Thursday, December 18, 2008

Comparison of the current decline in share prices with 1929

In a post in October this blog warned against any underestimation of how severe and how long a fall in share prices could be. The current post provides further comparative information on this, updates relevant data, and justifies the view that a relevant comparison for the current fall in share prices is with 1929 rather than a normal cyclical recession.

Taking first the latest data, Figure 1 shows the daily movement of the Dow Jones Industrial Average following its recent peak on 9 October 2007 with the movement following its peak on 3 September 1929. It updates the data given in the earlier post on Key Trends in Globalisation.

As may be seen the present decline in the Dow continues to be entirely comparable in magnitude, at this stage of the crisis, to its fall in 1929-32.

Figure 1


In order to show that such a severe decline in nominal share prices is a specific feature of the 1929 and 2007 crises, and not typical of any recession, Figure 2 shows a similar graph for the four most serious declines in the Dow in the last century - those starting in 1929, 1973, 2000, and 2007.

For the three earlier declines the data covers the period from the peak price preceding the decline to its low point. The data for the decline starting in 2007 are up to the latest available date - the close of trading on 20 November 2008.

Figure 2


It may be seen that the falls in nominal prices starting in 1973, associated with the oil price increases and recession of that year, and in 2000, following the bursting of the dot com financial bubble, were far less severe than the drops in either 1929 or in 2007.

The fall in real share prices following 1973 is understated by this graph, as at that time inflation was higher than in 1929, 2000 or 2007, while the decline in real terms following 1929 is somewhat exaggerated as at that time the overall price level in the economy was falling. But the differences of order of magnitude are sufficient to make the pattern clear.

The fall in nominal share prices following both 1929 and 2007 far exceeds that of any other drop in the last century. From the angle of share prices it is entirely justified, and without exaggeration, to speak of the present crisis as comparable only to 1929.

The difference between the fall starting in 2007 and that in 1929 is only, at present, in the duration of the decline. The decline after 1929 continued for 712 trading days before reaching its bottom on 7 July 1932. The decline following the peak of 9 October 2007 has so far continued for 284 trading days - slightly under forty per cent of the period of the decline following 1929.

From this data it should not be implied that is being argued that the current speed of decline of US share prices, which has no parallel since 1929, will continue for as prolonged a period as in 1929. The point is merely being made that the current decline in US share prices is not comparable to a simple cyclical recession - even of a severe type. The only standard of comparison for the current fall in US share prices is with 1929, and the experience of 1929 indicates that a fall in share prices can go significantly further than it has so far.

Taking one measure of fundamentals, the ratio of total equity, including private equity, to GDP this measure has dropped from 1.8 in 2000 at the height of the dot com boom, to 0.8 at present. But during the trough of the decline in share prices in the mid-1970s it was only 0.4. An equivalent drop would imply a further 50 per cent fall of the Dow to around 4000 - meaning that the total fall from peak to trough would be around 72 per cent.

Such decline is not inconceivable in a very serious fall in share prices - the nominal decline of the Dow after 1929 was 89 per cent although, as overall price deflation was occurring, the decline in real prices was somewhat less. The maximum decline of the Nikkei since its peak at the end of 1989 has been 80.2 per cent - although as Japan has been undergoing moderate price deflation the fall in terms of real prices is again slightly less. A fall of the Dow by more than seventy per cent would not, therefore, be historically unprecedented - which is not the same as to say it will occur. At the close of trading on 20 November the decline of the Dow since its peak in 2007 was 46.7 per cent.

Regarding the potential period of a decline of share prices it took 25 years after 1929 for the Dow to regain its pre-crash level even in nominal terms. As Figure 3 shows the performance of the Nikkei after 1989 was even worse than that of the Dow after 1929 - the Nikkei was still registering new lows almost 18 years after the beginning of its decline.

The figures given above are for major stock exchanges, those of the US and Japan, during major stock market crashes. Performance of more minor stock markets, considered historically and for earlier periods, can be worse.

Prices on the French stock market failed even to keep up with inflation for 53 years from 1900-1952. Prices on the German stock market failed to keep up with inflation for 55 years from 1900-1954. Prices on the Japanese stock market, in addition to the recent fall of the Nikkei, failed to keep up with inflation for 51 years from 1900-1950. Prices on the Italian stock market failed to keep up with inflation for 73 years from 1906-1978.

The reasons for making these points and comparisons are not merely theoretical. Private individuals and companies may believe that the decline in share prices will necessarily only be short term and will be followed by a bounce and take investment decisions accordingly. Governments, when undertaking major programmes of purchases of shares in banks and other institutions, may believe that they are buying 'at the bottom of the market' and this will be followed by the taxpayer making profits as share prices rise.

There is no justification for such views. Historical comparisons show that there remains considerable space for downward potential in share prices even in nominal terms. Historical study indicates it may take many years, possible decades, for share prices to recover to previous levels from falls of the present magnitude.

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