9%monthly collapse and the tobacco sector a 21.3% decline. Investorswho tookthisasasignoffinalcapitulationboughtequitieson1OctoberandweretolosehalftheirmoneybyJuly1932.Iftheprecipitatedeclineinso-calledsafesectorsisindeedanindicatorthebearmarketisending,thenitisafactorthatmustbeconsideredinrelationtootherindicators.

Adevelopmentnotedasbullishin1921wasthatvolumestendedtodeclineonaweakmarketandincreasewitharisingmarket.Onceagain,thistraitwasevidentasearlyasJune1932and inclearcontrast towhathadcomebefore.The lowvolumeona fallingmarketwas thought to indicate therewere fewer investors prepared to liquidate their positions. The rise involumeinarisingmarketwasattributedtothearrivaloftheso-called“bigconstructiveinterests”.

In 1921, this increase in volumewas also partly attributed to shorts coveringtheirpositions ina risingmarket.Although thisdidoccur in selected issues in

thesummerof1932,thisbear-marketbottomwasnoticeablefortheabsenceofanysignificantbear-marketcovering.Whiletheshortscoveredquicklyin1921,shortpositionscontinuedtoincreasefromthemarketbottomon8Julyto27Julyin1932.Notuntil3Augustwereshortpositionsbelowtheir8Julylevel.Inthatperiod,theDJIArose29%,sotheshortshadtoendureconsiderablepainbeforetheyentertainedcapitulation.

ThefailureoftheshortstocoverinJulywasonepositivesignastowhythisparticularriseinthestockmarketwaslikelytobesustainedpastJuly.Thereluctanceofbearstocapitulate,orotherstoborrowandspeculate,wasapositivesignalthatthenascentrecoveryinstockpricescouldbesustained.

FIGURE61.VOLUMESANDDOWJONESINDUSTRIALAVERAGEATBOTTOMS

Source:DowJones&Co.

AstockmarketadageweinvestigatedinPartIhasitthatbearmarketsendwithaso-called“capitulation”event.Suchaneventispopularlydescribedasafinalsharpdeclineinthemarketassociatedwithhighvolumeasthelastbullssellout.In 1921 we see the final decline in the market happened on low volume. Asimilarsituationwasevidentin1932.

AsFigure61shows,tradingvolumedeclinedthroughoutthefinalfewmonthsofthestockmarket’sdecline.Atthebottomofthemarket,two-weekdailyaveragevolumewasjustlessthan650,000shares.By23July,two-weekmovingaveragevolumewasstilllessthan750,000shares.Therewerethenfourconsecutivedaysfrom25July,whendailyvolumeexceededonemillionshares,alevelofactivitynotwitnessedsinceearlyMay1932.

Onceagain theevidenceshows the finalmarketdeclineoccurringoneverlower volume. It is only after the initial rise of the market that highervolumesdevelop.Thispattern,alsoevidentin1921,ismoreindicativeofabear market bottom than the high-volume capitulation event of popularbelief.

Investorswhowereawaitinganearningsrecoverybeforereturning to thestockmarketmissed the bottom of themarket in July 1932. The CowlesFoundationdatafortheS&PCompositeIndexshowsearningsbottominginDecember1932.Given thedelay inreportingearnings itwouldhavebeensometime in the second quarter of 1933 before it was evident tocontemporaryinvestorsthatearningswereimproving.

Even in 1933 it was difficult to proclaim that earnings growth would besustainable.Basedonpreviousexperienceinvestorsshouldhaveexpectedstrongearningsgrowthastheeconomyrecovered.However,in1933reportedearningswere just7%above their1932 level.Soatbest investorsawaitinganearningsimprovementwould have been holding fire until early summer 1933, but it ismore likely that they would have kept their powder dry right through 1933.Indeedearningsgrowthin1934wasananaemic11%andnotuntil1935whenearnings increased 55% could one see categorical evidence of the normalcyclicalrecoveryinearnings.

As a group, listed companies never reported a loss at any period through thedepression. However, there was a very different picture if one looks at UScorporationsintheaggregate.

The data in Figure 62 showsUS corporations reporting losses in 1932,whileS&Pdataforthelistedsectorreportsprofitfor1932,albeit75%belowthe1929high.Dataonthepercentageofcompaniesreportingprofitprovidessomeinsightastowhentheprofitrecoverybeganforcorporationsingeneral.

FIGURE62.NETPROFITOFALLUSCORPORATIONS($M)

Source:HaroldBorger,OutlayandIncomeintheUnitedStates1921-1938

Awaitingsignsof theearnings recoverywouldnothaveput investors inat,ornear, the bottom of the stock market in July 1932. Even the most trustinginvestor could not have suggested a sustainable earnings recovery until thesecond quarter of 1933 and it is probable, given the anaemic recovery in theearnings of the listed sector, that not until 1935 could one bet on thesustainability of the earnings recovery.TheDJIAbottomed on 8 July 1932 at41.22. Investors buying in early summer 1933would already be paying twicethis price.However, the next leg of the bullmarketwas not to find purchaseuntil around March 1935. This second leg of the bull market saw it almostdouble again fromMarch1935 toFebruary 1937. It is probable that investorsfocusedsolelyonearningsgrowthwouldhaveparticipatedinthissecondstageoftherally.Theywouldstillhavemadedoubletheirmoneywhile thoseluckyenoughtoinvestinJuly1932hadmadefourtimestheirmoney.

Inboth1921and1932,considerableeffortwasmadetomonitorthenumberofshareholdersof listedcompanies.If thenumberofshareholdersbegantoreach

newhighsthiswastakenasanimportantbullishsignal.Onewouldexpectthatinabearmarketwithwaningpublicinterestthenumberofshareholderswoulddecrease.Thereverseisthecase.Ofthe346companiesmonitoredbyR.G.Dun&Co.inMay1932,thenumberofstockholdershadincreased42%sinceMay1930. This trend, particularly for the stock market bellwethers, was so wellknown that market calls had been made for over two decades based on thediffusionofholdingsinUSSteel.

FIGURE63.PERCENTAGEOFCOMPANIESREPORTINGPROFIT

SourceG.H.Moore,BusinessCycleIndicators

Onachartwithawell-chosenbase,itcouldbeseenthatwhenthepriceofUSSteelfellbelowthenumberofitsshareholders,themarketwasabuy.Thischarthadproducedaccuratebuysignalsin1903,1914,1920and1923.Inthe1921-29bullmarket,thenumberofholdersofUSSteelwasunchanged.In1929-32,thenumber of stockholders almost doubled. Presumably this represented investorsrushingfrommorespeculativeissuesbacktothepresumedsafetyofoneofthecountry’s largest corporations. The next buy signal on the US Steel chart, in

termsofshareholdernumberrelativetoshareprice,wasinearly1931,whenthestockmarketstillhada longway todecline.Notsurprisingly thisbrought thisparticularmethodofanalysisintosomedisrepute.Howeveritisstillirrefutable,based on the R.G. Dun data, that there were more shareholders in UScorporationsin1932thantherehadbeenin1929.Thisfact,alongwiththefactthat almost one-third of allNYSE-listed shareswere traded in 1932, suggeststhat interest in the market was higher than is commonly believed. Thoseawaiting evidence of complete public distrust of the equity market were stillwaitingin1932whenthemarketbottomed.

It is interesting that even the leading stock of the 1920s boom, RCA, saw amajor increase in its number of shareholders in the 1929-32 bearmarket. Thetrendinbothbearmarketswasforamovementofshares intothehandsof thepublicattheexpenseofWallStreetandwhatwouldbedescribedatthetimeas“big constructive interest”. At the bottom, as in 1921, it was the return ofprofessionalbuyers,stockbrokersandrichcapitaliststhatmarkedthebottomofthemarket.Themoveinstockswasthenawayfromthepublicandbacktotheprofessionals as the bull market developed. In 1932, as in 1921, it was theconcentration of stock back in the hands of bigger players that indicated thereturnofthebullmarketratherthananyreturnofpublicenthusiasm.

Onemajorerrorevident from investorcommentsat the timewas the focusonthe deteriorating fiscal position. The Wall Street Journal carries constantreferencetochangesinthefiscaloutlookandthesupposedpositiveornegativeimpact on the stockmarket. The pages of theWSJ suggest the culprit for thefinalplungeinstockpriceswastheprospectofanunbalancedbudget.TheDJIAhalvedinthefourmonthsfromMarchtoJuly1932.Bythestandardsofanybearmarket, that was a vicious and rapid final downturn. The scale of this finaldeclineexceededthoseenduredintheOctober1929crashandinbothbankingcrises. There was no doubt that government actions were undermining publicconfidenceasthefollowingextractsfromtheWSJreveal:

NewJerseyLegislature ‘walksout’onTheronMcCampbell,militant legislator,who insistsonreadinga1,500-wordspeechonthequestion‘IsTheNewJerseyLegislatureanInsaneAsylum?’,despitemeasurestakentopreventhim,includinghisses,cheers,songs,andturningoutthelights.Recessdeclaredasalastresort,butspeechwasreaduntilfinished.

WallStreetJournal,25May1932

‘Haveweagovernment?’Thatissurelya‘mouthful’.WasthereeverbeforesuchashamelessandcheapbunchofpoliticiansinWashington?Shoot’emagain,onlymuchseverer.Youaretooeasy.

LetterfromMr.CharlesN.ThomsonofOrient,LongIsland,WallStreetJournal,17May1932

Asitturnedout,theconstantcallforabalancedbudgetbeforeanyimprovementin the equity or bond markets could materialise was the most erroneousinvestmentjudgementmadein1932.

In 1931, the budget deficit amounted to just 0.60% of GDP, and there werenumerous pro-spending lobbies in Congress who created a number ofexpansionary bills in early 1932 suggesting further fiscal deterioration.Contemporary reasoning was that this produced the final crash. As Congresscametowardsadjournmenton16July1932,thesteadyfailureofthesebillsandthebalanced-budgetstatementsofPresidentHooverwereseenasgoodnewsforthestockmarket.Atthetime, theimprovementinthemarketwasattributedtothisstepbackfromasupposedfiscalabyss.

A fiscal deficit results when government spending exceeds governmentrevenue. The deficit in revenue is usually met by borrowing moneythroughtheissuanceofbonds,althoughthesaleofgovernmentassets isanotheroption.Financialpractitionersview fiscaldeficitsasanegativefactor.However,atleastsincetheabolitionofthegoldstandard,thereislittleevidenceadeterioratingfiscalpositioncanproduceorexacerbateabearmarketinequities.

AlsoinJuly,theDemocratsendorsedRooseveltastheircandidateforPresident.Roosevelt was also surprisingly vociferous in his demands for a balancedbudget.Ifthiswaspartofthereasonfortherecoveryintheequitymarket,whichbeganinJuly1932,subsequenteventsweretoshowthatitwasmisguided.Priorto the 1930s, the US had grown used to a federal surplus during periods ofpeace. Inwhatwas probably the largest economic contraction recorded in theUS,in1837, thefiscaldeficitreachedonly0.68%ofGDP.Inthiscontext, thepeace-timebudgetdeficitof0.60%in1931wasenoughtoseriouslyfrightentheinvestmentcommunityin1932.Howeverthedeficitwouldescalate to4.6%ofGDP in 1932, 4.61% in 1933 and peak at 5.50% of GDP in 1934. It seemsunlikely thatanybodyat the timewouldhave foreseenoneof thegreatestbull

marketsinthehistoryofUSequitiesoccurringwhilesuchanunparalleledfiscaldeterioration was underway. Those who called for a balanced budget as anessentialprecursorforarecovery inequitiescouldnothavebeenmorewrong.Government’s desperation across the globe to balance their budgetsmay thushavebeenmisplacedandthebirdownersofMoraviamayhavesufferedinvain.

Toraisemoneytomeetmunicipalexpenses,cityofHihenstadtinMoraviadecidedtoimposetaxonallpetsongbirdsof$2.97ayearforeachnightingaleandlowerforcanariesandthrushesetc.[44]

Thisabilityofequitiestorisethroughamajorfiscaldeteriorationfrom1932to1937suggests that thefinaldownward lurch in themarket fromMarch toJuly1932wasnot causedby concerns over the fiscal situation.Therewas amajordrainonUSgoldreservesatthistimewhichclearlydepressedtheequitymarketbuttherewereotherpotentialcatalystsforthisdrain.SomecommentatorsintheWSJ attributed the decline in the equity market to the worsening politicalsituation inWashington,whichwas causing the drain on gold reserve and thecollapseof themarket. Itwasnot surprising that theWallStreetJournal, laterdescribed by President Truman as ‘the Republican bible’, should attribute adecline in confidence on the increasing probability of aDemocratic President.TherewashoweveramorefundamentalreasonwhygoldwouldbeleavingtheUS-thedevaluationofalmostallthecountry’smajortradingpartners.Justhowdramatically these currency changes could impact the trade position wasbecomingevidentinearly1932,whentheUKimportedonly396automobilesinthe first fourmonthsof theyear, comparedwith5,188 for thewholeof1928.UKexports,inthesameperiod,totalled8,771cars,anincreaseofroughly50%over the like 1928 period. [45]TheUS trade surplus had already halved from1930to1931.

Theincreasinglyapparenttradedeterioration,andtheimpactthismighthaveonthe country’s commitment to the gold standard, played a role in producingcapitalflightfromtheUSinthisperiod.Withthebenefitofhindsight,itisverylikelytheFederalReserve’schangeinmonetarypolicyinApril1932wasalsoacontributing factor to this gold outflow. In many circles, the move to boostliquidity, seemingly under political pressure, had to be a precursor to theabandonmentofthegoldstandard.Thispersuadedforeigninvestorsinparticular

that holding assets valued inUSdollarswas increasingly risky. From January1932 to July, the monetary gold stock contracted 12% to $3.65 billion. TheoutflowofgoldcametoanendatalmostthesametimeastheFederalReserveended its openmarket purchase programmeand the adjournment ofCongress.Contemporary opinion that a balanced budget was necessary to stabilise theequitymarketwaswrong, and itwas probably alsowrong to blame events inWashington for the final terrible slump in the market. The combination ofdeteriorationinthetradepositionandthelaunchoftheFed’sliquidityinjectionwere the key factorswhich persuadedmany that theUSwas on the verge ofleaving thegold standard. Itwas in this environment that thepriceof equitiescouldhalveinjustfourmonths.

ThenegativeresponsetotheFed’sactionsmusthavebeenabitterblowtothosewhobelievedithadtheantidotetobusinessrecessions.Thoughmany,includingtheNewYorkFederalReserve,hadbeenarguingforliquidityinjectionsintothesystemforsomeyears,thereisevidencetheinjection,whenitfinallycame,andwithin the confines of the gold standard, may have resulted in capital flight,effectively neutralising the positive impact of the liquidity injections. Suchactionsearlierintheeconomiccontraction,whentheUStradesurpluswaslargerand before other countries had devalued their currencies, may have producedpositiveratherthannegativereactions.HoweverbyApril1932confidenceinthecommitmenttogoldwasalreadyshakenandtheFed’sactionfurtherunderminedsuchconfidenceexacerbatingthedeclineinthestockmarket.

Thekeyquestionfor investors is:What finallystopped this rout inJuly1932?Withthebenefitofhindsightitappearsthattherewasoneeventuniqueto1932thathelpedrelievethegolddrainandbolsterthestockmarket-theinternationalagreement concluded at Lausanne on Germany’s war reparations. From pressreports of the time, it is evident that no breakthrough was expected on thesenegotiations.

Germany,asithadsincethesigningoftheTreatyofVersailles,wasarguingforsmallerreparationpayments.Others, inparticularFrance,werearguingagainstanysuchreduction.Thishadbeenalong-runningdisagreementandthemarketswere inured todiplomaticcompromiseandobfuscation.Germany’sreparationswere agreed in1921,butwithin theyear it haddefaultedon itspayments andwas granted a one-yearmoratorium. Before themoratorium expired, BelgiumandFranceoccupiedtheindustrialisedRuhrandsoonthereafterhyper-inflation

sweptGermany.TheDawesPlanof1924rescheduledGermany’sdebtandthecountrycontinued tomeet reparationpaymentsbyborrowing funds in theUS.FromOctober1921toJuly1930,GermanyofferedforsaleintheUS135dollar-denominatedbonds-theparvalueoftheoutstandingobligationsinAugust1932was just short of $1 billion. Despite the success of the debt issues, a furtherreduction in Germany’s burden was needed in 1929, and this was achievedthrough theYoung Plan.However, the burden of economic contraction in theGreat Depression intensified Germany’s economic problems, and PresidentHooverannounced in thesummerof1931aone-yearmoratoriumonwar-debtpayments from theAllies and reparations fromGermany.As thismoratoriumapproached expiration, interested parties met in Lausanne and surprisedeveryonewithadeal to abolishGermany’s reparationobligations in return forbonds.ThisagreementamountedtoadefactoreductioninGermany’sfinancialburden of some 90%. France’s longstanding antipathy towards a reduction ofreparations had mysteriously vanished. (Not made public was the informalagreementthattheUSwouldcanceloutstandingwardebtsowedbyitsEuropeanallies,anagreementtheUSCongresssubsequentlyrefusedtohonour.)

Whenthenewsofanapparentbreakthroughonreparationswasannounced,theimpactwasparticularlypositiveoncommoditymarkets. Investorsbelieved theinternational financial log jam had been broken and that consumption fromGermany and the debtor nations was likely to rise. The WSJ on 24 Juneillustratedthepositiveconsequencesflowingfromtheagreement.

FrancenowrankswithHollandandSwitzerlandasoneofthethree countries with gold unit for unit circulation. Worldrecoverydepends,inpartatleast,onshiftingthisconcentrationof gold from these countries to the debtor and exportingcountries.Thatwillcomeabouteventually, througheconomicprocesses,butitcanbespeededupifpoliticalleaderscanworkout some solution of the present intergovernmental debtproblems.[46]

TheLausanneagreementheldouttheprospectofjustsuchaspeedingupoftheglobal economic recovery. In particular the agreement was a key factor thathelped stabilise commodity prices, which, in turn, was, as we have seen, animportantfactorinstabilisingthestockmarket.Alsoatthetime,thedownward

pressureon theSwiss franc following theagreementwas thought tobeaveryimportant positive indicator for global financial markets. Capital had beenattractedtoSwitzerlandasitfullybackeditscurrencyingold.Theweaknessinthe Swiss currency following Lausanne was thought to signify that this“unemployed capital” was moving back into employment elsewhere in theworld.

AfurtherimprovementintheinternationaloutlookoccurredinGermany.Therewas increasing optimism about the outlook for German government bonds,widely held in theUS, as the rise of theNational Socialist party appeared tofalter. In April 1932, Adolf Hitler was defeated by President Paul vonHindenburg in the presidential election.Despite some commentators believingHitlerwould be good for business, theWall Street Journal did not hesitate torefer tohimasa“shoddyleader” throughout thisperiod.WallStreetgenerallywelcomedthefactthattheNazipartyfailedtoincreaseitsvoteinthesubsequent31JulyReichstagelections,believingthiswouldimprovethechancesof“order”inacountrydisruptedbycivil strife.TheWSJgaveadownbeatassessmentofHitler’sfutureprospects.

Theopinionisgrowing,however,thattheHitlermovementhasreached its peak in Germany and that, the Nazi party willcontinuetobeatroublesomeelementtothoseseekingorderlygovernment,HerrHitlerwill not be able to secure control ofthegovernment.[47]

Unfortunatelyfortheworld,Hitler’sprogresswasnotstoppedbyhisfailuretomakeprogressthroughthedemocraticprocess.

As in 1921, theDowTheory scored a notable success in 1932. Thereweremovestofractionalnewlows,buttheDowexpertsattheWSJmadeitclearthiscouldbeaverybullishsignal.

Althoughtherecentsimultaneousentryofboththerailroadandindustrialaverages intonew low territorymaybe regardedassymptomatic of prospective continuance of the majordownward movement, according to the theory, thisinterpretation is subject to confirmation by further marketaction.Normally,penetrationofprevious low,orhigh,points

mustbemorethanfractionaltoqualifyasadefinitivesignal.Afractional penetration, though perhaps justifying someexpectationofa furthermovement in thesamedirection,alsohaspossibilitiesofinterpretationasadoublebottomordoubletop,whosesignificancewouldbequitedifferentfromthatofabreakthrough.[48]

Abullishdoublebottomwassoonconfirmed.OnceagaintheWSJ’sanalysisoftheDowTheoryhadsuggestedthatthebottomofthebearmarketwasimminent.William Peter Hamilton died in 1929, but the baton as leader of the Dowtheoristswasnotpassedtothenexteditorofthepaper.InsteadRobertRhea,anindependentcommentatorwhostudiedtheDowTheoryeditorialsofbothDowandHamiltonintheWallStreetJournal,becamethenewguru.Rheacalledthebottom of the great bear market on 21 July 1932 - two-for-two for the DowTheory.

Cynics might note that the Republican Advisory Committee of New YorkCounty had urged legislation to prevent casualty insurance companies frombuying common stocks. The stock market bottomed within two weeks of thepublication of this report. Panic may have been rife but it may be worthremembering that not everyone was concerned with the future for commonstocksinthesummerof1932.

Alex Stillman, 20-year-old son of James A Stillman,announcedheplanstoflytheAtlanticnextyear.Heexplained‘Dadhadonlyabout$65,000,000leftafterthemarketcrashsoImayhavetogotowork.’[49]

Bondsandthebear

‘Irememberthepanicsof1907,and1893,andtheywerebad.Butnotasbadasnow.Idon’tknowhowmanymillionsofmenthere’sonthestreets.’

‘Howdidthedepressioninthoseyearsend?’

‘Well, theygot to end.There’s action, and then reaction, andthenactionagain.Whenathinggoesup,ithastocomedown,andthenwhenitcomesdown,ithastogoupagain.’

JamesT.Farrell,JudgementDay

Somethingpeculiarhappenedinthisdeflationarydepression- thepriceofUS government bonds declined. The daily average yield of long-termgovernment paper in January 1932 was 4.26%, comparedwith 3.70% inSeptember 1929. Over that same period, the wholesale price index haddeclined31%.Giventhedeclineinthegeneralpricelevelandtherisingcreditrisk associated with other investments, most investors would have expectedgovernmentbonds tohave risen through theeconomiccontraction. Indeed thiswas the trend fromSeptember 1929 to June 1931,when the yield declined to3.15% from 3.70%. However, June 1931 proved to be the high point for thegovernmentbondmarketandpricesdeclinedasthesecondbankingcrisestookhold in theUS and as the crisiswas internationalised.Althoughprices driftedlowerfromJune1931toAugust,therealslumpingovernmentbondpricescamewiththedepartureofsterlingfromthegoldstandard.

Sterling’s departure from the gold standard prompted foreign central banks toliquidateUS dollar assets and the gold stock declined. This external drain onliquidity occurred just as domestic depositors, shocked by a new surge incommercial bank failures, sought to hold an even greater proportion of theirassets inUS currency rather than deposits. To exacerbate the pressure onUScommercialbankstoliquidateassets,theFedsprangtothedefenceofthegoldstandardexchangerate.On16October,theNewYorkFedraiseditsrediscountratefrom1.5%to3.5%.Thisriseininterestratesputfurtherpressureonbondprices.

Prior to September 1931, banks had been liquidating lower-quality corporatebonds, and yields on these instruments had already been rising from the thirdquarterof1930.

By September 1931, both corporate bonds and US-government bonds werebeing dumped and the yields on both instruments now moved higher. Astabilisation of government bond prices was not evident until February 1932.Whileitispossiblethefearofbiggerfiscaldeficitsplayedaroleindepressing

the price of government bonds, this factorwas probablyminor, given that themarketwasrallyinginFebruary1932,yearsbeforetherewasanyprospectofareturn to fiscal rectitude. It is noticeable however that the stabilisation in thegovernment bond market did coincide with the establishment of theReconstruction Finance Corporation in January 1932. The government-backedRFC had borrowing power of $1.5 billion (increased to $3.3 billion by theEmergencyReliefandConstructionActof21July1932)andwaschargedwithlendingmoney to banks and other institutions.This availability of new credit,which alleviated banks’ needs to liquidate government bonds, seems to havebeenmore important than any change in the fiscal situation in stabilising thegovernment bond market. Another fillip for bond prices was the FederalReserve’s buying of government bonds, launched in April 1932, aimed atinjectingliquidityintothesystem.

FIGURE64.YIELDONUSGOVERNMENTLONG-TERMSECURITIES–SEPT1929-SEPT1932

Source:NationalBureauofEconomicResearch

The collapse in government bondpriceswas rapid, and recoverywasgradual.GovernmentbondyieldsdidnotreturntoJune1931levelsuntilApril1934.Thecollapse has to be put into the context of a longer-term bullmarket in bonds,underway sinceAugust 1920. In this secular bullmarket yields declined from

5.67%inAugust1920tojust2.16%byJune1946.Inthiscontext,theJune1931to January 1932 setback, when yields rose from 3.13% to 4.11%, may seemminor.Howeverthiscollapseinthepriceofgovernmentbonds,duringaperiodof historically high deflation, must have considerably disrupted investorperceptionsofwhat represented“fairvalue” in financialassets.The impactonfinancial asset valuation in periods of declining prices and earnings but risingrisk-free rates is particularly negative. Even in the worst deflationary times acollapseinthepriceofgovernmentbondswasthusprovedpossible.Whatotherunexpectedreactionsmighttherebeinfinancialmarkets?

Investorsinthecorporatebondmarketwerealsotobeshockedbythescaleofthe bear. The performance of thismarket provides perhaps the best indicationthatinvestorsexpectedanormaleconomiccontractiontofollowafterthecrashof October 1929. The yield on Baa-rated corporate bonds, the sector of themarketwiththelowestcreditquality,actuallydeclinedfromtheSeptember1929level throughmostof1930.Notuntil theeruptionof thefirstbankingcrisis inthethirdquarterof1930didthefirstdeclineinthepriceofBaa-ratedcorporatebondsbegin.TheaveragemonthlyyieldonBaacorporatebonds inSeptember1929was6.12%andbySeptember1930yieldshaddeclinedto5.65%.AlthoughfaithhadbeenmaintainedinthisassetforalmostayearaftertheOctober1929crash, this faithwasquicklydemolished.ByNovember1930,Baayieldswerealready in excess of the September 1929 levels. The average yield exceeded6.7%byDecemberof1930andremainedaroundthatleveluntilApril1931.Itwasthen,withthesecondbankingcrisesandtheinternationalisationofthecrisisthatthereallydramaticbearmarketincorporatedebtbegan.BetweenAprilandDec1931,theaverageBaayieldjumpedfrom6.72%to10.42%.

BoththegovernmentbondmarketandtheBaacorporatemarketstabilisedinthefirstquarterof1932.However,whilethisstabilisationmarkedthebeginningofanewbullmarketforgovernmentbonds,therewasanotherfinalcrashcomingforthe corporate bondmarket. TheBaa corporate bondmarket bottomed in June1932whenthedailyaverageyieldforthemarketreached11.52%.Thetrendinprices in theAAA corporate bondmarketwas very similar to that in theBaamarket,althoughtheamplitudeofchangewasmorerestrained.

While thebearmarketmayhavecarriedgovernmentbondpricesbackto1924levels, the bear market in corporate bonds was of a considerably largermagnitude.Thehistoricaldataonbondyieldsbyqualityofissuerislimited,but

theBaayieldof11.52%wasone-thirdhigherthanthehighestyieldpreviouslyrecordedfromwhendatabecameavailablein1919.TheyieldofAAAcorporatebondsaveraged5.41%inJune1932,thehighestsinceDecember1921.TheDowJones Index of forty corporation bonds,which had been available since 1914,felltoanewlow.

FIGURE65.YIELDSONBAACORPORATEBONDS–SEPTEMBER1929TOSEPTEMBER1932

Source:NationalBureauofEconomicResearch

Figure66.YIELDSONAAACORPORATEBONDS–SEPTEMBER1929TOSEPTEMBER1932

Source:NationalBureauofEconomicResearch

Whatever stabilised the government bond market in January and February of1932,thechiefsuspectbeingtheestablishmentoftheRFC,itfailedtohavethesamepositiveimpactonthecorporatebondmarket.ItwasnotuntilJune1932thattheAAAandBaacorporatebondmarketsfoundtheirbottoms.

By the summer of 1932, the pages of theWall Street Journal were full ofindicationsthattheendofthesell-offincorporatebondswaslikely.Asin1921,thecompletedearthofcreditgrowthintheeconomyledthecommercialbankstobecomeeverlargerbuyersofbonds.Whiletheiroriginalpurchasesmayhavebeen secure government bonds rallies in the prices of these instrumentsincreased the attractiveness of corporate bonds. The prices of corporate bondshad fallen precipitouslywith theDow Jones&CoAverage of SecondGradeRailBondsdown49%fromthe1931high.Thecommercialbankswerejoinedinthecorporatebondbuyingspreebythecorporationsthemselves, temptedbythefactthatsomeoftheirobligationscouldbecancelledatlessthanhalfoffacevalue.

The most publicised new buyer for bonds was the American SecuritiesInvestmentCorporation,formedbythelargestcommercialbanksintheUS.Theideawas that this “pool”wouldbuybonds, thus spreading the risk among thenervousbankers.Themarketrosestronglyontheannouncementofthecreationof the pool, and the little buying the pool actually implementedwas at prices

wellabove the1932 lows. In termsof thegeneralgrowingbuying support forthebondmarket,theroleoftheResolutionFinanceCorporation(RFC)wasveryimportant. Of course, investors tend to discount the ability of government tofundamentallychangemarkets,butthereisnodoubttheprovisionoffinancingby theRFC todistressedbanksand railroadsalleviated thesellingpressureonthecorporatebondmarket.

Onceagain, thisperiod ismarkedbynumerouscommentatorspointingout theinvestment wisdom of borrowing cheap, short-term money to buy the bestqualitycorporatebonds. In1932,unlike1921,onekey factordepressingbondprices was the worsening fiscal position. In 1932, there was a real threatCongress would endorse the so-called “Garner Plan” which ‘called for theissuance of $1,000,000,000 bonds to raise funds for public construction’. Thebondmarketconstantlyfrettedabouttheimpactsuchanincreaseinthesupplyofbondswouldhaveonprices.TheGarnerPlanwasnot tomakeit into law,butoverthenextfewyearsthefiscaldeficitballooned,withoutproducinganymajorsell-offinthebondmarkets.Bond-investorfearsaboutthenegativeimpactfromcontinued fiscal deterioration were misplaced. And whatever fears may havebeenexpressed in thepagesof theWSJ, thefactwas thatbondofferingswereincreasinglyover-subscribed.

ItisclearthattheapparentagreementatLausanneregardingthecancellationofGermanreparationshadabigimpactonthecommoditymarkets,anditsimpactwasalsoevidentinthebondmarkets.Theargumentwasthattheremovalofthisburden on Germany, accompanied by some alleviation for the Allies on theirdebt repayments to theUS,wouldreduce the logjamin international tradeanddemand.GermanbondsjumpedtenpointswithindaysoftheannouncementofthedealatLausanne.TheagreementalsocoincideswithrenewedvigourintheupswingintheUSbondmarkets.Thereboundinbondpriceswasspectacular.

FIGURE67.THEDOWJONES&COMPANYBONDAVERAGES

¹Newhighsforyear.Source:WallStreetJournal,22August1932

While the government bondmarket had seen its lows in January 1932, itwas not until the first of June that corporate bonds bottomed, about fiveweeksbeforetheequitymarket.

However, the fiscaldeteriorationwas to reach levelsnot contemplated in June1932,andyetthebullmarketinbonds,whichcommencedthen,wastolastuntil1949.Whilebondinvestorsmayhavethought theadjournmentofCongressanimportantbullfactorin1932,theCongresswouldbebackwithbiggerspendingproposals and much bigger deficits, and still the bond bull market raged on.TherewereotherreasonsforthecorporatebondmarketbottominginearlyJune,and once again the role of stabilising and rising commodity priceswas to theforeandsignsofsuchstabilisationwereevidentbylateMay.

The WSJ was reporting as early as 24 May that ‘a few commodities’ wereshowing ‘a tendency to hold at present levels’. By the end of the month,commoditypriceriseswerebeingreportedinabroadrangeofcommodities,andFisher’sindexofwholesalepricespostedthreeconsecutiveweeksofgaininthemiddleof July.By the endofAugust, therewasgeneral confidence thatpricerises were sustainable as ‘the advance in wholesale prices has continued formorethantwomonths’.

The corporate bond market bottomed just as a number of commodity pricesbegantoimprove-twoweekspriortothebroadindicatorsofwholesalepricesrevealing improvement.Thedeflationaryprocesshadwroughtparticularhavocwithcorporations’abilitytorepayfixedobligations,sothereweregoodreasonswhya rise in thegeneralprice levelwasseenaspositive for investors.By themiddleofthemonth,thenewsfromLausannesuggestedafundamentalchangeintheglobalfinancialsystem,whichwouldfurtherunderpincommodityprices.[50]

There were several one-off events that also played a role in stabilising bondprices, themostnotableofwhichwerethecreationofthe“bondpool”andthelaunch of the RFC. The bottom of the corporate bondmarket coincided withrumoursoftheformationoftheAmericanSecuritiesInvestmentCorp(ASI).Asthe government-bond buying programme of the Federal Reserve had failed tocreate credit growth, the ASI was formed to pool the funds of commercialbankerstobuyaportfolioofbonds,utilisingsomeoftheliquiditycreatedbytheFed,whilespreadingtherisksofthepurchasers.Newsthatsuchanorganisationhadbeencreatedwasenoughtocauseasubstantialbondrally.Theturnaroundwasachievedwithout thecorporationinitiallyhavingtobuyanybonds.At theright time when bonds were cheap, economic conditions improving andcommodityprices rising, the support operationprovided thenecessaryupwardimpetus for prices. If a private support operation played a role in stabilisingfinancialmarketsin1932thenapublicsupportoperationplayedanevenbiggerrole.Althoughit isalwaysdifficulttodesegregatecause-and-effectinfinancialmarkets,theformationoftheRFCnotonlyassistedbankliquidityandstabilisedgovernment bond prices, but it led to some improvement in credit quality inthosesectorsofcommerce,notablyrailways,wherecreditavailabilityimproved.As well as these support operations there is also some suggestion that theconversionofBritain’s£2billion5%war loan intoa3.5%perpetual loanalsoplayedanimpactinstabilisingbondpricesintheUS.On2July,aboutamonthaftertheUScorporatebondmarkethadbottomed,theWallStreetJournalwasreporting:

TheLondonStockExchangetodaywitnessedfranticscenesofexcitement and activity such as have not occurred since theboom days of 1928…. Instead of the minor conversionoperationsexpectedearlierthisweek,dealerswereconfrontedwith the largest single conversion operation ever staged….Tradingbeganataround10.30a.m.whenBritishfundssoaredwith unprecedented advances. Gilt-edged securities usuallymoveonlyinfractionsofapointatatime,butattheopeningthismorning4%consolsrose8pointsto£110….Evenleadingcommonsharesamongtheindustrials,minesandoilsjoinedinthegeneraladvance.

It is noticeable from reading the WSJ for the summer of 1932 that “foreignbuying”ofallUSsecuritieswasmentionedmorebycommentatorsfollowingtheBritishconversion.Itiscertainlypossibletheconversionsentfundsoverseasdueto the reduction in interest rates, and the excitement in London over theconversionoccurredjustafewdayspriortothebottomoftheUSequitymarket.There were thus these various important one-off considerations impacting thecorporatebondmarket in theearlysummerof1932.However,as in1921, thekey consideration for stabilising the bond market appears to have been thestabilisationofselect-commodityandthengeneral-wholesaleprices.

Rooseveltandthebear‘Butgettingbacktopolitics,boys,thisspringisonlygoingtobeapreviewofthepresidentialelectionin1932.Thenwe’llhaveDemocratsallthewayfromtheWhiteHousetothestreetcleanersoneveryblock.Andthere’llbebettertimes,too,’Redsaidwithsmugpride.

JamesT.Farrell,JudgementDay

Onecannotanalysethefactorsimpactingthefinancialmarketsinthesummerof1932 without discussing the race for the White House. Was it merelycoincidentalthatthestockmarketbottomedjustafewdaysaftertheDemocratsselected Roosevelt as their Presidential candidate? Both Republicans andDemocrats held national conventions in June 1932 to choose candidates. TheRepublicans were bound to endorse their incumbent, Herbert Hoover. Thecontentious issue for themwas how far they would go to change the law onProhibition. With the public in open breach of the law, and the growth oforganised crime around the alcohol business, it was clear that a more lenientstance could only help the party’s election prospects. At the DemocraticconventionFranklinD.Rooseveltwastheclearfavouritetowinthenomination.However,hiscampaignwasbadlymanagedand,althoughtheConventionbeganon27June, theoutcomewasstilluncertainon1July.TheWSJreportedon2Julyoftheexcitementthedeadlockwascausinginthemarkets.

Withthefirstthreeballotsproducingavirtualdeadlock,hopeswere high that a compromise candidate, in whom businesswouldhaveconfidence,wouldbeagreedupon,andpricesforthe list, as a whole strengthened perceptibly on later advicesthatGovernorRooseveltwaslosingstrength.

According to theWSJ, Roosevelt as a likely President was depressing, ratherthansupporting,pricesintheequitymarket.Themarket’sexcitementregardinga compromise candidate was short-lived as Roosevelt gave his nominationacceptance speech the next day. Thus from 2 July onwards, it was lookingincreasingly likely that Roosevelt would be the next President. The public’sdisgruntlement over the depression was very likely to produce a change inadministration.JohnNanceGarner,Roosevelt’svice-presidentialrunningmate,wentontherecordtosaythattheDemocraticpartywouldwinthePresidentialelection if it could follow a ‘sit still and keep quiet’ policy. Of course,Republicans could hope that the public would not apportion blame for theDepressionontheincumbentandtheWSJvainlyarguedthecase.

14July:This1932Presidentialcampaignisthemostuncertainone since 1916. However, no neutral, and but few partisans,who have combed all possibilities, care to attempt a positiveforecastat this time….However,anyonewhohastalkedwithvoters finds their wrath against the Democratic House ofRepresentatives is probably greater than againstMr. Hoover,andtheleaderof theDemocraticHouseissecondmanontheRooseveltticket…Thecountryisinaframeofmindtotrynewmen and new measures. However, those sections which willdetermine the election do not appear to want this change tocarrythemtowardradicalismorevenadvancedliberalismandthat is the way the associates and the words of GovernorRooseveltseemtobeheadinghim.

However, suchoptimismofopinionwas refutedby the factsbeing reported inthesamenewspaper:

15 June: Survey of national political sentiment by Babsonstatisticalorganizationsaysnationisnow60%Democraticand40%Republican but that ‘the tide has recently turned and isnowclearlyrunningtowardPresidentHoover.’

23 August: President Hoover’s chances for re-election haverisenperceptiblyinthepastfewweeks.However,atthistimeitcannotbesaidthatMr.HooverhastheadvantageoverFranklinD.Roosevelt,hisDemocraticopponent.

30 August: Down Town Republican Club of Los Angelesabandonsplansfordinnerandrallyfollowingpollofmembersshowing 70% of them in favour of Governor Roosevelt forPresident.

1September:RooseveltCouldTriumph.

No Presidential election is a certainty with more than four months to go.However,itwashighlyprobablebythesummerof1932thatRooseveltwastobethenextPresidentoftheUnitedStates.Itisamatterforthehistoricalrecordthat Roosevelt’s nomination and the probability of a Roosevelt Presidencycoincidedwith thebottomingof theUSequitymarket.Therise ingovernmentbondprices,wholesalepricesandthecorporatebondmarketwasunderwaypriortohisnomination,butcontinuedstronglythereafter.Thattheequitymarkethadreacted positively to news on 1 July that Roosevelt would fail suggests theincipient recovery in financial markets was entirely coincidental with theincreasingprobabilityofaRooseveltvictory.Inthesummerof1932,itwasstillunclearwhatRooseveltmeantforbusiness.Duringhiscampaign,theRooseveltcampwassendingtwoverydifferentmessages.Ontheonehandtherewastheradical message of structural change being delivered by both himself and hiswifeandreportedintheWallStreetJournal:

23 May: Governor Roosevelt, in commencement address atOglethorpe University at Atlanta, Ga., asks for boldexperimentation to achieve redistribution of the nationalincome,statingthatinthefuturecapitalmustbecontentwithasmaller return and reward for the worker must beproportionatelygreaterifthemodernsystemistosurvive.

9 July: Mrs. Franklin D. Roosevelt, wife of Presidentialnominee, in speech at Chautauqua, N.Y., states that theovercentralization of big business is a factor in economicdepression, which has demonstrated the interdependence ofagriculture and urban industry and trade andof all nations inworldcommerce.

On the other hand Roosevelt alsomade a clear commitment to balancing thebudget, criticising Hoover for spending too much and, on 19 October in

Pittsburgh,promisedtocutthecostofgovernmentby25%.SoRooseveltwasinfavour of redistribution of the national income but somehow he expected toachieve thiswhileslashinggovernmentspending.Havingespousedapolicyof‘boldexperimentation’and‘redistributionofthenationalincome’inMay1932,thepoliciesofferedduringthecampaignseemedmuchmoreconservative.

Theparadoxof the 1932 campaignwas thatRoosevelt spokeoutagainstspending,againstunbalancedbudgetsandabloatedbureaucracy, while Hoover defended deficit spending andexperimentalmeasures - itwas as if the speeches had gottenmixedup.[51]

Did the markets really expect great liberal and radical policies to follow theelection of Roosevelt as President? In a report to clients on the eve of theDemocratic Convention, The Guaranty Trust Co. stated that ‘the PresidentialElection still looms as a disturbing factor. Largely imaginary, for its actualeconomic influence will be of little importance.’ Based on contemporarycomments,itseemsthatRoosevelt’selectionifanythingreducedconfidenceor,based on the Guaranty Trust report, had no material impact on the financialmarkets.

Whileitisalwaysdifficulttoseparatecauseandeffectinfinancialmarkets,thebalanceofevidencesuggests theprobableelectionofRooseveltwasnotakeycauseforthecommencementoftheequitybullmarketinJuly1932.Indeed,thefirst setback for the bullmarket beganwithRoosevelt’s election inNovemberand lasteduntil his inauguration inMarch.Therewasgreatuncertainty in thisperiodregardingRoosevelt’spoliciesingeneralandhiscommitmenttothegoldstandard in particular.Aswe shall see in Part III, themarket findsRooseveltadoptingsomeveryradicalpolicies,butthesedidnotpreventoneofthegreatestequitybullmarketsinUShistory.

There had never been a bearmarket like the bearmarket of1929-32. Themarket declined 89%, far surpassing the worstprevious market declines of 45% in the panics of 1857 and1907.Asin1921,equitypricesdidnotstopdeclininguntiltheyreacheda70%discounttoreplacementvalue.Atthebottomofthe equity market in July 1932, the same signals from thesummer of 1921 were flashing green, with a few notable

differences. On this occasion, the first reduction in the Feddiscount rate came right at the beginning of the bearmarketrather than at its end. The other key difference is that theeconomic and price recovery of 1932 was not sustainable.However, the DJIA remained above its July 1932 lows andinvestors made spectacular returns over the next five years.Despitetheincredibledifferencebetweentheeventsleadingto1921 and 1932, our bearmarket bottom indicators signalledonceagain thedeathof thebearand thebirthof thebull.Bythe next bearmarket bottom, the NewDeal had transformedthe structure of the US economy and the gold standard wasgone. In that environment, could the same indicators succeedinmarkingthetransitionfrombeartobull?

Endnotes31WallStreetJournal,15June1932[returntotext]

32WallStreetJournal.15June1932[returntotext]

33ArthurF.BurnsandWesleyC.Mitchell,MeasuringBusinessCycles[returntotext]

34RobertSobel,PaniconWallStreet:AHistoryofAmerica’sFinancialDisasters[returntotext]

35WallStreetJournal,10June1932[returntotext]

36WallStreetJournal,8July1932[returntotext]

37MauryKlein,Rainbow’sEnd:TheCrashof1929[returntotext]

38WallStreetJournal,5September1932[returntotext]

39WallStreetJournal,7May1932[returntotext]

40WallStreetJournal,30May1932[returntotext]

41WallStreetJournal,12July1932[returntotext]

42WallStreetJournal,30May1932[returntotext]

43WallStreetJournal,7June1932[returntotext]

44WallStreetJournal,10June1932[returntotext]

45WallStreetJournal,23May1932[returntotext]

46WallStreetJournal,24June1932[returntotext]

47WallStreetJournal,29August1932[returntotext]

48WallStreetJournal,12July1932[returntotext]

49WallStreetJournal,2September1932[returntotext]

50WallStreetJournal,19August1932[returntotext]

51TedMorgan,FDR[returntotext]

PartIII.June1949Hesatnexttoastoutmanwholivedinhishotel.Occasionallytheywouldspeak.

‘How’sthemarket?’askedthefatman,decidingnottoreadhispaper.

‘Themarket’sdoingfine,shouldgoup.’

‘Well, thatsureisgoodnews.I’vealittlebit thatI’dliketoputinit.I’dliketoputit insomethingsafe,though.Youknowofsomethingsafe?Somethingthat’sgoingtogowayup,say?’

‘Well, that’sahardquestion. It’s veryhard to tell just yet.Sugar’sdoingwell,’ saidRobertHolton.Healways said that same thing to these questions. No one cared what he said. They would repeat it toacquaintances,sayingthatafriendoftheirsinWallStreethadadvisedthemtobuysugarbuttheydidn’tfeelitwassuchagoodbuyatthistime.

‘Youwasinthearmyweren’tyou?’askedthestoutmansuddenly.

RobertHoltonnodded.

‘Beenoutlong?’

‘Overayear.’

–GoreVidal,InaYellowWood

Whenwe isolate the fourmost profitable times to invest in stocks, June 1949comessecondonourlistafterJuly1932,butwellaheadof1942,whentheDJIAwas at even lower levels. This is because, using a 40-year time horizon, aninvestorin1949benefitedfromthe1982-89bullmarket.Thatisnottosaythebear-marketbottomofApril1942shouldbeignored–itwasoneofthoseveryrare times when the q ratio fell below 0.3x, making it a period worthy ofinclusioninawiderstudy.The1940swasaresponsetotheDepressionandthenegativeimpactofthatcataclysmoninvestorsentimentthathadequitiestradedatdeepdiscounts to their fair value for the entiredecade.How, then,didonedetermineitwasnotuntil1949thattheequitymarketwouldbegininearnestthelongest bullmarket in the history of American equities?Aswewill see, therewere numerous lessons to be had at the bottom of the 1921 and 1932 bearmarkets,indicatingpricesandvaluationscouldonlyimprove.

TheroadtoJune1949

Theworld in1949wasaverydifferentplace than ithadbeen in1932.Hitler,whose attempt to becomePresident ofGermany had failed in 1932,was deadandsowere55millionpeoplekilledintheworld’sbloodiestconflict.Overtheperiod, theUnited States ofAmerica had increased its standingmilitary forcefrom a quarter of a million in 1932 to more than 12 million by 1945. Some300,000wholeftAmericatofightinthewardidnotreturnalive.

By 1949 more than 10 million Americans had left the military in search ofcivilian employment. In financial terms, the key changes were that thegovernment now accounted for amuch larger proportion of economic activityandthattheinvestingpublicwasonceagainalargeholderofgovernmentbonds.

The equity market was a backwater for investment in the immediate postwarperiod.DailyequityturnoverontheNYSEwasoftenlessthan$500,000andthepublic’sspeculativeenthusiasm,suchasitwas,focusedonthepropertymarket.

By the summer of 1949 there was another factor depressing interest inWallStreet – a record heat wave. On 13 June 1949, the day the DJIA reached itspostwar low, a New York Times headline proclaimed ‘1,500,000 Cool off atCity’sBeaches;TemperatureHits89.1,Only0.7BelowRecord’.Justthreedayslater,inDetroit,NewYork’sJakeLaMottawascrownedmiddleweightboxingchampionof theworld;and inManhattan,GeneKellyandFrankSinatrawerefilmingOnTheTown.

FIGURE68.DOWJONESINDUSTRIALAVERAGE–JULY1932-JULY1949

Source:DowJones&Co.

Thegreatbullmarket,whichhadbegun inJuly1932,didnotenduntilMarch1937. The DJIA rose from 41.22 to peak at 194.15. In terms of total capitalreturn over the period 1932-49, it was all over by 1937. The DJIA did notsurpassthe1937highuntilDecember1945and,intotal,fromthe6March1937high to the bottom of the 1949 bearmarket, it spent just 32weeks above the1937high.Peakingat212.5inMay1946,lessthan10%aboveits1937high,themarketthenenteredabearphasethatwastoendwiththeDJIAreachingbottomat 161.6 on 13 June 1949.A good gauge of investors’ varying interest in theequitymarketovertheperiodisprovidedbytheaveragemonthlymarketvolume(seeFigure69).

Thewaningvolumeshowsadramaticdeclineinthewillingnessofinvestorstoplaythegame.Fromtherecordtradingdayof1929tothelowof1942,volumeon theNYSEdeclined99%.The totalvalueof trades in1942was70% lowerthan in1932,when thepreviousbearmarkethadbottomed. In1942 thedollarvolume of trades in equities on the NYSE was below 1901 levels. While aportionofthedeclineinvolumewasduetothedeclineinmarketvalues,therewasafurtherimpactfromageneraldeclineininterestinthemarket.In1929,thetotalnumberofsharestradedaccountedfor119%ofalltheshareslistedontheNYSE. As late as 1937 this market turnover ratio was still as high as 30%.However,by1942annualtradingaccountedforjust9%ofallshareslistedand

thishadonlyrisento13%by1949.Inthepreviousbear-marketyearsof1921and1932, the ratiowas59%and32%respectively.Thegeneraldisinterest, asmeasuredbyactivity,wasthushigherin1949thanithadbeenevenintheworstdaysoftheDepression.ThemarketcapitalisationofNYSE-listedsharesin1949exceededthatoftheendof1929,butalmostnoonewantedtoplay.

FIGURE69.AVERAGEMONTHLYVALUEOFNYSESTOCKTRADES($M)1937-1949

Source:NYSE

The crisis of confidence in equities was based on poor long-term returns andsomedisconcertingfalsedawnsforthemarketandtheeconomy.Whileinvestorenthusiasmhadrebuiltinthe1932-37bullmarket,theinabilityoftheeconomyand the market thereafter to produce a normal, sustainable, cyclical recoveryunderminedfaithinthelong-termoutlookforequities.

Not surprisingly, trading volume was severely curtailed duringWWII. In theworstday’stradingof1942,only$206,680instockchangedhands.Therewasrenewedinterestinequitiesfrom15August1945,VictoryoverJapanDay,wellinto1946but,withthereturnofthebearmarket,volumeswereontheslideonceagain.

Insiders’waningenthusiasmforthemarket,showninthedeclineinthepriceofmembershipoftheNYSE,wasparticularlypronounced.

FIGURE70.NYSEMEMBERSHIPPRICES1932-49

Source:NYSE

While the DJIA bottomed in 1932, this was only the beginning of the bearmarketinNYSEseats.Fromthe1929hightothe1932low,thepriceofaseathadfallensome90%–almost inlinewiththemarket.However,from1932to1942,whentheDJIAdoubled,thepriceofaseatontheNYSEsaggedafurther75%.Worth$495,000in1929,ithaddroppedtojust$17,000in1942,recoveredfrom 1942 to 1946, then slid again to bottom in 1949, when the long-termrecoveryinpricesbegan.ThelongdeclineinthepriceofNYSEseatsisfurtherevidenceofagrowthinapathytowardsequities,whichcontinuedlongaftertheworstoftheDepressionwasover.

The concern investors had about long-term capital returns from equitiesappearedjustifiedbytherecord.By1949,theDJIAwasatthelevelithadfirst

reachedinFebruary1926.At its13June1949bottom, theDowwasstill57%below the all-timehigh set almost20yearsbefore inSeptember1929.Withinthislongperiodof17yearsfrom1932tothegreatbottomof1949,thereweretwodistinctbullandtwodistinctbearmarkets.

Whydowetrackthe1942-1946bullmarketand1946-1949bearmarket,whenthe index in1949doesnot returnbelowthe1942 level?Doesn't thismean thebullmarketbeganin1942?Onsomemeasuresthiscouldwellbethecase,andApril1942wasoneofthoseveryrareoccasionswhentheqratiodeclinedbelow0.3x.However,wearechoosingourbearmarketbottomsinrelationtovaluationparameters, primarily in relation to subsequent returns. Subsequent long-termreturns from1949significantlyexceeded those from1942,and theq ratiowasbackbelowthe0.3xlevelinJune1949.Forthelong-terminvestor,1949wasabettertimetoinvestthan1942.

ThecourseoftheDow–1932-37

Theperiod fromJuly1932 toMarch1937wasoneof thegreatest equitybullmarkets in US history. The DJIA rose 370% during a period when the bestavailableestimateoftheGDPdeflatorshowsan11%riseinprices.Aswellasthis spectacular capital gain, an investorwho purchased at the bottom in July1932securedadividendyieldof10%,baseduponthedividendsactuallypaidin1932,andagrowthindividendsto1937of60%.

Underpinning the 1932-37 bull market was the increasing solvency of thefinancialsystemfrom1933onward.Thisstabilisationofaseeminglybankruptfinancial systemhelpedpushequityvaluationsbackup tomorenormal levels.Thereturnfromthebrinkofnationalinsolvencywaspowerfullycombinedwithan improvement in the economy and corporate earnings. In real terms, netnationalproductgrewat12%perannumfromtheeconomictroughin1933tothepeakin1937.SucheconomicgrowthratesintheUnitedStateshavenotbeenrecordedbeforeorsince,andearningsgrowthwasevenmoredynamic.Fromthelow in 1932 the earnings series for the S&P Composite Index show earningsincreasing176%to1937,growthalmostthreetimesfasterthannominalGDP.

FIGURE71.DOWJONESINDUSTRIALAVERAGE–JULY1932TOJULY1937

Source:DowJones&Co

Despite the dramatic rebound in economic growth, ample excess capacitythroughout the system resulted in low inflation, and interest rates declinedthroughout this unparalleled economic expansion. Thus, there was a powerfulpositivemixforequityprices–surgingearnings,surgingdividendsandfallinginterestrates.

Theearnings anddividend recoverywasdramatic, butnotdramatic enough tolifteithertonewhighs.Despitethe176%riseinearningsfor1932-37,theS&Pdatashowmarketearningsin1937stillbelowthelevelsreportedin1929,1928,1926 and 1925, aswell as 1917 and 1916.Themarket’s earnings at the 1937peakwerestill30%belowanddividends49%belowthe1929peak.AtitspeakinMarch1937,themarketwasstill49%belowitsAugust1929all-timehigh.

Sowhile thismayhave been the greatest five-year bullmarket inUShistory,only thosewhohadpurchasedbeforeMarch1928orafterOctober1930couldboastanycapitalgains.Those luckyenoughtobuyat thebottominJuly1932had seen the DJIA rise 376% in just less than five years. It may not seemsurprisingthatequitypricesrosesodramaticallyfromsubstantiallyundervaluedlevels in 1932 supported by this profits explosion and falling interest rates.However, it has to be remembered that these dynamics overpowered thenumerousseeminglynegativedevelopments forAmericancapitalismoccurringatthesametime.

Thegreatbullmarketof1932-37occurredagainstthebackgroundofwhatmanyWall Street commentators referred to as the introduction of “socialism” inAmerica.Tosomethesenegativeforceswerealreadyactingtodepresspricesinlate1932.

Although the DJIA bottomed in July 1932, the nascent economic recoverypeteredoutinSeptemberofthatyear.Atthetimeinvestorsprimarilyattributedthis to the increaseduncertainty associatedwith the presidencyofFranklinD.Roosevelt,which seemed certain bySeptember 1932 andwas confirmed on 8November.AtthatstageinUShistory,theInaugurationwasnotuntil4March.There was a prolonged period with a “lame duck” administration and muchspeculationaboutRoosevelt’spolicies.Inparticular,therewasagrowingbeliefthatFDRwouldremovetheUSdollarfromthegoldstandardandthepresidentelectrefusedtodenysuchrumours.TheAmericanpublic,forthefirsttimeintheDepression, now sold dollars to buy gold. A further tightening of liquiditybegan.

During this interregnum, the recovery in the economy, the stability incommoditypricesandtherecoveryinbondpricesallended.Theperiodalsosawthethirdbankingcrisis,whichranfromNovember1932toMarch1933.Nevadadeclared a bank holiday in October 1932, Iowa in January, Louisiana andMichiganinFebruary.By3March1933,halfthestatesoftheUnionhadbeenforcedtosuspendoperations.

Although thiswas theworsteconomicparalysisof theDepression, theDJIA’sdeclineto50pointswasstillalmost10pointsaboveitsJuly1932low.Whateverfears the market had about Roosevelt’s policies, they failed to depress pricesbelowtheJuly1932low.AccordingtotheNBER,theeconomyreacheditslowpointinMarch1933,justmarginallybelowthelevelofJune1932,andthestagewassetforthebullmarketinequitiestobegininearnest.

The great bull market in US equities coincided with the revolutionary “NewDeal”.Byhis inauguration inMarch1933, few could havebeen in anydoubtthat FDR had major changes planned for financial institutions and financialmarkets inAmerica. InhisMarch1933InauguralAddress,Rooseveltdeclaredthat ‘the money changers have fled their high seats in the temple of ourcivilization. We may now restore that temple to the ancient truths.’ Withinweeks,Roosevelt’sfirstlegislativeactionagainstWallStreet–theSecuritiesAct

of1933–passed throughCongress, soon tobe followedby theGlass-SteagallActof1933,theSecuritiesExchangeActof1934,theBankingActof1935andthePublic Utility Holding Company Act of 1935. Against this background ofencroachinglegislationandregulation,thebullmarketinequitiesragedon.

The bull market in equities took place against a background of majorexperimentationwiththemonetarycornerstoneofAmerica–thegoldstandard.Asearlyashisseconddayinoffice,Rooseveltdecreeda“temporary”barontheexportofgold.Therewassomeevidencethatthemovewasindeedtemporaryassomebanksweregranted license toexportgold inMarchandApril.However,on 19April it was announced to theworld that Roosevelt would endorse theThomasAmendmenttotheAgriculturalAdjustmentAct,whichempoweredthePresidenttoissueunbackedcurrencyathisdiscretion.Americahadleftthegoldstandard andLewisDouglas,Director of theBudget, summed up the view ofmany in America when he remarked privately: ‘This is the end of WesternCivilization.’ [52]Roosevelt then criminalised the hoarding of gold in privatehandsandabrogatedgovernmentcontractspromisingpaymentingold.Notuntilhismid-January1934StateoftheUnionaddressdidthePresidentannouncethatAmerica would be returning to the gold standard. The dollar was finallystabilised, following the passage of the appropriate enabling legislation, at theendofthatmonth.InMarch1933, theUSTreasuryhadbeenredeemingevery$20.67foranounceofgold,butbyJanuary1933 it took$35 tobuy thesameamountofgold.Despitesuchlegerdemainwiththekeymonetarytargetthathadanchoredthefinancialsystemsince1879,andthedirewarningsofmostpundits,thebullmarketinequitiescontinued.

Accompanyingthenewbeliefthatlegislationcouldmakethefinancialmarketssafer and less volatile, the public sought scapegoats for the onset of theDepression.Almostas thestockmarketbottomed,PresidentHooverhadaskedCongress to investigate the stock exchange. The Senate Banking Committeehearings,whichbecameknownasthe“Pecora”hearingsforchiefcounseltothecommitteeFerdinandPecora,beganinApril1932.Thehearingsproducedluridheadlines for more than two years as they continued through to May 1934.Alongtheway,therewasampleevidenceofthemisdeedsofWallStreet,andthepublic howled.Over the course of the 1930s, numerousWall Street operatorswent before the criminal courts. Some convictions were not secured until the1940s – many of those suspected of causing the stock market crash and the

Depressionwentunpunished.Despite thepublicity, thebullmarket in equitiescontinued.

From 1932 to 1937, there was a vocal minority in America that believed thecountrywasheadedforsocialismandthatthe“attack”onthefinancialmarketswas ideological in nature. There was ample evidence of such trends. Inconjunctionwiththeincreasedregulationofbankingandfinancialmarkets,thegovernment set up state agencies to provide services it believed the privatesectorcouldnotprovide.

The state’s encroachment into the private sector progressed rapidly with thefounding of Federal Home Loan banks in 1932, the Home Owner’s LoanCorporation in 1933, theTennesseeValleyAuthority in 1933 and the FederalFarmMortgageCorporationin1934,amongothers.TheReconstructionFinanceCorporation,createdbyHooverandmassivelyexpandedbyRoosevelt,becamethelargestcompanyintheworld.Anationalminimumwagewasintroducedandthecostoflabourrosefurtherwiththeintroductionofsocialsecuritytaxesandothergovernmentmeasures.Increasinggovernmentinterferenceintheeconomyinduced growing public deficits. Prior to the Roosevelt Administration, thegreatest fiscal deficit reported by theUSgovernment, not associatedwithwarfinancing,was0.7%ofGDPinthecrashof1837.Thedeficitwas4.7%ofGDPin1932androsethroughtherecoverytopeakat5.5%ofGDPin1934.

Famously,AlSmith,aformerDemocraticcandidateforpresidency,inaspeechinJanuary1936,damnedtheDemocraticadministrationincomparingitwiththeadministrationinMoscow.

Therecanbeonlyonecapital–WashingtonorMoscow.Therecanonlybeoneatmosphereofgovernment,theclear,freshairoffreeAmericaorthefoulbreathofCommunisticRussia.[53]

Despiteall the fearsassociatedwithgrosspublicdeficits, theNewDealandamovetowardsasocialistorevencommunist future, thebullmarket inequitiesraged on. Whatever theoretical or practical impairments Roosevelt’s policieswroughtuponthefreemarketsystemintheUS,theequitymarketthoughtthemless important than the stabilisation of the financial system and a dramaticrecovery in corporate earnings and dividends. If there was any structuralimpairment to the efficiency of the US economic system, the reaction of the

equitymarketwasthatthiswasmuchlessimportantthanthepowerfulcyclicaleconomicrecovery.

ThecourseoftheDow–1937-42

Inthevigorouseconomicrecoveryto1937,realGDProsemarginallyabovethe1929level,butrapidpopulationgrowthmeantpercapitaGDPhadnotrecoveredto its1929peak.Evenat thepeakof the recovery in1937, theunemploymentratewas14.3%–half asmuchagain as theprevioushigh in1900-30.With anormaleconomicrecoveryseeminglyonlyinitsinfancytheeconomythenwentinto reverse gear. This interruption of the economic recovery at such an earlystageshookinvestorfaithinthesuretyofthebusinesscycle.

It is unclear whether the abrupt end of the economic recovery in 1937 had afiscal or a monetary cause. What is evident is that the decline did followincreasesinreserverequirementsbytheFederalReserve,whichbeganinAugust1936.

TheFed, utilisingnewpowersgrantedby theBankingAct, also increased themargin on security purchases from 25% to 50%.With excess reserves in thecommercial banking system at such high levels, and lendingmoribund, itwasconsidered that reserve-requirement increases would be the best way for theFederalReserveSystemtoregaincontrolofthemonetaryreins.By1937,therewerereasonswhytheFedmightwanttobeinpositiontoproduceaneffectivetightening of monetary policy.Wholesale prices were rising strongly and therisingstockmarketcausedconcernaboutspeculation.

FIGURE72.DOWJONESINDUSTRIALAVERAGE–MARCH1937TOMAY1942

Source:DowJones&Co.

Given the slack in the financial system, it was not thought the Fed’s moveswould have a negative impact on economic activity. The Fed blamed thecontractionthatfollowedonachangeinfiscalpolicy.Fiscalpolicymayindeedhavebeenafactor;thefederaldeficittoGDPratiodeclinedfrom4.2%in1936to 2.8% in 1937. Another factor may have been a sharp drop in corporateprofitability in early 1937 associated with higher costs in general and risinglabour costs in particular. On Wall Street, other culprits were sought forcurtailingthecyclicalrecoveryintheformofthestiflingregulationofbusinessflowing from Washington. Whether attributable to another Fed error ofjudgementornot,industrialproductiondeclinedbyathirdfromthe1937peaktothe1938lowandS&PCompositeIndexearningsdeclinedalmost50%.

Whateverthecauseoftherecession,thecyclicaltroughoccurredinJune1938,justtwomonthsafterthefirstreductioninreserverequirementsbytheFed.Thissharpeconomiccontraction,before theeconomicrecoveryhadanymeaningfulimpactonemployment,wasfarfromnormalandcameasaparticularshockforthosewhoexpectedtheeconomytocontinuetoexpanduntiltherewasevidenceofcapacityrestrictionsandinflation.Inthe12monthsfrom31March1937,theDJIA declined 49% andwas back tomid-1933 levels. Stockmarket turnoversuggests that this surprise economic recession within a depression played a

bigger role than the Depression itself in producing the growing antipathytowardsequitiesasaninvestmentmedium.

WhiletheeconomywasrecoveringfromJune1938,thebearmarketinequitiesdid not abate. That equity prices failed to recover along with the rebound incorporateearningssuggestsat thelossoffaithintheabilityof theeconomytoreturntothepre-1929normalcy.Fromthelowin1938,S&PCompositeIndexearningsdoubledbyDecember1941,buttheDJIAwasunchanged.Inaneraofwaningconfidence in theeconomic future,equitypricescould ignoreeven thestrongestofearningsrecoveries.

Perhapsmore importantly, the increasing prospect ofwar in Europewas nowplayinganimportantroleindeterminingthefinancialoutlook.Thisisnottosaythattheequitymarketwasnecessarilydepressedbytheprospectofwar.OnthedaytheUnitedKingdomdeclaredwaronGermany, therewasnopanicsellingonWallStreet–quite the reverse. In the firsteight tradingdaysofSeptember1939,asGermanysweptintoPoland,theDJIArose15%.InvestorsrememberedUSneutrality inWWIup to1917,when flight capital flowed into theUSand“warbride”stocksbenefitedsomarkedly fromorders fromEurope.How longwould this beneficial combination of factors last this time? As Germandominationseemedincreasinglyinevitable,andmaterielordersfromadefeatedEuropelesslikely,themarketbegantoslip.

Hitler launched his blitzkrieg of Western Europe on 10 May 1940, and thetactic’s successwasclear toallwithindays.From10May to25May,asTheNetherlands and Belgium surrendered and the British Forces were beingevacuated from Dunkirk, the DJIA declined 23%. Flight capital fell away asGermany locked up European capital and US war orders appeared now onlylikely tocomefromtheUK, though itwaswidelyexpected topay in IOUsofdubious credit quality. By the end of May it was thus evident that the twopositive factorswhichhadproduced the1915-16bullmarketwere unlikely torecur.

Theblitzkriegchangedeverythingandthepaceof thebearmarketaccelerated.As inWWI, the UK originally paid for materiel in cash, gold and securities.From the middle of 1940 to March 1941, there was thus an acceleration ofcapital inflows into the US associated with the war in Europe. With the US

continuing to operate the gold standard, these capital flows producedaccelerationinmonetarygrowth.

The equitymarket had recovered somewhat during the summer-longBattle ofBritain,supportedbygoldinflowsfromtheUK,butbySeptember1940itwasbecoming clear there would be more US involvement in the war as the UStransferred ownership of 50 obsolescent destroyers to the United Kingdom.From this stage, the market’s fears that cash payments would be diluted infavour of IOUs increased. The nature of the new form of US involvementbecameclearerinaradioaddresson16December1940whenRooseveltsaidtheUSwouldbe“lending”materieltoBritain.Thelend-leaseprogrammebeganinMarch1941.

Inexchangeformateriel, theUSgovernmentnowtookcreditorservicesfromtheAlliesinlieuofcashorgold.Thestockmarketdidnotrespondfavourablytothenews.FromSeptember1940to6December1941,theDJIAdeclined14%astheUSincreased its lend-leaseprogramme.Thewarwasalsoproducingdirectinflationary pressures in the US, which was an added negative. FromAugust1939 to November 1941, wholesale prices rose 23% as rawmaterial demandsurged,witheconomiesacrosstheglobe,includingtheUS,gearingupforwar.Althoughstillneutral,thewarhadalreadyenforcedchangesinlegislationintheUSwhichthreatenedtofurtherunderminecorporateprofitability.

On 1 September 1941, the Federal Reserve took action against inflation, andimposed controls on consumer credit in “Regulation W”, which stipulatedminimumdown-payments andmaximummaturities for credit on certain listedarticles.On1November1941,theFedincreasedthereserverequirementtothemaximumavailable25%.TheDJIAwasnowbackto1938levelsbuttherewasworsetocome.

The attack on Pearl Harbor on 7 December ended speculation about USinvolvement in the war. As in 1917, the increased prospect of direct militaryinvolvement depressed the price of equities. However the immediate marketimpactoftheattackonPearlHarborwasnotasdramaticastheimpactfollowingBritain’s declaration ofwar onGermany, or the success ofHitler’s blitzkrieg.Themarketcontinued the trendof thegradualdeclineevident fromSeptember1940and tookalmost fivemonths to falla further20%tobottomon28April1942.

However,thiswasnottobethebesttimeinthe1940stobuyequities–investorshadtoendureafurtherbullandbearmarket.Still,aninvestorusingtheqratioasa guide to extreme undervaluation would have noticed that, in April 1942,equitieswere trading atmore than a 70%discount to their replacement value.Thiswasalevelofundervaluationonlypreviouslyrecordedin1921and1932.From1942beganthesecondbullmarketof1932-49,andtheDJIArose128%toMay1946.

ThecourseoftheDow–1942-46

ThebottomofthebearmarketinequitiesinApril1942coincidedwithamajorchange to the US financial architecture and defeat of the country’s militaryforcesinthePhilippines.

FIGURE73.DOWJONESINDUSTRIALAVERAGE–APRIL1942TOMAY1946

Source:DowJones&Co.

Asin1917,theFedabandonedallotherfinancialgoalstofurthertheabilityofthe government to finance thewar effort. InApril 1942, theFed stated that itwould fix the rate on Treasury bills at three-eighths of one per cent by

intervening in the market. It was understood this rate would be fixed for thedurationofthewar.Infact,someformofinterventionpolicywastoremaininforce until March 1951. Although only the commitment to intervene in theTreasurybillmarketwasexplicit,inpracticetheactionsoftheFederalReservecreatedacappedfederaldebtyieldcurve.Therationalebehindtheseactionswasthatitwouldencourageinvestors,whowouldnotbespeculatingonhigherfutureinterestrates, tobuyWarBondsandthusreducethecostoffinancingthewar.Thede factomaximumpermittedyieldon the longest-termgovernmentbondswas 2.5%. The capped rates effectively enshrined the positively sloping yieldcurve,whichthemarketwasdictatingpriortoApril1942,forthedurationofthewarandbeyond.Notsurprisinglytheinvestingpublicandthecommercialbanksflocked to the long endof themarket,where the risk of capital loss hadbeeneliminatedforthedurationofthewar,andownershipoftheT-billmarketpassedincreasinglytotheFederalReserve.Duringthisperiod,theFed,inthewordsofitschairmanMarrinerEccles,‘merelyexecutedTreasurydecisions’.[54]

FIGURE74.DEFACTOYIELDSUPPORTFORGOVERNMENTSECURITIESDURINGWWII

Source:SidneyHomerandRichardSylla,AHistoryofInterestRates

AsinWWI,unlimitedmonetaryfuelwasmadeavailablebytheFedasneededto finance government bond sales and support bond prices. By buying bondsdirectly for its own account, the Fed boosted commercial bank reserves. Thecommercial banks, unlike in WWI, utilised the expanded reserves to buygovernmentsecuritiesdirectlyratherthantomakecommercialloanstootherstodo the buying. Between 1941 and 1945, the Treasury made seven war-bondissues,andthishugeincreaseinfinancingwasachievedwithoutsurgingyields,dueprimarily to the allocationof these issues to compliant commercialbanks.

With the Fed intervening in the Treasury market, the rise in interest ratesnormally associatedwith large fiscal deficits and strong economic growth didnotensue.The lowyields in the treasurymarketacted todampenotheryields.From April 1942, the monthly average prime corporate bond yield fell from2.63%anditaveraged2.55%in1942-46.

With inflation already rising steeply from1939 to 1941, andbondyields noweffectively fixed at low levels, it is not surprising that investors saw equities,yieldinginexcessof11%in1942,asofferingbetteropportunities.Whilebondsofferedfixedfuturepaymentsinvestorsinequitiescouldnormallyexpectgrowthindividendpayments.

Theheadlinefiguresoflowyieldsonfixed-interestsecuritiesandrisinginflationpersuadedmanyinvestorsthatequitieswouldbeabetterlong-terminvestment.However, even the headline figures underestimated just how powerful thedynamicsforequitieshadbecomeby1942.Althoughtheaverageannualrateofinflation fromNovember1941 toAugust1945was just4%, thisheadline ratewasachievedonlyviapricecontrolsand,forcertaingoods,rationing.Inflationwould undoubtedly have been higher without price controls (introduced inJanuary1942).Forthosepurchasinggoodsonthe“blackmarket”,inflationwasconsiderablyhigher than the reported level.Fixed-interest securitieswereevenlessattractivethanreportedfiguressuggestedandthustherelativeattractivenessofequitieswasevengreater.

While the outlook for equitiesmay have been improved by the government’sriggingofthedebtmarket,wartimefinanceproducedotheroff-settingnegatives.The US had financed its participation in WWI primarily by issuing debtsecurities.However,enteringWWIIfederaldebt levelswere,asaresultof theGreat Depression, much higher than they had been in 1917. This time thegovernment opted to place the burden ofwar financingmore squarely on thetaxpayer.TaxreceiptsasapercentageofGNProsefrom7%in1941to21%in1945.Thehighestrateofincometaxreached90%,onincomesof$1millionormore, well in excess of the 66.3% reached in WWI. This environment ofstrongly-rising tax rateswas a headwind against which equities had tomakeprogress.

Anotherproblemforequitieswasthemutedcorporateprofitgrowthfrom1942to1946.WhileUSbusinessmighthavebeenexpectedtoreportbumperprofits

duringWWII, thiswasnot tobe thecase.TheUSgovernment tooknumerousadministrativeactions tocontrolpricesduring thewartimeemergencyand thisputitindefactocontrolofcorporateprofitmargins.Theallocationofresourcesandcapitalpassedfromthemarketstobureaucrats.BetweentheWarProductionBoard, theWarLaborBoardand theOfficeofPriceAdministration,corporateprofitmarginswerefarlesssubjecttothelawsofsupplyanddemandandcouldbesqueezedtofurtherthewareffort.Also,theUSadministration,desperatefortaxrevenueandmindfulofprofiteeringduringWWI,dramaticallyratchetedupcorporatetaxrates.From1940to1942,thetoprateofcorporationtaxrosefrom19%to40%,andanexcessprofitstax,introducedatatoprateof50%in1940,reachedaflatrateof95%by1943.Asaresult,reportedS&PCompositeIndexearningsanddividendswerebasicallyunchangedin1946fromtheir1942level.

The 1942-46 equity bull market had been driven entirely by an expansion inequity valuations against a background of low real yields on fixed-interestsecurities.

WhilepartofthisriseinvaluationsmayhavereflectedUSprogressinthewar,theevidencesuggeststhisimpactwaslimited.ThenadirforUSinvolvementinthewarcanbestbedatedas9April1942,whenUSforces inThePhilippinessurrenderedatBataan,and6May,with thesurrenderatCorregidor.TheDJIAbottomedon28April.ByearlyJunetherewasalreadypositivewarnews,whentheBattle ofMidway evenedup the naval balanceof power in thePacific. InAugust, the US was on the offensive, landing troops at Guadalcanal. InNovember1942,withtheAlliedvictoryagainstGermanandItalianforcesatElAlamein, thewarnewsbeganto improvesignificantly. In thesamemonth, theSovietcounter-offensiveatStalingradencircledHitler’sSixthArmy.

The first legof the1942-46bullmarketwasunderwayduring this period andlasteduntilJuly1943.However,despitetheincreasinglypositivewarnews,theDJIAdidnot see a steady rise as theprospectofvictory improved.TheDJIAtraded sideways from July 1943 to the end of December 1944 as the Alliesliberated Sicily, Rome, Romania, Paris, Brussels, Antwerp, Athens, WakeIsland,Saipan,GuamandLeyte.ByDecember1944,AlliedtroopshadenteredGermany from thewest and theSovietswere fighting inEast Prussia, but theDJIA was unchanged from the previous year, when the Russians had beenalmostathousandmilesfromBerlinandtheotherAlliesweremassingatDover.

Despite thesemoves towards victory, itwas not until early 1945 that the bullresumeditsrun.Eventhen,themarketroseonlygradually,temperedbyaminoreconomiccontractionfromFebruary1945.Theeconomicdownturnconstrainedequitypricesandrisesinmarginrequirements–from40%to50%inFebruary1945, and to 75% in July – also hampered progress.Not untilVJDay did anaccelerated rise in stock prices begin, even though the economic contractioncontinueduntilOctober.

With the authorities aware of the possibility of undue speculation, in January1946marginrequirementsonsharesincreasedfrom75%to100%.On2January1946, Harry D Comer of Paine, Webber, Jackson & Curtis summed up thereasonstobebullishabouttheoutlookforUSequities.

Strongly fortified by elimination of excess profits taxes, netearningsofindustrialcompaniesasagrouppromisetobesome30%higherthanin1945…Dividendsintotalshouldincreasefully proportionately with earnings. During the war,distributionstoshareholderswereonlymoderate;theresultingimprovement in balance sheets will permit more liberaldividendpoliciesin1946.[55]

Buoyed by such optimism over earnings and dividends, the bull marketcontinueduntilMay1946,finallysurpassingthe1937highandreachinglevelsonlypreviouslyexceededfromJuly1928toSeptember1930.AtthisnewpeaktheDJIAwasstill44%belowitsall-timehighofSeptember1929.

ThecourseoftheDow–1946-49

Bullsof theUSmarket in1946saw theupside forequities fromaneconomicboombasedonpent-upconsumerdemandandareturnofcorporatetaxratestonormal levels. The economy was bouncing back strongly from the 1945recession.However,bearsrememberedhowpostwareuphoriainthe12monthsafter the1918Armisticehadproducedsoaring inflationand that thishadbeenfollowedbythesharpestannualboutofdeflationinUShistory,accompaniedbyaviciousbearmarketinequities.Bearswithevenlongermemoriesrememberedthe other necessary deflationary adjustment that followed the end of thecountry’spreviousmajorconflagration,theCivilWar.Aswehaveseen,thebull

market that began in the darkest days of 1942 continued for one year pastVJDay.Bytheendofsummer1946,however,thebearswerebackincontrol.

FIGURE75.DOWJONESINDUSTRIALAVERAGE–MAY1946-JULY1949

Source:DowJones&Co.

The index slide of late August and early September 1946, with the Dowdeclining 17%,was the sharpest decline in stock prices since theblitzkrieg ofMay 1940. The causes for the sharp break were spelt out in theWall StreetJournalon30August1946.

RobertS.ByfieldofLewisohn&Co.liststhefollowingfactorscontributing to the decline in quotations ‘(1) The legislativestruggleoverO.P.A.,(2)theacuteindigestioninthemarketfornew securities, (3) the evidence that interest rates had passedtheirlowpointandwerebeginningtofirmslightly.’

DuringAugustandSeptember, investorsworried thatPresidentTrumanwouldsucceed in extending thewartimeprice controls administeredby theOffice ofPriceAdministration(OPA),whichwereduetolapseinJune1946.Thiswould

put thesqueezebackoncorporateprofitmargins.Ultimately,Trumanfailedinhisbidtoextendpricecontrolswhich,followingabrief“emergency”extension,finallyendedinNovember1946.

Numerous other factors played their part in depressing themarket. Continueddemandforhigherwageswasakeyconcern.Manythoughtthatinflationwouldonlybeconqueredbyarerunofthedestructivedeflationaryepisodeof1920-21.InhisStateoftheUnionAddressof5January1949,evenTrumanwaspreparedtoadmitthatbadtimeswereprobablyjustaroundthecorner.‘Wecannotaffordtofloatalongceaselesslyonapostwarboomuntilitcollapses,’Trumantoldthenation.Thefearedpostwaradjustmentseemedincreasinglylikely.InMoneyofthe Mind, James Grant relates the impact the 1920-21 deflation had on theeconomic outlook of one prominent business man in 1949, Sewell Avery, ofMontgomeryWard.

When an economist at Montgomery Ward handed him adiagramofcommoditypricesreachingbacktothebeginningofthe nineteenth century, the chairman studied it raptly. Pricesrose and fell recurrently.They rose inwartime inflations andfellinsubsequentpostwardeflations.Thepatternhadrepeateditself as recently as 1919-1920… To Avery, a postwardepressionwasthereforeaforegoneconclusion.‘WhoamItoarguewithhistory?’heasked,andkeptonasking.[56]

Avery’sbetondeflationwentwrongandhisdecisiontostockupongovernmentbondsratherthaninvestinthefutureofhisbusinesswasdisastrous.However,in1949mostcommentatorsbelievedsomeformofare-runof1919-20wasonthecardsandthehighertherateofpostwarinflationthegreaterwouldbethepricecorrection.Ofthevariousfactorsmentionedbycontemporarycommentators, itisclear,withthebenefitofhindsight,thatrisinginflationandinterestrateswerethemostimportantcausesofthe1946-49bearmarket.Thefearwasnotoftheinflation but of a deflationary reaction which was seen as inevitable bymostinvestors.

Evidenceofbuilding inflationarypressuresgrewandgrewfrom1946 to1949.In1946itlookedpossiblethattheUScouldwitnessasimilarexplosioninpricesto thatwhich had erupted in 1919. In the first half of 1946,wage settlementswererisingsharplyinresponsetoawaveofstrikes.Worker-dayslosttostrikes

in January and February exceeded all those days lost in 1943 and 1944combined.Not surprisingly, a sudden surge in inflationoccurred later in 1946whenprice controlswere lifted.Thewholesale price index rose 32% in 1946,primarily in the second half of the year. It was believed by some that thestructural changes in the economy would institutionalise inflation. Thecomposition of the economy had changed and the government sector nowaccountedfor15%ofGDP,comparedwith3%attheendofthe1920s.Investorshad to ask whether this would be a one-off upward adjustment in prices orwhetherstructuralchangeswouldnowmakeinflationendemic.

Aswellasanincreaseinthepowerofgovernment,therehadbeenariseinthepower of labour.Would this structural alteration in the economy also producemoreingrainedinflation?Unionmilitancyreflectedthefactthat,by1949,non-agriculturalunionmembershiphadreached33%oftheworkforce,upmarkedlyfrom 13% in 1932. With particular piquancy, unions even demanded FDR’sbirthdaybeaholidayinnewemploymentcontracts.

Forsome,takingaviewoppositefromSewellAvery,itseemedthesestructuralchanges could result in inflation becoming institutionalised in the postwarperiod. While the majority expected a postwar deflation and equity pricesdeclined in anticipation, theminority saw a new era for inflation. The rise ininflation was, far from being a pre-cursor to a major price correction, anindication of the shape of things to come. The commitment to “maximumemployment”,enshrinedintheEmploymentActof1946,suggestedthepostwarinflation outlookwould be very different from that in 1919.Also, by 1946, itwas evident there would be no attempt to reconstruct the gold standard,considered an institutional bulwark against inflation. The new internationalmonetary arrangement thrashed out atBrettonWoods in July 1944was, at itscore, aimed at making deflationary periods less likely. If this was the case,investors could expect over the course of the business cycle inflation to behigher than it had been under the gold standard. Despite these institutionalchanges investors still expected the postwar period would suffer a period ofdeflationsimilartothatwhichfollowedWWI.Withinterestratesrisingandtheseeminglyinevitablecrashjustaroundthecorner,thedurationofthedeclineintheDJIAreachedrecordproportionsbyearly1949.

The1946-49bearmarketinequitieswasaccompaniedbyamutedbearmarketinbonds.Bondpricesdeclined,althoughthedeclineingovernmentbondprices

was halted by the continued actions of the Fed to support prices at pre-determinedlevels.RisinginflationaryfearsbegantohurtdebtmarketsasearlyasApril1946,finallyendingthegreatbullmarketforbondsthatbeganin1920.With the war over the floor put on government bond prices could not beexpected to continue. Official interest rates were not altered, but market-determined rates, trading well below caps enforced by the Federal Reserve,started torise inApril1946.TheyieldonAAA-ratedcorporatebondsreachedwhatremainstheirall-timelowof2.46%inApril1946,beforerisingsteadilyto2.86%byDecember1947.

Figure76.YIELDONAAA-RATEDCORPORATEBONDS–JANUARY1942TODECECEMBER1949

Source:NationalBureauofEconomicResearch

Therewasapauseintheriseofmarket-determinedinterestratesfromtheendof1946 to the middle of 1947, as government bonds had risen towards cappedlevels. However, over the course of 1947, the support of shorter-termgovernment securities was discontinued and the support price for longer-termgovernment securities was lowered. In July 1947, the posted buying rate forTreasurybills, of three-eighthsof oneper cent,was lifted and theT-bill yieldrose gradually to reach 1.25% by the end of 1948. Apart from the negativeimpactofrisingmarket-determinedinterestrates,investorsalsoworriedoverthe

government response to rising inflation. Official concern was so great thatTrumansoughtpowersinthefallof1947toreintroduceprice,wageandcreditcontrols.Congressdeniedhisrequest.

WhilemarketinterestrateshadbeenrisingsinceApril1946,thefirstincreaseinofficialratesonlymaterialisedinJanuary1948.Thediscountratewasraised25basispointsinthatmonthandasimilarriseinAugust1948broughttherateto1½%.Rises in reserve requirementswere implemented in February, June andSeptember,andinAugust,Congressrestored,fora12-monthperiod,theFed’sabilitytoimplementcreditcontrols.AlloftheseactionsfinallybegantodampendemandandeconomicactivitypeakedinNovember1948.

InthetwoyearsfollowingthesharpdeclineofAugustandSeptember1946,theDJIArange-tradedbetween163and190.Thefinal legofthebearmarketthenbegan in November 1948 with the commencement of the recession and thesurprise electionofTrumanasPresident inhisown right.TheDJIA fell from190inNovember1948toitslowof162on13June1949.

Inthe1946-1949bearmarket,S&PCompositeIndexearningsincreasedalmosttwohundredpercent.Theoptimismconcerningearningsfor1946wasmisplacedbut earnings exploded after 1946. In 1947, reported earnings finally exceededthe1916levelandthiswastoprovetobealevelfinallyreachedonapermanentbasis.

Dividend growth, however, lagged earnings growth significantly, as theretooling of America for the consumer society called for heavy corporateinvestment.Dividendsincreasedjust31%inthetwo-yearperiod.Theextenttowhichinvestorswereconcernedaboutpossibledeflationisevidentfromthefactthatthisscaleofearningsanddividendgrowthoccurredagainstthebackgroundofabearmarketinequities.

Whileeconomicfactors,intheformofthegreatdebateoninflationordeflation,were thekeydriverof the1946-49bearmarket, thedeterioration inUS/Sovietrelationsduringtheperiodalsoplayedanimportantrole.

Thedeterioration in theUS relationshipwith theUSSRhadbeen increasinglyweighingon themarket.AsearlyasMarch1946,WinstonChurchill famouslytoldaMissouriaudiencethat‘anironcurtain’haddescendedacrossEurope.

Inagreatnumberofcountries, far from theRussian frontiersand throughout the world, Communist fifth columns areestablishedandworkincompleteunityandabsoluteobedienceto the directions they receive from the Communist centre.Except in theBritishCommonwealthandin theUnitedStateswhereCommunismisinitsinfancy,theCommunistpartiesorfifth columns constitute a growing challenge and peril toChristiancivilization.[57]

ByMarch1947,theTrumanDoctrineofferedfinancialsupportto‘freepeopleswho are resisting attempted subjugation by armed minorities or by outsidepressures’. [58] Soon thereafter, the US began supplying monies to the Greekgovernment to fund the resistance against the Soviet-backed communistguerrillas in the north of the country. The birth of the Marshall Plan soonthereafterproducedfurthertensionbetweentheUSandtheSovietsasMoscowsawtheplanasanattempttoexpandUSinfluenceinEurope.InMay1948,theSovietsuppedtheanteandblockedthewesternpowersgroundaccesstoBerlin,prompting the Allies to implement an air lift of supplies to the city. Tensioncontinued tomount. The formation of the North Atlantic Treaty Organisation(NATO) in April 1949, was deemed by the Soviet Union to be an “openlyaggressive” alliance and inbreachof the charter of theUnitedNations. In theinfancy of the new bull market developing by the summer of 1949, theWallStreetJournalon12JulyquotedbrokerSamSmith,ofBache&Co,ascreditingSovietfailuretotakeactionoverNATO’sformationasanimportantbullfactor.

For over three years fears of what is now occurring in thebusiness world have dampened market sentiment, preventingnormalprice-earningsrelationships.Whenthisweightislifted,a welcome change in psychology should evolvewith a toniceffectonourmarkets.Thereshouldberoomforplentyofcheerintherealisationthat:Thereisn’tgoingtobeawar…

ByJuly1949,themuchexpecteddeflationaryepisodewasfinallyunderwaybutthe prospect of war with the Soviet Union seemed to be abating. Despite theoccasionalhotepisodesuchassooneruptedinKorea,a“peacefulwar”ensued,based on an arms race, which had decidedly better implications for equityinvestors than the third global conflagration that seemed to be getting closer

between1946and1949.WiththeSovietUniondetonatingitsfirstatomicbombon29August1949,theprospectsofsomeformofstand-offratherthanoutrightwarfare increased. For investors this global environment of de facto USneutrality combined with a rearmament boom had some of the very positivecharacteristicsoftheboom1915-16market.Thisslideintoa“cold”ratherthan“hot” war played an important role in stabilising the equity market in thesummerof1949.Thestagewasnowsetforabullmarketwhichwouldlastforalmost20years.

Endnotes52JohnBrooks,OnceInGolconda–ATrueDramaofWallStreet1920–1938[returntotext]

53AddresstotheAmericanLibertyLeague,25January1936,MayflowerHotel.WashingtonDC[returntotext]

54MarrinerEccles,BeckoningFrontiers–PublicandPersonalRecollections[returntotext]

55WallStreetJournal,2January1946[returntotext]

56JamesGrant,Moneyof theMind:BorrowingandLendinginAmericaFromtheCivilWartoMichaelMilken[returntotext]

57AddressatWestminsterCollege,Fulton,Missouri,5March1946[returntotext]

58PresidentTruman’saddresstoCongress,12March1947[returntotext]

Structureofthemarketin1949Ononesideoftheroomwerethedoorsofoffices;theothersidewascoveredwithtremendouspicturesoffactoriesandshipsandrailroads.ThepictureswereMrGolden’sidea.Hewantedtoexplaintocustomersthe realmeaningof the stocks theywerebuying.MrGoldenalwayswantedpeople to feel that the stockmarketwasacreative,aproductivething.

GoreVidal,InAYellowWood

Thestockmarketin1949

BytheendofMay1949, the totalmarketvalueofallNYSE-listedstockswas$64billion.WhilemarketcapitalisationwasstillathirdlowerthanithadbeeninSeptember1929 itwas four times larger than it hadbeenat thebottomof the1932bearmarket.Asin1932,NYSElistingsaccountedforalmost90%ofthetotalmarket capitalisation ofUS-listed stocks.At the end of 1949 therewere1,457listedequitysecuritiesontheNYSEbeingonlyamarginalincreasefromthe1,293 issues listedat theendof1929.With1,043companies listedon theexchange,theaveragemarketcapitalisationofacompanywas$58million.Thesizeofthemarketneedstobeputintothecontextofaninvestmentmanagementindustry decimated by depression and war. In June 1949 there were just 150investmentmanagementcompaniesregisteredwiththeSECandtheirtotalfundsunder management were $2.7 billion. Even had this industry completelyeschewedbondinvestmentitwouldhaveownedlessthan5%oftheUSequitymarket.

Atthebottomofthemarket,inearlyJuly1949,anaverageofjustover900ofsome1,500equity issues listedwere tradedonadailybasis.Thiscompares tothepeakofactivityatthetopofthemarketin1946,whenabout1,000of1,300issues were trading. In 1946, monthly stock volume on the NYSE reached$1,946millioninJanuaryandhadalreadydeclinedto$1,432millionwhenthemarketpeakedinMayofthatyear.BythetimetheDowreacheditslowinJuly1949,monthlyvolumewasjust$526million.Themarketwastradinghalf-daysonSaturday,sotheaveragedailyvolumeinJulywasjust$23.4million.WhiletheDJIAhaddeclined24%from itsMay1946high, average tradingvolumesweredown70%.Thepeakvolumeforthemarketwasstill$16.4millionon19

October 1929. The lowest daily volume in 1949 was $541,360, almost 97%belowlevelsof20yearsearlier.

Over the 17 years since 1932, the composition of the market had changedconsiderably.

FIGURE77.NYSETENBIGGESTCAPSECTORSVERSUSTOTALMARKETCAP,1949RANKINGS

Source:KennethR.French,IndustryPortfolioData.Note:¹Alltransport,includingrailways.

Figure 77 shows how the ten largest industrial sectors listed on the NYSEchangedoverthecourseoftheDepressionandthewar.Whiletheimportanceoftheutilities sectorhadwanedsomewhat,oilwasevenmore important in1949than it had been in 1932. In 1949, oil and chemicals together accounted for aquarter ofmarket capitalisation. The rise in the importance of petrochemicalswasofparticular importancefor thechemicalcompanies.Thewar-bornplasticcalledpolyethylenewasfinding‘newusesdaily’andproductionhadquadrupledinayeartotheannualoutputrateof50millionpounds.[59]

With the German chemical industry largely destroyed, the outlook for UScompanieswasparticularlybright.Thedrugsbusinesshadalsoexploded,withexportsofpenicillinaloneaddinguptomorethanthetotaldrugexportsofthe

country before the war. Other areas of the market which had becomesignificantlymoreimportantsince1932wereretailandautos.By1949theautosector,preventedfromproducingcarsduringWWII,wasretoolinginanattemptto satisfy longwaiting lists. In contrast, utilities, tobacco and communicationswere much less important than in 1932. Figure 78 shows the role of sectorperformanceinthechangingstructureofthemarket.

FIGURE78.BEST,WORSTNYSEINDUSTRIALSECTORS–JUNE1932-JUNE1949(TOTALRETURNS)

Source:KennethR.French,IndustryPortfolioData.Note:Calculatedonbasisofdividendsre-invested.

A simple description of the sector performance over the period can be takenfrom Matthew’s Gospel – ‘The last shall be first and the first last.’ Sectorsoutperforming in the 1929-32 bear market – utilities, tobacco andtelecommunications–underperformedin1932-49.

The brewers performed particularlywell due to the repeal of prohibition. TherepealofprohibitionwasincreasinglylikelyinJune1932astheprospectsofaDemocratic President grew. Still, the repeal in December 1933 had a majorpositiveimpactonthebeersector.Withampleadvancewarning,investorswerestillrichlyrewardedbyinvestinginthesector.Thesectorperformanceillustratesthe importance of new equity issuance in the 1932-49 period in changing the

structureof themarket.Over theperiod thenumberof sharesoutstandinghadincreased by 59% while the number of companies with listed securities hadincreasedjust27%.Inparticulartheriseinimportanceofthechemicalindustrywas as much due to its ability to attract new capital as to its share priceperformance.

The bear market of 1946-49 was long in duration, but mild in magnitude.Equitiesbecameverycheapin1949,notbecauseofthescaleofthebearmarket,butbecauseof theboominearningsover theperiod. In thismildbearmarket,fromMay1946toJune1949,theutilitysectoronceagainshoweditsdefensivequalities.

Figure79.RETURNOFTENLARGESTINDUSTRYSECTORS(JUNE1949)–MAY1946TOJUNE1949

Source:KennethR.French,‘IndustryPortfolioData’

Theoilsectorperformedparticularlywellthroughthebearmarketasithadthefewestproblemsshiftingfromwartimeproduction.Amazingly,oildemandwashigherin1946thanithadbeenin1945and,unlikeotherindustries,fewchangesin the product were necessary to cater for the civilian, rather than military,market.Theoilindustrybenefitedintheperiodfrombothrisingdemandforitsproductsand risingprices.Theautosector facedamoredifficult transitionas,withthecollapseindemandfromthemilitary,itneededsubstantialretoolingtoshiftbacktocivilianproduction.Thetransportsectorwascomposedlargelyof

railroads and continued to be burdened with government regulation. Thedifficulty in securing freight rate rises in the postwar, high inflation, periodfurtherunderminedtheindustry’sprofits.

Thebondmarketin1949Hestoppedathisdesk.Itwasadullolivecolour.Hisdifferentbooksofstatisticswerepiledneatlyononecorner;notebooksandpaperswerescatteredoverthetopanditlookedasifhewerebusy.

GoreVidal,InAYellowWood

By 1949, the market value of NYSE-listed bonds had reached $128 billioncompared to just $32 billion in 1932. Over the same period, the governmentbondpriceindexrose16%andthecorporatehigh-gradebondindexrose43%.InJuly1949theWSJexplainedhowtheNYSEbondmarkethadchanged.

Thereweremorethan1,600issuesofbondslistedontheBoardin 1932. By the end of 1940 there were still nearly 1,400.Today there areonly912, and75of these are representedbyUnited States Treasury and World Bank issues – which aretraded entirely by dealer specialists in the over-the-countermarket.

ThenumberofNYSE-listedbondswasreducedtoalevelnotseensince1905.Thedifferenceintrendbetweenthesizeofthemarketandthenumberofissueswas driven by the increased importance of a few large issues by the federalgovernment.Thecorporatebondmarkethadbeenshrinkingformanyyears.Inevery year from 1932 to 1945, with the exceptions of 1936 and 1938, themonetaryvalueofcorporatebondretirementsexceedednewissues.Intotaloverthat period therewere net corporate bond retirements of $42.8 billion and by1949thetotalvalueofcorporatebondsoutstandingwasprobablylessthan$30billion.

FIGURE80.MARKETVALUEOFNYSEBONDS&EQUITIES

Source:NewYorkStockExchange

NYSE statistics show the bond bull market, which had been underway since1920,happenedagainstabackgroundofdecliningvolumes.Thepeakyear forNYSEbondtradingwas1922,whentradingvolumeexceededanaverageof$15millionperday.Asequitiesdominatedinvestorinterestduringthe1920s,bondvolumesdeclinedto$11.4millionperdayby1929.Whilevolumesintheequitymarket reachedbottom in1942, the lowest trading interest in thebondmarketwas not registered until 1949, when daily average volume reached just $3millionaday.Intotal,lessthan$1billioninbondswastradedontheNYSEin1949,lessthan1%ofthe$128billionmarketvalueofoutstandingissues.

As early as 1924, annual trading volume in theNYSE bondmarket had beenalmost14%ofthetotalmarketvalueofthosebondslisted.Intermsofvolumestradedon theNYSE,bonds remainedmore important thanequities throughoutthe period.Only in 1929 did even the highest trading day for equities see the

monetaryvalueofequitiestradedexceedtheaveragedailyvolumeforbonds.By1949, bond volumes on theNYSE averaged $3million per day, while equitytradingvolumerangedfrom$2millionto$500,000.

Ithastobestressed,however,thatthisisananalysisofthebondmarketutilisingonlyNYSEdata–theonlycompletedataavailable,intermsoftradingvolumesofbonds.However,overthisperiodtherewasanimportantchangetakingplacein the US bond market. As Figure 81 shows, the NYSE remained the mostimportantvenueintheUSforthelistingofcorporatebonds.

FIGURE81.LISTINGSTATUSOFUSCORPORATEBONDS–PARAS%OFTOTALPARVALUE

Source:W.BraddockHickman,StatisticalMeasuresofCorporateBondFinancingSince1900

While the NYSE remained important for the corporate bond market itsimportance to the government bond market had been on the wane for manyyears.C.F.Childsexplainshowthedynamicsof thegovernmentbondmarket,evenbythetimeofWWI,wereincreasinglyoperatingoutsideoftheNYSE.

… virtually all purchases and sales of government securitieswere customarily made through dealers specializing in thosebonds.Thenominalquotations issuedby theStockExchangehad always been recognized as reflecting merely a generalofficial price record for appraisal reference rather than theactual going market for large amounts. For every $1,000Government bond sale recorded on the Exchange there were$1,000,000parvalueunrecorded transactionsmadebyavery

few banking houseswhichwere known asGovernment bonddealers.[60]

Thegovernmentbondmarkethadonlybecomeasignificantfinancialasset forindividual investors following the explosion of government debt duringWWI.LibertyBondswereprimarilytradedontheNYSEand,in1919,76%ofallbondtradingontheNYSEwasingovernmentbonds.However,thiswasahigh-pointfor individual ownership and, as the bonds moved to institutional ownership,largeoff-markettransactionsonceagaincametodominatethemarket.

Despite the explosion in the amount of federal debt outstanding, less and lesstrading in these securities occurred on the NYSE. It had decreased to non-material sums by 1940. Even with the rise of the individual holder of bondsduring WWII finance drives, the NYSE was not to attain a position ofimportanceinthegovernmentbondmarket.

Thus NYSE data provides an increasingly inaccurate picture of the USgovernmentbondmarketastimeprogresses.Abetterindicationcanbegarneredfromstudyingthegrowthintotaloutstandinggovernmentdebtovertheperiod.Even before the US had entered WWII, total gross debt of the federalgovernmentwas $48.9 billion in 1941 and it then peaked at $269.4 billion in1946. The public debt was now almost ten times higher than it had beenfollowing the end of WWI. By March 1946, individuals alone held $167.6billion of government debt. In 1932 the nominal value of issued governmentbondswas$14.2billion,withnotesandbillsbringingthetotalto$19.5billion.By 1949, the face value of government bondswas $168.6 billion, with $56.3billionofthiscomprisedofsavingsbonds.Thebalanceofthetotalpublicdebtwasmadeupby$82.2billioninnotes,billsandspecialissues.Thefederaldebtmarketalonewasthusalmostthreetimeslargerthantheequitymarketin1949.

In describing theUSbondmarket in 1949, it isworthmentioning the foreignissues market. While the 1920s are remembered as a period of US publicspeculationinequities,therewasalsoasimilareuphoriaforthebondsofforeignissuers.TheUShadbeen enfranchised as thekey creditornation to theworldbecauseofWWI.Althoughforeignsovereigncreditshadbeenseepingontothemarketforsometime, the1920ssawanewissuanceboomfedbyenthusiasticpublicparticipation.

On 30 June 1914, prior to the outbreak of war in Europe, only two foreignbonds,ArgentinaandJapan,tradedontheNYSE.Britain,theworld’spreviouscreditor nation, had had its first terrible introduction to the world of foreignbondsintheearly1820s.Therehadbeenseveralsurgesinnewissuesandbullandbearmarketsatdecentintervalsthereafter.IntheUS,thiswasanewmarketanditmetwithanenthusiasmthathadallthehallmarksofBritishforeigndebtmaniasofthe19thCentury.

BySeptember1929,therewere202foreignbondissuestradingregularlyontheNYSE and they accounted for one third of the bond trading volume on theExchange. Not surprisingly, a global depression and world war had whittleddown the number of foreign bonds still trading in 1949. When the DJIAbottomed on 13 June 1949, only 46 foreign bond issues were listed on theNYSE. There remained only 20 sovereign issuers with bonds trading on theExchange and many of these issues traded below half their par value: Chile,Colombia,CostaRica,Greece,Italy,Mexico,Peru,SerbiaandYugoslavia.Justoverhalfofalltheforeignbondsstilltradingwerepayinginterestinfull.Attheend of 1948, there was $1,030 million of European dollar bonds paying nointerest,64%ofthisaccountedforbyGermany.

FollowingtheattackonPearlHarbor,theSecuritiesandExchangeCommissionhadbanneddealersfromquotingpricesordealinginthe$1,250millioninfacevalue of dollar bonds issued by theAxis powers. This had ended trade in thedebt of seven nations –Germany, Italy,Austria, Romania,Hungary, BulgariaandJapan.Evenby1949, themarket in thesesecurities,with theexceptionofItaly,hadnotbeenreopened.

One reason provided for the continued suspension was a fear that Germangovernmentsecurities,repurchasedbythegovernmentpriortoDecember1941,hadbeenaccumulatedinBerlinbutnotcancelled.Itwasnowfearedthosebondswere in thehandsof theSoviets. It is a fairgeneralisation to say that the firstrushofenthusiasmbyUSinvestorsforforeigngovernmentbondshadbeenjustasdisastrousastheBritishinvolvementinthe1820s.BenjaminGraham,writingafter the war, was able to dismiss the entire asset class with some disdain,arguing that foreign bonds had ‘a bad investment history since 1914’, madeworsebytwoworldwarsandaworlddepression.

Yet every few years, market conditions are sufficientlyfavourable topermit the saleof somenew foreign issuesat aprice about par. This phenomenon tells us a good deal abouttheworkingof theaverage investor’smind–andnotonly inthefieldofbonds.[61]

Endnotes59WallStreetJournal,6July1949[returntotext]

60C.F.Childs,ConcerningUSGovernmentSecurities[returntotext]

61BenjaminGraham,TheIntelligentInvestor[returntotext]

Atthebottomwiththebear–Summer1949‘Weshouldhaveabigrushsoon.I’mdoingareportnow.Well,notreallyareport;I’vebeengettingsomestatisticsonaircraftstockreadyforthefrontoffice.It’sbeensomejob.’

GoreVidal,InAYellowWood

Inboth1921and1932therewerelargeslumpsinequityprices.Thebearmarketthatendedinsummer1949wasverydifferent.FromthepeakinMay1946,ata16-year high, the market declined just 24% to reach its low in June 1949.However, despite the lackofdrama, thisbearmarketwas, inonekey respect,similartothatof1921.In1929-32,equitiescrashedfromhighvaluationstolow.This sudden lurch from over-valuation was exceptional. As we have seen in1921, equities had spent a long time seeking lower valuations before reachingtheminafinalmaterialpricedecline.

In 1949, the final price decline was more muted, but the prolongeddowndriftinvaluationsechoedthepre-1921experience.

FIGURE82.S&PCOMPOSITEINDEXCYCLICALLYADJUSTEDPE–1933-49

Source:www.econ.yale.edu/~shiller/data.htm

Akeydriverfortheprolongeddeclineinequityvaluations,asithadbeenpriorto1921,wasthefailureofcorporateprofitstofullybenefitfromthegrowthoftheeconomy.ThepathfortheUSeconomyfrom1929-46hadbeenalotmorerocky than it had been prior to 1921. Despite the Great Depression in theinterveningperiod,theUSeconomyhadexpandedwhiletheDJIAwasbacktolevelsfirstseenin1926.

FIGURE83.ECONOMICGROWTH1926AND1949[POPULATIONTOCRUDEOILPRODUCTION]

FIGURE83CTD.ECONOMICGROWTH1926AND1949[VALUEOFNEWPRIVATEANDPUBLICCONSTRUCTION]

Source:USBureauoftheCensus

While the equitymarket had gone nowhere since 1926, the economy hadexpandedmaterially.RealGDPwasbelowits1926levelas lateas1935andthe entire growth in the economy in the period happened from 1935 to 1949.ContinuedpopulationgrowthpreventedadoublinginrealGDPpercapita,butitstill increased 62% in the 1926 to 1949 period. One possible reason for thediscrepancybetweentheexpansionoftheeconomyandcorporateprofitgrowthwastheriseinimportanceofbothgovernmentandlabour.Figure83showshowthe government sector had become an increasingly large portion of the USeconomy.Overthe1926-49period,governmentexpenditureasapercentageofGDP had risen from 3% to 15%. While the first half of the period wascalamitousforlabour,therewasamarkedimprovementinthesecondhalf.Theconsumer price index rose 73% from 1935 to 1949 but the average hourlyearningsofmanufacturingworkersincreased155%.

Despitethegrowingroleofthegovernmentandtheunionisationoflabour, thereported profits of listed companies did grow marginally faster than nominalGDP in 1932-49. However it is very dangerous to measure corporate

profitabilitysolelybytheincreaseinprofitsoveronespecificperiod.Theabilityfor corporate profits to grow in line with nominal GDP from 1932-49 is notparticularlyimpressivewhenoneconsidershowdepressedprofitswerein1932.TheS&PComposite Indexearnings series for listedcompaniesbegan in1871andby1872profitswere alreadyhigher than theywere tobe in1932 inbothnominalandrealterms.

Given the verydepressednature of earnings in 1932, the 10-year averagereported earning figure, compared with the 1949 equivalent, provides abetter general estimate of “normalised” earnings. This comparison shows“normalised” earnings in 1949 to be 33% higher than “normalised”earnings in 1932. Given the growth in nominal GDP over that period,corporateprofitabilityhadclearlybeendisappointing.

Thetotalgrowthinlistedcompanyprofitfrom1932to1949containstwoverydifferent periods.Almost two-thirds of all growth in reportedprofit in the13-yearperiodoccurredbetween1945and1949.The repealof the excessprofitstaxin1945playedanimportantroleinthissuddensurge.Aswehaveseenthisprofitssurgecoincidedwiththefinaldeclineinequityprices.

This suggests that investors doubted the sustainability of the postwar profitsexplosionandweretreatingtheverylowlevelsofprofitabilityin1945asmoreindicative of the earnings power of US corporations. Thus even the sub-parprofits growth from 1932 to 1949 was treated as perhaps an over-generousrepresentation of the future earnings power of listed companies. This lack offaithinthecontinuationofeventhislowlevelofprofitabilitywasevidencedbyadeclineinvaluations.

Formanyinvestorsitmusthavebeendifficult tobelievethatequityvaluationscoulddeclinefromtheirverylow1932levels.WhentheDJIAreacheditslowestlevel inJune1932themarketwas tradingonamodestPEof just9.4xcurrentearnings, compared with the 1871 to 1932 average of 13.7x. As the earningscontractionhadnotrunitscoursebyJune1932, thePEwasmuchhigheronaprospectiveearningsbasis.ReportedearningshittheirlowsfortheDepressioninDecember1932,andbasedonthatlevelofearningsthemarketwastradingon11.6xPEinJune1932.

Even at this very depressed level of earnings, a level already surpassed fromApril 1872 to June 1876, the market was valuing equities at a very steepdiscount.An investor in June 1932, even foreseeing the further contraction inearningsmighthaveexpectedthatthevaluation,overthelongterm,waslikelyto rise towards the13.7x1871-1932average level.HoweverbyJune1949 theS&PCompositeIndexPEhadfallenevenfurtherto5.8xearnings.Earningsdidhavealittlebitfurthertocontractin1949buteventakingthisintoaccountthemarketwastradingonjust6.4xinJune1949.

Investorsbuyingatthebottomin1932,expectingthatatleastvaluationsofequities would rise, saw those valuations decline a further 40% by thebottomofthe1949bearmarket.Earningsgrowthwaspoorovertheperiod,buttheabilityofequitiestoreacheverlowervaluationswasthekeydriverofpoorreturns–particularlypost1937.

FIGURE84.S&PCOMPOSITEINDEX(12-MTHTRAILINGEARNINGS)–1929-49

Source:www.econ.yale.edu/~shiller/data.htm

Theyear-endqratiofortheUSmarketdeclinedfrom0.43xatyear-end1932tojust 0.36x at year-end1949.By1949, equities hadbecomeexceedingly cheapandthescenewassetforthelongestbullmarketofthe20thCentury.

Goodnewsandthebear

‘AlthoughIhavethegreatestpersonalesteemfortheopinionsofyourselfandassociates,uh,inretothestockmarket,Imust,inthisinstance,disagreewithyou,forIamoftheopinionthatthisisarisingmarketandwillcontinuetobeso.Allstatisticsathand…no,available,pointtojustthat.Hopingtohearfromyouagain,andsoon.’

GoreVidal,InAYellowWood

The summer of June 1949 was more like 1921 than 1932. Investors had notrecently suffered a calamitous collapse in prices. Bymid-1949, investors hadbeen through a prolonged period of sideways trading despite better economicconditions and, since 1945, dramatic improvements in corporate earnings.Tempering thebetter economicandearningspicturewas the fearof apostwardepression and deflation, as had occurred in 1921, or a continued heavygovernment involvement in the economy which would stifle corporateprofitability in the long term.Despite this general uncertainty, the recoveryofequitypricesprecededtherecoveryintheeconomy.

TheDJIAbottomed inJune1949,while theNBERreferencedate for theendoftherecessionisOctober1949.

Yet,evenforinvestorswhocouldforeseetheeconomicimprovementthereweregoodreasonstobecautious.Inthelongperiodsince1932,therehadbeentwoprevious occasions, June 1938 andOctober 1945, when recessions had endedand economic expansion had recommenced. On neither occasion did theeconomicturnaroundproduceasustainableriseinequityprices.TobepreparedtoinvestinequitiesinJune1949aninvestorhadtobelievethatthistimeitwasdifferent.

Oneofthegreatmarkettruismsisthattheendofabearmarketwillbesignalledby theabsenceofgoodnewsandoptimism.Aswehaveseen thiswasnot thecaseatthebottomofthemarketin1921and1932.Similarlyin1949therewasamplegoodnewsandoptimismatthebottomofthemarket.

The economymay not have bottomed until October 1949 but there had beenplenty of good economic news in the pages of theWall Street Journal thatsummer.

21April:…firstquarterreportshavebeenbetterthangenerallyexpected.

22April:InternationalHarvesterCo.thusfarinitscurrentfiscalyear,whichstartedlastNovember1,hasproducedatleast30%morefarmequipmenttheninthelikeperiodayearago.

22April:‘Anumberofeconomicobservershavereachedtheconclusion,orareveeringtotheview,thatthereadjustmentswhichareprogressinginoureconomicsituationwillultimatelysetthestageforavigorousbusinessrevival.’SamSmithofBache&Co.

22April:W.W.AxepresidentofAxe-HoughtonFundInc.,writesstockholdersinpart:‘Thereareanumberoffactorswhicharelikelytolimitthedurationofabusinessdecline.Oneofthemostimportantisthecreditsupply,whichislargeandprobablywillbeincreasedbytheFederalReserveBankoperations.Governmentexpendituresprobablywillbeincreasedifthereisfurthercontractioninbusiness.Thereisalsoagreatdealofconstructionworkwhichmustbedone,notablyintheutilityfield.Adeclineinprocessandimprovementinlabourefficiencywouldprobablybringinnewdemand.Finally,thedownwardtrendingeneralbusinessactivityshouldmodifylegislationlikelytobepassedbyCongress.Thesituationisveryunlikethatobtainingatthestartofareallyseverebusinessdeclineinthepast,suchas1907and1920.Butashort,perhapssharpbusinesscontractionin1949isarealpossibility.’

25April:EvansWollenJr.presidentoftheAmericanBankersAssociation-AsstrongspotsinthebusinesspictureMr.Woollenenumeratedthese:Animportantpent-updemandforgoods:thelargeamountofmoneyinthehandsofthepublic:theEuropeanaidprogram,whichwhileitinvolvesseriousproblemsoverthelongtermiscertainlyastimulanttobusinesscurrentlyandtheexpectedmilitaryaidtothiscountry’sassociatesintheAtlanticPact.

28April:Thebudgetsoffirstquarterreports,ledbysuchcompaniesasU.S.Steel,DuPontandGeneralMotors,includemanyimprovementsbutinvestorsarenotconcernedwithhistoryandaretradingonwhatmaytakeplaceincomingmonths.

28April:SalesofgasolinebyStandardOilCo.ofOhiointhefirstquarterwereabout8%aheadyearonyear.

2May:Earningsofthe197firmstopped$732millionmorethan21%greaterthan1948.[WSJsurveyof1Q1949in20majorlistedindustries]

12May:SecretaryoftheTreasurySnydersaidpostwar‘adjustments’arenow‘practicallycompleted’inmanylinesofbusiness.

14May:Announcementafterthecloseofthecent-a-poundincreaseinthepriceofscrapcopperheartenedtheconstructivelymindedinWallStreet.

21May:ItisreportedthatU.S.Pipe&Foundryhasnotedanimprovementinnewordersinthesecondquarter.Municipalitiesandpublicutilityfirms,itsmajorcustomers,areexpectedtomaintainitsoperationsatahighrateforsometime.

23May:Thebulkofindicationistherecessionwillbealightone.

3June:PrivateresidentialconstructioninMayfell15%belowthelikemonthlastyear.Forthefirstfivemonthsof1949,residentialbuildingwasdown15%fromlastyear…Forthefirstfivemonthsofthisyear,allconstructionran3%abovethelikeperiodlastyear…Publicconstructionhitamorepositivenote…Forthefirstfivemonthsthisyearpublicconstructionwas40%overlastyear.

8June:FollowersoftheaircraftsharessayBoeing’s1949salesshouldbedoublelastyear’sandearningsconsiderablyabovethoseof1948.

9June:Droppingforthe20thconsecutivetime,businessloansfellanother$152millionduringtheweekendedJune1,theFederalReserveBoardreported.Realestateloans,runninganoppositetrend,advancedtoanewrecordhighof$4,092millionatleadingcitybanksJune1.Realestateloanswere$324higherthanayearago.

16June:Aboutayear–that’showlongmanybusinessmenthinkthedowntrendwilllast…PresidentSpangofGillette,forinstance,suggeststhedownswingwillbeoverinfourtosixmonths.

16June:PresidentGeorgeB.Beitzelofchemical-producingPennsylvaniaSaltsays,‘Inthelastfewdayswe’venoticedmoreactivityincertainlines.Mostofusinthecompanyfeelbyfallwewillbeactiveagain.’…Abigpaintcompanynotesarecentsalespickup.Itsexplanationisthatdealersstoppedbuyingtocutinventoriesandthen

foundconsumerdemandwasstillprettystrong.Wouldbebuyerscomplainstorestocksareskimpyinwanteditems.

16June:‘Rollingrecession’isatermusedmoreandmoretodescribethesituation.AWhiteHouseeconomicadvisergetscreditasthephrasecoiner.Byrollinghemeansindustrialshavebeenhitinseriesratherthanallatonce.Somesuchascotton,textiles,airlines,frozenfoods,radiosets,distillers,luxurygoodsranintotroubleayearormoreago.Therehasbeensomecomebacksinthislist.Stillotherindustrieshaven’treallyfeltthedownswing.Autosanimportantexample.Drugmakersanother.Electricpowersalescontinuetotopthoseofayearago.Telephonecompanyhasabigbacklogoforders.Truckersprofitablybusypartlyattheexpenseofcompetingrailroads.Thegovernment’seconomicpulse-takerssuggestthatontheaverageitappearstotakeaboutayearforeachindustrytocompletetheslidefromitsloftypostwarbusinesspeaktoalevellingoffplace.

16June:Ifabusinessrecessionseemedtobegainingmomentumearlythisyear,agoodmanyU.S.consumersweren’ttooworriedaboutit…AccordingtofigurescollectedfortheFederalReserveBoard,theyhadmoremoneytospendthaneverbefore,feltprettyoptimisticabouttheirfutureprospectsandintendedtobuyautomobiles,housesandotherdurablegoods…Theresultssaidone‘lookedqueercomparedwithwhatotherthingsweknowabouttheeconomicpicture.’…TheynoteaslumponappliancesalescontinuingthroughAprilthenapickuplessthanseasonalbutenoughtoindicatethatlowerpriceswerestimulatingsales.FederalReservebanksreportthatdealerswhogoaftercustomersmostaggressivelywithpricecutsandadvertisinggetresults.

22June:WalterMaynardofShearson,Hammill&Co.:‘EvidenceseemstopointtoanupturninbothbusinessactivityandthestockmarketinJuly.Underthecircumstances,investorswoulddowelltoadoptasomewhatmoreaggressiveattitude.’

29June:RalphRothemofHarrisUpham&Co.‘Itisjustpossiblethatbusinessactivitymaybeabletorecoversomeincomingweeksbecauseoftheneedforincreasedproductionofcertainnon-durablegoodswhereinventorieshavebeenreduced.’

30June:Therayonbusiness,whichhasdippedsteeplyoflate,is

showingsignsofperkingup…AspokesmanforNorthAmericanRayonandAmericanBembergCo.bothunderthesamemanagementsays:‘Thisisadefiniteturnfromthebottom.Weconsideritsignificantandexpectbetterbusinessfortherestoftheyear.’

1July:Consideringtheinterveningpricereductions,physicalvolumeatretailissofarholdingupremarkablywellintheaggregate.Theriseinunemploymenthasnotyetmademuchofanimpressionnthegeneralexerciseofpurchasingpower.Thedifferencebetweenindustrialproductionanddistributiontoconsumersisobviouslyaccountedforbyreductionofinventories.Baringsuchcontingenciesasprolongedworkstoppagesandgreatlossofwageincome,consumptionmustinduecourseover-takeproductionandcallforgreateractivityatthemillsandfactories.Theautomobileandbuildingconstructionindustriesremainconspicuouslyactive.

1July:Therehavebeenscatteredinstancesofbusinessimprovement,notablyintherayonfield.Therehasalsobeenaslightbreakinthecloudsblanketingtheinternationaleconomicoutlook.ThosewhohadbeenwarningofanimminentdevaluationofthepoundsterlingforaweekortwopastnowbelievethatnosuchclimaxtoBritain’seconomiccrisisislikelyforamonthortwo,oruntilafterthemeetingofcommonwealthfinanceministersinLondon.

2July:Unemploymentjumpedtoasevenyearhighof3,778,000.Buttherewasnoincreaseinthenumberofadultjoblessthedepartmentsaid.The489,000increaseoverMayfigurescameinthe25-and-underagegroup…Theincreaseinnon-farmemploymentreversedafive-monthdeclineandwasattributedtoexpansionofconstructionandoutdoorwork.

6July:‘Itisbecomingquitepopularnowtopredictthatourcurrentrecessionwilltendtobottomoutinthefallandthatagradualpick-upinoverallbusinessactivitywilloccurinthespringofnextyear.’DanielF.Rice&Co.ofChicago

8July:LucienHooperofW.E.Hutton&Co.–‘Fieldreports,gatheredfromawidecrosssectionofindustry,indicatethattheusualconditionswhichprecedeamajordepressionarelacking.’

8July:Salesofelectricitytothenation’slargerindustrialplantsinMay

declinedbelowthelikemonthayearago…Itwasthefirstyear-to-yeardeclineinanymonthsinceAugust1946…SalestoresidentialcustomersinMaytotalled4,470millionkilowatthours,or14.2%abovethelikemonthayearago,andsalestocommercialconsumersamountedto3,625millionkilowatthours,or7.2%abovetheMay,1948,total.

11July:Thebrassindustry,whoseproductionhasslumped50%inthepastsixmonthsnotedasubstantialpick-upinsaleslatelastweek.

12July:SamSmithBache&Co.–‘Foroverthreeyearsfearsofwhatisnowoccurringinthebusinessworldhavedampenedmarketsentiment,preventingnormalprice-earningsrelationships.Whenthisweightislifted,awelcomechangeinpsychologyshouldevolvewithtoniceffectonourmarkets.Thereshouldberoomforplentyofcheerintherealizationthat:Thereisn’tgoingtobeawar;therewon’tbeataxincrease;wehavenoviciouslaborbill;wererapidlyheadingforbusinessnormalcy;costlyinventoriesareshrinking;excessinefficientplantspaceisbeingidledorscrapped;publicneedsarestillhugeandpurchasingpowerenormous;vastadditionalmarketswillbetappedwiththereturntorealisticprices;moneyischeapandcreditplentiful;andstocksarelowandyieldsarehigh.’

14July:Textilemakersareencouragedby‘feelers’fromcottonandrayonclothbuyers.NewEnglandmillssaythispreliminarynibblingbycuttersandgarmentmakersforfallgoodsisthefirstevidenceofrealbuyinginterestinthesefabricsinoverayear.

18July:Outdooradvertisingfirms,whichsensethegeneraladvertisingtrendfirst,report1950isshapingupasanotherbigyear.

21July:Tradeatretailstoreshasbeenrelativelystablesincethebeginningoftheyear,theCommerceDepartmentsaid.Inthefirstsixmonthsthetotalvariationsontheadjustedindexfromthefirstsixmonthsof1948hasbeenonly1%itadded.

22July:TheapplianceindustryhasreachedthebottominitsreadjustmentintheopinionofJamesJ.NancepresidentofHotpoint…‘Pricereductionsforelectricalappliances,whichtookplacearoundtheendofthefirstquarterofthisyear,wererapidandthorough.Theyhavebroughtappliancepriceswellwithin…levelsofthenationseconomy.’

23July:CorporationDividendsPaidinMayWere14%Abovelike1948Month-ForthethreemonthsendedMay31,cashdividendpaymentstotalled$1,373,300,000,up10%fromthe$1,251,900,00paidoutinthesameperiodof1948.

25July:NewEngland,HitHardByBusinessDip,SeesHintsofRecovery.NewEnglandwithahighproportionofconsumergoodsindustriesisusuallythefirstsectionofthecountrytofeelabusinesschangeforthebetterorfortheworse.

1August:BusinesscontinuedtodeclineinJulybutataslowerratethaninMayandJune,theNationalAssociationofPurchasingAgentssaid…AtthesametimeorderbookingrevealeditsgreateststrengthsincethestartofthedeclinelastOctoberwith30%ofthepurchasingexecutivesreportingincreasescomparedwith28%showingdecreases.SurveyshowsthesecommoditiesincreasedinpriceinJuly-Copper,lead,zinc,alcohol,newburlap,ceramics,corn,limerock,cottonseedoil,tungoil,rosinandstarch.

4August:Steelmillsreportadefinitepickupindemand.

5August:Indeedthisnewspaper,whichhashadtheunfortunatechoreofreporting‘bad’newsforseveralmonths,hascarriedenoughsuchcheeringitemslatelytobringforthcommentfromPresidentTrumanatyesterday’spressconference.Foronceheispleasedwithus.

6August:AftertheclosetheFederalReserveBoardannouncedcutstobemadeoverthenextfewweeksinreserverequirementsofmemberbanks.

Thereductionswillincreaseby$1,800milliontheamountofbankfundsavailableforinvestmentingovernmentsecuritiesorloanstobusiness.

10August:Bache&Cosaid.‘ThebeginningofanewspiritcanbesensedinWallStreet.ThiscouldeasilybethefoundationforthenextmajorexpansioninAmericanbusinessactivity.’

10August:Hemphill,Noyes&Co.‘Nevertheless,webelievethataseverebusinessdepressionwillbeavoidedthatwarisimprobableandthatanyadverseeffectsherefromsterlingorothercurrencydevaluationswillbetemporary.’

Ofcourse, therewasplentyofbadnewsaswell.But theaboveexcerptsagainshowthatthosewhoawaittheuniversalbadnewsthatmythicallysignalstheendofabearmarketwillmisstheboat.Asin1921and1932,themarket’sfailuretorespondtogoodnewswasmoreindicativeoftheendofthebearmarketthananyproliferationofbadnews.Therewerenumerousothersimilarities,in1949,with the signsofnascent economicrecovery in1921and in1932.On all three occasions, it was remarked that the economic recovery, tospread through the country, began in New England. Another factorcommon to all three bear market bottoms is that the auto industryexpandedwhilethegeneraleconomycontinuedtocontract.

With autoproductionhalted inFebruary1942,only749newcars, taken frominventory,weresoldin1943and1944.Motorvehicleregistrationsin1945werestillbelow1939levels.Thislackofproductionproducedaveryabnormalautomarket which distorted pricing for many years after the war. The pent-updemand for car ownership had sent second-hand car prices to large premiumsandcreatedaqueuefornewcarsafterthewar.FromtheWallStreetJournalof5April1949comesthisitem:

UsedCar Doldrums – Lower prices and slower sales meansliming profits for used car men who have watched theirfabulousmarketcrackslowlybutsurelyinthepasttwoyears.During thewarandearlypostwar theycouldsellanycar thatran for almost any price. In the winter of 1946-47 sales offantastically-priced luxury models began to skid. Businessboomedthrough1947butconsumerresistancegrewgraduallyandmore new cars came off assembly lines complete. In the1947-48winterpricesslipped10%to20%,inSeptember1948,theywereoffanestimated25%from1947peaks.Businessthispastwinter dipped to postwar lows…A 1937Chevrolet thatcost $900 new would probably have been marked off about$250thefirstyear,$200morethenextyearand$150morethenext, bringing it down to one-third its original price in threeyears.After thewar, a 1946Chevy listed at $1,200newwaslikely to sell in a used car lot for $1,500 early in 47, $1,300early thisyearandmaybe$1,100 today– threeyears later.Athree-year-oldCadillacthatlistedat$2,500newin1946would

have sold for just about that early this year. Today it wouldbring$800less.

Oneexpertestimated,inthesameWSJstory, that therewere40,000dealersintheUScomparedwith19,000pre-war.Thedecliningpremiumonsecond-handcarsandthedeclineinthenumberofsecond-handcardealerssignalledthatthemarketwasreturningtonormality.

In the first full year of peace, in 1946, US factory sales of autos totalled 2.1millionandthiswastoreach5.1millionin1949.Whilepricedeclinesonnewcars did not begin until 1949, they did not progress far before resurgence indemandoccurred.The 5.1million sales figure seemedhigh relative to the 3.8millionunits sold in1941, the lastyearofpeace for theUS.Not surprisingly,investorsworriedthatsalescouldnotbemaintainedatsuchhighlevelsoncethewartime pent-up demand had been satisfied. Such concern was unjustified aspostwar sales continued to grow strongly. Some foresaw continuation of thepostwarboom.WilliamF.Hufstader,GeneralMotors’vicepresidentinchargeofdistribution,wasquotedintheWSJon4June1949assaying:

The average age of cars in use during 1948 was 8.73 years,comparedwith 5.33 years in 1941; nearly 13million cars onthehighwaysintheUnitedStateslastyearwere10yearsoldoroldercomparedwithabout5millionbeforethewar;disposableincome is at a record high, population has increased and alarger proportion of people are in income brackets generallyregardedasthenewcarmarket.

Cardealershadtheirownuniquewaysofclinchingasale,accordingtotheWSJof11August1949:

Gotahorse?ANewYorkCityForddealerwillacceptone(oramuleoragoat)asa$300allowanceonanewtruck.

In 1921, 1932 and 1949 rising demand for autos presaged a more generalimprovement in demand. This resilience may be based on the fact that autoownershipwas still rising fromwhatwould subsequently be proved very lowlevels.Forsuchproductswithlowdiffusionrates,itmaybethatthesignoftheunleashing of pent-up demand provides an important indicator of general

economic improvement.While autos seemedoneof the very first products onthebuyinglistsofthereinvigoratedconsumerthespendingurgesoonspreadtootherproducts.Theremayofcoursebeotherproductsatthetopofconsumers’shoppinglistswhentheirconfidencereturns.On4May1949,theWSJpointedoutanotherindustryalreadyundergoingsomethingofaboom.

Business Booms Again At Las Vegas – In the bar of theFlamingo, Ben Goffstein, one of the managers, says, ‘I getreportsfromotherpartsofthecountrythatliquorsalesareoffasmuchas40%,butthelastfewweeksourbargrosshasbeen10%betterthanayearago.’…GamblinginNevadaisnosure-fire economic weathervane. But as one guide to luxuryspending,ithasbeenaccurateinthepast.Forexample,aslumpinRenogamblinginthewinterof1947-48precededbyseveralmonths the national let down in demand for luxuries. LasVegashopessoontopassthe30,000populationlevelofRenotobecomethebiggestmetropolisinNevada.

This interview took place just three years after Bugsy Siegel had opened theFlamingo.IfevertherewasanindustryandatowninastructuralgrowthphaseitwasLasVegasin1949.Thecitythathopedtohaveapopulationinexcessof30,000cannowboastalmost twomillionpeople livingwithin itsmetropolitanareaand36millionvisitorsayear.

Pricestabilityandthebear

Inthesummerof1949,theWallStreetJournalchroniclednumerouseconomicimprovements.As in 1921 and 1932, therewas rising demand for products atlowerprices.Thisechoesanimportantchangeunderwayat thebottomofboththe 1921 and 1932 bear markets. Perhaps autos and gambling saw strongdemand first, being products benefiting from structural growth. But risingdemand was soon evident in more mundane products and commodities. Animportant indicator of the 1921, 1932 and 1949 bearmarket bottomswas thefirstevidenceofincreaseddemandforcommoditiesappearingatlowerprices.In1949 as in 1921 and 1932 this provided a clear indication that deflation wasending.As ithadbeendeflation thatwascrushingcorporateearnings, it isnotsurprisingthattheequitymarketrespondedsopositivelytothefirstevidenceof

price stability. The rise in demand and prices happened at different times fordifferentgoodsandcommodities.

In1949,as in1921and1932,a returnofgeneralprice stability coincidedwiththeendofthebearmarketinequities.Asin1921and1932,spreadingdemand for and price stability of selected commodities augured well forgeneralpricestabilisation.

In1949,as in1921and1932, lowlevelsof inventory in thesystemsuggestedthatanypricerisesmightbesustainable.

Itseemsthe tendencytooverstockcanimpacteventhose industrieswithmorepredictable demand characteristics, as theWall Street Journal reported on 19May.

LowerDeathRateHitsCasketManufacturersThebiggestfactor in declining production is that many funeral directors,likepurchasersinotherlines,boughtheavilylastyear–andarenowoverstocked.

Inventory liquidation had played a role in depressing prices so, now thatinventories were at rock bottom, perhaps deflation would abate. For theeconomyasawhole,inventoryliquidationhaderuptedinlate1948.AccordingtotheDepartmentofLabor’swholesalepriceindex,thepostwarpeakforpricescamethatsamemonth.Thiswasexactlythreeyearsaftertheendofthewar.Thecontinuationofwartimeinflationhadlastedalmosttwiceaslongasithaddonefollowing the endofWWI.By the time theDJIAbottomed in June1949, thewholesalepriceindexhadalreadyfallen7.5%fromtheAugust1948peak,andasFigure85shows,therewasonlyafurthermarginaldeclinetocome.

FIGURE85.USWHOLESALEPRICEINDEX1939TO1951

Source:NationalBureauofEconomicResearch

Theconsumerpriceindexperformedverysimilarlytothewholesalepriceindex.So,whiletheequitymarketbottomdidnotcoincidewiththebottomforgeneralprice levels, it did occur as the period of sharp decline in prices ended.As in1921and1932, growing indicationsof stability in commoditypricesproved agoodindicatorofthechangeintrendofgeneralpricesandtheendoftheequitybearmarket.

TherewasampleevidenceofthischangeinthepagesoftheWallStreetJournalinthesummerof1949.AsearlyasAprilariseinthepriceofrentsandfoodwasevidentwithintheretailpriceindex.Themarketpriceofwheatandoilimprovedin June. A key confirming feature of the rise in prices was the fact thatinventories were low and that there was evidence of rising demand at lowerprices.AstheWSJputiton8July,‘thepubliciswillingtospendifitconsidersthepriceis“right”’.ByJuly,pricerisesinlead,rayon,poultry,zincandcopperwere remarked upon as further evidence that general deflationary trendswereabating.ThewholesalepriceindexmarkedamarginalriseinpricesinJulyandthe accelerating pace of deflation, frightening themarkets,was nowhere to beseen.

The big call for investors in 1949 was the degree of deflation that wouldnecessarily follow the war. When would it end? The crucial answer to thatquestioncamefromtheperformanceofgeneralprices,andnottheeconomyin

general,ortheequitymarketitself.Inparticular,signsofincreaseddemandforcommoditiesatlowerpricesleadingtopricesstabilisinginthesummerof1949suggestedthescaleofdeflationwouldhavetobemuchsmallerthanoccurredin1920-22.Asin1921,andin1932,closescrutinyofpricetrendsingeneralandcommodityprices inparticularwas akey element indeterminingwhenequitypriceswereapproachingtheirnadir.

Thetotaldeclineof7.9%inthewholesalepriceindexfromAugust1948toJune1950was inmarked contrast to the 45%decline in prices following the post-WWIpeakforprices.ItisclearfromthepagesoftheWSJthatamuchgreaterdegreeofdeflationhadbeenexpected.Thebearmarketinequitiesduring1946-49, when corporate earnings doubled, also suggests that investors expected amuch greater degree of deflation. For the investor who saw commodity pricestabilisationasthefirstsignofgeneralpricestabilisationtherewereverycheapsharestobeboughtinthesummerof1949.

Ofcourse,thekeyquestioniswhetheritwasanyeasiertoforecastthischangeinprices than it was to forecast the bullmarket in equities. In particular, was itpossibletoforeseethatdeflationwouldbeofsuchminormagnitudecomparedto1921and1932?While theremayhavebeenmany reasons for the constrained1948-50 price decline, key institutional changes between 1921 and 1949 didstronglysuggestpricedeclinesinthepost-WWIIeconomiccyclewouldbemoremuted. It is clear froma former vice-president at theTeachers’ Insurance andAnnuity Association that the prospect of a new era for inflation was beingactivelydiscussed.

Eminent authorities believe that our economic system is now‘repletewithbuilt-ininflationarybias,’especiallyinperiodsofwar or international tension accompanied by heavyexpenditures for defense. They point to the tax structure,escalator wage clauses, parity prices, budget deficits,government borrowing from commercial banks, low rates ofinterest,cost-pluscontracts,subsidiesandthelike.Somepointto Keynesian economics, emphasis on full employment, thepublic welfare state, disinclination to return to the goldstandard.[62]

So therewere thosewho foresaw that the postwar deflationwould bemuted.These investors presumably were increasing their exposure to cheap equitiesthroughout the1946-49bearmarket. It did indeed turnout tobedifferent thistime.Forthosewithsuchforesight,thereweregoodprofitstobemadeinbuyingequities in the summer of 1949, confident a postwar gross deflationaryadjustmentwasnotonthecards.However,asalreadysuggestedabove,investorsdid not necessarily need to have such an expert grasp of the changinginstitutionalarchitecturedictatinga“built-ininflationarybias”.Asin1921and1932, therewasnoneedtopre-judgethe levelatwhichpriceswouldstabilise.One could wait and assess evidence in the summer of 1949 that prices werestabilising.

Theanalysissofarhasfocusedonhowsignsofpricingstabilityforcommoditieshave been an important tactical consideration in timing entry into the equitymarket.Of course, there is an increasingly evident strategicmessage from theimportanceofchangesinthegeneralpricelevel.Itisevidentthattheperiodsofextreme undervaluation for equities have all followed a shock to the generalprice level. In 1921 and 1949 investorswere pondering just howmuch of thegross wartime inflation would have to be reversed. The answer was verydifferentonbothoccasionsbut themassiveuncertainty regarding futurepricesand corporate profits depressed equity prices. In 1932 there had been noinflationary surge associated with the previous bull market. This perhapsresultedinfurtheruncertaintyasdeflationeruptedandinvestorshadtoguessatwhatlevelpriceswouldstabilise.

Inthisbook,wearestudyingthoseperiodswhenequitypriceswereverycheapandprovidedexcellentsubsequentreturns.Canitbemerelyacoincidencethatin1921-49 we find equities reaching their cheapest levels following materialdisturbances to the general price level? This has important ramifications forinvestors. It suggests thesafest time tobuyequities is followingamajorpricedisturbance.Ifnosuchpriceadjustmentisassociatedwithadeclineinthestockmarketthenthismaynotbeoneofthesegreatbuyingopportunities.

Thisisnottosaythatonecan’tbuyintodecliningequitypricesintheabsenceofa major disruption of the general price level. However it is to say that theabsenceofsuchapricedisruptionmaymeanthatequitieshavenotreachedsuchalowlevelas topermitonetopursuea long-termbuyandholdstrategy.Low

valuations,whencombinedwithareturntonormalcyinthegeneralpricelevel,arelikelytoprovidethebestprospectofabove-normalreturnsforinvestors.

Thegeneralprice level refers to thepricesofallgoodsandservicesintheeconomy.Thetermisusedinthisbooktoavoidconfusionwith the regular references tomore specific pricechanges.Adisturbanceusefullycoverseitherariseorafallinprices.Butwhatisamaterialdisturbance?It isatermofconvenience,but it isusedheretoreflect that themagnitudeof the disturbance to the general price levelwas significantenoughtohavehadamajorimpactonthemarket.

LiquidityandthebearAnursewithababycarriagewashurryingstreetward.Itwaslate,probablymuchtoolateforhertobeoutwith thebaby.As shepassedhimhe caughtaglimpseof the childand saw that itwas staring vacantlyahead,concentratingupongrowth.

GoreVidal,InAYellowWood

Foreachof thefourkeyepisodescoveredby thisbookwe lookathowusefulliquidity analysis has been to those seeking to find the bottom of the bearmarket.In1921and1932welookedatwhatrole increases inFederalReservecredit outstanding and other changes in monetary policy had on the stockmarket.InPartIandPartII,wesawhowthecreationoftheFederalReserve,towork in conjunctionwith the gold standard, had significantly complicated thebusinessofforecastingliquiditytrends.By1949,theFedhadbeenoperatingforalmost35years,andthisshouldhaveresultedinanincreasedabilitytoforecastits actions. However, as we have seen, inconsistency and error in its policysettingsoverthose35yearsmeantthatFedactionswereprobablyasdifficulttopredictin1949astheyhadbeenwhenitopenedforbusinessinNovember1914.

Thebadnewsin1949wasthat themonetarymechanismhadchangedandthismade Fed watching even more difficult. The Fed’s wartime responsibility tosupportgovernmentsecuritiesatpre-determinedlevelsmeant itwasaprovider

ofunlimitedamountsofhigh-poweredmoney.Littlehadchangedby1949andalthoughsupportprices forTreasurybillsandcertificateswerediscontinued in1947,theFedremainedcommittedtosupportinggovernmentsecuritypricesoflonger maturities. The support price for government bonds was lowered onChristmasEve1947,but thenewprice remained inplace throughout1948. Inpractice this policy meant that the “elastic currency” would have to keepexpandingaslongastheFedneededtobuysuchsecuritiestosupporttheirprice.Thus when market forces were forcing government bond prices below theirsupportleveltheFed’skeymonetarytoolwasplacedondefactoauto-pilot.Inthis situation the expansion of the “elastic currency” was an administrativecertaintyandnotanindicationoftheFed’spreferredmonetarystance.

Thecommitmenttosupportgovernmentbondpricesproducedotherdistortionsin thenormaloperationsof themonetarysystem.Raisingreserverequirementswasnotaseffectiveasitwouldhavebeeninperiodsofnormalcy.Therewasarise that began on 27 February 1948, aimed at slowing economic activity andinflation,andthisforcedbankstosellgovernmentsecurities.HowevertheFedwas then forced to intervene in the market to support the prices of thesesecurities,thusraisingFedcreditoutstanding.TheFedthusfoundthemselvesintheridiculouspositionofhavingtoexpandthe“elasticcurrency”inresponsetotheir ownmeasure aimed at curtailing economic activity.Whilemarket forcessought to push government bond prices below their support levels suchdistortions to the monetary system were inevitable. Investors could have noconditionedresponsetochangesimplementedbytheFed.IfithadbeendifficulttoworkoutwhattheFedwasuptoin1921and1932itwasmuchmoredifficultnow.

Withthekeymonetarytoolonauto-pilotinvestorshadtolookatotheractionsofthe Federal Reserve to assess its future monetary intentions. Since the 1935bankinglegislationtheFedhadthepowertodeterminemarginrequirementsforsecurity purchases. Themargin requirements had been reduced from 100% to75% in February 1947. The subsequent decisions not to make any furtherreductions,despiteaprolongedbearmarket inequities, suggested that theFedwas not unhappy with the price adjustment. In August 1948 anotheradministrative power was added as the Fed regained powers to regulateconsumercredit,whichCongresshadremovedinNovember1947.AsearlyasSeptember1948thesenewpowerswerebeingusedtorestrictconsumercredit.

TheuseoftheadministrativemeasuresalsoindicatedtheFedfavouredatighterpolicy.

Thereactionoftheeconomytotheadministrativemeasureswasswift.Thepeakfor prices had already been reached in August 1948 and economic activitypeakedinNovemberofthatyear.Withtheeconomyslowingandpricesfallingin the first quarter of 1949, those trying to time a movement into the fallingequity market would have been seeking guidance on future liquidity trends.Whenwould the Fed signal a change in policy and how, given the confusingjointtargetingofthetime,wouldsuchachangeinstancebevisible?

Fortuitously, a change in market conditions occurred in 1949, which restoredsomefreedomofaction to theFedandallowed it toshow itshand.TheFed’slegalobligationwastointervenetobuygovernmentbondpricesat thesupportlevel,butclearlythisobligationendedifmarketforcespushedpricesabovethesupport level.This isexactlywhathappened in the lastquarterof1948and inthatenvironmenttheFed’sactionscouldnowbeseenasprovidingatruesignofits intentions. Should the Fed permit the market-led rally to continue thisindicatedthattheyfavouredlowerinterestratesandaneasierpolicy?However,iftheFednowintervenedtosellgovernmentsecuritiesandrestraintherallythiswouldresultinacontractionoftheelasticcurrencyandaclearindicationthatitfavoured a tightermonetary policy.TheFed responded to themarket rally byselling government bonds and in January 1949 alone effected a five percentcontractionintheelasticcurrency.AssoonasanopportunityhadarisentheFedhad moved swiftly to implement an important contraction in their creditoutstanding. Now investors prepared themselves to cope with the postwardeflationwhichhadbeensolongexpected.

Therewerethosewhoexpectedare-runofthepostWWIcontraction,andasaguidewouldhavelookedtothebehaviourofFederalReservecreditoutstandingin that period. These investors expected dramatic deflation as Fed creditoutstandinghaddeclined50%bythetimetheequitymarketbottomedin1921.ThedeclinedidnotenduntilJuly1922,when theFedhadorchestrateda totaldeclineinitscreditoutstandingof69%.WouldthisbethescaleofcontractionintheelasticcurrencytheBoardofGovernorsdeemednecessaryafterWWII?

TheFedhadpermittedanothermajorcontractioninitscreditoutstandingfrom1928-31, even though there had been no previous inflationary excesseswhich

needederasing.FromNovember1928toMay1931,a50%declineinFedcreditoutstandingwaspermittedbefore theFedbegan tostretch theelasticcurrency.WiththeFedcontractingcreditoutstandingbyfivepercent intheirfirstmonthbackincontrolitwaseasytoseewhyinvestorsexpectedare-runofthe1919-21and1928-31experience.

Suchamajorcontractionwasparticularlylikelyas therehadbeenaverylargeincreaseinFederalReservecreditoutstandingduringWWII.FromPearlHarbortoVJDay,Fedcreditoutstanding increasedfrom$2.3billion,still32%belowits 1920peak, to $22.9 billion, almost six times its pre-war high.The amountpeaked at $24.7 billion in December 1946. Would there now be a 50-60%decline as theFed’s previous actions suggested?By the time theFed finishedsqueezing the wartime inflation out of the system after WWI, its creditoutstandingwasjust60%largerthanithadbeenwhenwarwasdeclared.Ifthiswas thestandardoperatingprocedure then investorscouldnowexpectan85%declineintheelasticcurrency.Itwastheprospectofthismagnitudeofmonetarycontractionwhichproducedabearmarketinequitiesfrom1946to1949,whilecorporateearningsdoubled.

The rapid tightening evident in January 1949 continued. In just eight monthsfrom December 1948 there was a 25% contraction in Federal Reserve creditoutstanding. This is just what the bears had expected and they awaited thecompletion of the expected 50-85% contraction which history suggested waslikely. It never occurred. The contraction was over by October 1949 and theelastic currency had been stretched back to its December 1948 level bySeptember 1951. The Fed decided to stop the contraction of Fed creditoutstanding afterwhat could only be described as amild liquidity squeeze byhistoricstandards.Therewasnoelementofforcemajeureaboutthisdecisionasgovernmentbondpricescontinuedtotradewellabovetheirsupport level.Thisdecisionwasmade by the freewill of theBoard ofGovernors butwho couldhaveguessedthattheywouldpermittheelasticcurrencytoremainsostretchedrelative to itspre-war level.AfocusonFedcreditoutstandingwouldnothavebeen suggesting cause for optimism until the final quarter of 1949 while thestockmarkethadbottomedinJuneofthatyear.

An investor focusing on the Fed balance sheet would have been unlikely toguess the DJIA would bottom in June 1949. The contraction in Fed creditoutstanding was in full swing and a historical analysis suggested that the

contractionwas,atbest,onlyhalfcompleted.Asin1921and1932itcannotbesaidthatdetailedanalysisoftheFedbalancesheetproducedanyclearindicationthatthebottomofthebearmarkethadbeenreached.

Whilenotprovidingagoodbuyingsignalin1949thisapproachwasstillmuchmore successful than it had been at the bottom of the 1921 and 1932 bearmarkets.While those analysing theFed balance sheet in 1949may have beenaboutfivemonthslateforthepartythiswasmuchbetterthanthesignalprovidedtocommitfundsinJuly1931andinthesummerof1924.

In1921and1932,creditexpansionsignificantlylaggedtheimprovementintheequity market and the economy. In 1949, things were very different andcommercialbankloansbottomedinJuly1949,justafterthebottomoftheequitymarket.Fromthere,creditgrewsteadily,ifslowly,throughtherestoftheyear.Those prepared to act on the July data might have been buying equities byAugust, but it ismore likely that anyactionwouldhavebeenpostponed for afew months until a new trend was evident. In 1949, waiting for a creditexpansionbeforebuyingequitieswasasounderpolicythanatthebottomoftheother bear markets. However, it was still a lagging, rather than a leading,indicatorof any improvement inequityprices.Waiting foran improvement inbroad-money growth proved asmisleading in 1949 as in 1921 and 1932. Theearliest indication of any improvement in broad-money growth was in thesecond quarter of 1950, long after the equitymarket had bottomed. Even thisimprovement was short-lived, and the major trend of decelerating growth inbroadmoney did not come to a halt until 1953. Inflation-adjustedM2 growthshows noticeable improvement from August to September of 1949. Thismeasure of monetary alteration thus appears to have had some value in both1921and1949,althoughitsturnaroundwaswellafterthebottomofthemarketinJuly1932.

ThoughthebalancesheetoftheFeddidnotgiveagoodindicationofwhentobuyequities,changesinitspolicystancedidprovidetimelysignals.Thefirsteasingofcreditcontrols imposedinSeptember1948cameasearlyasMarch1949,providingclearevidencetheFedbelievedthat,ifanything,thepaceoftheeconomiccontractionwastoorapid.

FromMarch1949,itwasevidenttheFedprobablybelievedithadsqueezedtheeconomyhardenough.Aseriesofreductionsinreserverequirementsbeganon1

May.On29 June, theWSJ reportedFederalReserveofficials confirming theywould stop intervening to prevent a rise in the price of government bonds.Althoughthisdidnotresult inarise inFedcreditoutstandinguntilOctober, itwas another policy statement that made it clear the Fed preferred an easiermonetarypolicy.ThesesignsofpolicychangeswereamuchbetterindicatorthattheliquiditysqueezewasmorelikelytoendthananydetailedanalysisoftheFedbalancesheet.

Investors buying equities on the first sign of easier monetary policy, inMarch1949,weretoseetheDJIAdeclineafurther10%beforebottomingon 13 June. As the commercial bankers were responding to both policyannouncements and the availability of Federal Reserve credit, their balancesheets proved a better indicator of altering liquidity conditions. CommercialbankloansoutstandingbottomedinJune1949andhadalreadyexpanded3.2%by November of that year. This resumption of credit growth was occurring,whileFed credit outstanding continued to contract.Readers of theWall StreetJournalwereawareoftheturnaroundincommercialbankbehaviourbytheendof July 1949, when business loans by New York City banks broke out of arecord 27-week decline. The end of the contraction in commercial bank loanbookswas underway about threemonths before the Fed began to increase itsowncreditoutstanding.

Thegoodnewsfor investors in1949was that theyhadvery little time towaitbefore thestockmarket responded to the first signsofeasing, the reduction inconsumer credit controls inMarch, from the FederalReserve.The subsequent10%declineinpriceswasinhindsightnotanextremepricetopaytoinvestatthebottomofwhatwastobeoneofthegreatestbullmarketsinUShistory.In1921,investingonthefirstsignofapolicychange,areductionindiscountrate,wouldhavehadinvestorscommittingfundstoequitiesinMayofthatyearandseeingadecline in theDJIAof20%before the indexbottomedon22August.On both occasions following changes in the Fed balance sheet, as opposed tochange inpolicy signals,wouldhavebrought investors to themarket after thefirstsignificantrisesinequityprices.

Themajorproblemforthoseseekingtoinvestatthebottomofbearmarketswasthat pursuing a similar policy in the 1929-32 bear market would have beendisastrous. Reductions in Fed discount rates were already underway byNovember1929whenthebearmarkethadaverylongwaytogo.Searchingfor

theeaseinliquidityisbestdonebywatchingtheFed’spolicystance,ratherthanchangesinitsbalancesheet.

Eventhen,onewouldhavetodiscountthe1929-32periodasaone-offeventinordertosaythatbuyingequitiesonthefirstsignofachangeinFedpolicyisafruitfultactic.

ThebullsandthebearMrHeywoodspokeof themarket,ofstocksandshares,of thestateof theUnion.Hespokeconvincinglybecausehismannerwasconvincingand,also,becausehis ideasand factshadbeengivenhimbymanyclevermen.

GoreVidal,InAYellowWood

As we have seen, contrary to popular mythology, there is plenty of goodeconomic news around at the bottom of bear markets. The need to see thedominanceofbadnewsprovedmisleadingin1921and1932.Asimilarmarketcanard has it that one should be a buyer of equities when everybody else ispessimistic. If one determines pessimism by reference to the press and thebroking community, then itwas as absent in 1949 as it hadbeen in 1921 andeven1932.Therewereplentyofbullsringingthebellforequitiesatthebottomofthemarket.

13April:BroadStreetInvestingCorp.notesthatinitshistorytheaverageannualincomereturnonitsdiversifiedinvestmentfundwasabove5%onlyin1932,1911and1942,‘whichhindsightprovedtohavebeenhighlyauspiciousbuyingoccasions’.Currentyield5¼%.

18April:‘Wethinkitnoteworthythatwhilethebulkofrecentnewshasnotbeencheerful,themarkethasfailedtobreakdown.’SamSmithofBache&Co.

19April:HarryDComerofPaine,Webber,Jackson&Curtis‘Review’listed20commonstocksyielding8%to12%,aboutwhichhesaid‘Besidesbearingextra-liberaldividends,eachoftheseselectedstocksearnedatleast50%morethanthedividendpaymentsin1948.Alsoeachstockholdsarecordofuninterrupteddividendsfor20yearsormore,someofthemover50years.’

19April:W.MaynardofShearson,Hammill&Co.:‘Viewedpurelyfromthepointofviewofthemarket,thereissomefairlypersuasiveevidencethatadversityofagooddealmoreseriousnaturethanmanycompaniesarelikelytoencounterhasalreadybeenthoroughlytakenintoconsiderationbybothbuyersandsellers.’

25April:L.O.HooperofW.E.Hutton&Cosaid‘Thereareanumberofthingstorememberaboutthismarket.Theprogressofthebearmarketsincethesummerof1946,nearlythreeyearsago,hasbeenhighlyirregularandsomestocksaremuchmoreliquidatedthanothers;priceearningsratiosshouldriseasearningsdeclineandthepercentageofprofitpaidoutincreases,weshouldbegintolookfornewpricefactorsratherthanthinkthatthesameoldinfluencesaregoingtogovernsentimentindefinitely,and,morethanhalfofthetimeinrecentyearsstockpriceshavemovedinverselytothebusinessindexandprofits.’

25April:SaidArthurWeisenberger&Co.stockpriceshaveneverbeenlowerinrelationtodividends,exceptatthecriticalpointsofWWIandIIandinthedepthsofourworstdepressions,in1932and1873.

25April:NormanFunkofE.F.Hutton&Co.:Forthepresentthestockmarketmayhavetoremainonthedefensivebutthesoundnessofitsunderlyingpositionisindicatedbyitsgeneralstabilityinthefaceofadversetradereportsoveraperiodofmonthsandbytheverylargeshortinterestrevealedbytherecentlyrevealedfigures.

28April:GeorgeG.BassofHarris,Upham&Co.:‘Theinabilityofthemarkettomakeheadwayatthistimeisscarcelysurprising,butitis,ofcourse,evidentthattheday-to-dayplayoffavourableearningsandothernewsisexertingpracticallynomarketinfluence.’

2May:Tradersadoptedawait-and-seepolicytowarddevelopmentsabroadlastweekandinvestorsapparentlyweremoreconcernedwithincreasingsignsofdeflationathome.

2May:FailureoftheamplebudgetofgoodnewsearlyintheweektoresultinanythingbutthefeeblestrallyraisedbearsexpectationsofanearlytestofFebruarylows.

2May:SeveralofWallStreet’slargesthouseshavereportedtheycurrentlyarelending‘morestockthanatanytimesince1929’and‘more

thanatanytimeinourhistory’.SuchstatementslendcredencetowidespreadbeliefintheStreetthattheshortinterestagainhasexpandedinthelasttwoweeks.Ifso,thecushionagainstanyforthcomingdeclinemaybecomfortablydeep,accordingtothedwindlingherdofbulls.

2May:Coffin,Betz&Co.,Philadelphia:‘Onceagain,asatthebottominlateNovembertherearealotoflittlebearshopingtomakeaprofit.Theyrarelydo.’

9May:Althoughtherewasnofollowthrough,volumecontractedduringsubsequentfractionalsell-offsandtheoveralltechnicalpicturewassaidtobefavourable.

10May:HughWLong&Co.‘Foralmostadecadetherehasbeenlittleornorelationshipbetweenthelevelofbusinessactivityandthelevelofsecurityprices.Thusitcannotbeassumedthatthecurrentbusinessreadjustmentwillsurelybeaccompaniedbyacommensurateadjustmentinsecuritiesprices…’

10May:A.J.MessingofHertzfeld&Stern‘ItisoutofsuchdivergencesaswearewitnessingnowthatimportantreversalsoccurandIamnowreadytoexpressthedefiniteopinionthatthelowsoftheyearhavebeenmade.’

12May:KennethWard:‘Whensomanyhigh-gradestocksaresellingonapricebasisalloutofproportiontoevenasubstantialdeclineinearnings,thenitisusuallyclosetobuyingtime.’

12May:H.Hentz&Co.:‘Theinvestortodayhas,inouropinion,theopportunitytoavailhimselfofunusuallyattractivevalues.’

13May:L.O.Hooper-‘Technicalfactors,inouropinion,leaninfavourofaworthwhileseasonalrisesometimeearlythissummer.’

13May:Thestockmarketdeadlockcontinues.ItevensurvivedtheliftingoftheBerlinblockadewhichthebullsclaimedstoodinthewayofanadvance.Furtherthelistofstockslendingatapremiumislargerthaninmanymonths.

14May:Announcementafterthecloseofthecent-a-poundincreaseinthepriceofscrapcopperheartenedtheconstructivelymindedinWallStreet.

14May:EdmundW.TabellofWalston,Hoffman&Goodwinsaid‘Mytechnicalworkindicatesthatthemarketisveryrapidlyreachingasold-outcondition.Somefurtherpressuremayberequiredbutitwouldappearthatwearenearthestartofanimportantupsidemove.’

14May:Forthepastsixmonth,inspiteofallthebadnewsaboutbusiness,theDJIAhasbeenina7%tradingrange.

19May:ReleaseofshortinterestfiguresaftertheclosemadeevenbiggernewsthanWallStreethadforecast.Theincreaseof130,058sharesinthemonthendedMay13madethebearpositionof1,628,551thelargestinmorethan16years,orsincethereportofFebruary27,1933…Techniciansfounditevenmoresignificantthattheshortpositionasofthemostrecentreportrepresented213daystradingbasedonaveragedailyturnoverinthepastmonth…FirstsecondandthirdlargestshortpositionswereinPepsiCola,HudsonMotorsandGeneralMotors.

20May:Withafairlyfirmunderstructurestockscontinueinthetradingrut.Thisabilitytotakethelightsellinghasinspiredmanybrokercommentators,chartistsandotherstudentsofmarketmovementstosaytheupsidehasmoresubstancethanthedowninthefaceofalotofdeflationarynews.

24May:Themarketmovedalongstridenearerthecritical171.10resistancelevelintheindustrialaverageyesterday.Thefactthatthereactionwasaccompaniedbyreducedvolumewasnotlostontechnicians,whohaveforecastthatafurthereasingofpricesonevensmallervolumethanthe750,000dailyaverageofrecentweekswouldbeabullishfactorsecondonlyinimportancetoanadvanceonincreasedturnover.

25May:Vance,Sanders&Co.ofBoston;‘Withtheexceptionofthedepressionyearsof1932-33commonstocksaresellingataboutaslowalevelinrelationtodividendpaymentsastheyhavefor50years.’

1June:Theconsensuswasthat1949stestofthe163-165triplebottom,definedbythelowsof1946,1947and1946,isathand.

3June:Ontheotherhand,andnolessafactorintheconsensusofmarketopinion,arethecontinuedhighyieldsforstocksofcompaniesinstrongbalancesheetpositions.Doubtisexpressedthatanythingshortof

violentsurpriseintheday-to-daydevelopmentswouldpersuadeholdersoflargeblocksofsuchsecuritiestopitchthemoverboardatthisjuncture.

4June:Stockscompletedoneofthesorriestweeksinrecentmarkethistorybysinkingfurtherintotherutjustabovethehistoricallyimportantresistanceareameasuredbytheindustrialaverageat163-165.Volumeindications,ifnotbullish,atleastgavenoimmediatecauseforalarm.Turnoveryesterdaywasonly700,000shares.

6June:L.O.HooperofW.E.Hutton&Co.hascompiledalistof225stockswhichsellatlessthanworkingcapital.

10June:‘Forourpart,’saidL.O.Hooper,ofW.E.Hutton&Co.,‘Wewouldprefertobuythansell,fortradingpurposesifabearmarketisrecommendedbytheindustrialssellingthrough160and40respectively.Rememberthatthisintermediatemoveisofaboveaverageagealready,thestockmarketneverwasashighasbusinessandbusinessprofits,theshortinterestislarge,weareapproachinga‘saturationpoint’inpessimismregardingbusiness,institutionsareshowingagreaterbuyinginterest,andamid-summerrallyistraditional,eveninbearmarkets.’

11June:Anotherfactpartiallyobscuredbygloomwasthefailureoftherailroadstoreachnewlowsfortheyear,althoughindustrialsclosedatanewtwo-yearbottom.Finally,turnoverof800,000sharescomparedwith1,380,000and1,240,000ontheprecedingpost-MemorialDaybreaks…Onaclosingaveragebasis,industrialsare1.49abovealowdatingform1945,railroads1.54abovetheir1947bottom.Therewasagreementononepointbetweenbullsandbearsastheweekstradingclosed.Nextweekshouldbeinteresting.

13June:DJIAbottomsat161.6

14June:Allclosingaverageresistancepointsweresweptasideandstocksreachednewpostwarlowsinthefourthmajordeclineinthepast10sessions.Industrialsdropped3.01totheirlowestlevelsinceAugust7,1945.Railroadsslipped1.67throughallbottomssetsinceOctober3,1944.Volumeonceagainfailedtoreach‘climacticproportions’butrose540,000sharesaboveFriday’stotaltojustundertheturnovergeneratedonthebreakaweekago.

14June:ManagementofNationalSecuritiesSeries,oneofthelargest

truststoreportforthefiscalyearendedApril30believesthistobe‘agoodtimeforlong-terminvestmentincarefullyselectedincome-producingsecurities.Theyear1949willinouropinionbegoodforincometoinvestors.’

15June:Onethinbarriertolowerpricesagainremainedinviolate,however.Thatwastheintra-daylowsoftheindustrialsandtherailroads,setOctober301946andMay191947respectively.

15June:May29thmarkedthethirdanniversaryofthepresentbearmarket.Alreadyithaslastedlongerthananyother,exceedingeventhatfromSeptember1929toJuly1932.

16June:SaidKennethWard‘InthepastfewyearsDowTheoryspotshavebeencloserontheupsideforsellingpurposesandonthedownforbuyingopportunities.Thisisaselectivebuyingtimenotsellingtimeinthiswriter’sanalysis.’

17June:Theturnoverinthefinalhourhoweverwhenpriceswereatthelowsofthedaywaslittlemorethanhalfthatgeneratedinarisingmarketafter2pmonWednesday.

17June:L.O.HooperofW.E.Hutton-‘Thebearmarkethassomeofthefeaturesofbeinginitsfinalstages.Volumeoftradingitisimportanttoobservefallsoneachsucceedingattackonprices.’

21June:ThesmallreductionintheshortinterestannouncedaftertheclosecameassomewhatofasurprisetoStreetsourceswhohadbeenexpectingafurthercrowdingofthebearside.

25June:Someanalystssaythatahigherpremiumisbeingpaidforthesafetyinherentin‘defensive’stockstodaythanatanytimesince1942andsuggestthatswinginemphasistomorespeculativegroupsisonthecards.

29June:Overaperiodofyearsthe30stocksintheaveragehavesoldatabout15timesearningsnotedtheKeystoneCo.ofBoston.Inbullmarketstheysellashighas25timesearnings.Inrecentbearmarketstheyhavesoldatabout10timesearnings.Todaytheyaresellinga6-7timesthelatestreported12-monthearning.

1July:A/M.Kidder&Co.‘Werefusetobestampededintothebearish

campbytheoccurrenceofeventsthatwereanticipatedweeksandmonthsago’

5July:TheinterestdepressingaspectofthedecisionoftheFederalReserveSystemtoletgovernmentbondpricesrisewasdiscouragingtobanksharedealerswhowerelookingtoaresponsivemarketinanticipationoffavourablesecondquarterearnings.

6July:SamSmithofBache&Co.said:‘PrecedentsreadilycanbefoundwhereareversalinthetrendofsecuritypriceswasinstitutedbystrengthinTreasuries.Intime,suchdemandover-flowedintoothergradesofbondsandstocks,ultimatelyembracingpracticallyallcategories.Theconstantsearchforbetteryieldsandtheconfidenceimbuedbytheriseingovernmentbondsgraduallyexertedtheireffect.Itmaybeprematuretoassumeatthistimethatthispatternwillevolveinthecurrentinstance,butoneshouldbearsuchpossibilitiesinmind.’

7July:MorestockwastradedinthefinalhouryesterdaythaninanyfullsessionsinceJune15.The810,000shareswhichchangedhandsafter2pmwerethemostforany60-minuteperiodsinceMay17,1948andswelledturnoverforthedayasawholetoitshighestpointsinceMarch30,whentheabortivespringriseended.Thus,volumeyesterdayexceededanythinggeneratedonthedownsideduringrepeatedinterveningsellingdrives,apointwhoseimportancetechniciansemphasizedaftertheclose.

8July:Theanticipatedreactionfollowingfiveconsecutivedaysofrisingpricesfailedtogetfarandwasaccompaniedbyacontractioninvolume.

8July:Amodesttechnicalrallybecameabudding‘summerrise’onWednesdaywhenvolumeonthefifthconsecutivedayofadvanceexceededanythinggeneratedduringtherepetitivesellingdrivesofthesecondquarter.

14July:Themarkettookanotherpuzzlingstepupyesterday.Inthefaceofdisquietinglabornews,unrelievedtensionabroadandanimpairedtechnicalposition,allthreeaveragesreachedrecoveryhighsasvolumeoncemoresurpassedthemillion-sharelevel.Itwasalsoconsideredsignificantthatinamuchbroadermarketwith1016differentstocksappearingonthetape,comparedwith941Tuesday.

14July:Stocksfollowedarecentlyfamiliarpatternyesterdaybydoingtheirbestinthefinalhour.Inanattempttoexplainthispersistenceoflatesessionimprovementinpricesbrokerssaidthatsuchdemandprobablystemmedfromtimidshortswhowerewaryofconstructiveovernightnewsdevelopments.

16July:Inthefaceofaseeminglycertainstrikeinthesteelindustryandunsatisfactorylaborrelationsinseveralothersthemarketadvancedratherpersistentlyforseveraldaysthisweek.

19July:W.E.Buford&Co.ofCharlotesvilleVa.Hasissuedamemorandumon‘PloughedBackEarnings’whichsaysinpart:‘Resultsofastudyofsome3,000stocksdisclosethataboutone-fourthcurrentlyaresellingforlessthantheploughedbackearningsofthepastsixyears.’

20July:SaidthemanagerofoneofAmerica’slargeprivatefortunes‘I’mnotinclinedtofollowthisrally,butthelargenumberofinvestorsreadyingprogramstobeinitiated‘afterthenextmarketbreak’makesmenervousaboutmyownposition.InmattersliketheseIdon’tliketoomuchcompany.

20July:CarlM.LoebRoades&Co.:‘Itseemstobearoutthecommentscurrentamongconfidentinvestorsforthepastyearortwo.Theyarguedthatamarketwhichwasneverguiltyofexaggerationsofoptimismandwhichbeganpredictingabusinessdeclinetwoyearsbeforethefactwouldnotsuffertheusualslumpwhendepressionactuallystruck.’

21July:Bythemostrecentcounttherewere1,644,313sharesshort,allrepresentingstockwhichmustbepurchasedatsomefuturedate.Thisalmostexactlymatchedthefigureof1,643,047inJanuary,1933.TheratioofthelatestfiguretodailyaveragetradinginthemonthendedJuly15is2.40to1.ThisisthehighestpointatwhichthiscompilationhasstoodsinceMay,1938.Technicianssaiditmightbesignificantthatonboththoseprioroccasionsthebearswerewrong.

25July:HerbertG.King:‘Tradersshouldnotoverlookthatthemarketisrestingonapotentialkegofdynamite.Stockshavebeengoingintoverystronghandsforsometimeandthelatentpoweroftheextremelylargeshortinterestistremendous.Onethingappearscertain:Veryfewoftheamateurshortswillsucceedinmakingmoneyoutoftheirshortpositions.’

5August:‘Itwillbenotedthatduringtheboomyear1929whencommonstockswerehighlyinflatedinvalue,theyieldonbondswasactuallyinexcessofcommonstocksbyabout1¾%.Inthedepressionyear,1932,theyieldonstockswasalmostthesameasbondsandin1937thegapamountedtoonlyalittleover1½%infavourofstocks.During1942whenstockswerereflectingtheextremelyadversewaroutlook,theyieldgapincreasedtoover3%infavourofstocks.Stocksarenowsellingtoyield4%,morethanbondswhichisatagreatervarianceofspreadthanwehaveexperiencedduringanyoneofthepast20years.’RalphRotnemofHarris,Upham&Co.

9August:G.H.Walker&Co,initsSecuritiesOutlook,saidofthestockmarket:‘Asmattersnowstanditislikelythatanotherbuyingopportunityatlowerlevelswouldbewelcomedbyagreatnumberofpotentialstockpurchasers.’

14August:L.O.HooperofW.E.Hutton-‘Oneoftheconfusingthingsaboutthismarketatthemomentisthatsomanypeoplestill‘donotbelieveinit.’…Thisinvestorscepticismmakesfortechnicalhealthratherthantechnicalweakness.Asamatteroffactthosechartistswhobelievethatthecurrentadvanceisofhistoricalandtechnicalproportions,assertthattheturndownwillnotbeginuntilwehavehadsomeclimacticadvanceswithlargevolume.

So,at thebottom in1949,as in1932and1921, therewasplentyofoptimismconcerningtheoutlookfortheequitymarket.

Aswearelookingatthefourextremecasesfromthe20thCentury,itshouldnotbe a surprise that value investorswerebanging thedrum for equities in 1949.Buttheyhadbeenenthusiastictooearlyinthedecline,asequitiesreachedever-lower valuations. Value had been evident in the market from around January1947whentheS&PCompositePEratiodeclinedbelowits1871-1947average.This was almost 18months before themarket was to bottom, though on thisoccasiontheDJIAdeclinedjustafurther10%.

Thearrivalofvaluewasdeliveredbyamilddeclineinthemarket,butwithanexplosioninearnings.ByJune1949theS&PCompositeIndexPEwasalmost

60%belowthe1871-1947averagePE.Forthoseseekingtofindthebottomofthebearmarket,theclarioncallofvalueinvestorsisnotsufficient.

Althoughthedeclinebelowfairvaluein1949wasassociatedwithonlya10%price decline,we have seen in 1932 howmuch larger declines in priceswereracked up even after equities had already become cheap. Of course, valueinvestorsarenever fixatedby thecurrentearningsoutlookand thecurrentPE.Thosewho lookedat theunderlyingvalueof theassetsof thecorporatesectorwouldhaveseenthatequitieshadbeenundervaluedforaverylongtime.

Asearlyas1939, theqratioof themarketwasbelow itsgeometricmean,indicatingthatthemarketwastradingbelowfairvaluefrom1939to1949.Inseekingthebottomofthebearmarketitisimportanttodeterminethatequitiesarebelowfairvaluebutitisalsoimportanttolookatotherfactorsif one is to avoid investing too early andwatching cheap equities becomeverycheap.

ManycommentatorsnotedinMayandJune1949thatthefailureofthemarketto react negatively to bad news was a key sign that future declines may belimited.

FIGURE86.QRATIO

Source:Smithers&Co

Source:Smithers&Co

Suchresiliencewasevidentinthelastperiodofthebearmarketandintheearlystages of recovery. The general apathy towards good and bad news perhapssignalsthatbearsarenotcoveringtheirshorts,butatthesametimeareunabletodrivethemarketevenlower.Ifthisisthecase,thenthesupply/demandoutlookforthemarketisimprovingmarkedlywhenthemarketshowsgeneralapathytonews announcements. This position is of particular importance when seen inconjunctionwith the large short position,which had been growing for a verylongtime.

Oneparticularfeatureoftheendofthe1946-49bearmarketisthat,particularlyon the rebound,volumesoften reached theirhighs in the finalhourof trading.Thismight suggest thatbears, awaitinga setback for themarket, considered itprudent to decrease their exposure when another day passed without such asetback developing. There was a string of strong late sessions in the 1949reboundwhichsuggestedthatthosewaitingtobuyequitiesatlowerpriceswerethrowinginthetowel.

Thecombinationofalargeshortpositioninconjunctionwithamarketthatdoesnotdeclineonbadnewswasapositiveindicatorofareboundin1921,1932and1949.

A potential underlying reason for the potency of the combination is that itsignifies thateverybodywhocangoshorthasalreadydoneso.The increasingnumber of “little bears” on the short side seems particularly important. Thisappearstobethereverseoftheso-called“mania”periods,whennumeroussmallandinexperiencedinvestorsrushtoparticipate inbullmarkets.Whenasimilarmania for shorting stocks is evident by an increase in the number of “littlebears”, this is an indication that the willingness and ability to short stocks isreachingsomekindoflimit.

Inthefirststagesofthemarketrebound,whichoccursonlowvolume,theshortinterestappearsnottobeshakeninitsdetermination.Thereisusuallyalagofafewweeksbeforeanysignof“capitulation”bythesebearsisevident.Whetherthiscapitulationistriggeredbyrisingpricescombinedwithhighervolumes,oritselfcausesthehighervolumes,isunclear.Forequityinvestors,theconclusionis clear that a failure of the short interest to cover on a bounce increases theprospects of the recovery being sustainable. More importantly, should shorts

keep failing to cover when volumes begin to rise at the higher level of themarket,thisshouldbeatriggerpointforasharpriseinequities.

History shows that technical analysts are right to view declining pricesaccompanied by declining volumes and rising prices accompanied by risingvolumes as important elements in the overall picture associated with marketbottoms. Whatever role shorts play in increased trading volume, it is clearvolumesincreaseaftertheinitialsurgeinprices.Itisthisrise,evidentin1921,1932 and 1949, that confirms prices can be sustained at the newhigher level.Figure87showsrisingvolumesfollowingtheinitialriseinthemarketand,onceagain,theabsenceofthecapitulationevent.

FIGURE87.DOWJONESINDUSTRIALAVERAGE,TWO-WEEKMOVINGAVERAGEVOLUMES

Source:DowJones&Co.andNYSE

Asintheotherbearmarketsthereisafinalaccelerateddeclineinthemarketjustattheendofthebearmarket.However,thisfinaldeclineisnotassociatedwithanysurge involume.Aswehave seen,abearmarket ismarkedbya finaldeclineonnovolume,ratherthanhighvolume.

Asin1921and1932,thereplacementofbearsbybigconstructiveinterestswasakeyindicatorthatthebearmarketwasending.Despitesuchgeneralcomments,lessattentionwaspaid in1949 to thegeneraldiffusion instockholdings.Thiswas considered a key indicator of the bear’s demise in 1921 and 1932, as thegreater diffusion of holdings to historically high levels was seen as a goodindication that a concentration in the hands of big constructive interests wasimminent.However,theabilityoftheUSSteelpricetoreboundwhendiffusionratesonitsshareholderregisterreachedhighlevels,whichhadbeenaverygoodindicatorofachangeinthemarketupuntilthe1930s,hadsinceproducedsomeerroneous signals. The fall in accuracy of this particular indicator probablyaccounts for the lack of comment in 1949 regarding the diffusion of stockholdings.

However,theappearanceofconstructiveinterests,thebigholdersthatovertimereducethediffusionofholdings,isstillmentionedasanimportantsigntheendofthebearmarketisnear.

Once again the bottom of the bear market is more generally associated withlimited retail buying.Thepages of theWall Street Journal reveal a picture ofwidespreadownershipofUSequities,butwithlimitedactivitybythenumeroussmall shareholders.On20April 1949, the largest-ever stockholdervote inUShistory took place as 19million shares of AT&T’s total of 23million shareswere voted.The counting processmaywell have been epic as 94%ofAT&Tshareholdersheld100sharesorlessinthecompany.AtGeneralMotors,59%ofshareholdersheldfewerthan26shareseach.AttheGeneralElectricmeetinginApril1949,thecompanydisclosedthat45%ofshareholderswerewomen.Thisdiffusionofshareholdingsamongsmallholderswasthenormalsituationinbearmarketsand thebullsawaitedevidence that thebigconstructive interestswereappearing to consolidateholdings.While thebrokers awaited the returnof therichman,thepushforbusinessfromthe“littleman”continued:

‘He’s about concluded,’ saidoneWallStreeter, ‘thathemusteitherselltothelittlemanorlookforanotherjob.’Taxeshaveturnedthe“richman”intoa leancustomer…Somestockandbond merchants think one of their biggest problems iseducation. Thewartime and postwar inflation has putmoneyintothehandsofmanyfolkunaccustomedtobuyingsecurities.[63]

EducationclasseswerealreadyinfullswingasMerrillLynch,Pierce,Fenner&Beanewere to launchadrive for retail investors,whichwas topayhandsomedividends in the future. In May 1949 the company launched a ‘For WomenOnly’investmentclassbecause,inthewordsofaMerrill’sspokesman,‘Amannever thinksofboringhiswife tellingher about such things.’ (WSJ, 20May).Interest among some women was obviously very high and the Federation ofWomenShareholders inAmericanBusiness Inc.was alreadyactivelypressingfor female representationon theboardsofmajorUSbusinesses.When such aproposal was put to bring ‘the women’s viewpoint’ to the National DairyProductsboardofdirectors,theWSJreported:‘Astockholder–abachelor–saidhewassuremarrieddirectorswerealreadygettingthewomen’sviewpoint365daysayear.’

Inviting attendance at coeducational investment lectures,MerrillLynch placedads in theDetroit Labor News, anAmerican Federation of Labor paper. Oneworkerwhoshowedupsaidhehadheardsomuchaboutbrokersbeinga“bunchofcrooks”thathethoughthehadbettercheckitouthimself.Helateropenedanaccount.Thereareusuallyalotofsmallholdersaroundinabearmarketbuttheyareinthesafestofstocksandtheyareholdingandnottrading.

In the summer of 1949 theWSJ was awash with comments from technicalanalystsstressingtheimportanceofthe160-165supportlevelfortheDJIA.Thisdid indeed prove to be an important support level and the DJIA bottomed at161.6on13Juneandastrongreboundthenbegan.

TheDowTheory,asitdidin1921and1932,scoredanothernotablesuccessin1949.Reportingonthemarketof14June,thedayafterithitbottom,theWSJpointedout that the intra-day lowsof the industrials and the railroads hadnotbeenbreached.IntheWSJon16June,KennethWardcitedtheDowTheoryinrecommending selective buying. The Dow Theory now had a life outside theWall Street Journal. A key proponent, E. George Schaefer, famouslywrote averybullishnewsletterforhisclientsdated18June1949:

Uptothiswriting,themarkethasnotpenetratedtheintra-daylowsofits20-yeartradingrange.Untiladecisivebreakoutofthisareaoccurs,theaveragescouldadvanceandtesttheupperlimitsofthearea,orcontinuetofluctuatewithinthatrangeforanextendedperiodoftime.Theindustrialaverageestablished

an intra-day low of 160.49 in October, 1946, and the railaverage recorded its extreme intra-day low of 40.43 inMay,1947. These lows were closely approached by both averagesduring thepastweek,butwerenotviolated.OnTuesday, theextreme intra-day lows of the current bear market wererecordedat160.62and40.88.Aslightdecreaseinvolumewasnotedat the lows,whileodd-lot short saleorders skyrocketedto121ontheverylowday.Thefactthatthemarketrefusedtogiveadecisivedownsidepenetrationofitslong20-yeartradingarea implies that a rally from those lowswill develop after asufficienttestofthoselowshasbeenmade.[64]

In 1921, 1932 and 1949, the Dow Theory was used to correctly forecast thebottomoftheDJIAtowithinjustafewdays.

BondsandthebearRobertHoltonlookedathim.MrMurphycouldnottellwhathewasthinkingforhisfacewasrelaxedandcalm.‘Well,’saidHolton,‘Idon’tknow.Idon’twanttobeoutofmydepth.I’dliketomakemoremoney.Iliketheideaofbuyingandsellingstocks.Ilikethatideaverymuch.Infact,that’soneofthereasonsIcamehere.’

‘Of course, there’s a lot of work to knowing about stocks and bonds. You realize all the work that’sinvolved.’

‘Yes.’

GoreVidal,InAYellowWood

Theunnaturalconditionofthebondmarketinthepostwarerahasalreadybeendiscussed at some length. The FederalReserve’s de facto commitment to buygovernmentsecuritiesatsetyieldsalongthecurvedistortedmarketyields.Thisflooronthepricesoffederalsecuritiesobviouslyplayedaroleininfluencingthepriceofcommercial fixed-interestsecurities,whichare influencedby thepriceofgovernmentsecuritiesbutstilltradeinafreemarket.

By1946,USgovernmentlongbondstradedbelowthedefactoyieldsupportof2.25% and reached a yield low of 2.03% in the second week of April 1946.Prices declined thereafter and the Fed’s balance sheet indicates that not untilNovember 1947 was any material intervention necessary to prevent prices

breaching the support level. A large support operation was then necessarythroughout1948andthevalueofgovernmentbondsheldbytheFederalReserveSystemincreasedby129%overtheyear.Withsignsofadeclininggeneralpricelevel increasingly evident, a rally began inNovember of 1948 thatwasnot toenduntilyieldsreached2.18%inNovember1949.

FIGURE88.YIELDONLONGTERMGOVERNMENTSECURITIESANDBAACORPORATEDEBT

Source:DowJones&Co.andNYSE

TheyieldonMoody’sAAA-ratedcorporatebonds,liketheyieldongovernmentbonds,reachedalowinApril1946.Fromthatlowyieldof2.46%itthenroseto2.90% in the first week of January 1948 and from that level a gradual rallybegan,endingwithyieldsat2.57%onthelasttradingdayofDecember1949.AsimilarpatternisevidentintheyieldchangesonMoody’sBaa-ratedpaper.Theaverageyield,whichreachedalowof2.94%inApril1946,roseto3.56%inthefirstweek of January 1948, before amajor rally began.However, the rally inBaapaperwas to be prolongedover amuch longer period than that ofAAA-ratedpaperandwasnottoenduntilyieldsreached3.16%inFebruary1951.Theprice of AAA and Baa corporate bonds had bottomed in January 1948, tenmonths before the rally in government bonds and sixteen months before thebottomoftheequitymarket.Thiswasadifferentsequencefrom1921and1932

when the prices of government bonds, corporate bonds and then equitiesstabilisedinthatorder.

Although corporate bonds did rally prior to government bonds, it wasmuteduntiltherallyingovernmentbondsbeganinNovember1948.FromJanuary to November, the yield on Baa-rated corporate bonds declinedfrom3.56%to3.54%.

Althoughtherewasadifferentrelationshipin1949thanin1921and1932,therallyincorporatebonds,priortotherallyingovernmentbonds,hadbeenminor.

Thisdifferenceinorderbetweenthecorporatebondmarketandthegovernmentbondmarketin1949mayhavebeencausedbythedistortionsinthelatterbondmarket.Yieldsinthecorporatebondmarketwouldalsobedistortedinsuchanenvironment due to the impact of bond investors switching between the twomarkets. The Fed was forced to support the government bond price fromNovember1947 toNovember1948. In thissituation itmayhavebeen that therally in corporate debt, evident from January 1948,was effectively a result ofinvestors switching away from the pegged rate in the government market tohigherratesinthecorporatemarket.Thusthefactthatthecorporatebondmarketrallied ten months before the government bond market could be an anomalyassociatedwithFed’ssupportofthelattermarket.

While recognising the different sequence for the commencement of bullmarketsinfinancialassetsin1949,theabnormalityofthepostwarsituationmustberemembered. It seemsmore likely the1921and1932sequenceofstabilisationofgovernmentbondsfollowedbycorporatebondsfollowedbyequitiesismorelikelytobethenormalsequenceofevents.

Ashadhappened in1921and1932USequityprices stoppedfallingwhen theyreacheda70%discount to the replacementvalueof theirassets.All the same signalswerepositiveas in1921, with the exception that, with Fed interest rate policyconstrainedin1949,itwasareductionincreditcontrolsthatindicated the bearmarketwas in its final phase. In all threeinstances, theUSwas operating a fixed-exchange-rate policyofvaryingdegreesofstricture.Perhapsonecouldexpecttheseindicatorstoworkinsuchanenvironmentwhereotherfactors

adjusted inpredictableways tokeep theexternalvalueof thecurrency steady. The acid test for validity is whether theyworked in the last great bearmarket bottom–1982.TheUSdollar was in a free float, there was no constraint on the“elasticity” of the currency and deflation was a distantmemory.Wouldthesameindicatorsfrom1921,1932and1949providethesamepositiveindicatorsofthebirthofthebull?

Endnotes62WilliamCGreenough,ANewApproachtoRetirementIncome[returntotext]

63WallStreetJournal,7June1949[returntotext]

64E.GeorgeSchaefer,TheDowTheoryTrade,18June1949[returntotext]

PartIV.August1982Theoldtextileplantsgivenovertodiscountclothingoutlets…acresofdeadrailroadtrackandcarshopsandstockpiledwheelsandemptyboxcarsstickintheheartofthecitylikeagreatrustingdagger.

JohnUpdike,RabbitisRich

Itwasalongroadfrom1949to1982.Duringthisperiod,investorshadtocopewithsomethingtheyhadneverseenbefore-systemicinflation.Therehadbeenburstsofinflationbefore,mainlyassociatedwithwar,butthebasicpatternwasfor inflation during economic expansion, followed by deflation in economiccontraction. By the 1960s, it was becoming evident that inflation would notnecessarilybeextinguishedevenbyaneconomiccontraction.Manyarguedthatthis“newera”wouldbepositiveforequities,asmanagementwouldbeabletoprotect and even bolster profit margins. So did this “new era” alter thecharacteristicsofequities?Diditchangethenatureandultimatedenouementofbearmarkets?ByAugust 1982, the S&PComposite Indexwas, in real terms,back where it had first been in August 1906. The scene was now set for thetransformationofAmericaandabullmarketinequitiesthatranforalmost18years.

TheroadtoAugust1982

Intheswelteringsummerof1949,withWallStreetlanguishinginthedoldrums,NewYorkerscooledoff inopen-aircinemaswatchingthebigsummerrelease,TheGirlFromJonesBeach.Theywatchedastheleadcharacter,BobRandolph,a magazine illustrator, created the “perfect girl” only to later meet her livingpersonificationonJonesBeach.Randolphseized thesituationand,posingasalowlyCzechimmigranttoingratiatehimselfwiththegirl,triedtoprofitfromthepromotionalopportunities.Despite fullyutilising the talentsofVirginiaMayo,themovieflopped.However,theactorwhoplayedRandolphfaredmuchbetterand,by1982,RonaldReaganwaspresidentof theUnitedStates.Thecountryhad changed somewhat since Reagan’s beach outing on Long Island in 1949.Onethingremainedthesame,however.WallStreetwasinthedoldrums.

Theroadfromthesummerof1949tothesummerof1982isthelongestbetweentwoperiodsofextremeundervaluationcoveredin thisbook.This in itselfmaysuggestthatextremesofvaluationarebecominglessprevalent,butonemustbeverycarefulaboutsuchastatement.Itisinthenatureofselectingjustfourbearmarket bottoms for analysis that other, similar, episodes are excluded. If fivebearmarketbottomswerestudied,then1974wouldbeincludedintheanalysisand the distribution of periods of undervaluationwould appear very different.Formanymoderninvestors,December1974istheveryembodimentofagreatbearmarket bottom.Hence,we need to take a brief diversion to explainwhyDecember1974ranksonlyas thefifthof thegreatbearmarketbottomsof the20thCentury.AsFigure89 shows,by1974, equitieswere almost as cheap astheyhadbeenin1921,1932and1949.

FIGURE89.THEQRATIOATTHEFIVEBEARMARKETBOTTOMS

Source:Smithers&Co.

Lookingatyear-enddata,equitiesappearparticularlycheapin1974astheDJIAbottomedinDecemberofthatyear.ButinalltheotheryearscoveredinFigure89,therehadalreadybeenmajorralliesbyyear-end.IfoneadjuststheqratioforthereboundintheDJIAfromthesummersof1921,1932and1949,itisevidentequitieswerecheaperintheseperiodsthanin1974.Asimilarpictureemergesifonevalues themarketwith reference to the ten-year rolling earnings figure tocalculate the cyclically adjusted PE. The cyclically adjusted PE in December1974of11.2x iswellabove the7.4xreached inAugust1921and4.7x inJuly1932.ThecyclicallyadjustedPEin1974ismarginallylowerthanthe11.7xinJune1949,but stillhigher than the9.9x rackedup inAugust1982.Whenonelooks at the q ratio and cyclically adjusted PE, then 1974 ranks fifth in thepantheonofgreatbear-marketbottoms.

Ofcourse,aswellasdeterminingthebiggestbearmarketbottomsbyreferencetovaluationcriteria, thisstudyalsoselectsperiods foranalysisbyreference tosubsequent returns to investors. In particular,we focus on those periodswheninvestorscouldconfidentlypursueabuyandholdstrategyandachieveabove-normalreturns.AsFigure90shows,theDecember1974marketbottomcreatedagreat tradingopportunity,but it is lessclear that itproducedagreatbuyandholdopportunity.

FIGURE90.DOWJONESINDUSTRIALAVERAGE–JANUARY1965TODECEMBER1984

Source:DowJones&Co.

There is a clear contrast between the gyrations of themarket after December1974andthebroadadvanceinprices,whichset inafter1921,1932,1949and1982.

Afurther importantfactor thatrelegates1974tofifthpositionin thehistoryofgreat buying opportunities on Wall Street is inflation. Investors achievedexcellentsubsequentrealreturnsafter1921,1932,1949and1982.However,thereal price index of the S&P Composite Index in 1982, as calculated by YaleProfessor Robert Schiller, was 13% below the December 1974 level [65] . In1921,1932and1949,subsequentinflationwasquiescentanddidnotmateriallyreduce the real returnsof investors.From1982, inflationwashighandfalling,andalthoughadragonrealreturns,didnotpreventpositiverealreturnsaccruingto investors.AsFigure91shows, realcapitalgains to investorsweremuted inthefive-andten-yearperiodsfromDecember1974.

FIGURE91.CHANGESINTHES&PCOMPOSITEREALPRICEINDEXFROMMARKETBOTTOMS

Source:www.econ.yale.edu/~shiller/data.htm

Taking apunt in1974, investors achieved excellent returnsover15years, butthiswasduetoreturnsachievedafterthebearmarketbottomof1982.WhileitistruethatDecember1974wasagreattimetobuyequities,itwasnotarepeatofAugust1921,July1932,June1949orAugust1982.Onbothavaluationbasisandonthebasisofsubsequentreturns,1974doesnotfinditselfinthisstudyofthefourgreatbottomsforAmericanequities.

Ofthebestfourperiodstobuyequitiesinthe20thCentury,twofellinthefirsthalf,withthethirdmid-centuryandthefourthinthefinalquarter.Aswehaveseen, a study of five periods of undervaluation would create symmetry ofdistribution, with two periods of undervaluation in the final quarter of thecentury.Giventhestructuralchangesintheeconomyonemighthaveexpectedproclivitytoundervaluationtohavediminished.

Throughout thecentury, theelasticityof theUScurrencyincreased.Therewasthe move from the gold standard to one of gold exchange standard,implementationofBrettonWoods, and thena free-floatingexchange rate.Theincreasing ability of the Federal Reserve to provide a monetary response inperiods of distressmight suggest that the return of equities to fire-sale priceswould become less prevalent. It is interesting that such a phenomenon is notevidentinthedata.Theoscillationoftheqratioaroundthegeometricmeandoesnotappeartobeanymorevolatileinthefirsthalfofthecenturythanitwasinthesecond.Despitetheinstitutionaladvancessince1900,itappearsequitiesarejustaslikelytobereducedtogrossundervaluationtodayastheywereacenturyago.Howeasywas it, then, tospot the lastgrossundervaluationofequities in1982andwhatcanwelearnfromthatperiodin thehistoryofWallStreet?Tounderstandthedynamicsofthemarketin1982,itisfirstnecessarytounderstandthepreludeandthecourseoftheDowfrom1949to1982.

Inthe33-yearperiodfrom1949to1982,itispossibletopickoutaseriesofbulland bear markets on Wall Street. By one definition regularly employed, anydeclineintheindexofmorethan10%isabearmarketand,usingthismeasure,16 bear markets can be identified amid the events leading to the summer of1982.However,tounderstandhowequitiescametobesoundervaluedby1982,theperiodisbestseenasmarkedbyonebullmarketandonebearmarket.

ThecourseoftheDow-1949-68

IfweusetheDJIAasaguide,thebullmarketbeganinJune1949andendedinFebruary 1966. However, the broader S&P Composite Index shows the bullmarket did not end until December 1968, when the DJIA was still onepercentage point shy of its 1966 high. The peak for the broader index,whichcoincided with particularly high trading volumes, is generally recognised asrepresentingtheendofthebullmarket.

FIGURE92DOWJONESINDUSTRIALAVERAGE–JUNE1949TOJANUARY1969

Source:DowJones&Co.

While theDJIAmaynothavemadeanyprogressfrom1966,monthlyaveragetradingvolumes on theNYSE jumped48% from1966 to 1968.The two-yearperiod also saw a conglomerate-led takeover boom and the growth of newaggressiveapproachestoinvestmentmanagement.Asweshallsee,thereislittledoubt the great postwar bullmarket ended in 1968, andnot 1966.Within thisgreat bull market there were numerous index corrections in excess of 10%which,bysomedefinitions,alsoconstitutebearmarkets.Figure93showsalltheDJIAcorrectionsinexcessof10%for1949-68.

FIGURE93.BEARMARKETSIN1949-1966–PERCENTAGEDECLINESINTHEDOWJONESINDEX

Source:DowJones&Co.

Thebiggestofthesebearmarkets,namedafterthePresidentofthetime,wastheso-called “Kennedy break” of 1962. In this sorry episode for the market, thenewly elected John F. Kennedy was branded anti-business for preventing thesteel companies from raising their prices. The subsequent downturn in themarket, caused by the supposed threat to corporate profit margins fromKennedy’sactions,standsoutforitsscaleandrapidityofdecline.Thescaleofthis panic is particularly severe when one considers that, during the CubanMissileCrisisof22Octoberto28October,themarketpostedasmalladvance.Thenextsharpestdeclinewasin1966,aresultofacrisisinconfidencewhen,asAdam Smith explains in TheMoney Game,Wall Street stopped believing inanything:

They don’t believe Johnson, they don’t believe anything inWashington, theybelievetaxesaregoingtogoupbutnotenough,theydon’tbelievewe’llevergetoutofVietnam,and…nobodywillbelieveanyearnings.[66]

These were indeed vicious corrections. Brief bouts ofbearishnessnotwithstanding,1949-68wasbroadlybullish,witha662%riseintheS&PCompositeIndexrepresentinga413%riseinrealterms.

AsFigure92shows, it tooksomeyears for themarket togetup tofullsteam.There was a strong rebound from June to December 1949, but the marketrecoverythenslowedwiththeindexhavingrisenjust29%bySeptember1953.ThedominantthemeofthepostwarperiodonWallStreetbecametheriseofthedefence industry.While the administration initially sought to constrain publicspendingandhencedefencespending, theSovietUnion’s launchofSputnik inOctober 1957 resulted in a change of plan. The US began to build its firstpermanent armaments business separate from wartime exigencies, and thispromisedgreatprofits for investors in selectedstocks.The riseof the industrywas rapid, so much so that outgoing President Dwight D Eisenhower’s finalpublic address in January 1961 warned of ‘unwarranted influence’ by this‘military-industrialcomplex’.Investorsinthis‘military-industrialcomplex’hadbeenreapingfinancialrewardsthroughoutthesecondhalfofthe1950s.

The high growth levels of some of these companieswere rewardedwith highvaluations by Wall Street and, with listed equities trading at discounts toreplacement value throughout the 1950s, therewas growing takeover activity.Withthebenefitofsuchhighly-ratedsharesdefence/electronicsbusinessessuchasLittonIndustrieswereabletolaunchaggressiveacquisitionstrategiesasearlyas 1958. An acceleration of takeover activity was important fuel for the bullmarketintothe1960s.

Itwasasurprisetomanyinvestorsthatthe1949-68bullmarketcameagainstabackground of regular fiscal deficits. In 1949-68, the federal governmentreportedasurplusinonlyfourofthe19years.Inthebuoyantdecadeof1958-68, only one fiscal surplus was reported. Growing fiscal deficits had oftenspookedequityinvestors,andthiswasaperiodoffiscaldeterioration.Whatevernegativesassumed to flowfromfiscalprofligacyweremore thanoffsetby thepositivefactorsdrivingpriceshigher.

Throughoutthisbullmarket,interestintheequitymarketwastoremainlowbyhistoricalstandards,asFigure94shows.Thelowpointwas1942,whenjust9%of the average number of s listed hares traded. As the market began to rise,interestandvolumesdidincrease.However,asFigure94shows,annualturnoverratesin1949-68ofjust17%neverapproachedtheremarkablelevelswitnessedinthefirsthalfofthecentury.Peakturnoverin1949-68cameattheapexofthatcycle,whenannualturnoverreached24%,alevelsurpassedineveryyearfrom1900to1937,aperiodencompassingatleasttwomajorbearmarkets.Thislowlevelofmarketactivity in the1949-68bullmarketcontrastswithmuchhigherlevelsofactivityinthecentury’sothergreatbullmarkets.Atthetime,thereasongivenfor therestrainedtradingactivity,relativetothefirsthalfof thecentury,wasthegrowinginstitutionalisationofthemarket.Thismaywellhavebeenthecase,but,ifso,itstandsinmarkedcontrasttothemuchhigherturnoverratesthesameinstitutionswerecreatingbytheendofthecentury.

FIGURE94.TURNOVEROFNYSE–SHARESTRADEDASAPERCENTAGEOFTOTALLISTED

Source:NYSE

Whilegeneralinterestinstockswaslowthroughoutthebullmarket,thepriceofNYSEmembershipsindicatesaseachangeintotalinterestinthemarketinthesecondhalfofthe1950s.

FIGURE95.PRICESPAIDFORNYSEMEMBERSHIPS–1949-68

Source:NYSE

Aslateas1954,thepriceofaseatontheNYSEwasbelowlevelsachievedatthe bottom of the bear market in 1949. A marked rise in the price ofmembershipswasevidentfromthelate1950s,butitwasnotuntil1968thatthepriceofNYSEmembership finally surpassed the$450,000paid in1929, eventhough theDJIAhadexceeded its1929highas early asNovember1954.ThelaggedriseinthepriceofNYSEmembershipisduetothelowtradingvolumesassociatedwiththepostwarmarket.Itwasnotuntil1963thattheannualnumberofshares tradedontheNYSEexceededthe1929high.Eventhen, thepriceofNYSE membership was two-thirds lower than its 1929 high. This lag inmembershippricesispartlyexplainedbyincreasingcompetitionasitwasalsointhis period that the increasingly powerful institutions were able to trade off-market in large blocks of NYSE-listed stock. By 1968, when the 1929 highprices forNYSEmembershipwas finallysurpassed,annualvolumewas160%higherthan1929.TheslowriseofNYSEpricesinthepostwarperiodindicatedthenatureof thenew, institutionalisedWallStreetwith longerholdingperiodsandlowervolumes.

As the 1949-68 bull market played out, there was aninstitutionalisation of the market, with the mutual fundbecoming an increasingly important vehicle for privateinvestors, and pension funds and life companies increasingexposure to equities from very low levels.During the 1950s,the number of mutual-fund shareholder accounts increasedfromonemilliontofivemillion.Bytheendofthe1960s,therewere 10.7 million. The number of individual shareholdersdoubled during the 1960s, but their power diminished, downfromjustover50%oftradingin1961toone-thirdby1969.

Akeydriverforthebullmarketwastheendorsementoftheequityasasuitableinvestment for pension funds. In 1949, total pension assets of US citizensamounted to $14.3 billion, compared with a gross national product of $258.1billion.Thesepensionmonieswere investedprimarily ingovernmentbondsorinsurance company general accounts. This industry was transformed in thepostwareraandits transformationplayedanimportantrole infuelling thebullmarketinequities.Therapidgrowthinpensionfundswasspurredbyadecisionof theNationalLaborRelationsBoard in1948 forcing InlandSteel to includenegotiationsonpensionsaspartof thecollectivebargainingprocess.Notonlydid strong growth in assets ensue from this decision, but employers wereprepared to consider more risky asset allocations with a view to enhancingreturnsandrestrainingthesizeoffuturecorporatecontributionstothesefunds.In pursuit of higher returns, pension fund portfolios’ weightings in equitiesincreased.

FIGURE96.KEYSAVINGSVEHICLESINTHEUSAANDTHEIRCOMMITMENTTOEQUITIES

Source:FederalReserve,FlowofFundsAccountsoftheUnitedStates.

Figure96showsthegeneralgrowthfrom1952to1968infundsmanagedbykeyUS savings institutions.Over the 16-year period, the total size of funds undermanagement increasedmore than300%.Private pension fund assets increased11-foldandmutual funds13-fold.With theexceptionof the small, closed-endfund sector, therewerematerial increases in the holding of corporate equitieswithin all types of portfolios. The process was slow and, in the case of lifeinsurance companies, increases in equity weightings were only possiblefollowingchangesinrestrictivestatelegislation.Whiletotalfundsincreasedbyjust over 300% in 1952-68, the total holding of equities increased almost 12-fold. In 1952, when flow-of-funds statistics were first published by the Fed,holdings by these institutions of corporate equities represented just 9.5% ofNYSEequitymarketcapitalisation.By1968,thisfigurehadrisento21.3%.Aslate as 1960, institutions accounted for just one-third of the dollar value oftrading on the NYSE; by 1968 this had risen to 60%. Following the “GreatCrash”of1929,equitieshadbeenshunnedbyconservativeinvestors.Thestoryof the1949-68bullmarket is inpartabout therehabilitationof theequityasalong-term-savingsmedium.

There were many reasons why investment institutions increased theircommitment to equities, but the root cause was a change in inflationaryexpectations.Aswehaveseenin1946-49,investmentpractitionersdebatedthe

extent to which the general price level would have to deflate in the postwarperiod. Particularly prescient were those who believed a new global financialframeworkwouldmakeinflationmoreprevalent.Such“newera”thinkingwasridiculedbysomebuttheseinvestorscorrectlyidentifiedthekeychangeinthepostwarinvestmentarena.

As the 1950s and 1960s progressed, investors began to accept that structuralchanges reduced the prospects ofmaterial deflationary episodes in the future,which meant fewer periods when bonds would be so clearly preferable toequities.Whilethemanagementofcompaniescouldadjustandhopefullyprofitinthenewenvironmenttherealvalueoffixedpaymentstobondholderswouldbeunderminedbyinflation.Theshiftbyinstitutionalinvestorsoutofbondsandinto equitieswas at least partially driven by the evidence that the inflationaryoutlookhadchangedtofavourhigherreturnsfromequitiesrelativetobonds.

As long as there had been equities, the dividend yield on these instrumentsexceeded bond yields. Only dangerous “new era” thinkers believed thisfundamental long-runningrelationshipcouldbeupset.Theexistenceof theso-called“yieldgap” in favourofequitieswasoneof the fewconstants investorscouldrelyon.Onthisoccasion,therelationshipthatexistedfromthefoundingoftheNYSEin1792ceasedtobeaconstantandthenewerathinkersprovedtobecorrect.TheflowoffundsinfavourofequitiespushedtheyieldontheS&PComposite below long-termgovernment bondyields in July 1957, a state thatbecameentrenchedbySeptember1958, and the “reverseyieldgap”grew intothe1960s.BytheequitymarketpeakinDecember1968,theyieldontheS&PCompositewas2.88%andthelong-termgovernmentbondyieldwas5.65%.

Thisfundamentalchangeinvaluationbetweenbondsandequitiesgoesmuchofthewaytoexplaininghowabullmarketinequitiesfrom1949to1968coincidedwithabearmarketinbonds.Thesell-offingovernmentbondsbeganinJanuary1950,justsixmonthsaftertheendofthebearmarketinequities,whentheyieldonUSlong-termgovernmentbondsbeganrisingfrom2.19%.Intheequitybullmarketwhichfollowedbondyieldsdoubledand thedividendyieldonequitiesdeclined almost 60%. Even the new era thinkers of 1949 would have haddifficultybelievingsuchamassiverealignmentinyieldswaspossible.Foronceithadbeenrighttosaythatitwasdifferentthistime.Thedifferencewasanewpostwar financial and social infrastructure that made inflation much more

prevalent. For almost 20 years, equity investors reaped the rewards for thefinancialmarkets’adaptationtothenewlycreatedpermanenceofinflation.

Itwasthischangeinthevaluationsofequities,andnotcorporateprofitgrowth,which resulted in the long postwar bull market. As we have seen, S&PCompositeIndexearningsbottomedin1946andincreasedthroughoutthe1946-49 bearmarket. Themuch-forecast profit downturn for 1949 turned out to bebriefandminor,andwasignoredbyareboundingmarket.Fromtheprevailinglow level of December 1949, reported earnings increased 150% to December1968. This compares with a 240% increase in nominal GDP over the sameperiod.The 150% rise in reported earnings in nominal terms compareswith arise of 662% in theS&PComposite.AsFigure 97 shows, thosewho profitedfromholdingequitiesoverthe1949to1968periodowetheirexcessreturnstorisingvaluationsandnotrisingprofits.

FIGURE97.RISEINEQUITYVALUATIONS1949TO1968

Source:Smithers&Co;www.econ.yale.edu/~shiller/data.htm

Equitiesmovedfromundervaluationtoovervaluationand,asinanybullmarket,therewere plenty of experts around to justify the overvaluations.By themid-1960s,therewasanew,youngergenerationwhounderstoodwhyequitieshadtotrade on higher valuations than they had before. For the first time in theinstitutionalised markets, a performance-oriented and youthful sector of WallStreetemerged, fullyversed in theneweconomics. JohnBrookswrites inTheGo-GoYears that therewas abelief only someoneunder40 couldunderstandandforeseethegrowthoffast-movingandunconventionalcompanies.

WallStreet,whichlivesondreamsandfashions,was,forallofits pretensions to rational practicality, precisely the milieuwithinwhichthenewgospelofyouthcouldproliferate.[67]

By 1966, however, the belief in the value of the “new economy” had to beincreasingly reconciledwith the evidence of trouble in the real economy.Thecrux of the growing concern for investors was the seeming inability of theFederalReserve togetcontrolof inflationagainst thebackgroundof the fiscalspending associated with Johnson’s “Great Society” programme. Thisgovernmentprogramme,producedbyLyndonB.JohnsoninJanuary1965,wasonly rivalled by Roosevelt’s New Deal in its largesse. As the inflationaryimplications of the Great Society and the increasing military involvement inVietnambecameclear,thebondmarketwasspooked.AsFigure98shows,theyieldongovernmentlong-termsecuritiesrosetoever-higherlevels.

FIGURE98.YIELDONUSGOVERNMENTLONG-TERMSECURITIES

Source:Datastream

By the mid-1960s, the bond market was suggesting something had changed.That change was the shift from the sound monetary policy pursued by theFederalReservesince1951toincreasingrelianceonanactivistfiscalpolicyasthe key tool of economic management. The re-engagement with Keynesianmanagementtools,launchedbyPresidentKennedy,resultedinamajorboosttoeconomicgrowthunderPresidentJohnson.TheFedseemedtoacquiesceinthisshift in policy. PhilipColdwell, then-chairman of theDallas Fed, is quoted in

William Greider’s Secrets of the Temple as saying Johnson believed theeconomywasflexibleandcouldaccommodatehigherdefencespendingforthewar in Vietnam. Coldwell said the message was ‘the Fed shouldn’t be stiff-necked’aboutmonetisingtheincreaseindebt.

AnumberofusontheFederalOpenMarketCommitteearguedverystronglythatweshouldhavegreaterrestraint.Butothersweresaying,‘Well,weareinawarandwehavetosupportthewareffort.’Weneverdidit.[68]

TheFed’smonetaryinactionwasevident.Thediscountrate,at4.0%inOctober1967,wasthesameasinSeptember1959.Overthesameperiod,inflationhadrisen from 1.23% to 3.56%. Monetary tools were held in abeyance and thepoliticians were supposed to reduce inflation. However, the necessary fiscalrestraint proved politically impossible due to spending on thewar inVietnamandincreasedsocialsafetynets.Thelackofafiscalsolutiontoinflationwouldeventually put even greater pressure on the Fed, in the words of its then-chairmanWilliamMcChesneyMartin, to ‘lean against the wind’ of inflation.NotuntilNovember1967weremonetarymeasuresfinallymobilised.The50bprise in the Fed funds rate in that month was the first move in an attack oninflationwhichwastoseetherateexceed9.0%withintwoyears-anewhigh.

Wall Streetwas slow to react, and the equitymarket’s ability to ignore risinginterest rates in 1968 may have been spurred by President Johnson’sannouncementthathewouldnotrunforre-election,improvingtheprospectforaRepublicanadministration.TherewerealsotheParispeacetalksbetweentheUSandNorthVietnamtobuoy theequitymarket,and theRepublicanpresidentialcandidate,RichardM.Nixon,waspromisingtodeliver‘peacewithhonour’.Theprospectoffiscalrelieffromthisquarterwastoproveillusoryandthecontinuedsteadymarchtohigherinterestratesfinallybroughtthe1949-68bullmarkettoanend.ThemarketpeakedsoonafterNixon’sNovember1968electionvictoryandAmericaenteredaprolongedperiodofmalaiseanda14-yearbearmarket.

ThecourseoftheDow-1968-82

FIGURE99.DOWJONESINDUSTRIALAVERAGE–DECEMBER1968TOSEPTEMBER1982

Source:DowJones&Co.

Thekeyeventsthatshapedtheperiodfrom1968to1982werethedemiseoftheBrettonWoodsagreement and theacceleration in inflation.Speculationon thesustainability of the international monetary agreement had been growing foryears.Asearlyas1960,YaleProfessorRobertTriffinhadwarned,inhisbookGoldandtheDollarCrisis, that theUSwouldbeforcedtorunregularcurrentaccountdeficits toprovide therestof theworldwith thenecessary liquidity togrow. [69]Hepointedoutthatthelong-termresultofthesedeficitswouldbetounderminefaithinthedollarastheworldreservecurrencyandthusthestabilityoftheBrettonWoodssystemitself.Elevenyearslater,Triffin’spredictioncameto pass when, on 15 August 1971, President Nixon declared the US wassuspending the redemption of dollars for gold. The US dollar devalued inDecember 1971, from $35 to $38 an ounce of gold, and early in 1973 itwasdevaluedto$42.ByMarch1973,anypossibilityofresurrectingBrettonWoodswasdeadandthedollarenteredfreefloat.Withthegoldlinkgone,akeyfactorforeconomicdisciplinetocontaininflationwasremoved.Theequityandbondmarkets had been worried by inflation in the late 1960s and the end of theBrettonWoodsagreementexacerbatedtheseconcerns.

Inflation,andthefightagainstit,drovethe1968-82bearmarket.

FIGURE100.USCONSUMERPRICEINDEX(%CHANGEYEAR-ON-YEAR)

YEAR)

Source:Datastream

In1969,investorswerecopingwithaviciousdeclineinequitypricesastheFedpushedshort-term interest ratesabove9%.TheFedhad finallyupped theanteagainstinflationjustasitannouncedanewchairman-ArthurBurns.PresidentNixonhad tried to kick the incumbent chairman,WilliamMcChesneyMartin,upstairstotheTreasuryDepartmentimmediatelyonhiselectionin1968.Martin,Governorsince1951,hadrefusedtoleaveanditwasnotuntilhistermexpiredon30January1970thatBurnsfinallybecameChairman.OnswearinginBurnsastheFedchairman,Nixonremarked:

Irespecthisindependence.However,Ihopethatindependentlyhe will conclude that my views are the ones that should befollowed.[70]

TheviewsofNixonandBurnswereindeedregularlytocoincideandtheFed’sreputation as a guardian of price stability was to suffer. With the benefit ofhindsight,itiscleartheFedceasedtobetoughoninflationandtheresultwasaroller-coaster ride through the1970sfor interest rates (seeFigure102)and thestockmarket.WithinthefirstyearofBurns’tenure,short-termrateswerebackbelow4.0%andbelowtheaveragelevelmaintainedinthe1960s.However,bythemiddleof1971,rateswereontheriseagain,accompaniedbythefirstprice

controls since 1949.Therewas some evidence themedicinewasworking andannual inflation was back below 3% by the middle of 1972. In 1973, Nixondismantled price controls and inflationwas quickening, and the equitymarketdeclining,when along came the “oil shock” as theOrganisation of PetroleumExportingCountries (OPEC)more than tripled the price of oil - from$3.12 abarrelinOctober1973to$11.63inDecember.Annualinflation,runningat2.9%inAugust1972,surgedto12.5%byDecember1974.

There were actually two oil shocks in the 1970s. The first began inOctober1973,whenArabmembersof theOPECannounced theywouldnolongershipoiltocountriessupportingIsraelinitswarwithEgypt.TheoilpricehadtripledbyChristmas1973.ThesecondoilcrisiswascausedbyadeclineinoilexportsfromIranfollowingtherevolutionofJanuary1979.Byyear-end,theoilpricehadrisen150%.Within12monthsofbothoilshocks,G7GDPcontracted.FromDecember2002toJune2005,theoilpricehasrisen160%.

Thiswouldhavebeenbadenoughforinvestors,butthehugesurprisewasthatthe sharp recession, from November 1973 to March 1975, failed to bringinflationundercontrol. InApril1973, the term“stagflation”,acombinationoflow growth and inflation, made its first appearance in the pages of theWallStreetJournal.Suchacocktailcouldonlybebadnewsforequityinvestors.

TheFed’s response remainedmild, and theFederalFunds ratewasonly75bphigher in January 1977,when inflationwas 6.1%, than in January 1960wheninflationwas just 1.1%.By early 1977, the annual rate of inflationwas risingagain and this continued until it reached a newhigh of almost 15% inMarch1980. A further impetus to this inflation was political crisis in Iran, whichresultedinananti-USIslamictheocracy,andanotherleapinthepriceofoil.Thebottomlinewasthat,despitethedramaticbullandbearmarketsofthe1970s,theDJIAspentallbutafewdaysofthedecadetradingbelowits1968highs.

Stagflation is used to describe the unusual combination of economicstagnation and inflation, and was supposedly coined on 17 November1965byConservativePartyMPIanMacleodintheHouseofCommons.Heneededanewwordbecausethiswasanewphenomenon.Withinfiveyears,MacleodwasappointedChancellorof theExchequer.Whetherhehadaremedy for theconditionhedefinedwillneverbeknown.Hediedafteronlyamonthinoffice.

In this new inflationary environment, equities failed to deliver positive realreturns.Inthe1950s,consumer-priceinflationaveraged2.2%,andwas2.3%inthe 1960s. Through those two decades, investors secured above-normal realreturns from equities. The bearmarket in equities really got going in 1969 asinflation moved above 3%. The 1970s saw inflation averaging 7.1% and athresholdofinflationseemedtohavebeenpassed,beyondwhichequitiescouldnotprovidepositiverealreturns.Thisisnottosaythatthereweren’tfalsedawnsand hopes that inflation had finally been licked. In real terms, the S&PComposite Index declined 63% fromDecember 1968 to July 1982. This longdeclinewaspunctuatedbydramatic swings in themarket.The33%decline intheDJIA,fromtheDecember1968hightothelowsof1970,wasthefirstphaseofthesecularbearmarket.Itwasnottobethemostdramatic.FollowingamajorrallytoanewhighinJanuary1973,theDowdropped45%.WhenitbottomedinDecember1974, themarketwasdown37% innominal termsand57% in realtermsfrom1968.

For many investors, returns had been even worse. By 1972 many investorportfolioswerecomposedofso-called“one-decision”growthstockslabelledthe“Nifty Fifty”. It was believed that the “Nifty Fifty” would produce futureearningsanddividendgrowthtorenderirrelevantthepricepaidforthem.Itwastheriseofthese50stocksthattooktheDJIAtonewhighsinearly1973,whilebroader-based indices such as theValueLine Index failed to surpass previoushighs.Investorsbuyingin1972paidahistoricpriceearningsmultipleof42xforthe “Nifty Fifty”,which then suffered an average price decline of 62% in the1973-74bearmarket.ByDecember1974,themarketinnominaltermswasbacktolevelsof1958.Thiswasbadenoughbut,inreal-terms,returnshadbeenevenworse.

ByDecember1974theS&PCompositeIndex,expressedinrealterms,wasbacktolevelsfirstseeninNovember1928.TheIndexbottomedinnominaltermsinDecember1974,butinrealtermstherewasstillworsetocome.TheDJIAfellinreal terms below even its December 1974 level in April 1980, again inSeptembertoOctober1981,andinJanuarytoSeptember1982.Atitslowinrealterms in July 1982, the S&P Composite Index was 13% below its December1974low.Inrealterms,theIndexwasnowbacktolevelsfirstsurpassedinJune1905. Investors had been entirely reliant on dividends to provide positive realreturns.

TheNiftyFiftywasagroupof50stocks.InDecember1972,theaveragePEratioforthegroupwas42xearnings.Althoughall50ofthesestockswerepartoftheS&PCompositeIndex,thePEofthebroaderindexwasjust18xat that time. Itwas thought the futureearningsgrowthof thesestockscouldjustifysuchextremevaluations.Intheshortterm,thisprovedincorrectastheaveragepriceofaNiftyFiftydeclined62%inthe1973-1974 bearmarket.However, for those investorswho hung on, theFiftydiddeliversomeofthispromise.ProfessorJeremySiegelpointsoutinhisStocks for the Long Run that the annual return on the Nifty Fifty fromDecember1972toNovember2001was11.62%,justbelowthe12.14%oftheS&PCompositeIndexoverthesameperiod.

AlthoughequitypricesreboundedstronglyfromtheDecember1974low,1974-82was a period of further volatility, false dawns and poor returns.A generalsenseofdespairhungoverthefinancialmarketsinthesecondhalfofthe1970s.Even a renowned financial commentator such as SydneyHomer, the father ofmodern bond market research at Salomon Brothers, joined the chorus inNovember1976.

Thecompleteblindconfidenceofthe1950sinthedollar,andhenceinourstatusintheworld,canneverreturn.[71]

Homerlikenedthe“unprecedentedrise”inbondyieldstothecrashof1929-32andwarned:‘Itwillberememberedforgenerationsahead,andthismemorywilltendtoholdupyieldsandlimiteconomicgrowth.’ThislackoffaithinAmerica,

even from themost acute of analysts, acted to produce risingbondyields anddecliningequitypricesthroughthelate1970sandearly1980s.

The losses that accrued to equity investors in 1968-82were due to both poorearnings growth and a reduction in valuations. In nominal terms, reportedearningspershareincreasedjust143%intheperiod,comparedwithanincreaseinnominalGDPof246%.Theincreaseinreportedearningsrepresenteda12%declineinrealearningsovertheperiod.Thiswouldhavecomeassomethingofasurprise to investors in the 1950s and 1960s who, foreseeing the new high-inflation environment, bought equities to benefit from rising profits. Investorshadassumedthatmanagementcouldadapttoahigherinflationaryenvironmentwithincreasedoperatingmarginstoensurethenecessaryhigherreturns,thoughWarren Buffett, among others, was keen to point out the fallacies of thatargument.

Recentstatisticalevidence…doesnotinspireconfidenceinthepropositionthatmarginswillwideninaperiodofinflation.Inthedecadeendingin1965,aperiodofrelativelylowinflation,the universe of manufacturing companies… had an averageannualpre-taxmarginonsalesof8.6%. In thedecadeendingin 1975, the averagemarginwas 8%.Margins were down…despiteaveryconsiderableincreaseintheinflationrate.[72]

In 1949-68, inflation played an important role in pushing the valuation ofequities higher and creating the “reverse yield gap”. Inflation of the 1970sperpetuated the relative performance of equities against bonds, but it did notproducepositiverealreturnsforequities.Equityvaluationscontinuedtoriseinthe1960s,eventhoughtheaverageyieldongovernmentlongbondswas4.67%.By1968,equitieswereatthetopendoftheirvaluationrangetradingonaPEof18.5x historic earnings and at a q ratio of 1.06, only previously surpassed in1929 and 1905. With equity valuations at such high levels already, it isunsurprising that the rise in long-term government bond yields to more than15%, while the return on equity was largely unchanged, acted to depressvaluationsfrom1968to1982.

The widening of the “reverse yield gap” was driven by the collapse ofgovernment bond prices and thus, despite the shift in the bond-equityrelationship,thevaluationofequitiesdeclined.ByJuly1982,thehistoricPEof

theS&PCompositeIndexhadfallento7.8x,against18.5xinDecember1968.Cyclically adjusting earnings using the 10-year rolling average earnings levelshowequitiesdecliningfrom25.1xinDecember1968to9.9xinAugust1982.FromDecember1968toDecember1982theqratioforthemarketdeclinedfrom1.68xto0.38x.Themarketlookedcheap,butithaddonesoforsometimeasthehistoricPEhadbeenbelowtentimessinceMarch1977.By1982themarketqratiohadbeenbelowitsgeometricmeanforalmostnineyears.

Despite the chaos in the economy and the equitymarket in the 1970s,marketactivityneverdeclinedtothelowlevelsseeninthe1940sand1950s.ThelowpointfortheNYSEwas1974,whenturnoverwas16%,stillabovetheaverageturnover rate for 1949-68. Interest picked up steadily in 1974-82 to reach aturnover rateof42%in1982.Thiswasalmostdouble the level reachedat thetopofthebullmarketin1968andthehighestlevelrecordedsince1933.Interestin the equitymarket was rising long before the bottom of the bearmarket inAugust1982.

Whilemarketactivityreacheditsnadirin1974,thepriceofNYSEmembershipsdidnotbottomuntil1977.From1968to1977thepriceofaseatdeclined93%innominal termsduringaperiodwhenthegeneralprice levelalmostdoubled. In1977-82, prices rose almost ten-fold, reflecting the surge in volumes on theNYSE.RisingturnoverratesandhigherNYSEmembershippricesshowrisinginterest in equities in the second half of the 1970s, well before the marketbottomed in 1982. The rising turnover rates indicate much shorter holdingperiodsforinvestors.Theaverageholdingperiodofjustoversixyearsin1974hadbeen reduced to less than twoyearsby1982.Thiswas anoccasionwhenrising interest in themarket did not augur the birth of a newbullmarket, butratheranadaptationbyinvestorstoaneweraofincreasedvolatility.Throughouttheperiod,institutionalisationofthemarketcontinued.

FIGURE101.KEYUSSAVINGSINSTITUTIONS–1968-82

Source:FederalReserve,FlowofFundsAccountsoftheUnitedStates.

ThegrowthintotalfundsofUSsavingsinstitutionsincreasedbyslightlymorethanGDPover thecourseof thebearmarket.Whileequityweightings for thekeyinstitutionsdeclined,thetotalfundscommittedtoequitiesincreasedalmost300%,evenas theDJIAdeclinedbymore than20%. Institutionscontinued toincreaseholdingsofequities,althoughincreasinglyslowlythroughoutthe1970s,and the turnover rate on the NYSE increased substantially, but still the bearmarketpersisted.

The situation was reaching a climax by 1978, when President Jimmy CarterappointedG.WilliamMiller, aCEOandcorporate lawyer, aschairmanof theFederal Reserve. Extreme policies followed, with the US borrowing from theIMF, as well as borrowing foreign currency in international markets tosupplement support of the dollar. For the markets, there were clear signs ofdesperateshort-termsupportmeasures,butnolong-termsolutionstoAmerica’seconomicproblems.ByAugust1979,thepriceofgoldexceeded$300anounce,compared with the $35 an ounce maintained under the Bretton Woodsagreement.Miller’stermaschairmanoftheFedwasbriefandhemovedontobecome Secretary of the Treasury. Few could have foreseen that Miller’sdeparturewouldauguraneweraforAmerica.

ThepathoutofthemalaisecamewiththeappointmentofPaulVolckerasFedchairmanon6August1979.Withinamonth,hepushedthroughariseininterestratesonafour-to-threevote in theFOMC.Volcker thencalledanother,secret,meeting of the FOMC on 6 October, which pushed interest rates higher.Importantly,itwasaccompaniedbyanewFedpolicyoftargetingthegrowthofthe M-1 monetary aggregate and thus permitting interest rates to adjust towhateverlevelthispolicynecessitated.Toaccommodatethepotentialchangeininterestrates,theFedannouncedwithimmediateeffectthepermissiblerangefortheFed funds ratewouldbe11.5-15.5%.With theFed targeting themonetaryaggregates,therewashugeuncertaintyastothefuturelevelofinterestratesthatwouldresult.

Before there was a Greenspan there was a Volcker.Paul Volcker wasChairman of the Federal Reserve System from August 1979 to August1987andiscreditedwithbringingrunawayinflationundercontrol.WhenVolcker took office, inflationwas almost 12%.When he left, itwas just4%. Initially, the war on inflation was fought through targeting thegrowth of themonetary aggregates, such asM-1, rather than targetinginterestrates.Implementationofthepolicywasfraughtwithdifficultyandresulted involatile,andoftenveryhigh, interest rates. In1995,Volckerasked Alan Greenspan: ‘Whatever became of M-1?’ His successorreplied:‘Itwasoncethenameofaprettygoodrifle.’[73]

FIGURE102.FEDFUNDSEFFECTIVERATE1970-1983

Source:Datastream

Intheshortterm,itwasevidenttheFed’sM-1growthtargetwouldnecessitatetighter liquidity and thus higher interest rates. From just over 9%, USgovernment long-bond yields were approaching 13% within 12 months ofVolcker’s appointment. The markets remained sceptical about the impact oninflation, and the price of gold doubled in his first year. Indeed, inflationcontinuedtoriseandPresidentCarterusedhispowerstoimposecreditcontrols.Inatelevisionaddresson14March1980,herecommendedtheAmericanpublictostopspending.Toeverybody’ssurprise,thisisexactlywhathappened,andinthesecondquarterof1980GDPdeclinedat thefastestrateeverrecorded.Thecollapse inconsumerspendingandM-1wasso rapid theFedwassooneasingmonetary policy, with the Fed funds rate dropping from 20% to 8% in threemonths. It is clear the economy’s reactions also cameas a surprise to theFedchairman:

Itisallrecordedinthebooksasarecession,butinretrospectitwas an odd, almost accidental occurrence.Therewas a sharpdecline in production, but it only lasted about fourmonths…Asthefrightaboutaneconomicemergencydissipatedandthecredit controls were removed, spending (and the moneysupply)pickeduprapidly…Thenetresultmightnothavebeenmuch of a recession, but therewasn’tmuch progress againstinflationeither.Itcontinuedrunningatdouble-digitlevels,and

with the money supply rising strongly again we were in theuncomfortable position of tightening money and raising thediscountrateonlyafewweeksbeforetheelection.[74]

TheFed’sreactionagainstthecontinuedstronggrowthinmoneysupplypushedtheFedfundsratetoanewhighbytheendof1980.TheFedcontinuedtosteerbythemonetarystarand,asaresult,adeclineinshort-terminterestratesbeganinearly1981.InMayandJune1981,annual inflationfellbelow10%fromitsMarch1980peakof almost 15%, but bond investors continued to push yieldshigher.While theFedmayhavebeengaining some credibility, therewas realconcern the supply-side tax reforms being pursued by the new Reaganadministration would undermine the Fed’s progress against inflation. TheseconcernsseemedtobebackedupbyacceleratinggrowthofM-1.TheFedfeltitcould not take any risks and by May 1981 the fight to slow money supplygrowthwaspushing interest rateshigheryet again.TheFed funds rate,whichhadfallenfrom20%inJanuaryto13%inMarch,againexceeded20%byJuly.

The oscillation in short-term interest rates since Volcker’s appointment wasunparalleledandgreatlyaddedtotheuncertaintyoffinancialforecasts.NotuntilSeptember1981, twoyearsafterhisappointment,was thereanysign thebondmarketbelievedtheFedchairmanwassucceedinginhisbattlewithinflation.Inthatmonth,arallyingovernmentbondsbeganwhichwastolastmorethan20years.

Meanwhile, the equitymarket continued to slump.With inflation falling, realinterest rates were still the highest investors had had to live with since theDepression. Fiscal deterioration continued. In Washington, the ReaganAdministrationandCongresswereatoddsover taxandspendingcuts.DonaldRegan, Secretary of the Treasury, recalled a meeting with Volcker in March1982thatillustratesthedynamicskeepingrealinterestrateshigh.

Volcker had assured me that he would try to beaccommodating to theAdministration -hewouldeasemoneytobringinterestratesdownifhecouldseesomemovementbyusonthedeficits.[75]

Whilethisstand-offcontinued,amajorrecessionwasunderway.Theprospectofhighershort-terminterestratesasaresponsetostrongmoneysupplygrowthin

the firsthalfof1982didnotaugurwell for imminent recovery.Thisprospect,combinedwith interest-ratevolatility,whichmanyhadforecastas theresultofmonetary aggregate targeting, unsettled equity investors. While the dollarbenefited from high interest rates, and the government bondmarket rallied asinflationandshortratesdeclined,theequitymarketcontinuedtofall.

The rally in the government bond market was not the only improvement infinancialmarketstobeignoredbyequityinvestors.Throughthe1970s,investorshadthetriplenegativeofaweakdollar,aweakbondmarketandaweakequitymarket. The first financial market to improve had been foreign exchange.Volcker’spolicyoftargetingmonetaryaggregatesproducedhigherrealratesofinterest,whichfinallycreatedconfidenceinthegreenback.Fundsflowedtothedollar and the currency bottomed in mid-1980, rising strongly through 1981.Howeverwith theeconomy in sharp recession, theDJIAcontinued todecline.The equitymarket bottomed elevenmonths after thegovernment bondmarketandalmosttwoyearsafterthedollar.

Thebottomfortheequitymarketcoincidedwithaninternationalfinancialcrisis.Itwas clear in early1982 thatMexicowas in trouble and its largest companyhadgonebankrupt.TheFedbelievedtherewasarealriskofsovereigndefaultand itbegan toofferMexico,whichhadborrowedheavily fromUSbanks,defactobridging loans as early as30April 1982. InMay,DrysdaleGovernmentSecurities went bust. Then in early July a small Oklahoma institution, PennSquareBank, failed.Thebank itselfwassmall,but ithadhadoriginatedmorethan $1 billion in loans sold on to Continental Illinois and other largecommercial banks. Bank examiners realised similar problems were likely toexistintheloanssoldontootherbanks.Panicwasavoided,butitwasclearthatthefinancialstabilityoftheUSbankingsystemwasunderquestion.ByAugustit was public knowledge that Mexico was bust. A rescue package was puttogetherbutmajorUScommercial banks faced calamity as thepublicbecameawareofthescaleofwrite-downsontheirMexicandebt.WalterWriston,headofCitibank,describedtheatmosphereattheannualmeetingoftheInternationalMonetaryFundinTorontoinAugust1982:

We had 150-odd finance ministers, 50-odd central bankers,1,000journalists,1,000commercialbankers,alargesupplyofwhiskey… [which] produced an enormous head of steam

driving the engine called ‘the endof theworld is coming’. ItwastheTitanic.Wewerejustrearrangingthedeckchairs.[76]

TheFOMCconvenedon30June, fullyaware thatMexicowouldsoondefaulton itsdebt.DespiteM-1growth remaining strong, theprospectsof a financialcrisisresultedinachangeindirection.

Actually, by the summer of 1982 the financial fabric of theUnitedStatesitselfwasshowingclearsignsofstrain.Againstthe backgroundof the spreadingproblemsof the savings andloan industry and some well-publicized failures of marginalgovernment dealers, the bankruptcy of the high-flying butobscurePennSquareNationalBankinOklahomaexposedthatbillions of dollars of oil loans that it had originated werevirtually worthless. Some very large and well-known bankswere involved; theproudContinental IllinoisBank, largest inthe Midwest, was shaken to its foundations. All thatcontributedtothetimingofourdecisiontoeasepolicyinJuly1982.[77]

This was a de facto, if not de jure, abandonment of money-supply-growthtargeting.TheFedfundsrate,above14%inearlyJuly,wasbelow9%byearlySeptember. Itwas clear theFedwasno longer steeringby the compassof themonetaryaggregatesalone.Importantlythebondmarketwasnotspookedbythechangeinpolicy,andthedeclineinlong-termratesaccelerated.ItwaswiththepublicannouncementoftheMexicancrisisandtheFed’schangeinpolicythattheequitymarketfinallyhitbottominAugust1982.

Endnotes65RobertShiller,MarketVolatility[returntotext]

66AdamSmith,TheMoneyGame[returntotext]

67JohnBrooks,TheGo-GoYears-TheDramaandCrashingFinaleofWallStreet’sBullish’60s[returntotext]

68WilliamGreider,SecretsoftheTemple[returntotext]

69RobertTriffin,GoldandtheDollarCrisis:TheFutureofConvertability[returntotext]

70QuotedinWilliamGreider,SecretsoftheTemple[returntotext]

71QuotedinMarcFaber,TheGreatMoneyIllusion(Longman,1988)[returntotext]

72WarrenBuffett,“HowInflationSwindlestheEquityInvestor”,Fortune,May1977[returntotext]

73QuotedfromMartinMeyer,TheBankers-TheNextGeneration[returntotext]

74 In Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat toAmericanLeadership[returntotext]

75DonaldTRegan,FromWallStreettoWashington[returntotext]

76PhillipLZweig,CitibankandtheRiseandFallofAmericanFinancialSupremacy[returntotext]

77PaulVolcker,inVolckerandGyohten,ChangingFortunes[returntotext]

Structureofthemarketin1982

Thestockmarketin1982Charlie emits a sardonic, single-syllabled laugh, and explains, ‘The little man is acting like the oilcompaniesnow.I’llgetmine,andscrewyou.’

‘Idon’tblametheoilcompanies,’Harrysaystranquilly.‘It’stoobigforthemtoo.MotherEarthisdryingup,isall.’

JohnUpdike,RabbitisRich

By1982,thestockmarketwasnolongerafinancialsideshowinAmerica.AttheendofMay1949,thetotalvalueofallNYSE-listedstockswasjust$64billion,or 23% of GDP. In the bull market to December 1968, NYSE marketcapitalisation increased to $693 billion, or 76% of GDP. Despite the bearmarket,whichbeganin1968,marketcapitalisationcontinuedtoriseandbytheend of 1981 reached $1,143 billion or 36% of GDP. Growth in marketcapitalisationoutstrippedeventhe11-foldincreaseinnominalGDPfor1949-81.The public’s ownership of equities, primarily through financial intermediaries,alsosoared-from4%oftheadultpopulationin1952to28%in1985.Activityin the stock market had been rising since 1974, and in 1982 the highestpercentageoflistedsharestradedsince1933.ThevalueofsharestradedontheNYSEin1982was350%higherthanatthepeakofthebullmarketin1968.By1982publicparticipationandinterestinthemarketwasathighlevels.Activitywas alsoveryhigh,with the averageholdingperiod just exceeding twoyears,comparedtothefive-yearaverageperiodevidentfrom1949to1981.

Throughthisperiod,theNYSEcontinuedtoprovideagoodrepresentationoftheoverallmarket.While today’sreadersees theriseofNASDAQas increasinglyimportantinrelationtoNYSEactivitythiswasnotthekeythreattotheNYSEin1982.Inalonger-termtimehorizontherisingimportanceofNASDAQhastobeset against the continued decline in the importance of the American StockExchange(ASE).Atitspeakin1968,theASEaccountedforalmost18%ofallthe volume conducted on registered stock exchanges in theUS.By 1982, thishad declined to less than 4%and theNYSE’s share of trading volumeon theregisteredexchangeshadrisenfrom74%to85%overthesameperiod.In1982,

references to theNYSEcanstillbeequatedwithreferences to“themarket” inmoregeneralterms.

Thegrowthin thenumberof listedcompanies laggedfarbehindthegrowthinNYSEmarketcapitalisation.ThenumberofcompanieswithNYSE-listedstocksincreasedfrom1,043in1949to1,273bytheendofthebullmarketin1968.Bytheendof1982, therewere1,526companieswith shares listedon theNYSE.Withonlya46%increaseinthenumberoflistedcompaniessince1949thestoryof thegrowthin themarketwasofarise inaveragemarketcapitalisation.Theaveragemarket capitalisation of a listed company by themiddle of 1982wasaround$639million,upfrom$543millionattheendof1968and$58millioninthemiddle of 1949. By June 2005, there were 1,780 companies listed on theNYSE,withanaveragemarketcapitalisationof$5billion.

Whilemuch changed in termsof the industrial sectors comprising themarket,therewassomethingthatseemedalwaystostaythesame-theimportanceofoil.Though industry sector breakdowns only became available in 1926, oil wasprobablyonlysecondinimportancetotherailroadsectorin1921.Atthebear-marketbottomsof1932,1949and1982,oilhadthelargestmarketcapitalisationofanysector.Evenat the topof thebigbullmarketof1929,oil remained thethird largest industrial sector of themarket. The importance of this sector forinvestorsisgenerallyunderstatedinthestoryofWallStreet,wherethefocusissooftenonthenewthing.Figure103showstheshiftinimportanceofthekeyindustry sectors from1949 to1982, thecontinued importanceof theoil sectorandtheriseofnewindustries.

FIGURE103.TENLARGESTNYSESECTORS(MARKETCAPRANKEDBYSIZE)

Source:KennethR.French,‘IndustryPortfolioData’

Railroads,themostimportantsectoroftheUSstockmarketfromthemiddleofthe 19th Century until the end of the 1920s, had largely disappeared frominvestor radar screens by 1982. Similarly, with heavy industry such as steel,autos and chemicals declining in importance to investors, service-orientatedbusinessessuchasfinance,businessequipmentandhealthgainedinimportance.Themost importantchange in theperiodwas the riseand riseof the financialsector.In1949thefinancesectorwaslowlyweightedandcomposedlargelyofinvestment trusts and some consumer-finance companies. It was only in thepostwarperiodthatalreadywell-establishedbankingcompaniestookfullNYSElistingsandfinance,thesixteenthlargestsectorin1949,becamethesecondmostimportantsectorby1982.

DespitethemyriadchangesintheUSeconomyovertheperiod,therehasbeenasurprising permanence amongst the largest sectors of the stockmarket. In thethreeperiodsforwhichharddataisavailable-1932,1949and1982-sixsectorsalways appeared in the 10 largest bymarket capitalisation: oil, utilities, retail,communications,chemicalsandautos.Theimportanceofthe10largestsectorshasvariedlittleovertheyears,accountingfor76.6%ofmarketcapitalisationin1932, 74.5% in 1949 and 73.4% in 1982. Prior to this, themarket’s industry

concentrationwaslikelytohavebeenevenhigherduetothedominanceoftherailroadsector.Thekeychangeinthestockmarketbetween1949and1982wasthe shift from heavy industry to services. Figure 104 shows how service-orientated industriesprovidedparticularlygoodreturns from1949 to1982andthusbecameincreasinglylargeportionsofmarketcapitalisation.

FIGURE104.TOTALRETURNSFORINDUSTRIALSECTORSONNYSE–JUNE1949TOJULY1982

Source:KennethR.French,‘IndustryPortfolioData’

While share-price outperformance played an important role in the rise of thebusiness equipment and health sectors, this was not the case for the financesector. The finance sector index shows a 29.5x total return over the period,belowthe32.5xaveragesectortotalreturn.Therisingimportanceofthefinancesectorwasdrivenbynewlistings.Thecommunicationssectorwas theseventhlargest sector bymarket capitalisation in both 1949 and 1982. That the sectorindex produced very sub-par performance over the period indicates thiscontinued importancewas due to large capital raisings rather than exceptionalreturnsforinvestors.Thereverseimpactisobviousfortheelectricalequipmentsector, where the importance of the sector declined markedly despite itproducingthefourth-bestreturnofanyofthe30sectors.Theperformanceofthe

10 largest sectors in 1949, from 1949 to 1982, indicates how the oil sectormaintaineditsimportancetoinvestorspartlybyprovidingexcessreturns.

FIGURE105.INCREASEINTOTALRETURNINDEX–MAY1949TOJULY1982

Source:KennethR.French,‘IndustryPortfolioData’

By 1982, the composition of the market had been transformed. The finance,health and business equipment sectors accounted for less than 7% of marketcapitalisationin1949-theynowrepresentedalmost30%ofthemarket.Intermsof themost important stocks,1949-82marked the riseandriseof IBM. In thefirst Fortune 500 list of companies, compiled in 1955 and including only USindustrial concerns, IBM ranked 61st by sales. By 1982, its profits were thesecond-largestofanyAmericancorporation.

The1968-82bearmarketwasverydifferentfromtheothermajorbearmarketsanalysed in this book.While the 1921, 1932 and 1949 bearmarkets occurredagainstabackgroundofdeflation,1968-82wasdominatedbyhigh,andrising,inflation.Whenoneaccountsforreinvesteddividends,aninvestmentintheS&PCompositeIndexincreasedinvalueby82%overtheperiod.Theconsumerpriceindex increased 174% over the same period.While just one of the largest-30industrial sectors produced negative nominal returns, when one includes theimpact of reinvested dividends only five sectors produced any positive realreturntoinvestors.

FIGURE106.SECTORSGENERATINGREALTOTALRETURNS–DECEMBER1968TOAUGUST1982

Source:KennethR.French,‘IndustryPortfolioData’.Note:Totalreturn%includesdividendsreinvested

Tobacco,whichproveditselfthebestperformingsectorinthedeflationarybearmarket from 1929-32, turned out to be the best performing sector in theinflationary bearmarket of 1968-82.Management’s ability to adjust prices tomaintainmargins in the sector in differing inflationary climates seems almostunique. The oil sector was the fifth-best-performing sector in the deflationarybearmarketof1929-32and the fifth-best-performing sector in the inflationarybearmarketof1968-82.

Theaverageunweightedreturnfromthekey30industrialsectorsovertheperiodwas107%.Apartfromthesectorslistedabove,whichproducedrealreturnsforinvestors,only fourother sectorsproducedahigher return than theaverageof107% - food, electrical equipment, utilities andmines.Once again, the simplestrategyofover-weightingutilityandtobaccostocksinabearmarketproducedvery favourable relative returns. Interestingly theoil andhealth sectors,whichout performed from 1946 to 1968, also outperformed in the 1968-82 bearmarket.

Thebondmarketin1982

You think fourteen per cent is catastrophic, in Israel they live with a hundred eleven per cent, a colortelevisionsetcostseighteenhundreddollars.InArgentinait’sahundredfiftypercentperyear…theUSconsumerstillgetsthebestdealtobehadinanyindustrializednation.

JohnUpdike,RabbitisRich

By1982,theNYSEnolongerrepresentedanaccuratereflectionofthestructureof thebondmarket.The trade ingovernment fixed-interest securitieshadbeenswinging away from the NYSE for almost 100 years, and even the NYSE’scorporate bond market was dwindling in importance. As early as 1958, themarket value of all corporate and foreign bonds listed on theNYSEwas just33% of the total value of those instruments outstanding. By the end of 1981,NYSE listings accounted for just 28% of that total market. A more accuratepictureofthechangeinthebondmarketovertheperiodisprovidedbytheflowoffundstatisticspublishedbytheFederalReservesince1952.

FIGURE107.MARKETVALUEOFKEYCOMPONENTSOFUSFIXEDINTERESTMARKET($BN)

Source:FederalReserve,FlowofFundsAccountsoftheUnitedStates

Figure107covers fixed-interestsecuritiesofallmaturities. ItshowsUSfixed-interestmarketsin1952being1.8xlargerthantheequitymarket.Theratiowasbasicallyunchangedupto1982.Surprisingly,thefixed-interestmarketmanagedto grow marginally faster than GDP over the period, despite the significantdeclineinbondprices.Thescaleandrelativeimportanceofthisbearmarketinbonds is put in context by Sidney Homer and Richard Sylla in A History ofInterestRates:

Ifaconstantmaturitythirty-year2½%bondhadbeenavailablethroughout this second bear market of the century, its pricewouldhavedeclinedfrom101in1946to17in1981,or83%.[78]

Despitetheseverityofthisbearmarket,buyerswerefoundforever-largerissuesof government bonds. The boom in bond issuance was not confined to thegovernment and quasi-government bodies. From 1952 to 1982, the privatesector’s share of the bond market increased from 16% to 25%. Despite thecollapseinprices, therewasanactiveandgrowingmarketinbothgovernmentandprivatedebtthroughoutthebondbearmarket.

The two big changes over the period for bond investorswere the exponentialgrowthofthequasi-governmentfixed-interestsecurityandtheriseofyields.Thefew agency securities available in 1952 had been issued by those agenciescreated as part of theNewDeal.While these securities amounted to less thanonepercentofallfixedsecuritiesin1952,theyhadbecomealmost16percentofthemarketby1982.Investorshadtounderstandthisnewassetclassandalsothedynamicsbehindthenewrecordlevelofyieldsintheearly1980s.

Figure108showshowbondinvestorsin1982weresteeringthroughunchartedterritory. By February, the yield on Moody’s Baa-rated corporate bonds hadexceeded 17%.This contrastedmarkedlywith the deflationary corporate bondbear markets in 1921 and 1932, when yields peaked at 8.6% and 11.6%respectively. At the bottom of the last equity bear market in 1949, equityinvestors were assessing the impact of Baa yields just below 3.5%. By 1982,with yields in excess of 17%, bond investors were in a much more nervousconditionandanythingseemedpossible.

FIGURE108.YIELDONLONG-TERMGOVTSECURITIES&MOODY’SBAACORPORATEBONDS

Source:FederalReserve.

Endnote78SidneyHomerandRichardSylla,AHistoryofInterestRates[returntotext]

Atthebottomwiththebear-Summer1982Oilgoinguptakeseverythingupwithit…It’sjustliketheWeimarthing,people’savingsarebeingwashedrightdownthetube,everybodyagreesthere’sarecessioncomingtocurlyourhair.

JohnUpdike,RabbitisRich

Aprolongedbearmarketreducedequitiestogoodvalueinthesummerof1982.ByAugust, theDJIA had returned to a level first seen inApril 1964. In realterms,thecapitalindexwasbacktoApril1928,andjust22%abovetheheightsof 1916. Equities were cheap. Using year-end data, the q ratio was just0.38x,andadjustingforthelowlevelofthemarketinthemiddleof1982itwas probably nearer 0.27x.The cyclically adjustedPE of 9.9x, calculatedusing the ten-year rolling-earnings figures, was well below the 1881-1982averageof15.8x.Thesevaluationsareinmarkedcontrasttotheqratioof1.06xandthecyclicallyadjustedPEof25.1xreachedatthepeakofthebullmarketin1968.

It took almost 14 years for equities to move from an overvalued to anundervalued position. Thismight seem a long time, but in the context of thisstudyitcouldalmostbedescribedasnormal.Figure109showsthedurationofthe swing from high valuations to low as measured by the q ratio and thecyclicallyadjustedPE.

FIGURE109.DURATIONINYEARSOFSWINGFROMOVERVALUATIONTOUNDERVALUATION

Source:www.econ.yale.edu/~shiller/data.htm,Smithers&Co.

AsdiscussedinPartII,thebearmarketof1929-32wasverydifferentfromtheothergreatbearmarketsofthe20thCentury.Howonemeasuresthedurationoftheswingfromovervaluationtoundervaluationdependsonwhetherthisincidentis included in calculating average duration. If one includes this episode, theaveragedurationisaroundnineyears,butifitisexcludedasatypical,theperiodisaround14years.(Thesedurationsarebasedonthechangeintheqratio.Theyareeven longer ifonefocuseson thecyclicallyadjustedPE.) It isevident thatwe should notmodel our ideas on the course of a normal bearmarket on theevents of 1929-32. While it is possible equities could go from extremeovervaluationtoextremeundervaluationinjustthreeyears,it isunlikelyunder“normal”circumstances.ThemoderninvestorshouldrememberthattoachievethisrapidvaluerealignmentinjustthreeyearstheDJIAhadtodeclineby89%.

Historysuggeststhat,barringsuchamajorrapidcollapseinprices,ittakesabout 14 years for equities to make the journey from overvaluation toundervaluation.

Goodnewsandthebear‘Won’tthebubbleburst?’

‘Preciousmetalsaren’tabubble.Preciousmetalsaretheultimatesecurity.’

JohnUpdike,RabbitisRich

By1982,thebearmarketinequitieshadbeenunderwayforalmost14years,andyetitendedwithabang,notawhimper.Inthe15monthsfromApril1981,theDJIA fell another 30% to bottom inAugust 1982.While the price of equitiesdeclined,commoditypriceswerecontainedandreduced, thedollarralliedand,from September 1981, the government bond market finally firmed. ThiscombinationofpricechangesprovidedencouragementthattheFed’sbattlewithinflationwasbeingwon.However,equityinvestorswerefocusedonthepriceofthevictory,andinparticularthehavocbeingwreakedontheeconomy.

SomethingchangedinAugust1982,andaverystrongreboundinequitypricesbegan.Was this rebound driven by a change in the outlook for the economy?Based on the NBER reference date, the rebound in the equity marketprecededthereboundintheeconomy,whichbottomedinNovember1982.

However, GDP bottomed in the first quarter of 1982 and, based on thisdata,thereboundintheequitymarketlaggedimprovementintheeconomy.

Thisnear-coincidenceofthebottomsfortheeconomyandtheequitymarketisalso evident at the other great bear market bottoms. In 1921, the economybottomedinJuly,accordingtotheNBERreferencedate,andtheequitymarketin August. In the 1930s, things were not so clear-cut, but the equity marketbottominJuly1932coincidedwiththefirstofwhatwaslaterdescribedasthedoublebottomfortheeconomy.In1949,themarketdidleadtheeconomyasitbottomed inJune,while theNBERreferencedate for theendof theeconomiccontractionisNovember.Calculatinganaverageleadforthemarketfromthesefourincidentsislikelytomislead.Whatisclearisthatthepopularmyththatthe stockmarket leads the economy by six-to-ninemonths is not correct.Whileitmayhavesomevalidityifoneexaminesalleconomicrebounds,itdoesnotholdtrueforthefourgreatbear-marketbottomsofthepastcentury.Attheseextremetimesitseemsthebottomsfortheeconomyandtheequitymarketweremuchclosertogetherandtheeconomymighthaveledthestockmarket.

This tieswellwith our observation from theWall Street Journal that there isoftenamplegoodandimprovingeconomicnewsatthebottomofamarket.Thisallsuggests therisk to investorsat theseextreme timesmaynotbeasgreatasoftenassumed.Aninvestorneednotbuyequitiesbasedonhisforecastthattheeconomywill start to improve in six-to-ninemonths.At thegreatbearmarketbottoms there is likely to be growing evidence the economy is already on themend.

14June:Ininflation-adjusteddollars,businessinventorieswerecutatanannualrateof$17.5billioninthefirstquarter,thesharpestreductionforanyquartersinceWorldWarII.

14June:Indiscussingtheriseinbusinessinventories,RobertDedrick,assistantcommercesecretaryforeconomicaffairs,tookasomewhatupbeattone.‘Whileinventoryliquidationmaynotbeoveritclearlyhasdiminishedinintensity,’hesaid.‘Theabatementoftheinventorycutbacksuggestthatamajordrag’ontheeconomyiseasing.’

14June:Theimprovementinconsumerexpectations,whichgenerallyforeshadowactualeconomiceventsbythreetofourmonths,lendscredibilitytotheprevailingprofessionalviewthatbusinesswillbegin

recoveringfromthepresentrecessioninthemonthsimmediatelyahead.’

14June:SalesofnewcarsinMayrose5.9%fromayearearlier.

14June:Eventheemploymentsituationisprovidingsomereasonforhope.TheunemploymentrateinMayroseto9.5%ofthelaborforce,upfrom9.4%inAprilandthehighestratesinceWorldWarII.Butemploymentroseby777,000jobslastmonthtoaseasonallyadjusted100.1million.That’snotfarfromthe101millionreachedinMay1981.

14June:‘Thegrowthinrealdisposableincomehasbeenunusuallystronginthisrecession,’saysElisabethAllisonoftheconsultingfirmofDataResourcesInc.,‘largelybecauseofadeclineininflationtheautomaticstabilizersofunemploymentcompensationandSocialSecurity’andhighinterestincome-thebrightsideofthehighinterestrates.

14June:Asforfiscalpolicy,the10%taxcutJuly1isgenerallyexpecttogiveanupwardpushtoconsumeroutlays.

15June:Despiteconflictingsignals,‘thesecondquarterstillexpectedtomarktheendoftherecession,’saidDonaldH.StraszheimofWhartonEconometricForecastingAssociates,Philadelphia.

16June:Areautosalesontheroadback?Manyindustryofficialsbelievethatarecovery,ifnotalreadyunderway,isimminent…Includingimports,thelatest10-daysalespaceworkedouttoaseasonallyadjustedannualrateofabout8.3millionunits-toppingMay’s8.2millionrateandsubstantiallyaboveApril’s7.2million…Thefirstpleasantsurpriseforcarmakerswaslastmonth’s15.8%increaseinsalesfromMay1981,largelybecauseofareboundatGM…Theaverageageofcarsontheroadtodayisestimatedat7.5years,upfrom5.7yearsin1972…Infactwithinventoriesattheirlowestlevelssince1964,someanalyststhinkthatanysizablesurgeindemandcouldleavethecompaniesshortofcars.

16June:PaulVolcker,FederalReserveBoardChairman,saidthatrecentstrengtheningofconsumerspendingandslowingofinventoryreductionaresigns‘thattendtoaccompanyalevellingoutofarecessionandthebeginningofarecovery.’…Hedeclinedtopredictwhenrateswillfall,butsaid‘Idon’tseeanyplaceforthoseinterestratestogobutdown.’[BeforeJointEconomicCommitteeofCongress.]

17June:Possiblysignallingalong-awaitedrecovery,housingstartsclimbedasurprising22%inMayandroseabovetheonemillion-unitannuallevelforthefirsttimein10months.

17June:Weeklytake-homepayofmedian-incomefamilywillclimb$6inthesecondphaseofReagan’sindividualtaxratecutbeginningJuly1.

21June:Lastmonth’smoderateriseinpersonalincome,coupledwithrobustincreaseinconsumerspending,providedfreshevidencethataconsumer-ledrecoveryfromtherecessionisbeginningtotakehold.

22June:TheU.S.economyappearstobeexpandinginthecurrentquarterata0.6%annualrateafterinflation,thefirstgrowthsincethe1981thirdquarter,preliminarygovernmentfiguresshow.DavidStockman,WhiteHousebudgetofficedirector,toldreportersthat‘Wearepastthetroughoftherecession.’…Meantime,WhiteHousespokesmanLarrySpeakessaidthepreliminaryGNPfigureindicatesthat‘therecessionhasbottomedout.’…TreasurySecretaryDonaldRegantoldagatheringofaccountantsthat‘wecanbegintoseethevistasofrecovery’asaresultofthepreliminarycurrent-quarterGNPfigure.

23June:‘Recenteconomicdatacontinuetosupportthecaseformoderateeconomicrecovery.’SaidErichHeineman,vicepresidentofMorganStanley&Co.

23June:Thefirstsignsofrecoveryareclearlystirringintheland.Autosalesandhousingstartshavepickedupabit,ashaveretailsales.ConsumerdemandcanbeexpectedtoperkupfurthernextmonthonthestartofhigherSocialSecuritybenefitsandlowerpersonaltaxwithholdings(thefirstsignificantyieldfromlastyear’staxbill).

Businesscorporations,withanaemicbalancesheetstobeginwith,arewonderinghowtherecoverycanbefinancedwithoutarelaxationbytheFedand,quitepossibly,anewoutbreakofinflation.Thesedoubts,plustheriseinbusinessloandemandalreadyoccurring,giveussomecluetowhyinterestratesgotstuckontheirdownwardpath.

1July:Thetaxcutwillenrichconsumersby$32billionatanannualrate.Andthe7.4%cost-of-livingincreaseinSocialsecuritypaymentsistopumpanadditional$11billionintotheeconomyatanannualrate.

1July:TheCommerceDepartment’scompositeindexofleading

indicatorsrose0.3%inMay,thethirdconsecutivemonthlyincrease…BeforetheMarchrise,theindexhadfallenorremainedunchangedfor10months.

1July:AlanGreenspan,PresidentofaNewYorkforecastingfirmandacloseadvisertoPresidentReagan,contendsthat‘inamatterofweeks.’Thenationwillseethesignsofrecovery.

6July:Believersinastrongeconomicupturnaregettingsupportfromanuncommonsource:RobertWilsontheprominentNewYorkinvestorwhoheadsamoney-managementfirmbearinghisname.Overtheyears,Mr.Wilsonhasbeenbestknownforborrowingsharesofwhatheregardsasoverpricedstocks,andthensellingthemshort.Butcurrently,Mr.Wilsonisn’tshortallthatmanystocks.He’sintriguedbythenotionofaneconomicrecoveryamidhighinterestrates‘justbecauseeveryonesaysitcan’thappen.’

12July:Startingroughlynow,theconsensusseesasustainedeconomicrecovery,albeitweakerthannormal.It’saforecastbuttressedbymanykeybarometerstobusinessahead,frombuildingpermitstothemoneysupply.

12July:Invariably,themarkethasbeguntoriseatorjustbeforearecessionarytroughinthebusinesscycle,andthenkeptonclimbingbrisklywellintoanensuingrecoveryperiod.Themarketmayhavepredictedsomerecessionsthatdidn’tcome…butithasn’tsignalledanyrecoveriesthatdidn’tarrive…Ifanewrecoveryhasindeedbegun,itwillbehefirstoneinwhichattheoutsetthestockmarkethasfallenratherthanclimbedbriskly.

14July:U.S.retailsalesfell1.5%inJunebutmanyeconomistspredictedconsumerssoonwouldstepuptheirbuying,spurringamodestrecoveryfromtherecession.Salesin2Qwere3.1%higherthanintheprecedingperiod.

29July:PresidentReaganassertedthataneconomicrecoveryisbeginning,butheconcededthat‘it’sgoingtobeslow.’

2August:2Qpricedeflator5%halfthe1981levelof9.4%.

5August:AneconomistattheU.S.ChamberofCommercenotedinarecentreport:‘Theimprovedqualityofcorporateprofitshascontributed

toastrongperformanceincorporatecashflow-measuredasthesumofearningsplusdepreciationcharges.Onaseasonallyadjustedannualbasis,corporatecashflowduringthefirstquarterwashigherthanthatfor(all)1981.’

6August:PerhapsthenearestthingtoaconsensusforecastcanbefoundinBlueChipEconomicIndicators,amonthlysurveyofmorethan40prominentforecastersbyRobertJ.EggertofSedona,Ariz.OntheaveragetheBlueChipgrouppredictsgrowthof3.3%ininflation-adjustedgrossnationalproductintheyearahead.Allthosepolledanticipatedatleastsomegrowth,buttheestimatesrangefromaslowas1.3%tomorethan6%.Thelatestaverageof3.3%forinstance,isdownfrom3.6%intheJunesurvey.

12August:Salesatthenation’sretailstoresrose1%inJuly,providingfurtherevidencethattheU.S.economywillemergeslowlyfromtherecession.

18August:Mr.Regan[SecretaryoftheTreasury],theformerchairmanofMerrillLynch&Co.,welcomedMr.Kaufman’sprojectionoffallinginterestratesbutdisputedtheanalyst’sreasoning-thatrateswillfallbecausetheeconomywillremainweak.‘He’sgottherightanswersforthewrongreasons,’Mr.Regansaid.‘Whathe’smissingareemergingsignsofahealthyeconomy.’

23August:The3.2%increaseinfactoryordersfordurablegoodsinJuly,thefirstrisesinceMarch,maypresageimprovedindustrialproductionincomingmonths.

22September:TheU.S.economyappearstobegrowingata1.5%annualrateafterinflationinthecurrentquarter…Therevisedreportshowsthatinthesecondquartertheeconomyexpandedataseasonallyadjusted2.1%annualrate.

27September:Soitmightcomeasasurprisethatbusinessstart-upsareatanear-recordhigh.Areductionofthecapitalgainstaxlastyeartoamaximumof20%vs.themaximum49%in1978hasencouragedmoreinvestmentinsmallcompanies.

1October:AlanGreenspan,aNewYorkeconomistwhoadvisesPresidentReagan,expectsthe‘real’grossnationalproduct,oftotalvalue

ofallgoodsandservicesadjustedforinflation,togrowatananaemic2.3%annualrateinthefourthquarterandaboutthesamepaceinthe1983firsthalf.

5October:TheconfidenceofbusinessleadersintheU.S.economyhasimprovedforthethirdconsecutivequarter,theConferenceBoarddisclosed.

The government’s preliminary economic figures suggested the economicrecoverywasalreadyunderwayinthesecondquarterof1982.RealGDPinthesecondquarter did indeedpost a quarter-on-quarter growth rate commensuratewith an annual rateof expansionof2.2%.Theconsensus expectationof3.3%economicgrowthinthefollowing12monthswasaccurate,astheeconomygrewby3.2%.Thebottomofthe1982bearmarketoccurredagainstabackgroundofan improvingeconomyandahighdegreeofoptimismregarding theeconomicfuture.

Onceagain,asin1921,1932and1949,thebottomofabearmarketisnotmarkedbytheabsenceofgoodnews,butratherbyanincreasingsupplyofgoodnewsignoredbythemarket.Analysisofallfourbearmarketssuggeststheautosectorprovidesanimportantleadindicatorforinvestors.In1982,arecoveryintheautosectorwasevidentwellbeforetheeconomyingeneralandthestockmarketbottomed.Themonthlylow-pointfornewcarregistrationswasJanuary1982,whenregistrationsdeclined20%year-on-year.

ByJune1982,newcarregistrationsweredownonly4%fromthepreviousyearandthisimprovementwaswidelydiscussedamonginvestors.Thepatterninourfour periods is that there is a pent-up demand for this important consumerdurablewhichistriggeredbydecliningprices.In1921,1932and1949adeclineinthepriceofautosthemselveswasevident.In1982thesituationisnotasclearas the price of autos did not decline. On 1 September 1982, theWall StreetJournalwasreportingthatGMwasraisingthepriceofits1983modelsby1.9%.However,whilethepriceofanewautocontinuedtorise,thecostofbuyingonewasfallingquickly.TheUSprimelendingrate,whichhadbeenabove20%formost of 1981, had already fallen below 16% by the beginning of 1982. Thisdecline in financing rates, combined with muted price rises, meant cars werecheaper to buy in 1982 than theyhadbeen in 1981.Once again, this de factoprice decline triggered an improvement in demand and, as in 1921, 1932 and

1949, augured improved demand in the economy in general and an economicrecovery.Investorswhoseeequitiesreducedtolowvaluationsbyaneconomicrecessionwoulddowelltowatchtheautosectorasaleadingindicatorthattherecessionandthebearmarketarecomingtoanend.

Afeatureofthemajorbearmarketbottomswehavenotedisthattheeconomicrecovery,whichtriggersthecommencementofthenewbullmarket,isgenerallypresagedbynewsof recovery inNewEngland, andon19 July1982 theWallStreetJournalwasreporting:

… some of the perennially depressed states of the Northeasthavebeencoming throughwithflyingcolors…NewEnglandused tobe theprimeexampleofastagnantregion. In the lastfewyears,it’sbeenonthevergeofaboom[derived]fromtheshift to micro-computers, telecommunications and hightechnology in general as the engines of the nation’s growth.NewEnglandbyandlargemadethistransitionadecadebeforetherestofthecountry.

The quote above indicates the degree of transformation of the New Englandeconomyovertheperiod.Despitethistransformation,thefactremainsreportsofimprovements in the economy of New England have preceded, by just a fewweeks,thefourgreatbottomsforequities.

Pricestabilityandthebear

WehaveseenintheprecedingPartshowemergingpricestabilityhasbeenthemostimportantfactorsignallingtheendofthebearmarketinequities.Theendof deflation marked the end of the decline in equity prices for all the threepreviousgreatbottoms.The inflationaryenvironmentwasverydifferent in the1980s,withinflationfallingfromveryhighlevelsintherecession.Indeed,ifwemeasuredeflationasadeclineintheCPIindexthendeflationinthisperiodwasnotevidentuntilNovember1982.Inthefinalquarterof1982,theCPIdeclinedby 0.6% compared to its level in the third quarter. This veryminor and briefdeflationisingreatcontrasttotheeventsof1921,1932and1949.In1921and1932, thegoldstandardplayedamajorrole inenforcingdeflationandin1949thepostwaradjustmentof theeconomywasakeystructural factor.Onecould

seewhydeflationcouldoccurinthoseperiodsandwhyitsabatementwouldbesopositive forequityprices.However thingswereverydifferent in1982.ThelastformalexternalconstraintontheFed’smonetarypolicywaslonggone.Alsothefinancialmarkets,sickenedbyalmosttwodecadesofrisinginflation,wereinamoodtopanic if itappearedtheFedhadlostanotherbattleagainst inflation.What ismost surprisingabout1982, then, is that thegreatbottom for equitieswas once againmarked by the end of deflation. In 1982, themarket was notbuoyedbytheendofthedeclineinthegeneralpriceindex,astheCPIdidnotdecline until the new bull market was already underway. In 1982, the keyturning point for equities was, as it had been in 1921, 1932 and 1949,stabilisationofcommodityprices.

AswediscussedinthepreviousParts,thepricesofkeycommoditiesstabilisedand led amore general stabilisation in commodity prices and then the generalpricelevel.Equitypricesreactedpositivelyin1921,1932and1949tothesefirstsigns of stabilising commodity prices indicating general price stability wouldfollow. Interestingly, despite an entirely different inflationary background, asimilarpattern isevident in1982.Whileanydeflationmeasuredby theCPI inthisperiodwaslimited,itwasmuchmoremarkedifone’sguidetodeflationwascommodity prices. The Commodity Research Bureau (CRB) index ofcommoditypricesdeclinedmorethan30%fromitsNovember1980hightoitsOctober1982low.Figure110shows,from1982,howgeneralcommoditypricesbottomedinOctober,whilethemetalscomponentoftheindexbottomedinJune.

FIGURE110.COMMODITYRESEARCHBUREAUINDEX,INDEXOFSPOTMETALS(JAN-DEC1982)

Source:Datastream

While the October low for general commodities came two months after thebottomforequityprices,thebottomforthemetalscomponentwastwomonthsbefore the bottom for equities. This coincidence is particularly surprising in1982, when one might have expected investors would have been spooked byrising commodity prices. By 1982, investors could expect theVolcker Fed tocome down very hard on any signs of inflation, and a rebound in commodityprices might be seen to augur even higher real interest rates. With so muchpinnedontheFedfinallydefeatinginflation,wouldn’tareboundincommodityprices have warned investors that the Fed had once again failed to conquerinflation?Theremarkablethingisthatdespitethisbackgroundtothereboundincommodityprices,theendofcommoditydeflationonceagainmarkedtheendofthebearmarketinequities.

Inallfourofthegreatbearmarketbottomsanalysedinthisbook,theendofthedeclineincommoditypricesmarkstheendofthegreatbearmarketinequities.

Figure 110 provides data for general commodity prices andmetal prices. Thereason for the inclusion of the metal prices series is that a rebound in metalprices in general, and the copper price in particular, appears to precedemoregeneral price stabilisation. By May 1982, the price of copper had alreadydeclined 16% from its peak in August 1981. From May to June, the price

slumped a further 17%, then quickly rebounded, and by the time the equitymarket bottomed inAugust the price of copper had returned to itsMay level.The rebound in copper from the June lowswas the first sign that commoditypricesmayhavebottomed.TheCRBspot-metalsindexreacheditslowinJune1982and,unlike thegeneralcommodity index, remainedwellabove that levelfortherestoftheyear.Attheothergreatbearmarketbottoms,thecopperpricebottomed in August 1921, June 1949 and July 1932 (though the price wouldagainhitanewlowduringthebankingcrisisofearly1933).

Oneveryoccasion,thereboundincopperpricesprecededorcoincidedwiththe rebound in the equity market. This rule held even in 1982, when, tosomeinvestors,highercopperandcommoditypricesmayhavepresagedtherebound of inflation and tighter monetary policy. So, if stabilisation ofcommodity prices is a good indicator of the end of the bear market inequities,stabilisationofthecopperpricemaybethebestindicatorageneralstabilisationincommoditiesisimminent.

ThestrongreboundincommoditypricespushedtheCRBindex24%higherinthe ten months after October 1982. The bull market in equities continuedthroughout that period. The fact that the stabilisation of commodity prices isbeneficial for equity prices in these very differing inflationary/deflationaryenvironmentsmayindicatecommoditypricescarrymoreimportantinformation.Itmaybe that inperiodswhenequitiesareundervaluedandpricesstill fallingthat stabilising commodity prices provide evidence of imminent economicimprovement.Evenin1982,whentheFedcouldbereliedupontojumponanysignsofinflation,stabilisingcommoditypricesatleastindicatedtherewassomeevidenceofimprovingfinaldemand.WiththebondmarketalreadybuyingintotheprospectthattheFedhadwonthewaroninflation,perhapsthestabilisationofcommoditieswasmoreimportantasasignalofanimminentimprovementinthe economy, rather than a concern about future inflationary pressure. Thiscombinationoffallinginterestratesandanindicationofanimprovingeconomycouldaccountfor themorethan50%rise in theDJIAinless thanayearfromAugust1982.Whateverthereasonforthepositiverelationship,equityinvestorsshouldbelookingforastabilisationincommoditypricesingeneralandcopperpricesinparticulartoconfirmabearmarketinequitieshasended.

Thereisadifficultyinpredictingthefuturecourseofonesetofprices,equities,by predicting the future course of another set of prices, commodities.

Forecastingonemaybenoeasier than theother thus invalidating this formofanalysis. In this regard it is important to stress the confirming role of lowinventorypositions in theprocessofbottomingcommodityprices.IntheWallStreetJournalin1921,1932and1949,thelowlevelofinventorythroughoutthesystemisfeaturedasakeyreasonforbullishnessregardingthefuture.Asimilarsituationwasevidentin1982,withinventoryreductioninthefirstquarterthemostrapidrecordedinrealtermssincetheendofWWII.Forcommodities, any price reversalmay be fleeting, but this is clearly less likelywhen inventory levels arevery low.While investorsdoneed tobelieve in thesustainabilityofthepriceriseincommodities,itisnotnecessarytobuyequitieswhen commodity prices are declining and hope they will improve. Historysuggestsequityinvestorscanwaittoseearisingcopperpricebeforetakingthedecisionastothesustainabilityofthepricerise.Inarecessionaryperiod,whenequities have been reduced to cheap valuations, an equity investor looks forrisingcommoditypricescombinedwithlowinventorypositions.Ifthereisalsoevidence of rising final demand for autos, and not just predictions of higherfuture demand, then history suggests one is very close to the bottom of theequitymarket.

One of the key problems in comparing equity bear-market bottoms over alengthy period is that institutional frameworks change. Is it valid to use oneevent as a guide to the future if there had been a radical change in theinstitutional framework in the intervening period? In particular, can suchcomparisonsbevalid inaperiodwhenthemonetarysystemitselfhaschangeddramatically?

Between 1921 and 1982, the US monetary system underwent radical changewith the final abandonment of any form of fixed exchange rate. One wouldexpectadjustments in internalpricing toplayamore important role inperiodswhentheexchangerateisfixed.Inthisenvironment,internalpriceadjustments,giventherestrictiononexchange-rateadjustments,playacrucialroleindrivingthebusiness cycle.Similarly, onewould expect internal price alterations tobelessimportantinthebusinesscycleastheUSmovedtowardsthefreelyflexiblecurrency. Whatever the truth of this for the economy, price changes stillimparted important information for the equity investor in 1982, despite thechangeinthemonetaryframework.Despitetheremovaloftheexternalanchorformonetarypolicy,thelessonsfrom1921,1932and1949remainvalidinthis

one area where they are most likely to have been undermined by structuralchange.

LiquidityandthebearAsk yourself sometime who benefits from inflation. The people in debt benefit, society’s losers. Thegovernmentbenefitsbecauseitcollectsmoreintaxeswithoutraisingtherates.Whodoesn’tbenefit?Themanwithmoneyinhispocket,themanwhopaidhisbills.

JohnUpdike,RabbitisRich

Wehaveseenthroughoutthisbookthatso-called“Fedwatching”ismoreofanartthanascience.ByfocusingthroughoutonchangesintheFed’sbalancesheetthe aim has been to provide some objective guide as to the ability of Fedwatchers topick thebottomof theequitymarket.Wehavediscovered there ismore to Fed watching than simply analysing balance sheet alterations. Verysimilarlessonsaretobelearntfromeventsin1982.

Bythesummerof1982,investorshadveryclearguidelinesfromtheFedastowhat to expect in terms of its balance sheet adjustments. The Fed had set acourse for the growth for the non-borrowed reserves of the banking system,which itbelievedwasconsistentwith its target for thegrowthof themonetaryaggregates. If themonetaryaggregatesweregrowingtoofast, thiswouldforcethe banks to borrow reserves, thus placing upward pressure on the Fed fundsrate. Such a rise in interest rates was then supposed to dampen demand andreducethegrowthofthemonetaryaggregates.Alterationsinthegrowthofnon-borrowed reserves provided investors the best indication of how the Fed wasrespondingtothelatestmoneysupplydata.Figure111showsthegrowthinnon-borrowedreservesfromtheadoptionofthemonetarygrowthtargetingpolicyin1979.

FIGURE111.NON-BORROWEDRESERVESOFUSDEPOSITORYINSTITUTIONS($M)

Source:Datastream.Note:Seasonallyadjusted.

There is some indication from Figure 111 that the growth of non-borrowedreserves did accelerate in 1982, indicating the Fed was pursuing an easiermonetary policy. The Fed’s first tightening of liquidity in 1980 produced asharply negative economic reaction and, as the chart shows, Fed policy wasrapidly reversed. Following the reversal of the early 1980 squeeze, non-borrowedreservegrowthhadbeenmuted.Theseasonally-adjustedfiguresshownon-borrowedreserveshad increasedby just1.8%in the21months fromJuly1980 to April 1982. There was then a change inMay 1982, with seasonally-adjusted, non-borrowed reserves growing 2.4%month-on-month. This was tomarkanewgrowthtrackfornon-borrowedreserves,whichexpanded10.6%inthenexteightmonths.Whilethechangeingrowthisevidentfromthecompletesetofdata,itisnotalwayssoeasytospotthesetrendchangesatthetime,anditwasnotuntilAugust thatonecouldseeanewtrendemergingfromthefogofstatistics.

While the evidence of a higher growth rate in non-borrowed reserves wasincreasinglyevidentfromMay,aninvestorstillhadtodecidewhetherthiswassimply a response to on-targetmonetary aggregate growth or a newmonetarypolicy.Interpretingtheacceleratedgrowthinnon-borrowedreservesinrelationtomoney-supplygrowthwasnoteasygiventhevolatilityof themoneysupplydata.ThepagesoftheWSJinthesummerof1982showhowthegrowthinnon-

borrowed reserves could be considered meagre in the light of one month’smoneysupplydatabutexcessiveinthelightofthenextmonth’sdata.

BythemiddleofJunetheM-1annualgrowthratewas6.7%well inexcessoftheFed’stargetof3.5%.ItwasthusreasonableforinvestorstoexpectthattheFed would act to slow the growth in non-borrowed reserves with a view toreducingthegrowthinM-1.However,therewasacomplicatingissue.Arecentbankinginnovationhadseenthecreationof“NOW”accounts-interest-bearingchequeaccounts.This innovationencourageddepositors tohavemorefunds intheir current accounts than was previously the case. This alteration could beexpectedtopromotehighergrowthinM-1thanwouldotherwisehaveoccurred,althoughitdidnotnecessarilymeanthatdepositorsweregettingreadytoshopratherthansave.Sothemarketwasconfusedandthisconfusionwasn’thelpedby the fact that, according to aBankof International Settlements (BIS) reportpublishedon16June,theFedhadexceededitsmoneysupplytargetsforthepastthree years. If missing the targets was the norm, then forecasting future Fedaction,inreactiontoM-1data,wasparticularlydifficult.

Thevolatilityof thedata added to theproblem.The suggestionof strongM-1growth changed in the first week of July, theWSJ reporting: ‘Those figuresshowedthebasicmoneysupply,knownasM-1,plunged$3.7billionintheweekendedJune30,bringingtheweeklynumberwellwithintheFed’stargetrange.’So,whilesomemayhaveregardedthisasasignalthatarelaxationofmonetarypolicywouldfollow,thekeymessagewasthatweeklymoney-supplydatacouldbe highly volatile. Further confusion was evident by September, when M-1growth accelerated at an annual rate of 16%. Any investor who saw that asauguringatighteningof liquiditybytheFederalReservewastobecompletelywrong-footed.

What did the acceleration in non-borrowed reserves mean when the Fed hadregularlyfailedtomeetitsmoneysupplygrowthtargetsandwhenthegrowthofNOW accounts distorted the data? In June it looked like the growth in non-borrowedreserveswasbeingpermitteddespitehighmoneysupplygrowth.ByJuly,itseemedtheFedwasaddingliquidityinresponsetothe“steepdecline”inmoneysupply.ThedifficultyininterpretationisevidentfromtheopinionsoftheexpertsquotedbytheWallStreetJournal.

If commentators were generally wrong-footed by their focus on themonetarydata,theconcernaboutthefiscaldeteriorationalsoledtoforecastingerrors.TheWSJreportedon14JunethatFederalReserveBoardChairmanPaulVolckerhadtold Congress action on the budget was a ‘pre-requisite for easier’ creditconditions.Soitwasnotsurprisingthat theinabilityof thepoliticianstomakeground on this issue convinced many that easier money was not around thecorner. Presumably this fiscal impasse was one of the reasons why the BISconfidently predicted at its AGM that world interest rates would rise in thesecondhalfoftheyear.Eventhemostastuteeconomicforecastersbelievedtheoutlookforlowerinterestrateswasveryunlikely:

6July: ‘Ihadexpectedacompromisewouldbestruckonthebudget during the first half, and I was wrong,’ said AlanGreenspan, president of a New York consulting firm and aneconomic adviser to President Reagan. Mr. Greenspan hadpredicted a prime rate of 11¾% by June 30, a three-monthTreasurybillrateof8.8%anda30-yearTreasurybondyieldof12.9%.Bycontrastthree-monthbillsclosedJune30at12.6%,while the Treasury bond closed at 137⁄8%. ‘I can’t beoptimistic about the long-term outlook in view of what ishappeningon thebudget,’Mr.Greenspansaid. ‘It isgoing torequire a rededication of effort by Congress to budgetaryrestraint.’

While the future chairman of the Federal Reserve was aligned with theconsensusthatinterestratescouldnotdecline,Volckerwaspreparedtoproposeadifferentoutlook:

21 July: The Treasury borrowing that will be necessary tofinance record federal budget deficits doesn’t present ‘aninsuperableobstacletolowerinterestratesduringthisperiod,’the Fed chief told the Senate Banking Committee. Whilegovernment pressure on the capital markets will keep ratesfromfallingquickly,Mr.Volckersaidheis‘hopeful’that‘wecouldgetthroughthisperiodwithdeclininginterestrates.’

When the seemingly impossible combination of lower long-term interest ratesand continued fiscal impasse did develop, commentators were adamant a

reversalwasimminent.Asthebondmarketrallied,disbeliefmounted,withtheWSJ reporting‘thebulkof theFed’seasingisprobablybehindus’(2August),‘manyeconomistswarnthatmortgageratesaren’tlikelytodeclinesignificantlythisyear’(3August),‘butmosteconomistsdon’t thinkthatthedrophasmuchfurther to go’ (19 August), ‘most analysts, however, believe that any kind ofrecovery,eventheweakoneinprospect,wouldsetafloorunderratesoverthenext year’ (13September). If therewasone reason such fears about the fiscalimpasseprovedmisplaced,itwasbecauseafinancialcrisiswasdevelopingthatwould create a demand for the safety of government bonds surpassing theincreaseinsupply.

Evidence that the Fed was permitting accelerated growth in non-borrowedreservesasearlyasMay1982wasnot thateasy to interpretasan indicatoroffuturemonetarypolicy.MostcommentatorshadbeenconditionedtoviewalltheFed’s actions in the light of the money supply data. The key change in thesummer of 1982 was that the Fed in effect abandoned that policy. Noannouncement of this policy change was made, but for those schooled ininterpretingthewordsofchairmanVolcker, itwasclearinlateJulysomethinghadchanged.On21JulytheWallStreetJournalreportedVolckersayingatthemidyearreviewofmonetarypolicytotheSenateBankingCommittee:

‘Moreover - and I would emphasize this - growth somewhatabove the targeted ranges would be tolerated for a time incircumstancesinwhichitappearedthatprecautionaryliquiditymotivations, during a period of economic turbulence, wereleadingtoastronger-than-anticipateddemandformoney.’

Couchedinthemostrestrainedlanguagewastheadmissionthatmoneysupplygrowth targeting would be abandoned if there was a period of ‘economicturbulence’. Under questioning, Volcker admitted the recent bankruptcies ofDrysdaleGovernmentSecuritiesandPennSquareBankdidnotconstitutesuch‘economic turbulence’.WhatVolcker knewand thepublic didn’twas that thebankruptcyofMexicowas imminent,andagovernmentbonddealer,LombardWall, was in trouble. The ‘economic turbulence’ that would justify the newpolicy was already evident and the Fed had, in effect, already abandoned itsmoney supply growth targets. The catalyst for the change in policy was thepotentialimpactontheUSbankingsystemoffurtherdebtdefaultsbysovereigncredits.ItwasevidentinJulythatbankbalancesheetswereinworsecondition

than they were prepared to admit and the Mexican situation could onlyexacerbatethesituation.TheWallStreetJournaleditorialisedon30July:

Unlike the thrift institutions, which are losing billions ofdollars a year, most banks are continuing to earn enough todefray heavy loan losses… Curiously, little of the surge inproblemloansshowedupinbankearningsreportsthroughthefirst quarter. In fact a 24-bank index compiled by Keefe,Bruyette & Woods a bank-consulting firm in New York,indicated that troubled loanswere still only half as bad, as apercentage of assets, as they had been five years earlier…Increases in nonperforming loans Continental Illinois’s wereup 54% to $1.3 billion and Chase’s 47% to $1.05 billion…Perhaps the shakiest house of cards is being built upoverseas…About two thirds of Citibank’s loans and 50% ofManufacturer’sHanoverareoverseas…Onesecuritiesanalyst,however, says, ‘Not one dime is classified as bad debt eventhoughthereisnowayPolandcanpayitback.’…Inthepastthe big banks have defended their loans to such countries bysayingthatnationsdon’tgobankrupt.

By 15 September, a clearer picture of the scale of the disarray in theinternationalbankingsystemwasevident,promptingtheWSJtocomment:

Poland, Mexico, Argentina, East Germany, Brazil, Nigeria,Chile, Zaire, Yugoslavia, Bolivia, Nigeria, Venezuela, Peru,Tanzania,Sudan,Indonesia,Romania,andadozenothers.Thelist is an international banker’s nightmare. The first twocountries -PolandandMexico-alreadyhaverunoutofcashand are near default… The other countries are among theimponderablesinbankers’portfolios.

Manybankersandgovernmentofficials fear that ifArgentinaand Brazil default on their loans, a ‘domino effect’ wouldimpelothercountries todolikewise, thuspushingmanylargebanks over the brink and setting off a world-wide financialpanic that ultimately could lead to a global depression ashappenedinthe1930s.Alltoldthedebtburdenofdeveloping

countries had soared from$100billon in1973 to about $540billion at the end of last year. It is expected to reach $640billion this year. Some $327 billion of this is owed tocommercialbanksintheWest…WalterSeipp,thechairmanofCommerzbank,oneofWestGermany’slargestforeignlenders,recalls that until the Polish andMexican troubles, it was anaccepted principle among bankers that ‘it was inconceivablethatasovereigncountrywouldallowitselftogointodefault.’Any largebank that stayedoutof international lending in the1970s‘wouldnothavestayedalargebank,’headds.

Given the increasingly perilous condition of commercial bank balance sheets,the momentous decision to ignore money supply growth targets and providefurther liquidityhadbeen takenby theFederalOpenMarketsCommitteeon1July.Volcker’scommentson21Julywerethefirstsubtleindicationthatanewpolicyhadbeenadopted.

While the Fed was explicitly tolerating money supply growth above itstargets, therewas a hidden agenda to prevent any undue rise in the Fedfunds rate. This discussion on “capping” interest rates at the FOMCmeeting was the background against which the “toleration” of highermoney supply growthwas agreed.Thiswas a subtle shift as the Fedwastargetingbothmoney-supplygrowthand interestrates. Itwas thischangeinpolicywhichwas topermit thecontinuedacceleration innon-borrowedreservesandeasiermonetarypolicydespite the factmoney supply targetswereexceeded.ForthoseabletointerprettheChairman’sruniccomments,thiswasthebestsignaleasiermoneywasontheway.

Hadoneknownthatmoney-supplytargetshadbeenabandoned,alltheliquiditysignalsfromtheFedwerenowflashing“go”forthebuyerofequities.Inthesixmonths from 19 July, the discount rate was reduced 350bp. The change ofemphasis frommoney-supplygrowth targetswas finally formalised inOctober1982,when the Fed issued a statement that the Fed funds ratewould also betargeted.Importantly,atnostagewasthegovernmentbondmarketspookedbythe prospect of easier money. From August to December, the long-termgovernment bond yield fell from around 14% to 10.5%. The rally in equitiesoccurred against a background of declining short-and long-term interest rates.Allofthisfollowedfromthearrivalofthe“economicturbulence”evidenttoall

in early August with the announcement of the economic collapse ofMexico.LiquidityanalystsstruggledtointerpretFedpolicyinthelightoftheoldtargetsandcouldnotforeseethedegreeofmonetaryeasingthatoccurredinthesecondhalf of 1982.Thosewhoprofitedwere thosewhounderstood, fromVolcker’sguardedcomments,thatmonetarytargetshadbeenabandonedand,asaresult,amucheasiermonetarypolicywouldfollow.

Ingeneral,analysingtheFed’sbalancesheetforindicationsofliquiditychangeseemsadangerouswayoftryingtofindthebottomoftheequitybearmarket.Itproved to bewrong in 1921 and 1932, and therewere extreme difficulties ofinterpretationofthedatain1949.Itwasamuchmoreaccurateindicatoroftheendoftheequitybearmarketin1982.However,onthisoccasionthetriggerfortheeasingofliquiditywasgrowingevidenceoffinancialdistressinJuly1982.

In1982, theFedhadafreerein torespondtosuchdistresswithout limitationsimposedbythegoldexchangestandardorBrettonWoods.ItwasnotnecessarytoengageinsophisticatedliquidityanalysisinJuly1982torealisethestatementof theFedchairmanauguredforeasier liquidityat leastfor thedurationof the“economicturbulence”.

The equity market bottomed just as the scale of the lesser-developed-countrydebt crisis became known, and theworse the news on sovereign defaults, thegreatertheriseinthepriceofequitiesandthepriceofUSgovernmentbonds.Ifonecandraw lessons from justonebearmarketepisode, it is that thepriceofequities will respond positively in a situation where the Fed is riding to therescueofanimperilledfinancialsystem.In1982, itdidn’tseemtomatterhowbadthenewswas,solongas investorswerecertainofapositiveFedresponseandsolongasthebondmarketwasnotspooked.

TheFedhadcometo thesupportof thefinancialsysteminonepreviousgreatbearmarketbottom.Bysummer1931,theFedwasmakingconcertedeffortstoeaseliquidityandsupportthefinancialsystem,butthispolicywasabandonedasthe devaluation of sterling put pressure on the dollar. In 1982, such externalconstraintshadlongceasedtobeafactor,andanyFedresponsewasmorelikelyto be greeted with the enthusiasm evident that year, rather than the capitalexodusthatemergedin1931.Whethertherecord-highforeignownershiplevelsofUSgovernmentbondstodaywouldactasaninformalconstraintonmonetarypolicyis,ofcourse,thesubjectofmuchdebate.

Throughout this book we have assessed the usefulness of changes in broadmoneyinfindingthebottomofbearmarkets.In1921,1932and1949itdidnotproveanaccuratesignal,andthesamewastruein1982.Whereasareboundinmonetary growth had lagged bear-market bottoms in 1982, it significantly ledthe improvement in the equitymarket. From aroundApril 1981 a rebound inbroad-moneygrowth,innominalandrealterms,becameincreasinglyapparent.However,thatreboundcoincidedwithaviciousbearmarketthatsawtheDJIAdecline almost 24% in the next 16months.By 1982, broad-money growth, innominalandreal terms,hadreachedaplateaufollowingthe1981acceleration.There was nothing in the data in 1982 or 1983 amounting to acceleration inbroad-money growth. A focus on credit growth would have provided verysimilarsignals.Inbothnominalandrealterms,areboundincreditgrowthbeganin the final quarter of 1980 - long before the stock market bottomed. Thosefindingbuysignalsforequitiesfromcreditgrowthwouldhavebeenbadlystunginthe1980-82bearmarket.

WehavefocusedprimarilyonchangesontheFedbalancesheetasindicatingaperiodofeasingliquidity.ThisindicatorprovidestheacidtestofwhentheFedisseekingtoexpandwhatusedtobeknownasthe“elasticcurrency”.Onecanalsolookat thekeyFed-controlledinterestrate, thediscountrate,asprovidingsome indication of its future stance. In all but one of the four periods underexamination,thediscount-ratetrendprovedsuccessful.TheFed’sfirstcutinthediscountrate,inMay1921,wasfollowedbytheendoftheequitybearmarketinAugust1921,andaninterveninglosstoinvestorsof20%.In1949,thechangeincredit controls inMarchwas the first signal the Fed believed it had probablysqueezed inflation hard enough. The equity market bottomed in July and, inMarch-July,investorshadlostabout10%oftheirmoney.

ItwasOctober1981when theFed implemented the first reduction in thediscountrate.Althoughtheequitymarketwasnot tobottomuntilAugust1982,onceagain thecapital loss in theensuingperiodwas less than10%.Taking the first reduction in Fed interest rates as an indicator of future,easier liquidity has been quite successful, with minimal capital lossescompared with the scale of the capital gains that have followed rapidlythereafter.

The main problem is that an investor following this policy would have beenplunging into the market on the first reduction in the Fed discount rate on 1

November1929andwouldhaveincurreddreadfullosses.

Itmightbepossibletosetasidethe1929exampleandsimplysayreductionsofFed interest rates in Fed-induced recessions are a good time to buy cheapequities. Recessions were clearly the result of Fed policy in 1921, 1949 and1982. The first sign the Fed thought the economy had had enough anti-inflationarypressurewasagoodtimetobuy.Onallthreeoccasions,theFedhadraisedratestocombatinflationandreducedrateswhenitbelievedthewarwascomingtoanend.Thiswasnotthecasein1929.Inflationhadbeeninabeyancein the 1920s and the malaise that swept the US from late 1929 was almostcertainly not the result of a Fed-induced recession, but rather the inevitableconsequencesofaglobalfinancialsystemthathadbeenunbalancedbyGermanreparations, Allied debt repayments and the inept reconstruction of the goldstandard.Ifthe1929-32bearmarketistheexception,ratherthantherule,theninvesting in equities following the first discount rate cut is a sound policy.Perhaps the rule-of-thumb should be that an investor should await a furtherdecline of 10% in the stockmarket before contemplating investment. Historysuggeststhedownsidewouldthenbeminimalandtheupsideverysignificant.

A further caveat is necessary regarding this policy of investing in equitiesfollowing the first reduction in the discount rate. As we have seen the initialimplementation of the Fed’s monetary targeting regime produced a dramaticreversalofpolicyinthemiddleof1980.InvestorstakingtheplungeintoequitiesfollowingareductioninthediscountrateinMay1980sawariseinthediscountratebeforeitdeclinedagainandhadtowaituntilAugust1982beforetheequitymarket bottomed. On this occasion, the capital loss was again less than 10%beforethemarketbottomedinAugust1982,butitwasalmostdoublethisinrealterms.Thiszig-zagofofficialrateswasadirectconsequenceofmoney-supplygrowth targeting. This reversal in the discount rate, necessitated by thatparticularmonetarypolicy,mightprovetobeaneventconfinedtoperiodswhensuch targeting is underway.With November 1929 andMay 1980 in mind,investorsshouldtreadwarily,butbepreparedtobuycheapequitieswhenareductioninthediscountratesignalsthebeginningoftheendforaFedwaroninflation.

Thebullsandthebears

HelovesNature, thoughhecannamealmostnothinginit.Arethesepines,orspruces,or firs?Helovesmoney,thoughhedoesn’tunderstandhowitflowstohim,orhowitleaksaway.

JohnUpdike,RabbitisRich

Itisamyththatbullsareextinctatthebottomofabearmarket.Thebullswerecertainlynotextinct in1982.TheWallStreetJournalcarriesnumerouscommentsbypunditswhosawnotjusttheendofabearmarket,butthestartofamajorbullmarket.

14June:DanielS.AhernWellingtonManagement/TDP&Lsayssignsofimprovedconsumeratmosphereincludeanupturninautosaleslastmonth,andgainsingeneralretailsalesinAprilandMay,thebestinseveralmonths.Henotesthe‘sizable’stimulusthatwillbeprovidedbythe10%income-taxratecutnextmonthandbytheinflationadjustmentonSocialSecuritypayments.

15June:EricT.MillerofDonaldson,Lufkin&Jenrettesaid,‘Wecontinuetothinkthatmoststockshaveseentheirlowsandthat…themarkethasabsorbedpooreconomicnewsquitewell.’

18June:Theultimate‘goldbug’hasturnedfromthemetal.After20yearsofadvocatingbullioninvestments,JamesDineshassenttelegramstosubscribersofhisadvisoryservicetellingthemtoselltheirgoldholdings…Withthesewords,somemarketfollowerssay,cametheendofthe‘goldbug’era.

23June:‘Bearmarketsendineitherasellingclimax(asharpdropaccompaniedbyavolumesurge)orflatperiodwhenpricesdolittleornothing,andweappeartobeinsuchadeadperiod,’contendedAlanC.Poole,vicepresidentofLaidlawAdams&PeckInc.

28June:‘We’remorebullishonequitiesthanwehavebeeninalongtimebecausewethinkwe’rewalkingalongamarketbottom,’assertsJamesR.McCall,seniorvicePresidentofKeystoneCustodianFundInc.,Boston.

2July:The$1.6billionDreyfusFundhasbeentrimmingitsutility-stockholdingsthatdidsowellforitin1981.Andagrowingpartofitscashreservesaregoingbackintothestockmarket.‘Icanseea50%gaininthesestocksalotmoreeasilytheninmost,’saysHowardStein,president

ofthefund.

14July:TheeminentbrokeragefirmsofMerrillLynch,Pierce,Fenner&Smith;GoldmanSachs;BearStearnsandE.F.Huttoneachcanproduceratherlengthylistsofstocksdeemedworthyofpurchase.Theyhavesomethingelseincommon,however.Theirtopstrategistsallthinkinvestorswouldbebetteroffinbonds.

27July:‘Itwasanormalcorrectionasthemarketpulledbackanddigestedtherecentdeclinesininterestrates,’assertedvicepresidentRalphAcamporaofKidderPeabody,encouragedthat‘volumetendedtodryup’whenpriceswerefalling.Andheaddedthat‘anytimeapickupinthemarkethasoccurredrecentlythere’sbeenaground-swellintheconsumerstocks.’

28July:‘Thehistoricalimplicationsofthedropsininterestrateswe’veseensincelastyearcombinedwiththeassumptionthatcorporateprofitswon’tdeclinefurtherwouldindicatethestockmarkethasreachedabottom.’JohnS.BrushofColumbineCapitalServices,ColoradoSprings,Colo.Headded:‘Itseemscrystalclearthatinflationisgoingtobecoolingforthenextfewyears.’

30July:LeonG.Cooperman,investmentpolicycommitteechairmanatGoldmanSachs&Co.,assertedthat‘entryintoaclassicalbullmarketmustbevalidatedbyafurtherandsustaineddeclineininterestrates.’Headded:‘Lowerinterestratesaretheessentialmarkettonicandnecessaryforonetogainconfidencethataneconomicrecoveryofsubstancecanproceedandprice-earnings(multiples)expansioncandevelop.’

2August:‘I’musuallysuspiciousoftheconsensusview,butIhavetoagreewiththecurrentconsensusthatstockscan’tgoanywhereuntilinterestratescomedown,’RobertKirby,chairmanCapitalGuardianTrustCo.,LosAngeles.Mr.Kirbysayshedoubtsthatthemarkethaseversoldlowerrelativetobookvalueoverthepast50yearsto60yearsthanitdideachtimetheindustrialaveragefellbelow800thisyear.

6August:‘Thespiritofthebearisstillwithus-fearoffinancialcollapses,bothbankingandcorporate,highinterestrates,rekindledinflation,politicaldisarray,poorsecond-quarterearningsandMiddleEasthostilitiesareallkeepinggrizzly’simageinthefore.’SaidAlanR.ShawseniorvicepresidentatSmithBarney,HarrisUpham&Co.

12August:DJIAbottoms

13August:LacyH.huntthechiefeconomistofPhiladelphia’sFidelitybanksays:‘Theconfidenceproblemnowhasmoretodowithfiscalpolicythanmonetarypolicy.Unlessthepoliticalprocesscandealwiththeentitlementsprograms,includingSocialSecurity,we’llhavebiggerandbiggerdeficitsin1984,1985andbeyond.’

13August:Thatthestockmarketrecentlyhas‘demonstratednoabilitytomountasustainedrallyongoodnewsprobablyindicatesthatasellingclimaxwillberequiredtoendthebearmarket.’SaidRichardE.Minshall,presidentofCapitalAdvisorsInc.ofTulsa.

18August:‘Interestratesaregoingtoplummet,therealcostofmoneyabovetheinflationratewon’tlast,andthisisgoingtostimulateoneofthegreatboomsinthehistoryofthiscountry,’SethGlickenhaus,chiefofmoney-managementfirmofGlickenhaus&Co.‘TheDowisgoingsomuchhigher,itisfoolhardytopredict,butIcanseeitsurpassing1200eventually.’

18August:Anearly-morningsignalyesterdayfromGoldmanSachswhich,likeSolomonBrothers,dealprimarilywithinstitutionswasalsogivenpartofthecreditfortheadvanceofthestockprices.Goldmantolditsclientstoincreasetheirequityholdingsto55%ofportfoliosfrom35%andtoreduceholdingsinbondsandcashreserves.

18August:Yesterday’sheavytradingwaswidelylinkedtothesurprisepronouncementsofasingleanalyst.SalomonBrotherscreditanalystHenryKaufman,reversinghislongstandingpessimismonfinancialmarkets,toldthefirm’sclientsheexpectssubstantialdropsininterestrateswithinthenext12months.Mr.Kaufmansaidtherateonlong-termTreasurybondscouldfalltoaslowas9%fromthecurrentlevelofabout12.5%,andhepredictedadeclineofasmuchasthreepercentagepointsinshort-termrates.

18August:‘Thisisn’tgoingtostophere,’predictedJonathanF.Gutman,abrokerwithFerris&Co.ofWashington.‘Weweredueforabounce,but38pointsisn’tabounce.Somearesayingthisisthestartofthe1980’sboom.’

18August:AlfredEGoldmanA.G.Edwards&Sons.‘Onoftheclassic

ingredientsofarealbottom(inthemarket)iswhenyou’vehadacapitulation(heavyselling)bytheinstitutions,ahighlevelofdisgustandlackofconfidence…Butthey’vebeencomplacent,confident.It’sunusualtogetabullmarketwithsolittlepain.’

19August:HeavyinstitutionalbuyingpushedtradingvolumeontheNYSEtoaone-dayrecordwhilethesmallinvestormainlyremainedonthesidelines.Otherbrokerssaidthesmallinvestorseemsscepticalthatthebearmarketandrecessionareover.

23August:TechnicalanalystsatMerrillLynchbelievelastweek’spricesurgewasafalsestart.RichardMcCabe,marketanalyst,saidthatinstitutionsdidn’treachastateofdesperatesellingpriortotherally,astheyhavepriortootherlong-lastingbullmoves.

24August:LastTuesday,whentheNYSEsawalmost93millionshareschangehands,therewere95,000trades,comparedwith130,000onacomparabledayin1981,whensmallinvestorsplayedalargerrole.

25August:Bluechipstumbledsharplyyesterday,butthebroadermarketcontinuedtomoveaheadinlargevolumeofnearly122millionshares,thesecondhighestonrecord…‘Thepullbackswereshallow,barelyallowingtimetogetaboard,whilethebroadmarket,remainedontheplusside,whichisactiontypicalofabullmarket,’assertedHildegardLagorskisecondvicepresidentofBacheHalseyStuartShieldsInc.

2September:‘Withinstitutionalcashreservesstilllargedespitethefrenziedactivityofrecentweeks,andwithgoodvaluestillpresentinequities,’hesaid,‘Itislikelythatfurtherretrenchmentinstockpricesmaybeshort-lived.’JacquesS.TheriotHarris,Upham&Co.

3September:‘Untiltherearemoredefinitivesignsthatcash(reserves)hasbeenexpended,itisunlikelythatasustainedsetbackwilloccur,’assertedDonaldKimsey,vicepresidentandseniormarketanalystatDeanWitterInc.‘Inthepast,oncepsychologyshiftedfrombearishtobullish,themarkethasnotshownapenchantforallowingplayerseasyentry.’

10September:JamesH.FarrellJr.ofCashmanFarrell&Associates,Philadelphia,assertedthataccordingto‘conventionalwisdom’everymajormarketupswingisfollowedbyasubstantialpullback.Howeverhe

believesthatpeoplewaitingforsuchamajorpullbacksoon‘willbedisappointedbecauseitwillbemild.’Thereasons,hesaid,arethat‘there’sstilllotsofcashwaitingtogetintothemarketandpensionfundmanagerswouldbeembarrassedtoshowlargecashreservesintheirreportsattheendofthecurrentquarter.’Also,there’slotsofnervousmoneyworld-wideseekingasafehavenintheU.S.stockmarket,’hecontended.

17September:LeeH.Idleman,investmentpolicycommitteememberatDeanWitterReynoldsInc.,assertedthat‘ifthestockmarketactionofthepastfewweeksis,aswebelieve,thestartofthenewbullcycle,theneventhefireworksofAugustareonlyasmallpartofwhatistocome.’Headdedthatinitialphasestypicallyshowgainsof30%and‘morelikely50%’.

21September:‘Themarketwasdigestingsomeofitsrecentgains,’assertedPeterJ.DaPuzzo,executivevicepresidentatShearson/AmericanExpress,Inc.‘Thefactthatvolumetendedtodryupasthemarketwasretreatingwaspositive.Individualinvestorswerenibblingatsomeofthesecondaryissues.’

23September:MichaelT.Murray,vicepresidentatLoomisSaylesInc.,Chicago,assertedthatchangesgivetheappearanceofahighlyvolatilemarket,theoverallmomentumestablishedinrecentweekssuggeststhatthemarkethasmuchfarthertogoontheupside.Headdedthat‘thecriticalfactinthisprocessisdisinflation,whichultimatelyrewardstheequityinvestors.’

23September:Notingthe25%jumpintheBigBoardshortinterestinthemonthtoSept.15,NewtonDZinderofE.F.Hutton&Co.assertedthat‘verylargeincreasesinthemonthlyshortinterestoftenoccurintheearlystagesofmajorbullphases.’Hecitedbigshort-interestpercentagegainsinFeb1975,June1970andJune1962.

29September:‘Webelieveweareintheearlystagesofabullmarket’andthebulkofit‘stillliesahead,’assertedLeonG.Cooperman,investpolicycommitteechairmanatGoldman,Sachs&Co.Hesaidtheaveragepostwarbullmarket‘haslasted30monthsandyieldedanaveragetrough-to-peakadvanceof66%’.

Therewereplentyofbullsaroundatthebottomofthemarketin1982andtherewere some who foresaw the forthcoming turnaround, quite correctly, as thebeginningofthegreatbullmarketofthe1980s.

The 1982 bearmarket bottom is againmarked by the absence of a finalslump in stock prices on high volumes.The great final slump in prices onrisingvolumewasasabsentin1982asitwasin1921,1932and1949.Thebeliefinthenecessityofsuchanepisodediscouragedsomeinvestorsin1982.Indeedonecommentator,AlfredEGoldman,ofA.G.Edwards&Sons,statedthat theabsenceofsuchhighvolumesellinginthemarket’sfinaldeclineindicatedthatthe bear market was not over. [79] Ten days after the rally began, RichardMcCabe ofMerrill Lynch doubted the sustainability of themarket rise in theabsence of the capitulation event. This is not to say this event does notsometimes occur, but it did not occur at any of our four great bottoms,whenequities were at their cheapest. There were numerous turning points in thetradingmarketfrom1968to1982andperhaps,inthistradingenvironment,thefinalhigh-volumesell-offwasmoreofafeature.

FIGURE112.NOCAPITULATION:THEDJIAANDNYSEVOLUMES(TWOWEEKMOVINGAVERAGE)

Source:DowJones&Co.,NYSE

Ifonehadtocharacterisetheendofabearmarketwhenequitiesarecheap,thenitwouldbejustlike1982,withamarkettradingsidewaysordriftingdownwards and then slumping lower on low volume. In the period ofsidewaysmovement,themarkethasamuchmoresubduedreactiontobothgood and bad news than one might have expected. It might recover onlimited volume or, as in 1982, large volume, but at the new, higher levelvolumeswill start to increase. It is thehighervolumeathigher levels thatconfirmsthebearmarketisover.

Somefeaturescommonto1921,1932and1949didnotrecurin1982.Onekeydifference is that volumes had been picking up in themarket formany yearsprior to the1982bottom.Atother turningpointsfor theequitymarketgeneralinterest,asmeasuredbyturnoverrates,hadnotseensuchrisesinpreviousyears.There seems to be little that one can learn in relation tomarket bottoms fromabsolutelevelsoftheturnoverratio.Theannualturnoverratein1982was42%,compared with 13% in 1949, 32% in 1932 and 59% in 1921. Another keydifference in1982 is that the initial rebound inequitypricesoccurredonveryhighvolumes,whereasinotherepisodesthereboundcameonlowvolumes.

Numeroustechnicalindicatorshaveprovedusefulinspottingtheendofthe1968-82 bearmarket. Common to all the great bearmarket bottoms hasbeentheproclivityofthemarkettodeclineonlowvolumeandriseonhighvolume. This was taken correctly to indicate liquidation pressures wereabating.

Aclearconsensusinthesummerof1982wasthatequitypricescouldnotclimbunlessinterestratesfell.

There was a preponderance of opinion that the continued fiscaldeteriorationwouldpreventsuchdeclinesininterestrates.Onceagain,thisfocus on the economic negatives that would flow from the fiscal malaiseprovedmisplaced.

Interestratesdeclinedquicklyin1982andcontinuedtodosothroughthe1980s,despiteever-growingfiscaldeficits.The trigger for thedecline in interest rateswasnottocomedirectlyfromthedomesticeconomy,butfromoverseas.

Itwas the signsof financialdistress in theglobal financial system thatprovedthe catalyst for the reduction in short-term interest ratesdespite theworseningfiscaldeficit.Theextentofthedeclineinsuchrateswassurprising,buttherealsurprisewas the collapse in long-term interest rates. Itwas not surprising thatequity prices rallied dramatically in this environment, butwho could possiblyhaveforeseen thecollapse in long-termrates thatwouldwarrantsucha rise invaluations? In 1982, the answer to that question was Henry Kaufman.Kaufman’s changeof forecast for long-term interest rates occurredon the daythemajorrallyonWallStreetbegan.Thesignificantrallyonlargevolumethatfollowedwas,atthetime,largelyattributedtohiscomments.

Kaufman, dubbed “Dr Doom”, had a solid reputation as an interest-rateforecaster due to his calculations on supply and demand for credit. In hisautobiography, he describes why, on his 17 August return from a Europeanvacation,hestoppedbeingabearandpublishedabullishforecast:

So after catching up on some urgent business at Salomon, Icalledtogethermyassociatestoreviewthedataonthecurrentinterest rate situation. After doing so, I concluded that asignificant interest ratedecline layahead.Whathadchanged?Tobeginwith, theeconomywasstalling,whichwas likely tomoderate inflation. Second, financial blockages and intenseinternational competition were straitjacketing the economy.Businesses were coming under intense pressure to refurbishtheirbalancesheets.Atthesametime,financialinstitutionsnolonger were enjoying conditions favourable to aggressivelending and investing. Another factor that was restrictinglending - domestically and internationally - was the hugeburdenofinternationaldebt.[80]

Although the interest-rate forecast was predicated on bearish economicconditions,Kaufman’schangeofopinionspurredthebiggestone-dayrallyintheDJIA ever recorded.His forecasts proved correct, and the big surprise for theconsensuswasthatsuchmajordeclinesinlong-terminterestrateswerepossibledespite continuing fiscal malaise. In June 1982, the Senate budget resolutioncalledforadeficitof$103.9billionforfiscal1983(theactualreporteddeficitin1983turnedouttobe$208billion).Therallyininterestratescontinued,despite

thismarkedfiscaldeterioration.Thefiscaldeficitin1982reached3.9%ofGDP,thehighestsincetheendofWWII.Thedeteriorationcontinued,withthedeficitpeakingat5.9%ofGDPin1985,surpassingthepeace-timepeaksrackedupbyRooseveltinthe1930s.Thatinterestratesdeclined,andtheeconomyrecoveredagainstthisbackground,wasthebiggestsurpriseforinvestorsinthesummerof1982. Some of the brightest commentators had difficulty foreseeing such anoutcome:

AlanGreenspan,presidentofaNewYorkforecastingfirmandacloseadvisertoPresidentReagan,contendsthat‘inamatterofweeks’ thenationwill see thesignsof recovery…Hesaidinterest rates will remain high until financial markets areconvinced that Congress is committed to lowering federaldeficitspendinginfutureyears.[81]

Asimilar fearof fiscaldeteriorationhadstalked themarkets in thesummerof1932. The gross fiscal deterioration that ensued did not prevent the strongesteconomic growth in US history and a bull market in equities. There is clearevidence from both periods that a continued fiscal deterioration will notnecessarilypreventarallyinbondsandequities,andaneconomicrecovery.

TheDowTheory,asinterpretedbyHamilton,RheaandSchaefer,hadprovidedexcellent timing signals for those seeking the bottom of the equity market in1921, 1932 and 1949. Unfortunately, the Dow Theory is not entirelymechanistic, and different Dow theorists often arrive at different answersregarding the direction of the market. By 1982 there were numerous DowTheorists, not all necessarily saying the same things. On at least someinterpretationsof theDowTheory,a“buy”signal forequitieswasseen inOctober1982.By this stage, theDJIAhadrisenalmost30%, justa smallportionofthetotalreturntoemergeoverthecourseofthe1982-2000bullmarket.Although the evidence is less clear-cut for 1982, theDowTheoryagainappearstohaveassistedtheinvestors’abilitytodeterminethebottomofthisgreatbear-marketbottom.

Atpreviousequitybottoms,akeysignofthesustainabilityofanyrallywastheinitialrefusalofshortstocover.In1982,notonlydidshortsnotcoverintheexplosivehigh-volumerallyofAugust,buttheyactuallyincreasedpositions.Apeakof103.6millionsharessoldshortwasreachedon14May,decliningto

just96.4millionbythemiddleofAugust.However,whenthemarketralliedinAugust,asharpincreaseinshortingoccurredandshortpositionsreachedanewrecordof120.5millionon15September.Therefusaloftheshortstocapitulateon the initial rallyproved the rally in thestockmarkethadcharacteristicsofapricemovementlikelytobemorepermanentinduration.

The pages of theWall Street Journal in the summer of 1982 indicate equityinvestorswerefocusedontheoutlookforinterestrates.Therewaslesscommenton the outlook for corporate earnings in 1982 than at any of the other bearmarketbottoms.ThismayhavebeendrivenbytheFed’snewoperationaltargetwhich,in1982,seemedcertaintokeepinterestratesveryhighandpreventanyearningsrecovery.Inthisenvironment,itseemedverylikelycorporateearningscouldnot recover until interest rates declined.This focuson interest rates andnotearningswasjustified.TheequitymarketbottomedinAugust1982whenthereal rally in the bond market began and short-and long-term interest ratesdeclined.

Those investorswhowaited for evidence of an improvement in corporateearnings would have kept their powder dry until the second quarter of1983.Ateachofthefourgreatmarketbottoms,thenadirforearningshascome some months after the bottom for equities. The range of lag inearningshadbeenfour-to-sevenmonths,theaveragelagalmostsixmonths.

BondsandthebearThelittlestonehouse,onceagardener’scottage, inPennParkcost$78,000.Janicewantedtoputdown$25,000,butHarrypointedouttoherthatininflationarytimesdebtisagoodthingtohave,thatmortgageinterestistax-deductible,andthatsixmonth$10,000-minimummoneymarketcertificatesarepayingcloseto12%thesedays.

JohnUpdike,RabbitisRich

FIGURE113.USGOVTBONDYIELD(LONG-TERM),YIELDONMOODY’SBAA

Source:FederalReserve

Thebearmarket inbonds, in its fifthdecade,ended inOctober1981.Theyieldonlong-termUSTreasurieshadrisenfrom2.03%inApril1946to15.1%in the first week of October 1981. The government bond market had beenunimpressedbydeclines in inflation.TheannualratepeakedinMarch1980at14.6%, and by September had declined to 11.0%. The bond market had alsobeenunimpressedby thedecline incommodityprices.TheCRBfutures indexpeaked in November 1980 and declined 20% by September 1981. There wasample evidence inflation was coming under control, but the key factorsunsettlingthebondmarketweretheveryhighlevelofshort-terminterestratesand the fiscal implications of a supply-side orientated White House and aDemocrat-controlledCongress.

SinceOctober1979,theFedhadtargetedmoney-supplygrowth,whichallowedshort-term interest rates to adjust to whatever level necessary to achieve themonetarytargets.Nobodyknewthelevelofshort-terminterestratesthatwouldresult. The Fed funds ratewas hitting 20% in the early summer of 1981 as aresultofthispolicy.BySeptember,theratewasnearer15%,butthevolatilityoftherateunderthemonetary-targetingregimemadeitdifficulttoforecastthatthiswas the beginning of any sustained decline in interest rates. The change ininvestor perceptions began in the final quarter of 1981.From earlyOctober1981 to the end of July 1982, the yield on the US long-term governmentbonddeclinedsome200basispointsto13.1%.

Onekeydriverof thedecline in long-terminterest rateswasacontinuedrapiddeclineininflation.Theannualrateofinflationdeclinedbyalmostfourpercentin thatperiod,andbyJuly1982 ithadmore thanhalved from itsMarch1980peak.ThecontinueddeclineofinflationandtheevidentdeterminationoftheFedto stay the course on this occasion finally began to encourage bond investors.Whilenominalyieldsongovernmentbondsdeclined,realratesof interestrosesteadily. The real yield on government bonds, calculated using the September1981andJuly1982 levelsofconsumerprice inflation,hadrisenfrom4.4%inSeptember 1981 to 7.4% in July 1982. The first stage of the great bond bullmarket had begun, but the soaring real rates indicated bond investors stillremained sceptical about the long-term outlook. The pages of theWall StreetJournal in the summer of 1982 provide an insight into the concerns that keptinterest rates so high, and also an insight into the events of 17August 1982,whenachangeinmarketsentimentoccurred.

Among those issueswhich theWSJ reported as keeping real yields highwere‘thecurrentepidemicofcorporatebankruptcyfilings’,‘theU.S.Treasury’shugeborrowing needs’ and ‘the recent default of Drysdale Government SecuritiesInc’.TheattitudewassummedupbyWilliamH.Gross,apensionfundmanageratPacificInvestmentManagementCo.,whenhetoldtheWSJon15June:‘Thesystemhasbeenundergoinganextensiveperiodofpressure,andthatcanleadtoaccidents. It’s better to be safe at times like this.’ Indeed, it was theintensification of this fear which sent investors stampeding into bonds on 17August. Henry Kaufman’s bullish call on bonds had a positive impact, butprobably because it was predicated on further deterioration in the economicoutlook. In such an environment, with the stability of the financial systemalready under question, the desire ‘to be safe at times like this’ pushedgovernment bond prices higher. Indeed it was not just US investors whosuddenlyfundanappetiteforgovernmentbonds.‘Investorsaroundtheworldarepouring more of their funds into gold and the US bond market because ofgrowing nervousness about the plight of Mexico and rumors of potentialproblems in Argentina’ (WSJ, 3 September). The positive change in thepsychologyofthegovernmentbondmarketfollowedonfromthefirstrealsignsofrisktoUSfinancialstability.

It was only with the advent of clear signs of financial distress that the bondmarketbegantoacceptshort-terminterestrateswereunlikelytosurgeagainand

the real rally in the government bondmarket began. In this environment, theprospect, and then reality, of ever-larger fiscal deficits did not preventsubstantial declines in short-term and long-term interest rates. While thegovernment bondmarket technically bottomed in September 1981, itwasnot until July 1982, when the Fed’s fixation with money supply growthtargetingended,thatthemajorrallyingovernmentbondpricesbegan.Thecoincidencewasironic.TheFOMCconstantlyfrettedaboutthenegativeimpactonthebondmarketsiftheywereseentoberenegingontheirmonetarygrowthtargets.BondinvestorsignoredtheshiftbytheFedandwereinsteaddrivenintothesecurityofgovernmentbondsbytheincreasingevidenceofalikelyfinancialcollapse. This fear factor swamped concerns about the Fed’s anti-inflationcommitmentandfearsaboutfiscalprofligacy.

In 1982, as in 1921 and 1932, the corporate bond market lagged theimprovementinthegovernmentbondmarket,butledtheimprovementinequityprices.In1949,governmentbondsralliedbeforethecorporatebondmarket, but thiswas anaberration causedby theFed’spolicy of cappingthe government bond yield. Both markets in 1949 recovered before theequitymarket.In1982,thelong-termUStreasurymarketbottomedinthefirstweekofOctober1981,whereastheyieldontheMoody’sBaacorporatebondindexdidnotpeakuntilthemiddleofFebruary1982.

Fromthepeakyieldinmid-February1982of17.3%,theMoody’sBaacorporatebond index saw little improvement and by the middle of July the yield haddeclinedtojust16.8%.TheyieldpremiumforBaacorporatebondscontinuedtorise from February 1982, and continued rising after the major bull market incorporateandgovernmentbondsthatdevelopedinJuly1982.ThepeakfortheBaa yield premium over government bonds was not reached until November1982.TheriseintheBaayieldpremium,despitetherallyinthecorporatebondmarket, is not surprising when one considers that investors were piling intogovernment bonds partly due to the prospect of a financial crisis. Thus, 1982followed the sequence evident at the bottom of the other great bear-marketbottomsofarally ingovernmentbondprices, followedbyarally inBaa-ratedcorporatebondsandfinallyfollowedbytheequitymarket.InvestorswaitingtobuyequitiesaftertheapparentpeakoftheBaa-yieldpremiumwerecommittingfundstoequitieswellafterthebottom.

Growingevidenceofstability inselectedcommoditypriceshasproventobea

lead indicator for an improvement in equity prices. The same is also true forcorporatebonds.Thesamebasicrelationshipseemstoexistevenin1982,eventhough the entiremonetary framework has changed and the Fedwas fightinginflation rather than deflation. The marginal improvement in corporate bondpricesfromFebruarytoJulyoccuredagainstabackgroundoffallingcommodityprices.However,theBaacorporatebondpremium,whichpeakedinNovember1982, declined markedly thereafter as commodity prices improved. Thisimprovement could be coincidental, but once again this sequence of eventsmirrors1921and1932.

Suffice to say, the indicators that signalled the bottomof thebear market in 1921, 1932 and 1949 worked again in 1982.Thisisparticularlyencouragingforinvestorsseekingpatterns-the new monetary regime in 1982 suggested bear-marketbottomswouldbeverydifferentthistimearound.Thisbookisaimed at making sure investors are looking at the rightindicators.However,theinvestormuststilldeterminewhetherthe positive changes in those indicators are sustainable. It isappropriate, then, toconcludeourexaminationofbear-marketbottomswithsomequestionsaboutwheretheUSstockmarketisin2005andwhereitisheaded.

Endnotes79WallStreetJournal,18August1982[returntotext]

80HenryKaufman,OnMoneyandMarkets:AWallStreetMemoir[returntotext]

81WallStreetJournal,1July1982[returntotext]

ConclusionsExit,pursuedbyabear.

WilliamShakespeare,TheWinter’sTalePerhapssurprisingly,thesameindicatorsthathelpedidentifytheendofthebearmarketin1921,1932and1949workedagainin1982.Thesimilaritiesbetweenallfourbear-marketbottomsareparticularlyintriguingwhenoneconsidersthehugechangestotheinstitutionalframeworkovertheperiod.Investorsshouldfocusontheseindicators.Wecanrefertotheseas“Einstein'squestions”.Allthat’smissingareanswersthatarebetterthanmosteveryoneelse.Thefollowingisanattempttoanswerthosequestions,whichservestomapoutthefuturefortheUSequitymarketoverthenextdecade.

Strategic

Asthisbookisconcernedwiththefourperiodswhenequitiesproducedthebestsubsequentreturns, it isaxiomatictosayequitiesarecheapestat thebottomofthemarket.One indicatorofvalueavailable to investorsat the timewas theqratio.Itfellbelow0.3xatallfourbearmarketbottoms.ThecyclicallyadjustedPEprovidesthenextbestcontemporaryindicatorofvalue,butitsrangehasbeenratherwideatthebottom-from4.7xin1932to11.7xin1949.EvencalculatingcyclicallyadjustedPEusinginflation-adjustedearnings,therangeisstillawide5.2xto9.1x.

Equities become cheap slowly. On average, it took nine years for equities tomovefrompeakqratiostotheirlows.Ifoneexcludesthe1929-32bearmarket,theaverageperiodfortheadjustmentinvaluationswas14years.TheUSequitymarket reached its highest-ever valuations inMarch2000, and all extremesofvaluationhavebeenfollowedbythisslowmovetoundervaluation.

Withtheexceptionof1929-32,ourbearmarketsoccurredagainstabackgroundofeconomicexpansion.Onaverage,realGDPexpanded52%overthecourseofourthreelongbearmarkets.NominalGDPexpandedbyanaverageof285%.

Reportedcorporateearningsgrowth,at least in real terms, ismutedduringourbears, but it too has a wide range. Inflation-adjusted earnings growth rangedfrom-67%to+28%.Fornominalearningsinthefourbearmarkets,therangeis-67%to+119%.

Amaterial disturbance to thegeneralprice levelwill be the catalyst to reduceequities to cheap levels. On three occasions - 1921, 1949 and 1982 - thedisturbance was a period of high inflation followed by deflation, although in1982deflationwasconfinedtocommodityprices.Therewasnoinitialinflationin1932,buttherewasstillamaterialdisturbancetothegeneralpricelevelintheform of severe deflation. In such periods of price disturbance, there is greatuncertaintyastoboththeleveloffuturecorporateearningsandthepriceofthekeyalternatelow-riskasset-governmentbonds.Thisinturnleadstoadeclineinequityvaluations.

Wehaveseenthatallfourofourbear-marketbottomsoccurredduringeconomicrecession.Wehavealsoseenthatareturnofpricestability,followingaperiodofdeflation, signals the bottom of the bear market in equities. In particular,stabilisingcommoditypricesaugurmoregeneralpricestabilityaheadandsignalthereboundinequityprices.Ofallthecommodities,thechangeinthetrendofthepriceofcopperhasbeenaparticularlyaccuratesignalofbetterequityprices.Inassessingwhetherpricestabilityissustainable,investorsshouldlookforlowinventory levels, rising demand for products at lower prices, and whetherproducershavebeensellingbelowcost.

Wehaveseen thatasell-off ingovernmentbondsaccompaniesat leastpartofthe bear market in equities. Things were slightly different in 1929-32, whenbondsralliedfromSeptember1929toJune1931.Onlythendidasell-offbegin,lastinguntilJanuary1932.Buteveninthetwobearmarketsassociatedwithhighlevels of deflation - 1921 and 1932 - there was some sell-off in governmentbonds.

Tactical

Investorsshouldlookoutforthekeystrategicfactorswhenattemptingtoassesswhether the move from overvalued to undervalued equities is nearingcompletion.Whenthestrategicfactorssuggestthisprocessmaybecomingtoanend,thereareahostoftacticalconsiderationstobeconsideredinattemptingtofindthebottomofthemarket.Aswehaveseen,arecoveryingovernmentbondprices precedes a recovery of equities. In 1932, equity prices bottomed sevenmonths after the government bond market. In 1921, 1949 and 1982, the lagswere 14, nine and 11 months respectively. The price decline in the DJIAfollowingthebottomofthebondmarketwas23%in1921,46%in1932,14%in1949and6%in1982.

Thebirthofanewbullmarketforcorporatebondswillprecedetheendofthebearmarket in equities.The recovery in corporate bondprices led equities bytwomonths in1921,onemonth in1932andfivemonths in1982. In1949 theleadwasmuchlarger-15or17months-dependingonhowonedefinesit,butthiswasprobablyduetothedistortionstothebondmarketsinthepost-warera.

In our three long bear markets, reductions in interest rates by the FederalReserve preceded the bottom for equity prices. The lag before equity pricesbottomedwasthreemonthsfor1921and1949,and11monthsfor1982.Onallthreeoccasions,thedeclineintheDJIAovertheperiodofthelagwaslessthan20%.Itwasadifferentstoryin1929-32.TheFedcutratesinNovember1929,whilethebearmarketwasstillinitsinfancy.

Anumberoffurthertacticalconclusionscanbesummedupbriefly:

Economic and stockmarket recoveries roughly coincide.Recovery in the autosectorprecedesrecoveryintheequitymarket.

Bear market bottoms are characterised by an increasing supply of goodeconomic news being ignored by themarket.While numerous bulls bang thedrumforequitiesevenatthebottomofthemarket,theywillbeignored.

Many commentators will suggest the worsening fiscal position will preventeconomicrecoveryorabullmarketinequities.Theywillbewrong.

Declineinreportedcorporateearningswillcontinuewellpastthebottomofthemarket.

The bottom is preceded by a period in which the market declines on lowvolumesandrisesonhighvolumes.Theendofabearmarketischaracterisedbyafinalslumpofpricesonlowtradingvolumes.Confirmationthatthebeartrendisoverwillberisingvolumesatthenewhigherlevelsafterthefirstreboundinequityprices.

There will be a large number of individual investors shorting stocks at thebottomofthemarket.Shortpositionswillreachhighlevelsatthebottomoftheequitymarketandwillincreaseinthefirstfewweeksofthenewbullmarket.

DowTheoryworkstosignalabuyforequities.

These are the identifying features of the bear and its bottom. Just as thepossessionoffurdoesnot,of itself,permit the identificationofananimalasabear,thepossessionofanyoneofthefeaturesaboveshouldnotbeconsideredasconstituting positive identification of its financial equivalent. Our list is thefinancialequivalentofEinstein’squestions.Intryingtoidentifythebear-marketbottomyouwillhavetofindtheanswerstomost,ifnotall,ofthequestions.

Thenandnow

Asfaras Iamaware,wecannotasyetpointacopyofa fieldguideatawildcreatureandask it forpositive identification.However, for thisparticular fieldguide, which aims to be as practical as possible, failure to venture a positiveidentificationwould be somewhat remiss.Utilising the strategic features fromthechecklistabove,onewouldhavetoassertthattheUSbearmarketthatbeganin2000isinitsearlydays.

At the end of 1999, the q ratio for US equities reached an all-time high. Asimilarnewall-timehighwasreachedforthecyclicallyadjustedPE.Theqratiowas2.9x,itsgeometricmean,andthecyclicallyadjustedPEwas170%aboveits1881-to-June2005average.Thereisnohistoryofanythingbutafalltodeeply-discountedvaluations following fromsuchpeak levels.Aswehave seen fromthesehighlevelstherehasbeen,withtheexceptionof1929-32,aslowshiftbackto low valuations. One should expect the adjustment to take from nine to 14years.Ourcurrentmarketpeakedfiveyearsago.

FromtheJune2005level,thecyclicallyadjustedPEwouldhavetodecline40%toreachitslong-termaverage.Assumingitdeclinedtothelowlevelsseenatthebottomofthegreatbearmarketbottoms,onewouldexpectadeclineintherangeof60%to84%.Justhowlargeadeclinethiswillbeinpriceswilldependuponhowearningsperformovertheperiod.

At the end of June 2005, the q ratio was 44% above fair value. If it is toapproach the level recorded at the bottom of all the four great bear marketbottomsofthe20thCentury,itwillhavetodecline67%fromthere.Onceagainthedegreetowhichthisalterationoccursduetopricedeclineswilldependuponthegrowthinthereplacementvalueofassetsovertheperiod.

There has yet been no disturbance to the general price level to create theuncertainty topushequities tocheap levels.But it isnormal for thedecline invaluations to have been underway for many years before the general pricedisturbance comes along to prompt the final price adjustment. If, as MiltonFriedman asserts, inflation ‘is everywhere and at all times a monetary

phenomenon’, the next general price disturbance is likely to be inflationary,giventhecurrentinstitutionalframework.

Thedeclineinthepriceofgovernmentbondshassofarbeenmuted.Thisisalsotrue for the decline in the price of corporate bonds. History suggests a largeradjustmentinthesepricesisnecessary.

TherehasbeennoreductionininterestratesbytheFed-quitethereverse.

Thereisnorecession.

So,ifthisbearisgoingtolookliketheotherbears,quiteafewthingsstillhavetohappen.Equitieswillhavetofalltobelowfairvalueandthelikelycatalystforthiswillbeaboutofdeflationor,morelikely,inflation.Therewillhavetobeabearmarketinbondsandarecession.Beforethebearmarketisover,theDJIAislikelytodeclinebyatleast60%-perhapssomethingmorethan80%(giventhecurrentlevelofearningsandreplacementvalueofassets).

This bear market will likely come to an end sometime after 2009, thoughprobablynearer to2014.Sometimearound thenyou couldperhaps reread thisbook and see if it can help you recognise the bear market bottom. In themeantime,ifyouhavetogodowntothewoods,keepyourwitsaboutyou.

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