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 early-1920s depression. It is slightly less well known, but the Dow lost over 40% of its value between the end of the First World War and the early-1920s.
Now, the great thing about studying crashes is that they can teach you everything you need to know about value investing and stock market returns. Ripping equity bull markets are deceptive in that sense: they are where the big returns show up, but not where they are made. Anyway, let’s start with the depression of 1920/21. Several factors came together to create an extremely nasty deflationary recession, but mainly tight monetary policy and a surge of war veterans into a peacetime labor market (which suppressed wages and sent unemployment skyrocketing). The stock market fell around 50% from its 1919 peak before bottoming in the summer of 1921.
Imagine stepping out of of a time machine in mid-1921. You would be facing a highly deflationary period; a high rate of unemployment; a very uncertain economic outlook and a falling stock market. That doesn’t sound like the best time to be putting cash into stocks now 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. The chances are they wouldn’t want to hear it. They would be more likely to talk about the awful outlook than accept your reasoned arguments about future market returns. The pain and memory of losing money is enough to keep people out of the markets at precisely the time they should be scaling into them.
Gems For Pennies
What if they took 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 traded for less than 2x forward earnings back in the depths of the 1921 bear market. Its dividend yield was over 5%. Gillette, which is still selling its famous shaving products today, saw its shares trade for around 5x 1922 earnings. Its dividend yield approached the double-digit mark at the time.
The investing world of the early-20th century was obviously a lot different to today. Even acquiring some data likely meant flipping through a big old Moody’s manual. Compare that to the quick internet searches we are used to these days. The value opportunities available to those who took the time to find them were probably vast back then. Heck, they are 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. I mean, just think about the economic havoc that was taking place globally in 2009. Despite a deeply uncertain outlook for the economy, stocks closed the year 20% above their March lows. What could you buy on the cheap in 2009? How about Johnson & Johnson trading at 11x prior year earnings? Procter & Gamble traded at a similar multiple of about 11.5x its 2008 earnings. Even Coca-Cola traded for 13x earnings and close to a 4% dividend yield.
Let’s return to the example of the depression of 1921. What kind of returns did investors who were smart enough to ride out the crash see? As it happens, and 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 Dow went on to post 25% per annum gains from the 1921 bottom to the 1929 peak. Coca-Cola traded for under $20 per share in 1921, equivalent to a 50% drop on its 1919 IPO price. The forward PE ratio at the time was 1.6. It then went on to close the following bull market at around $140 per share – with quick math putting that performance at 27% per annum excluding dividends.
The Wall Street Crash
Obviously we all know what came next: 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 a falling stock market, it might be reasonable to assume that their outlook changed once things looked bright again. 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 was a walk in the park compared to the depression of the 1930s. The ultimate bottom of the Dow Jones Industrial Average even breached the lows of 1921. We are talking 90%-plus capital losses from the market’s peak.
Most texts will tell you that anyone who bought at the top of the market in 1929 had to wait twenty-five years before breaking even, however this number ignores 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. I mean, seven years to break even versus twenty-five years? Yeah, that’s a huge difference, and in the worst financial crisis in modern history no less. It also ignores the effect of deflation, which exaggerated 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 brutal bear market of 1929 to 1933. This was a period in which some of the best stocks around were trading at fractions of book value. The aggregate dividend yield was in the double-digits. Needless to say, the subsequent returns were significant. Investing in the early-1930s generated circa 17% annual returns up to the start of the Second World War. That is equivalent to trebling your money in around seven years.
Note that this is not necessarily about market timing either. The same exact effect plays out with dollar cost averaging, where investing in periods of high valuation is offset by investing in times of low valuations. The result is the same, with capital losses recovering much more quickly than they otherwise would.
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