There are three or four great stock market crashes that instantly stick out: The Wall Street Crash of 1929; Black Monday in 1987; the bursting of the dot-com bubble in 2000; and, of course, the most recent stock market crash in 2007/2008. I’d add a fourth to that list, which is the bear market during the post WWI recession. It’s slightly less well known, but the Dow lost over 40% of its value between the end of WWI and the early 1920s.The great thing about studying crashes and the associated slumps is that they can teach you everything you need to know about value investing and stock market returns. Ripping equity bull markets such as the one that we’ve experienced over the last several years are deceptive in that sense. They are where the big returns show up, but not where they are made.
The Depression Of 1920-1921
First off, let’s look at the depression of 1920-1921. Several factors had come together to create an extremely nasty deflationary recession, but mainly tight monetary policy combined with the surge of veterans from the war into a peacetime labor market (which suppressed wages and sent unemployment skyrocketing). The stock market fell somewhere in the region of 50% from its 1919 peak before bottoming in the summer of 1921.
Imagine you have just stepped out of a time machine in mid-1921 and then think about all these factors for a moment. You would be facing a highly deflationary period, a high rate of unemployment, a pretty uncertain economic outlook and a falling stock market.
On the face of it that doesn’t sound like the best time to be putting cash into stocks and shares does it? With the benefit of hindsight afforded to you by this time machine you could try to set the average investor in 1921 straight. Chances are they would be more likely to talk about the negative outlook than accept your reasoned argument that future market returns will not be impaired by the current economic situation. In these circumstances, the pain and memory of losing money is enough to keep people out of the markets at precisely the time they should be scaling in.
What if they had listened to that advice back in 1921? They would have found gems going for pennies by today’s standards. Coca-Cola, for example, had a 1921 market capitalization of $10m, yet the company had earnings of over $5m in 1922. That’s not a typo. Coca-Cola stock was trading for less than 2x forward earnings back in the depths of the 1921 bear market. The dividend yield was over 5%. Gillette, which is still selling its famous razor blades and shaving products today, was trading at near enough a double-digit dividend yield and around 5x its 1922 earnings.
The investing world of the early twentieth century was obviously a lot different than today. Even getting your hands on data would have likely meant flipping through a big Moody’s manual compared to the quick internet searches that we are used to. The value opportunities available to those who took the time to find them were probably vast; almost unthinkable in today’s markets which are much more efficient at pricing stocks.
The point about forward looking market returns is that they tend not to correlate with the current economic climate. To use a more recent example just think about the economic havoc that was taking place globally in 2009. Stocks went on to rally from the March bottom and close out the year nearly 20% up, despite the very uncertain outlook for the economy. What could you have picked up on the cheap in 2009? How about Johnson & Johnson trading at 11x prior year earnings? Procter & Gamble was trading at a similar multiple of about 11.5x its 2008 earnings. Even Coca-Cola was trading at 13x earnings and close to a 4% dividend yield.
This really gets to the heart of long-term investing. It’s all about stacking the odds firmly in your favor. Nobody can predict the future, even when it comes to the highest quality businesses with the strongest durable competitive advantages. Buying stocks like Johnson & Johnson and Procter & Gamble at 11x earnings and a 4% yield is the closest you can ever get to a sure thing. Even more so in an era of ultra low interest rates. The chances are that stock bought at those valuations will deliver attractive compounded returns going forward, coming from both earnings growth and expansion of the low earnings multiple. This is exactly what has happened so far in the ensuing bull market.
Consider averaging, say, $5,000 into Johnson & Johnson stock at the end of 2006, 2007 and 2008. The total return on that $15,000 outlay, with dividends reinvested, would be $33,300 worth of stock today. A lump sum of $15,000 invested at the end of 2006 would have delivered almost exactly the same returns (actually 1% lower), despite having longer time in the market. That’s the effect of averaging in or reinvesting dividends in periods of declining valuation.
Let’s return to the example of the forgotten depression of 1921. What kind of returns did investors who were smart enough to ride out the crash see? As it happens, despite double-digit deflation and mass unemployment, the following seven or so years delivered an economic and stock market boom that would go down in history. The Roaring Twenties is remembered not just in economic terms, but as a landmark historical period in cultural and social terms too. All of that was born from a nasty deflationary recession at the start of the decade.
As for stocks, the Dow went on to post 25% CAGR gains from the 1921 bottom up to the peak in 1929. Coca-Cola, trading for under $20 per-share in 1921, some 50% down on its IPO price and with a forward P/E of 1.6, closed that bull market at about $140 per-share. That’s 27% annual returns for the period excluding dividends.
Returns From The Wall Street Crash
The flip-side to looking at the outcomes and returns of investing during the bear market of 1919-1921 is what came right after the bull market of the 1920s: The Wall Street Crash and The Great Depression. Having established that most people would have looked at the terrible economic conditions in 1921 and stayed away from investing in the falling stock market, it might be reasonable to assume that when things started to look bright again their outlook changed.
Let’s say they were so scarred by the last bear market that they waited until the worst possible moment to invest in the stock market again: October 1929. If what happened to the economy in 1921 looks bad on paper, then it’s a walk in the park compared to the depression of the 1930s. The ultimate bottom of the Dow even breached the lows of 1921, a fact which is exaggerated by the effects of massive deflation. We’re talking 90%-plus capital losses from the peak.
Most texts will tell you that anyone who bought at the top of the market in 1929 would have to wait twenty-five years before breaking even. What this number ignores though is the effect of reinvesting dividends. Even someone unlucky enough to have bought into the market in September 1929 would have broke even in about seven years.
Putting cash dividends to work in a bear market is itself a form of value investing. Seven years to break even versus twenty-five years is a huge difference, and in the worst financial crisis in modern history as well. It also ignores the effect of deflation, which exaggerates the effect of the decline compared to actual purchasing power. Finally, it says nothing at all about those who were prepared to put money to work during the vicious bear market of 1929 to 1933. A period in which some of the best stocks on the market were trading at fractions of book value and the aggregate dividend yield was in the double digits. Needless to say the subsequent returns would have been significant.
- Investing in the the early 1930s would have generated 17% annual returns up to the start of the Second World War. That’s a trebling of the index in the worst economic conditions of the last century.
This is absolutely not about market timing either. The same exact effect plays out with dollar cost averaging, where investing in periods of high valuation is offset by investments in times of low valuations. The result is that capital losses recover much more quickly than they otherwise would. The market could have gone on to fall another 50% from any of the bottoms in 1921, 1932, 1987, 2000 or 2009. It still wouldn’t change the fact that increasing exposure to stocks at those moments was the right thing to do. In the long run, over 20+ years, those investments would likely show great returns. This is why a long-term approach is absolutely paramount, not only in terms of general market outlook but also with the individual holdings.
For the vast majority of private investors it is always better to view individual stocks as private companies. The market value can fluctuate, often wildly, but as long as the core fundamentals and earnings power of your holdings remain intact then there is no reason to sell. Collect the dividends and reinvest them. If the stock doesn’t pay dividends then trust management will take advantage of the low valuations in other ways: whether through cheap stock buybacks or a cheap acquisition to boost per-share earnings. Ignoring the wild swings in the market and having a long-term approach are the ultimate lessons from stock market crashes.