Exorcising the ghost of 1929 sharemarket crash — part two

Brent Sheather

Opinion

INVESTMENT VIEWS

This week’s report is the second part of a review of how the 1929 sharemarket crash actually impacted stockmarket investors. It is August 1929, the very top of the bull market and Aunt Daisy has just retired. Taking the advice of her certified financial planner, she has invested all her hard-earned $50,000 in the stockmarket. Fasten your safety belt, Daisy!

Whereas last week Uncle Sam was interested in total return — capital gain plus dividend income — Daisy is primarily interested in cash dividends because she intends to live off her capital and reluctantly leave the residual to her three useless children who apparently spend all day sleeping and all night dancing, taking drugs and having sex. Except for the stockmarket crash, 1929 doesn’t sound like a bad time to be alive — in fact, if my memory serves me right, which is questionable, it sounds a bit like Whakātane in the 1970s.

But I digress — the scary thing about the 1929 sharemarket crash (as opposed to the ’87 crash) was that it was followed by a really bad depression in the real world where growth and inflation went into reverse and millions of people became unemployed. J.K. Galbraith writes in the Crash of 29: “A common feature of earlier stockmarket crashes was that having happened, they were over. The worst was reasonably recognisable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning.”

Needless to say, when the economy turned down, company profits plummeted, so Daisy’s dividend income fell precipitously also. But if you owned the market portfolio — every listed company weighted according to its size, as index funds do and Daisy did — dividends didn’t disappear completely. The graph adjacent shows Daisy’s income from a widely diversified portfolio of US stocks. We also include for comparison the cash income that Daisy would have earned if she put the money into short-term bank deposits or 10-year government stock.

The really shocking thing from the graph is that if Daisy had invested all her $50,000 in the bank, her annual income from 1933 to 1942 would have averaged less than $100 per year and in some years was actually zero, as bank deposit rates got down to nothing. Could that scenario happen again? It is unlikely but you can never rule anything out, so portfolios need to be constructed in such a way that some component will do relatively well in every scenario.

The ’29 crash was followed by a deflationary slump where prices consistently fell. In that environment, the best investment is usually high-quality long-term bonds which can be relied upon to make their interest payments irrespective of what’s going on in the economy — think government bonds, for example. People like saying that “cash is king” but in a depression, cash is anything but king. Not only does it not diversify portfolios as well as bonds, it potentially produces no income either.

Analysis of the actual historical dividends paid for the period shows that Aunt Daisy’s income from stocks did not dry up completely. Sure it halved in 1932 and as the graph illustrates it was very volatile, but over the 15.5 years it was about equal to the income from a government bond portfolio and more than three times that from short-term treasury bills (a proxy for bank interest rates). The dividend yield on US stocks stayed reasonably constant over the period at 4-7 percent; however, this yield was on a rapidly diminishing capital base. In fact, Daisy’s children received less than half, in nominal terms, of the amount that Daisy originally invested some 15 year previous. Most people would consider 15 years as being “long term” but even 15 years wasn’t enough for Aunt Daisy to get her initial capital back.

When one reads about the 1929 crash all the comments seem to be about how stock prices plummeted, but that time was also interesting in respect of interest rates. Short-term government stock rates — a close proxy for bank rates at the time — plummeted after 1929 and averaged less than 0.5 percent per annum in the period 1932-1947. If the history of the 1930-1940 period has one fundamental lesson, it is the attraction of long-dated government stock in a depression. Many banks went bust in the ’30s so there are no prizes for guessing what happened to finance companies lending to the entrepreneurs.

Sensibly constructed investment portfolios must be robust enough to cope with all economic conditions, ranging from inflation to deflation. The risk of this latter phenomenon, a fall in the general level of consumer prices, presents investment advisers with an overwhelming case for including some long-term, low-risk bonds in each and every client’s investment portfolio, no matter how young and “aggressive” they are. In 1922 in the UK, consumer prices fell by 18 percent. Even with government bonds yielding just 3 percent, this was a real interest rate of 21 percent. Deflation, if sustained, would put highly geared companies under huge pressure as the real value of contracts fixed in money terms would be increased, just as inflation reduces them.

Over the past 50 years or so the biggest threat to most New Zealanders’ wealth has come from inflation, so investors have been conditioned to concentrate on the risk of increasing rather than falling prices. In an environment of high inflation, high tax rates and low real interest rates, the most appropriate investment response has been to borrow heavily and invest in assets with a proven inflation-proofing ability, for example residential property. Deflation requires an entirely different investment strategy where security of cashflow is paramount and debt is minimised.

Some lessons from the 1929 crash which are especially relevant today are as follows:

■ Hold a diversified portfolio including lots of medium and longer term, safe bonds;

■ If possible eliminate debt and where it is unavoidable, choose a floating rate;

■ Diversify your equity portfolio widely — holding only 10 stocks is asking for trouble;

■ Gearing either via options or margin trading is a very risky strategy;

■ Don’t panic, things eventually will (probably) get better. But if you must panic, make sure you are the first one to panic. However, recall the old joke that “if you keep your head when all others around you are losing theirs, you obviously don’t appreciate the seriousness of the situation”.

■ Brent Sheather is a financial advice provider and a personal finance and investments writer. A disclosure statement is available upon request.