Implications of The Wall Street Crash of 1929 and The

First World War on the canons in the Theory of Common

Stocks and their impact on the modern financial crises

Abstract

What this work expects to accomplish is to find what has changed in The
Theory of Common Stock as to produce The Stock Market Crash of 1929 .
It also attempts to discover the reasons behind the changes in viewpoints of the
stock buying public . It also strives to observe similarities between the The
Stock Market Crash of 1929 and The 2008 Financial Crises and whether or not
these resemblances are also rooted in the change of The Theory of Common
Stocks and what should differ from the currently accepted theory as to not
repeat such financial disasters .

The PreWar concepts and Principles of Common Stock

Theory

For most of the period leading up to the First World War the principles of
Common Stock Investments were based on the concept that the buyer of
common shares in public companies is not different from the investor buying a
stake in a private enterprise except to the fact that he who buys marketable
securities has the benefit of liquid holdings , but it may be stated that the ability
to control a business may counterweight this benefit .

Based on the foregoing fundamental concept , the balance sheet was given as
much , maybe even more, attention than the income statements of the given
company , like a private businessman would do , valuing the shares at a
discount or premium to the “ Book Value “ depending on the attractiveness of
the earnings of the company , but the net asset value still remained the basis of
the calculation , for it is really the “ net worth ” of the business .
The only technical problem to the analysis of Balance Sheets was that of
“Watered Assets” which showed value where it doesn't exist , but this problem
was mostly gotten rid of thanks to stricter accounting rules and the S.E.C.

So the investment theory during the prewar years was based on the following
concepts , that it should have :
1 A satisfactory and established dividend , for the shareholder does not directly
benefit from the earnings of his company unless they are at one point in time
given to him .
2 A relatively stable record of earnings of the company , for an enterprise that
has volatile earnings isnt suitable for analysis and presents too much uncertainty
, those being left to the speculators .
3 A satisfactory backing of the market price by tangible assets , so that even in
the case of liquidation , the shareholder isn't left with nothing .

Analysis of Common Stocks on other points than the ones mentioned above
were classified as speculative , so the analysis was confined mostly on these
threefold concepts .
As I have already mentioned , the investment concepts of the prewar investor
weren't too different from that of a businessman , as they should be .

The PreWar Theory of Common Stocks and its relationship with the future

It was a widespread belief before The World War that when strong emphasis
was put on future prospects of a given enterprise rather than its performance in
the past , the operation became one of speculation rather than one of investment
. The explanation of this thinking is a simple and rather logical one , as the
future is unknown , therefore speculative and the past present real and proven
quantitative figures upon which analysis may be conceived , therefore it
presented investment opportunities and was the basis of safety .

For the foregoing reasons , prior the The World War investment usually
encompassed only the prominent and entrenched companies for they had long
track records of earnings and dividends in addition to , usually , healthy balance
sheets , in turn leaving the smaller companies and lesser known in the
speculative area .
The New Era Theory of Common Stocks

After the end of The First World War however , the attitudes of the investors
and analysts alike has changed significantly . From the 3 elements which we
have mentioned as used to value a company only one of it remained in the
public interest ,i.e. the earnings , specifically the earnings trend rather than that
of the earnings average which was commonly used in the prewar era .
The philosophy of the New Era Theory , which for most analysts and investors
of today remains true , can be summed by by the following sentence : “ The
value of a common stock is made up of what it will earn from today onwards “
This theory is continued by security analysts and investors to this day ,
demonstrated by the reliance on Discounted Cash Flow Models , Forward P/E
ratios and the trend of earnings in today's stock market .
Expanding the theory leads to the following conclusions :
1 That the dividend rate is irrelevant to the value of common stock as it is
common belief now that any dividend “comes out” of the stock price .
2 The fact that because there seemed to not be any direct relationship between
the earnings power and the assets value , the book value became irrelevant .
3 The past average income was not of any importance to the investor , and the
earnings were looked at only in the case that they revealed a trend , may it be
positive or negative .
4 Investments in Common Stocks are viewed as long term investments , and
they will always grow , on average , because they usually earn 6% on market
price but pay in forms of dividends only 3% which in turn means that the
surplus is added to their balance sheet , so the stock price should follow suit .

My arguments against these conclusions (and thereby for the whole new era
theory) are as followers :
1* Even though , indeed , the value of a company should reflect any earnings
that are made , and the dividend which goes to existing shareholders of a public
enterprise are of no benefit to the buyer , it may be said on the one hand that
one cannot rely upon the market to accurately represent the correct value of his
shares for the reasons that it is more often than not irrational , and on the second
hand the earnings are legally his , and thereby has a right to demand it from the
management .
2* For the second conclusion a simple hypothetical example could demonstrate
the flaws of the new era theory in relation to book value . Let's say that
Corporation A has a Tangible Book Value Per Share of 100 $ and that
Corporation B has a Tangible Book Value Per Share of just 20$ . Now let's
assume that both have Earnings Per Share equal to 5 $ and the trend of earnings
is the same . In this case a proponent of the New Era Theory would value Corp.
B at least as much as Corp.A , and more often than not even higher for having a
bigger “ Return on Tangible Common Equity” , and I would say that this is
contrary to any logic , as the more TBVPS a company is backed by the more it
can afford to lose in case of unexpected problems , therefore safer and deserving
to be valued higher .
3*If you accept that any trend of earnings in the past may well continue itself in
the future is false , because sometimes it will have to stop or may be even
reverse itself , as a company cant grow forever , and if you are willing to accept
that the relationship between past earnings will show in the future than you have
to accept that the average of earnings will reveal itself too in the following years
4* This theory may not have flaws at first sight but the conclusions from this
statement are very dangerous , for it implies that a stock price is never to high ,
because it will always grow , but this in fact would destroy all the advantage of
the Common Stock investor , as the stock price rising will shrink more and more
the Earnings yield , so the investor turns this basic advantage in a basic
disadvantage .

Causes for the change in principles

The change in the concepts of the Theory of Common Stocks is rooted in the
fact that the old principles unpopular for the following reasons:

1 Being an old established company with a long record of stable earnings had
ceased to guarantee safety , for the reason that there were many prominent
corporations that had decades worth of stable and growing earnings swiftly
declined and became insolvent in just a couple of years . And there were other
small and relatively unknown companies which quickly rose to incredible sizes
due to innovations . One example would be the railroads , which for decades
benefited from the general economic growth of the United States , but in the
1920s definitely showed signs of setback .
2 The Roaring 20s , named by many , was one of rapid economic expansion ,
being one of the most prosperous times in the U.S. , and it was really hard ,
however tough an investor might be , to look at all of this growth with
indifference and not try to profit from it .
3 The asset value of a company became practically worthless in many cases in
the case of receiverships current assets diminished from what they showed on
the book and long term assets sold for pennies on the dollars , and so the Book
Value vanished from the criterias of investments by 1929 .

It may be stated that the New Era Investment Theory is not in any meaningful
way different from PreWar speculation , but only in the mind of those who
practice it .

The New Era Theory as the root of The Stock Market

Crash of 1929 and thereby the Great Depression

As said above , the 1920s was one of the best decades for the American
Economy that it has ever seen . Reasons for this period of prosperity may have
been that of the War ending which transformed the American economy from a
war-time economy to a pace-time one , which saw a great increase in jobs which
moved from the Military-Industrial complex to the general economy .This had
the greatest impact on the automotive industry which lead the economic growth
of the country , this in turn having effects on the steel and metallurgical coal
industry , which then for a very industrialized American economy produced
phenomenal growth . From 1920 to 1925 , in the span of 6 years , the
Axe-Houghton Index of Trade and Industrial Activity showed growth of almost
80% .
This , in turn , meant that companies generated enormous amounts of profits
from that period , and this newly created wealth trickled down to the workers of
these companies , and , as it seems , this newfound cash found its way to the
stock market as well . The stock market rose at about the same pace as the
Axe-Houghton Index of Trade and Industrial Activity , so more and more
investors were incentivised to invest in this phenomenal bull market . Banks
were the ones that created the growth of the economy in the first place , by
providing cheap credit at less than 1% interest rates for the last decade . These
credits were not just for the industrial bone of the American economy , as the
banks joined the rising market as well through loaning money for investors , at
one point almost ⅔ % of the money in the stock market was on margin .

The New Era Theory at work

At this point it can easily be seen why investors were now more than ever
inclined to The New Era Theory , for that this incredible market never seemed
to stop rising , but , in this time , the production and underlying fundamentals
did as well . An unexpected thing happened when , in 1925 , the Axe-Houghton
Index of Trade and Industrial Activity flattened out . To the classic investors this
signaled the fact that the stock market would soon follow , but the New Era
investors didn't , for as long as the trend was up, seem to care about the lower
actual production . And so , for more than 4 years with no underlying industrial
growth , stock prices rallied up more that 200% , which for any rational
investor would seem illogical , but we should remember that those who
speculated on these stocks and called themselves “ investors “ have never seen a
bear market for a decade . The problem is that however excitingly optimistic
were speculators on the prospect of American Business , if the underlying
companies on which they “bet” don't live up to the standards expected from
them for 5 consecutive years the bubble bursts , and that's exactly what it did ,
on October 24 , 1929 , the stock market losing 12.82% and on the following day
, on October 25 losing another 11.73% . 3 years later , the stock was selling at
only a tenth of what they were in 1929 , being the biggest stock market crash
ever .

The Great Depression

The Great Depression , as said above , may have started because of a stock
market crash , which bankrupted tens of thousands of investors and made it
impossible for companies to raise money through equity , but what really his the
general economy was a disruption of credit because from the Great Crash the
banks were hit the most , having the biggest exposure to stock market . Not even
those who didn't invest in the stock market were protected from tragedy , having
lost almost the same amount of money as the speculator , for the banks returned
only 10 cents to the depositors for every dollar they had in deposits . And with
that , companies not being unable to cover their bond payments were going
bankrupt by the day for that they couldn't raise money in any way , and that
meant large layoffs , which rose the unemployment rate to a never seen before
25% , and americans having no jobs and left with no money meant that , for the
decade that followed , it was the worst period for the American economy ever ,
then spreading in the entire world , a decade of stagnation , in 1940 the
Industrial Index being only 90% of what it was 11 years ago . As a direct
response to the problems that this kind of speculation is done by investors and
financial institutions the U.S. Government introduced two new regulating
bodies , i.e. The Federal Deposits and Insurance Corporation and The Securities
and Exchange Commision .

The New Era Theory as the root to Modern Financial

Crises including but not exclusively The Financial Crisis
of 2008

A great but not so significant resemblance can be made between the Dot Com
Bubble and The Wall Street Crash of 1929 , as both were made on the reliance
on future prospects without accounting for current profits and balance sheets ,
and many similarities can be drawn from these two .

A more profound resemblance in the psychology of investors and management

alike can be seen in the Financial Crisis of 2008 which i will try to summarise in
the following paragraphs :

In 1968 Lewis S. Ranieri invented the Mortgage Backed Security which was a
bond issued by banks to investors and backed by mortgage interest payments .
The M.B.S. really gained popularity at the very start of the third millennium ,
and by their 2% fees on securitizing these financial products investment banks
started to profit , banks included but not limited to Citi, Bank of America ,
Lehman Brothers , Merryl Lynch , Goldman Sachs , Morgan Stanley and the
newly merged J.P. Morgan Chase & Co. This practice was a very profitable one
for the banks and a sound investment for the buyers of such securities . The
problem that emerged was that demand for the so profitable bonds had increased
so much and the eligible borrowers were not , so the commercial banks started
to increase their subprime lending , which in turn were bought by the
investment banks , securitised in M.B.S. and then sold to the common investors
. Here was the first time that the risks increased , but not on the part of banks ,
as they got rid of the risky loans after securitizations , and the risks began rising
for the buyers of such securities . Another way that banks provided exposure to
investors to the Housing Sector was by Collateralized Debt Obligations , which
down the road merged in riskier and riskier securities , like the Synthetic C.D.O.
, which were not backed by any real assets , and , in its most intrinsic scene , is a
way of gambling on credit default .
The banks knew the risks involved in even just the securitizing of these
subprime loans ,so they insured their subprime assets with Credit Default Swaps
, moving the risk out of their book to the insurance companies , enabling them
to continue selling these securities without the risk of themselves losing , and
the company most prominent in the Credit Default Swap business was
American International Group , making billions from this insuring .
But tragedy happened when it could have been foreseen but no one wanted to .It
was then common belief that because the housing market had consistently risen
then even if the borrower defaulted , the house could still be sold for at least
what it was bought for , returning back the principal . But by providing this
much credit for mortgages , this put many houses on the market , which in
2007-2008 started to decline massively , creditors not being able to sell those
houses to return their principal . Tragedy , however, struck when the defaults of
the subprime borrowers were so many that AIG defaulted itself , only being able
to meet its obligation with a bailout from the Treasury , but it wasn't without
repercussions , as Lehman Brothers , of whose stock fell so rapidly , not being
able to raise capital was faced with bankruptcy and then partially sold off to
Barclays .

Could the 2008 Financial Crisis been avoided by competent

management

There was one Investment Bank that , even though hurt by this crisis , had the
most to gain from it , that was J.P. Morgan Chase & Co. thanks to C.E.O. Jamie
Dimon ,which had already prepared its balance sheet for this kind of disaster
from 2004-2005 , even though dealing with M.B.S. from Chase Division , they
did not provide subprime loans in the quantity and volumes that other banks like
Citi or Bank of America would . They also had strong liquidity which really
comed in as very useful in the situation that they had to buyout giant like Bear
Stearns and Washington Mutual , showing their conservatism again in the
Spring of 2023 when they bought First Republic Bank at pennies on the dollar ,
resulting in a 2.7 billion bargain gain , as shown by their Q2 reports .

Conclusions and Lessons to be made from this crises and

what it means to the Theory of Common Stocks :

In the world of finance , which is ever changing and dynamic , history remains
the one constant , and there are lessons to be made from past mistakes .
In the case of the 2008 financial crisis , as in the 1929 Stock Market Crash ,
people relied to much on future growth and its potentials for profit , that they
forgot old principles of business , which should be applied in the field of
Common Stocks of Public Companies in the same portion as in private
operations. The reason for investors not abandoning the New Era Theory even
though it creates this type of crises would be that it is the most assuring school
of tough , in the period of great prosperity the future looking the most applying
for its potential and in the periods of downfall , right after crises ,the prospect of
future growth would be the only insurance that things will get better , and so the
New Era Theory has persisted in the minds of common investors and
professionals alike ,and would take many strong minded persons to reverse from
this . The lesson to be made by the Common Stock investor would be that he
should only look at the future as to guard from it rather than to profit from it ,
which would be my view on the future of The Theory of Common Stocks, as
that of returning to the PreWar concepts of viewing the stock market through the
eyes of businessman rather than speculators .Even with its downfalls , being
much more reliant and conservative than the currently accepted New Era
Theory .
Sources :
Benjamin Graham's and David Dodd's Security Analysis , 2nd Edition .
Pages 343-361 Chapter XXVII The Theory of Common Stocks investments
Benjamin Graham's The Intelligent Investor - Chapter 19 Shareholders &
Management : Dividend Policy
Andrew Ross Sorkin's Too Big To Fail
Noua Ferma a Animalelor si criza economica globala , Mario Seppi & Anna
Maria Darmanin Pages 205-214