(Palgrave Studies in The History of Finance) Ali Kabiri (Auth.) - The Great Crash of 1929 - A Reconciliation of Theory and Evidence-Palgrave Macmillan UK (2014)

The Great Crash of 1929
Palgrave Studies in the History of Finance

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THE GREAT CRASH OF 1929
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The Great Crash of 1929
A Reconciliation of Theory and Evidence
Ali Kabiri
Lecturer in Economics, University of Buckingham, UK
© Ali Kabiri 2014
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To my parents Mahin and Mohammad
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Contents
List of Figures ix
List of Tables xi
Preface xiii
Acknowledgements xv
Prologue 1
The 1920s US stock market and the evolution
of finance theory: the emergence of investment science 7
The estimation of the longevity of dividend income 8
New ideas on risk and uncertainty 8
1 Introduction 17
2 Literature Review and Methodology 31
2.1 Modern literature related to the 1920s 31
2.2 ‘Bubbles’ 37
2.3 Methodology 49
3 The US Economy and the Financial System 58
3.1 The boom and bust of the US stock market 58
3.2 The real economy 61
3.3 The Gold Standard 64
3.4 Monetary dynamics and the US stock market 71
3.5 The Federal Reserve in its first fifteen years of operation 85
4 The Returns to US Common Stocks from 1871 to 2010 94
4.1 Measuring the ‘fundamental’ value of the US
stock market 94
4.2 The realised return on stocks from the 1920s to 2010 105
4.3 A growth model to value new technology stocks 108
4.4 The formation of closed-end funds 127
4.5 The 1927–9 phase of the boom 131
5 The October Crash of 1929 and the NYSE
Credit System 145
5.1 Financial stability and the NYSE credit system 145
5.2 Money market leverage for Common Stock trading 149
5.3 The October crash of 1929 163
vii
viii Contents
6 The Great Contraction of 1929–1932 and

the Value of Stocks 174
7 Conclusions 187
Appendix: Results of cross-sectional tests 206
Notes 210
Bibliography 217
Index 229
List of Figures
0.1 Consumer Price Index (1825–1929) 15

1.1 Prices and Dividend Index (Cowles) (Base = 100, Jan. 1913) 21
3.1 Prices and Dividend Index (Cowles) (Base = 100, Jan. 1913) 59
3.2 US Treasury/central bank gold reserves (metric tonnes) 72
3.3 US money supply (1899–1931) 73
3.4 US money supply growth (1900–1931) 73
3.5 Private debt levels by sector (1900–1934) 75
3.6 US consumer prices (1900–1952) 77
3.7 US Unskilled Labour Wage Index (1900–1944) 78
3.8 Nominal GDP (1900–1939) 78
3.9 Real GDP (1895–1945) 79
3.10 Real and Nominal Dividend Index for
US stocks (1900–1933) 79
3.11 Monthly returns (Cowles Index) (1915–1927) 81
3.12 US long-term Government Bond yield (1900–1940) 83
3.13 Bank rate – Federal Reserve Bank of New York (1915–1937) 87
4.1 Index of airplane manufacturing stocks (1928–1933) 127
4.2 Volume of shares traded on NYSE (millions/month) 140
4.3 Fundamental changes and non-fundamental
component of P/D ratio changes 142
5.1 Volume of lending via ‘others’ 151
5.2 Total demand and time loans (1926–1931) 152
5.3 Profits from corporate lending to NYSE 156
5.4 Profit from covered interest
arbitrage £ bank rate / $ call rate 161
5.5 Bank of England and NY Fed discount rates 166
5.6 Money market rates (October 1929) 167
5.7 Daily NYSE volume (1929) 168
ix
x List of Figures
5.8 Ratio of Cowles (1938) Index to Credit Index 172

6.1 Index of US business activity (1899–1937) 175
6.2 Nominal dividends and prices 177
6.3 Real dividends and earnings (1929–1935) 178
6.4 Long-term bond yields (1920–1936) 179
6.5 P/D ratio (1926–1935) 180
6.6 Book to market ratio of CRSP stocks (1926–1946) 181
6.7 Monthly change in Consumer Price Index 184
6.8 US House Price Index (1900–1935) 185
List of Tables
0.1 Smith (1924) estimates of return premium on stocks 13

4.1 Individual sector growth rates 98
4.2 Average P/D ratio for US stocks (Commercial &
Financial Chronicle), September 1929 100
4.3 Annual S.D. of stock and bond indexes and actual and
implied returns 101
4.4 P/D ratio for different risk premiums and growth rates for
US stocks 103
4.5 P/D ratio for different risk premiums and growth rates for
US stocks 104
4.6 Conversion table for Investment Fund A 106
4.7 1903 data on auto firms sales and profits (Seltzer, 1928) 119
4.8 Stages and inputs of the growth model 120
4.9 Results of sensitivity analysis 123
4.10 Automobile industry growth data 125
4.11 Auto high prices from September (Week 2)
(Commercial & Financial Chronicle, 1929) 126
4.12 Results 131
4.13 Results (risk premium = 3.6 per cent) 135
5.1 Securities loans in 1929 (millions of dollars) 167
A.1 Results of regression of percentage change in P/D ratio
from 1927–9 (DEP) with earnings growth rates
from 1927–9 206
from 1928–9 with annual earnings growth rates
from 1928–9 206
from 1927–8 (DEP) and annual earnings growth rates
from 1927–8 206
xi
xii List of Tables

from 1927–8 (DEP) with annual dividend growth rates
from 1927–8 207
from 1927–9 on dividend growth rates from 1927–9 207
from 1927–9 with dividend growth rates from 1924–7 207
from 1927–9 on earnings growth rates from 1924–7 208
from 1927–8 with age, net current assets,
market capitalisation (size) in 1927 and percentage
change in P/D ratio in 1926–7 208
A.9 Results of regression of percentage change in market
capitalisation from 1927–9 on net current assets,
age, and risk rating 208
Preface
This book aims to produce in as detailed a way as possible a guide to

the American stock market boom and crash of the 1920s and 1930s. We
do this using a new approach to the study of financial history, known
as historical finance, which follows the Cliometric Revolution, but
aims to blend the use of historical study with more advanced financial
econometric techniques, which are grounded in contemporary models.
By studying the evolution of investment theory and through research
on the models used at the time, we can value the stock market through
the lens of the investors of the 1920s.
Using the statistical tests of the present day, but applied within the
context of the models investors were known to have been using, we
are able to draw clearer conclusions about what investors did and did
not know about stock pricing in the 1920s. From this position, we are
able to offer new ideas about how valuations were formed and make
more informed judgements about whether the market was overval-
ued. Investors were keenly aware of what we would consider today as
advanced financial data and tools of valuation analysis, as well as data
on long-term returns to stocks relative to bonds.
There are three main areas of innovation in the book. First, it contains
hand-collected data from source manuals from the 1900 to 1930 period on
the dividend growth rates of US Common Stock, which allows the study of
the returns to investing in stocks in the USA over the long term.
The second major innovation is to reconstruct valuation models of
high technology stocks in the 1920s for the aviation industry. This
industry is most often associated with the boom and we calibrate a
valuation model based on the growth path of earlier new technology
industry. Both of these tests are based on the actual models investors
were using at the time, and the discovery of new evidence for these
models is a major step forward in the field. It represents an addition to
the literature on the evolution of finance theory, as well as a good way
of estimating how investors would have valued stocks. The approach
therefore stands in diametric opposition to the use of modern tools of
valuation in research of historical episodes. The new approach allows
us to make more informed judgements about ‘rationality’ in the sense
that we do not measure investors’ behaviour by our yardsticks alone.
The existence of the models also indicates the level of sophistication of
xiii
xiv Preface
valuation in the period, even in the event that we find a deviation from
fundamentals, which we estimate.
The third innovation is to use the returns to a new type of investment
vehicle, which emerged following a new study on the returns to stocks,
which appeared in the 1920s. We follow the performance of an index-
tracking fund, Investment Trust Fund ‘A’ from 1925 to 2010 in order to
find ex-post returns to investing in a diversified basket of US stocks. This
method tracks the representative investor’s returns through merger and
takeover of the fund through its history and is free from survival bias.
We are therefore able to assess whether the use of such a fund would
have made sense to the average investor who sought to reduce volatility
of returns and vitally, whether returns over the long run after the 1920s
indicate that higher expectations of returns made during the 1927–9
period were justified. Together, these approaches yield interesting and
testable results about the values of stocks.
The book deals with a controversial area of finance, namely asset price
‘bubbles’ and their potential causes in a particular historical market. The
1920s US stock market is the most famous alleged period of asset over-
valuation in US history. In keeping with the approach towards using
historically based financial models the work also looks at the devel-
opment of theories about asset bubbles and market efficiency, which
occurred before and during the period in question.
Although generally the main focus of the work is on asset prices
and asset pricing theory, set within the framework of the 1920s and
1930s, there are some areas which are investigated which will lead to
more research about bubbles. These areas have direct relevance for the
post-mortem of the 2008 Global Financial Crisis and the lessons to be
learned because 1920s USA also witnessed factors common to the recent
crisis. One common factor was a substantial expansion in the volume
of credit to the real economy during the First World War and a major
boom in property prices, which recent econometric studies suggest con-
tained a bubble component (White, 2009).
Acknowledgements
The author would like to thank Professor Geoffrey E. Wood, Professor

Forrest H. Capie, and Professor Ian Marsh at Cass Business School,
Professor Charles A. E. Goodhart and the Financial Markets Group
(FMG) at the London School of Economics and Political Science, and
funding from the Economic and Social Research Council (ESRC).
A debt of gratitude must also be extended to Professor William N.
Goetzmann and Professor Roger Ibbotson at the International Center
for Finance at the Yale School of Management, Yale University, Professor
Charles Calomiris at Columbia Business School, Columbia University,
Dr David Chambers and Dr D’Maris Coffman at the Centre for Financial
History, Cambridge University, and Professor Eugene White at Rutgers
University. The guidance of Professor Martin Ricketts and Mr Michael J.
McCrostie at the University of Buckingham is also acknowledged.
Funding for the research was provided by the ESRC as part of the PhD
research which forms the basis of the book and is duly acknowledged.
xv
Prologue
The research, which forms the basis of this book, was motivated by a
desire to understand one of the most controversial topics in economic
history. Using new data, current financial models and financial theory
from the 1920s, we reconstruct fundamental estimates of the values of
US stocks and test for causes of the boom and bust. Our time frame of
analysis centres on the 1915–33 period, but we use data over the very
long term, from 1871 to 2010, to establish and resolve whether a
‘bubble’ – defined as a deviation from ex-post fundamental values –
formed and then crashed.
We offer new insights into the nature of the boom and bust. A house
price bubble, monetary expansion on a large scale, rapidly rising stock
prices, new investment vehicles, new investors and a technology boom,
all combined with new theories on asset returns and new models of
how to value stocks. In a seemingly intractable combination, these fac-
tors generated a 400 per cent rise in stock prices from 1921–9. Equally
puzzling is the 1929–32 crash. The market crashed from 1929–32 by the
same magnitude as the boom, returning stock prices to their original
levels in 1921 or lower. This was a staggering fall of over 80 per cent. All
of the factors at work during the 1920s make the resolution of the ques-
tion of the legitimacy of the rise in prices and the identification of the
drivers of the rise in prices extremely challenging, due to the difficulty
in controlling for various factors.
The symmetry of the boom and bust, however appealing at first
glance, does not explain much about what drove securities prices
through boom and bust. By observing the stock market’s behaviour
ex-post the nature of any potential uncertainty that existed at the
time due to technological shock or other factors could be overlooked
and some potentially legitimate trigger for the boom missed. In
1
2 The Great Crash of 1929
order to develop a clearer understanding of the causes of boom and

crash, we take a broad look at the event, examining the economic
dynamics of the USA, the new financial theory that evolved in the
first two decades of the twentieth century, the microstructure of the
New York Stock Exchange (NYSE) market, and the behaviour of other
financial assets relative to stocks. New econometric tests of the ex-ante
expected returns and ex-post realised returns to investing in US
Common Stocks yield additional insights using original data sources.
As a result of the research, we are now able to better understand the
dynamics of the boom and bust. We employ in our analysis comple-
mentary research and additional tests which have been conducted
by leading experts in the field of economics, finance, and historical
finance, combined with our own contributions, to develop a more
complete picture of the economy of the time. The work owes a huge
debt to these researchers whose work is acknowledged in Chapter 2
and throughout the book.
The 1920s were a time of new theories on asset returns and asset
pricing related specifically to Common Stocks. Perhaps the most
prominent pre-boom book, and one which is often credited as having
played a major role in the formation of the boom, was Edgar L. Smith’s
Common Stocks as Long-Term Investments (1924). Smith’s work contained
a long-term empirical study of the return to a series of Common Stock
and corporate bond portfolios, from 1866 to 1922, which found that a
large excess return on Common Stocks over corporate bonds could be
earned using a passive buy-and-hold strategy. Smith (1924) identified
what we now know as the Equity Risk Premium, but at the time that
his book was written, no clear link was made between the volatility of
stocks and the premium. His discussion does contain some reference
to how downside risk was reduced by holding for periods of between 4
and 15 years, so that no capital loss would be incurred. The work refers,
therefore, to a non-standard measure of the ‘Risk’ of investing in stocks.
Importantly, the reason for the observed return premium for stocks was
never explained.
Smith (1924) has been proven to be an accurate description of the
long-term returns to Common Stocks (Goetzmann and Ibbotson, 2006).
The many critics of the book, who blamed the boom and crash on the
public’s interest in the book which started a fascination with Common
Stocks (Graham and Dodd, 1934; Williams, 1938), can only justifiably
refer to the ambiguity in the book regarding the source of the excess
return of stocks over bonds, and the potential misuse of its findings by
speculators.1 Fisher (1930)2 stated that the increase of Common Stock
Prologue 3
prices in the 1920s was driven by Smith’s (1924) theory and the reduc-
tion of risk by diversification, inherent in the book.
The new research helped to generate the formation of a new type of
investment vehicle – the ‘closed-end fund’ – which aimed to earn this
stock return premium by holding diversified stock portfolios, over the
long-term. The 1920s should be viewed as a time of financial innova-
tion, which could help undiversified investors reduce their volatility
of returns and earn a long-term premium, which was based on sound
empirical research. Earlier quantitative research on portfolio diversifica-
tion and the reduction of return volatility (Lowenfeld, 1909b), asset
lifespan, and dividend discount modelling (Fisher, 1906) all illustrate
the type and level of sophistication of the financial modelling going on
in the years leading up to the boom of the 1920s.
For those especially interested in how investors thought in this
period, we present the results of our tests of the long-run Equity Risk
Premium (ERP) and our models of expected dividend income from the
aggregate stock market. These tests suggest investors already demanded
a premium over the risk-free asset in the 1920s. There is much to
suggest that even in the 1920s, the volatility of stock returns was the
reason for the ERP. The risk aversion of investors seems to be apparent
and also that there was no reward for diversifiable risk, as is the expec-
tation of Modern Portfolio Theory (MPT) (Markowitz, 1952). While
we do not know if investors used MPT in the 1920s or desired com-
pensation for stock market return volatility, there seems to have been
no reward for this volatility-based ‘riskiness’ that could be reduced by
holding a large portfolio of stocks.
The stock market boom of the 1920s engendered much research work to
explain why the stock market was rising so much and how the technologi-
cal innovations of the time were a source for optimism. This is exemplified
in Dice (1926, 1929) who believed that the boom was justified on the basis
of the progress of the US economy being witnessed in the 1920s.
Analysis of the economic data related to the 1920s shows that this
period preceded substantial increases in productivity growth rates, ema-
nating from the innovations of the time (Gordon, 2010). Patent num-
bers based on these new innovations surged (Nicholas, 2008) and the
entrepreneurial innovators characteristic of the USA before the 1920s
moved progressively within the boundaries of the firm in organised
research and development (R&D) labs (Schmookler, 1957).
In a new discovery made by our research, evidence of a two-stage
industrial growth model, used to value stocks, based on a method
using numerically calibrated models, was found in Moody’s Manual
of Investments (1930). This model was intended for investors to value

the aviation industry. These new ideas on modelling high technology
growth illustrate the extent to which investors were capable of model-
ling financial assets and high growth industries. The level of sophistica-
tion, although not high by today’s standards, is nonetheless advanced
enough to indicate that serious efforts were being made to value high
technology industries. The model did this by showing other historical
examples of high technology growth and offering numerical inputs to
the growth model. The model also gave an estimate of the stage of the
industrial growth cycle that the aviation industry had reached in 1929
relative to historical examples.
The US stock market rocketed by 400 per cent from 1921 to 1929.
The 1920s boom also coincided with and was potentially influenced
by other economic developments. The 1920s witnessed the effects of
a monetary expansion of substantial scale (Friedman and Schwartz,
1963). All three factors – new theory, technology, and monetary effects –
contributed to the 1920s boom.
The period before 1929 also saw advances in financial information and
financial analysis of US corporations. Our tests which indicate that stocks
became overvalued should be separated from the advances made during
the decade in financial theory, data sources on stocks, economic and busi-
ness analysis and information technology related to stock investments.
Roger Babson founded the Babson Statistical Organisation in 1904,
which aimed to introduce scientific analysis to forecasting economic and
business trends. Moody’s Investors Service started publishing analysis of
Common Stocks in 1900 (Moody’s Manual of Industrial and Miscellaneous
Securities, 1900). By the 1920s these voluminous and detailed manuals
gave investors rich information and data on balance sheets, profits and
loss accounts, dividend history, and numerous other calculations of
financial information (Moody’s Manual of Investments, 1930). The non-
professional investor also had access to data on international commodity,
currency and asset markets, and Common Stock price data at a weekly
publication frequency for hundreds of Common Stocks and bonds
(Commercial & Financial Chronicle, 1929).
The sophistication of the 1920s financial markets and of the financial
literature about them, has been overshadowed by the Wall Street Crash
of 1929 and the Great Depression, which together serve as a cautionary
tale against financial speculation. Yet that afterlife should not distract
attention from our research findings. These suggest overvaluation of
stocks, intermingled with a genuine belief in a new technological or
high productivity era.
Prologue 5
Key texts related to the boom and bust of the stock market appeared
in the aftermath of the Crash. New books, on how to scientifically value
stocks, were penned in the years following, by both academics and prac-
titioners. It is reasonable to assume that much of the technical ability
for such advanced work in financial theory was already being developed
during the 1920s. The most famous of these post-Crash advances in tech-
nical and theoretical finance, are the now immortal works of Benjamin
Graham and David Dodd, Security Analysis (1934) and J. B. Williams
The Theory of Investment Value (1938). Graham and Dodd (1934) were
motivated, in part, by the losses of Benjamin Graham’s investment
fund, during the Crash. Following the near failure of his investment
fund, he turned to devising a new way to invest in stocks. His aim was
to derive a safe return from undervalued stocks based on fundamentals,
through careful balance sheet analysis to seek ‘value’ in investments,
rather than to predict the movements of stock prices. In this way the
Crash motivated him to develop a new school of investment theory
based on the ‘value investing approach’. Graham was not alone in this
change to a new philosophy to try to beat the market. Another invest-
ment practitioner, who went on to earn his PhD at Harvard University
as a result of the boom and bust, and the desire to understand the causes
of and remedies to the Great Depression was John Burr Williams. J. B.
Williams is widely regarded as the first to show the full mathematical
formula for the Dividend Discount Model (DDM) (Williams, 1938). The
Theory of Investment Value (Williams, 1938) is an investment classic con-
taining voluminous and detailed, methodical, quantitative analysis of the
actual worth of a company. He devised a series of very advanced math-
ematical formulae and rigorous financial analyses of balance sheets and
other financial information to value stocks. He looked at industry life-
cycles and growth, and different types of stocks such as utilities, which
require different pricing formulae. He conducted detailed case studies
of individual stocks in an attempt to determine the value of a stock
from its fundamental characteristics and drew a deliberate line between
the ‘investor’ who was in stocks for the long term, and the ‘speculator’.
Williams (1938) also discussed the idea of how prices are set in financial
markets, concluding that ‘marginal opinion’ caused prices to fluctuate.
The book offers some clues as to the nature of the boom. He chided the
popularity of Smith (1924) in the eyes of the investors and he lays the
blame for the boom and bust on their use of the book. Throughout his
analysis of actual case studies in financial valuation, such as US Steel,
he compares his estimates to the actual market highs in 1929, and finds
that there were large divergences between them.
The motivation for both of these new theorists was the rejection of, and
frustration with, speculative valuations and their search for the ‘intrinsic
value’ of a security. Both of these post-crash classics of investing, which
are substantial in length and technical complexity, refer to the work of
Smith (1924) as encouraging speculation in Common Stocks. Graham
and Dodd believed that investors’ irrational ideas on the source of the
ERP came from Smith (1924). Graham and Dodd believed that a focus on
‘retained earnings’ as the source of the ERP drove investor sentiment to
exuberant levels. They lambast investors, rightly or wrongly, for a short-
term focus on high earnings growth trends as an indicator of worth and
the impulse for the bubble. Smith (1924) contains a good measurement
of the ERP, as modern tests of the historical data show. Therefore, blaming
this work for the formation of the bubble, if in fact a cause of investors’
fascination with Common Stocks, seems to have been because the con-
tents of Smith’s innovative study were used by investors in the wrong way.
Fisher’s The Stock Market Crash and After (1930) analysed the events of
the boom and was written in the wake of the initial crash in October
1929. He explained why the boom was justified, based on the techno-
logical progress of the era, and concluded that the outlook ‘remained
bright’ for the US economy and US stocks. He also thought that risk
assessments of stocks were changing in the 1920s.
By 1932 when the US market had bottomed out, the economy had
already fallen into a depression. Systematic analysis of the boom and crash
appeared in 1938, after a major research exercise by Alfred Cowles (Cowles,
1938), who was concerned with understanding the experience of the Great
Depression and the challenge it posed to the efficiency of the stock market,
and thus to the benefits of investing in stocks for the long-run. Cowles’
research (Cowles, 1938)3 involved the collation of stock prices, price and
return indexes, dividends and earnings for over 60 major sectors, from
1871 to 1938. These data, which still form the historical time series used by
Shiller and many other financial historians, are of high quality and reveal
detail about which sectors rose and fell from the 1870s to 1938.
The most famous and the most lasting literature on the 1920s regard-
ing the boom and crash, written in the 1950s, was J. K. Galbraith’s
famous work The Great Crash (1954). Galbraith focused on the idea that
the 1920s, although a new technological era for the USA, which the
USA had previously experienced with railways and automobiles, led to
an irrational over-optimism that created a bubble from 1928 to 1929,
which evaporated in October 1929.
Galbraith’s main focus was the financial scandal and wild exuber-
ance generated by quick profits, the novelty of the companies, public
Prologue 7
participation in the boom, and mass media coverage. Galbraith’s book is

both highly instructive and advanced in its analysis. It explains the ‘arbi-
trage’ induced flow of funds to the investors and traders and the anoma-
lously tight conditions in the call money markets, thereby debunking
the ‘easy credit’ explanation of the boom and pointing to expectations
driven by overly exuberant valuation of stocks. He acknowledged that
no definitive understanding of the boom and crash had come to light
since the event although he does conclude that prices were too high
from 1928–9, fraud was widespread, and investors got ‘rimmed’. The
book was a clarion call to future generations that such events should not
be forgotten. What we do is to add more technical rigour to the analysis
of the boom, so that we can deconstruct it as far as is possible. This is to
allow the reader to examine the dynamics of the boom and bust.
The 1920s US stock market and the evolution of finance

theory: the emergence of investment science
In 1900 Louis Bachelier (Bachelier, 1900) was already investigating the

behaviour of stock market prices on the Paris Bourse. The social sciences
had begun to take notice of this area of the financial economy and
although ideas about market risk and investment trust diversification
were already in practical use in the UK investment trust industry, the
theories that underpinned the actual strategies used by fund managers
developed in the academic sphere from 1900 onwards.
Scientific studies of equity valuation and portfolio diversification first
came to the fore in the early twentieth century. Lowenfeld (1909b) pro-
posed new theories based on quantitative studies of international port-
folios, on how diversification could reduce volatility and earn higher,
and less volatile returns for an investor.
Fisher (1906) looked at how dividend discounting could be used to
value stocks. The introduction of the concept of the discounting of
income from Common Stocks in the form of dividends, in order to
derive the value of the asset, comes from Fisher’s The Nature of Capital
and Income (1906). Fisher discussed the concepts of corporate bond
valuation and risk by finding the ‘risk-free’, ‘mathematical’ and ‘com-
mercial’ value of the bond. This process involved discounting income at
the ‘risk-free rate’. He also then determined two risk factors, which were
applied by bond investors:
1. The ‘probability’ of these income payments.

2. A ‘caution’ factor.
Therefore the value of the bond would be lowered by a ‘probability fac-

tor’ to capture the ‘risk’ element of the income from the bond to derive
the ‘mathematical’ value, and then he added a ‘caution’ factor to derive
the ‘commercial value’.
Fisher then applied these principles of valuation to Common Stocks:
in the general case we have to do not simply with the risk of falling
income, nor with the risk of falling below a specified income, but with
both. Thus the dividends from common stock have no fixed minimum
as do those from good preferred stock nor any fixed minimum as do
the interest payments from bonds. They may vary and vary widely in
either direction. The amount of variation may be measured with refer-
ence to any specified amount selected arbitrarily as the basis of the
comparison. For instance in the case of a stock which has yielded, in
successive years, the following percentages 5, 5, 6, 5, 5, 4, 5, 7, 5, 3, 4, 5,
we may for convenience take 5 per cent to serve as a basis for computa-
tion. If these frequencies are our only guide to judging the future, they
represent the probabilities of receiving the respective dividends.
On the basis of the foregoing figures it is possible to calculate the
‘risk less’ and the ‘mathematical’ value of the stock, and if we know
the caution factor, it is possible to calculate the ‘commercial’ value
also. (Fisher, 1906: 276–83)
Fisher also describes the use of the ‘risk-free’ yield curve in the discounting
of income and effects of the variation of the yield curve on valuation. In
addition, the use of a discount rate, which reflected the risk on Common
Stock income, as well as adding a premium for ‘caution’ were defined.
The estimation of the longevity of dividend income
Another key theory detailed by Fisher (1906) was the effect of the
longevity of the asset and its income on its value. Fisher’s theories
demonstrate the plausibility of the idea that investors could calcu-
late Common Stock value by discounting dividend income over the
expected timescale of the income and that rational calculation of the
lifespan of assets was also being conducted.
New ideas on risk and uncertainty
The 1920s saw a change in the academic treatment of risk and uncer-
tainty. Chicago economist Frank Knight in Risk, Uncertainty, and Profit
Prologue 9
(1921) first conceived of an explicit distinction between quantifiable

and unquantifiable risk.
The practical difference between the two categories, risk and uncer-
tainty, is that in the former the distribution of the outcome in the
group of instances is known (either a priori or from statistics of
past experience), while in the case of uncertainty this is not true,
the reason being in general that it is impossible to form a group of
instances, because the situation being dealt with is in a high degree
unique.
The best example of uncertainty is in connection of judgement
or the formation of those opinions as to the future course of events,
which opinions (and not scientific knowledge) actually guide most
of our conduct.
Now if the distribution of the different possible outcomes in a
group of instances is known, it is possible to get rid of any real uncer-
tainty by the expedient of grouping or consolidating experiences …
Uncertainty must be taken in a sense radically different from the
familiar notion of risk, from which it has never properly been sepa-
rated … The essential fact is that ‘risk’ means in some cases a quan-
tity susceptible of measurement while at other times it is something
distinctly not of this character; and there are far reaching and crucial
differences in the bearings of the phenomenon depending on which
of the two is really present and operating. There are other ambigui-
ties in the term ‘risk’ as well but this is the most important. It will
appear that a measurable uncertainty, or ‘risk’ proper as we shall use
the term, is so far different from an unmeasurable one that it is not
in effect an uncertainty at all. We shall accordingly restrict the term
‘uncertainty’ to cases of the non quantitative type. (Knight, 1921:
19, 233–4)
In the UK, John Maynard Keynes (1921) was also making advances
towards the distinction between risk and uncertainty. He expressed
the idea that probability could not be truly known in some instances.
Furthermore, he discussed the non-linear nature of probability, which
may change completely in new circumstances that have not been
observed before, thus making guessing about probability in an unknown
future state of the world impossible. It is clear from Knight (1921) that
‘uncertainty’ had been conceptualised, prior to the 1920s boom, as dis-
tinct from ‘risk’, the former being incalculable and the latter conducive
to the application of probability theory. The ‘Knightian/Keynesian’
ideas on what cannot be truly known show to what extent academic

theory had mastered these intricate concepts.
Our subsequent econometric tests of long-term equity returns and the
Equity Risk Premium show that Price/Dividend (P/D) ratios for the stock
market implied no compensation for diversifiable risk. This suggests
that the 1920s market before the alleged bubble phase was efficient in
the sense that there was no ‘free lunch’. The market itself would not
compensate the undiversified investor and our historical volatility cal-
culations suggest investors required a compensation for the volatility
of the market portfolio over the risk-free asset comparable to the excess
volatility of other assets.
New research on equity returns proved a major insight into the new
asset class and how much an investor could earn from these assets if
diversification was used. By the 1920s these ideas about investment
started to come into the domain of the ordinary investor via the pub-
lication of a major study on asset returns, which had started out as an
investigation by a bond salesman who was aiming to show how bonds
were a good investment over the long term.
Smith (1924) illustrates that by the 1920s, the financial literature had
made significant advances in the methods for calculating the returns
to diversified Common Stock holdings. Smith’s Common Stocks as Long-
Term Investments (1924) detailed comparative tests of ten stock and bond
holdings using total return calculations, over a 56-year timeframe from
1866 to 1922. He found evidence of superior total return performance
of Common Stocks over corporate bonds. Over the long-term (20-year)
frame of the analysis, Smith also noticed that investors had overestimated
the ‘long-term’ risks of stocks relative to bonds and the risks implied by
prices in 1924 were lower than the prices being paid for Common Stocks.
These studies are the record of a failure – the failure of facts to sus-
tain a preconceived theory. This preconceived theory may be stated
as follows:
While a diversity of Common Stocks has, without doubt, proved
a more profitable investment than high grade bonds in the period
from 1897 to 1923, during which dollars were depreciating,4 yet with
the upturn in the dollar,5 bonds may be relied upon to show better
results than Common Stocks, as they did in the period from the close
of the Civil War to 1896, during which the dollar was constantly
increasing in purchasing power. Based upon a general understanding
of the results which logically follow changes in the purchasing power
of the dollar, such a theory should have been demonstrable, and the
Prologue 11
tests of the comparative investment value of bonds and of Common

Stocks covering the period from 1866 to the end of the century,
which are outlined in the following pages, were undertaken in its
support. But they failed, because, quite unexpectedly, they demon-
strated that the premise on which the preconceived theory rested,
namely that high grade bonds had proved to be better investments
during the period of appreciating dollars, could not be sustained by
any evidence available. (Smith, 1924: v)
Although Smith focused initially on changes in the returns to

Common Stocks as a result of price level changes and the ‘purchasing
power’ of the dollar, the result of his work was the identification of a
need for a change in investors’ assessments of the ‘riskiness’ or per-
ceived riskiness of Common Stocks, held in groups, and his advocacy of
investment in Common Stocks over corporate bonds.
Smith (1924) advocated the measurement of dividend income return
by adjusting for ‘stock splits’ and ‘bonus shares’, indicating the level of
sophistication of the methodology for valuing returns from Common
Stocks.
The usual data and charts representing market fluctuations of

Common Stocks are of no value in this connection, as they disregard
stock dividends, the subdivision of shares, securities of different
character given in exchange, and all the other changes in the form
of holdings which would come to an actual investor in Common
Stocks who retained the capital distributions of his original holdings
throughout an indefinite period of time. (Smith, 1924: 68–9)
Data from Moody’s investors’ manuals provided detailed informa-

tion on profits, dividends, debt levels, ‘bonus shares’, and ‘stock splits’
extending back to 1908 with less detailed but still meaningful data
going back to 1900. Therefore, the calculation methods advocated by
Smith were accessible to investors over this timeframe.
E. L. Smith constructed a ‘spliced’ long-term return series from his
total returns over the 20-year timeframes; we base our estimates of the
ERP which Smith found using the method of overlapping his samples,
to find an average premium over his corporate bond returns data.
We have, then, data relating to four separate stock holdings covering

various periods from 1866 to 1922. The data of no one group cover
the entire period, but the several groups overlap and if we are able
to discover that these differing groups of stock have the same invest-
ment rating in those years when they do overlap, then we shall be
justified in the supposition that we have made no vital change in the
investment character of our holdings if we shift them at their market
prices from one group of stocks into another in those years. … in pre-
paring a composite series from data derived from these several groups
we may be warranted in giving a wider application to our resulting
conclusions than if the series were derived from a single group of
stocks held throughout the entire period. (Smith, 1924: 70)
Using Smith’s original data, our analysis suggested an investor could earn
a total return including capital gains and dividend income, which was
on average 2.5 per cent per annum higher than corporate bonds, when
holding over a long timeframe. We do not have the data to generate the
corporate bond returns, and we use an estimate of 1.5 per cent over the
Government Bond return for bonds. The AAA bond total return from
1870–1929 was about 4.3 per cent, during which time the return to
Government Bonds was about 3 per cent. We therefore assume a 1.3 per
cent premium for high-grade bonds.
The high-grade (AAA) bond index uses the yield from Macaulay’s
High Grade Rails Index from 1857 to 1918 and the yields from Moody’s
AAA Corporate Bond Index from 1919 on to calculate the total returns
for the index. The corporate bonds in the index are long-term with a
maturity of over 20 years.
Although we cannot be sure of the bond returns from Smith, as the
data are not evident, we also estimate that Baa bonds had a premium of
about 1.5 per cent based on their higher volatility. The findings of a 4
per cent premium estimated from Smith (1924) seem to be reasonable,
and the scale of the premium has been verified by research at the ICF at
Yale, USA (Goetzmann and Ibbotson, 2006) who also find about a 4 per
cent equity risk premium, over the long term before 1926 (Table 0.1).
Smith (1924) also introduced new ideas on the ‘riskiness’ of stocks. A
new concept called ‘time hazard’ was demonstrated in Chapter 10 of his
book. The shortest time hazard showed that an investment horizon for
the 10-stock portfolio, of more than four years, reduced capital losses
to zero.
In other words, there was no need for stocks to be deemed ‘risky’ when
held over the longer term. Even the more conservative measure of this
‘zero capital loss’ horizon using data from the 1830s to the 1920s, was
15 years. Smith also indicated that the volatility of economic growth in
the USA around its long-term trend had been falling since the 1830s.
Prologue 13
Table 0.1 Smith (1924) estimates of return premium on stocks
Timeframe Investment Total return Capital Income ($) Premium

($) over bonds growth ($) over bonds
($)
1901–1922 10 000 16 400 5420 10 980 5.2%

1901–1922 10 000 9242 953 8289 3.0%
1901–1922 10 000 21 954 10 590 11 364 6.0%
1880–1899 10 000 12 002 8654 3348 4.8%
1866–1885 10 000 2967 900 2067 2.5%
1866–1885 10 000 –1012 500 –1512 1.1%
1892–1911 10 000 11 723 7375 4348 4.7%
1902–1922 10 000 6651 4137 2514 4.0%
1906–1922 10 000 4938 264 4674 3.5%
The US economy was therefore seen as becoming more stable and hence
the ‘riskiness’ of stocks was falling as the US economy developed. The
ideas put forward were that ‘riskiness’ or volatility was reduced:
• Over time as the US economy became more stable.

• If investors used a longer holding period of four years or more.
• By using diversification to smooth out returns thereby reducing
volatility.
Smith (1924) had discovered what we now call the Equity Risk
Premium, but also challenged whether short-term volatility was a
meaningful concept when investors held over the long term. Smith
also did not explicitly connect the volatility of stocks with excess
returns to stocks.
At its core the innovation was a sound one, as it was an advantage
to investors, if handled correctly, and if the level of leverage was vis-
ible. How investors looked at new technology valuation was also fairly
sophisticated in the 1920s. Moody’s Manual of Investments (1930) shows
that two-stage industrial growth models were being used to value high
technology stocks, and that both the type of model and the explicit
reference it makes to a knowledge of the industry life-cycle and the sur-
vival probability of an industry shows that investors, leaving aside the
overvaluation period, were quite advanced in their thinking.
Science and progress have moved forward and another great indus-
try has been born. Aviation has come into its own. There have
been many other new industries that now appear as commonplace.

Railways in 1833, petroleum in 1865, telegraphs in 1868, auto-
mobiles in 1903, radio in 1914, rayon in 1917. We look for great
developments in the fields of aviation and aeronautics. We have
observed from our investigations that all new industries follow
similar courses of development in arriving at maturity, and that
this arrival is accomplished in three distinct stages. The first is the
inventive stage where the proposition is regarded as an idle dream
and the public has to be slowly convinced of its feasibility. During
this time the industry grows only a few percent per annum. The
second is the boom stage occurring after the feasibility and worth
of the industry have been demonstrated and the public mind has
at last been fired with the idea. During the second stage the typical
new industry in America expands at the rate of about 40 per cent per
annum. In the third stage after the industry has reached maturity,
the rate of expansion is reduced to an approximate equality with the
rate of growth in wealth, which here is about 5 per cent per annum.
Notwithstanding the certainty of losses in some stocks, the huge
profits are to be made in a new industry during the second stage,
and for the aircraft industry this means during the next five or ten
years. However, exceedingly keen judgment in investing is neces-
sary at this time, and diversification is essential. (Moody’s Manual of
Investments, 1930: xvi)
Our modelling of the automobile industry, which we do when

we build our model to value new technology industries, shows that
Moody’s (1930) growth assumptions are quite accurate, based on
this industry. Although we do not model the other industries listed
as other examples such as rayon, the model they produce seems to
reflect an accurate idea about the expected growth paths of successful
new industries.
One of our major aims is to understand the minds of the investors
in the 1920s in order to see how changes in investment theory may
have influenced behaviour; the increasing number of new investors
is also important for understanding this period. Industrial Common
Stocks were not used to a high degree by the average investor in the
USA before the 1920s. At the height of the boom, from a population
of 122 million people in the USA about 30 million held some form of
Common Stock and many of these holdings were via new investment
trusts or closed-end funds rather than direct stock holdings. That is
25 per cent of the population (Ott, 2011) and should be contrasted
Prologue 15
with modern-day USA where the figure for stock ownership was 52 per
cent of adults in 2013, of a total population of 320 million (Saad, 2013).
Stocks were a new and exciting asset class for many investors in the
1920s and from a very low base of stock holdings in 1900, the rise to
25 per cent is significant. However, a major segment of the population,
75 per cent, did not have any direct link to them. Therefore the ubiq-
uity of stock holdings is not a fair characterisation of the 1920s, but
the period did witness an increase in the use of Common Stocks by the
investing public, to fairly high levels (Ott, 2011).
Bonds were the traditional asset class used by investors with stocks
being seen as speculative, the instrument of the business-savvy and
subject to manipulation, and prone to major swings in prices not con-
ducive to use by the non-business class (Ott, 2011; Fisher, 1930).
The inflation of the 1915–20 period (Figure 0.1) reduced the real
returns to fixed income assets, as coupons and the face value of the
bonds, paid at maturity, are fixed. Such a deleterious effect of inflation
on the real returns on fixed income securities may have influenced the
behaviour of investors towards looking at stocks instead, as they were
known to be protected during times of inflation (Smith, 1924). There
25
20
15
Index
10
0
1825
1829
1833
1837
1841
1845
1849
1853
1857
1861
1865
1869
1873
1877
1881
1885
1889
1893
1897
1901
1905
1909
1913
1917
1921
1925
1929
Year
Figure 0.1 Consumer Price Index (1825–1929)

Source: NBER Macrohistory Database.
is, however, nothing to suggest that the boom was rationally created
by the need to avoid the effects of anticipated inflation. We can dem-
onstrate that investors were not seeking inflation protection of this
kind by testing the data on long-term Government Bond yields and the
growth rate of the US economy, and also by measuring the returns to
investment in US Government Bonds. We perform this calculation later
in Chapter 3 to show that inflation expectations in the 1920s were low.
1
Introduction
The financial crisis of 2008 has rekindled interest in topics within the
diverse field of economics, ranging from understanding systemic risk
within the global banking system (Acharya, 2009), to how the financial
system interacts with the real economy (Bayoumi and Darius, 2011),
to the neuronal activity of the human brain during asset bubbles
(De Martino et al., 2013). These extremely complex and enlightening
fields will drive research into many interesting questions in economics
for the coming decades and promise a great insight into these areas.
What the devastating effects of the crisis have also done is to bring
the study of economic history, historical finance and the history of
economic thought back into the consciousness of the general public
and the mainstream of economics. There are some parallels drawn
between the 1920s–1930s Great Depression and today due to the
widespread and prolonged crises common to both periods, and hence
a natural tendency to look back at the economic history of that period
has become evident.
History matters. The reason why we should be concerned about ensur-
ing that its relevance to economics and the social sciences is cultivated
is that human thought, and the economic systems which we form, are
in a constant state of change. Yet, many aspects of human behaviour
are common to all times. Being able to grasp this subtle concept is a
cornerstone of understanding economics. Although we do not seek to
pre-empt the conclusions of the book, it appears that financial history
contains periods of less than rational behaviour. The aim of the research
was to conduct comprehensive tests to establish whether an overvalu-
ation of the US stock market occurred and identify potential causes
and its underlying nature. The study of long-term data, when control-
ling for potential changes through time, can yield powerful insights
17
about how the economy and economic actors behave. The research
also aimed to understand asset valuation in its historical context, by
basing our assessment of investors’ behaviour on the valuation models
they used. This is important for the rigour of our conclusions and also
because the tools of financial analysis developed in the 1920s and 1930s
have shaped the development of modern finance theory.
The state of the art in research into asset bubbles comes from the
new field of neuro-economics, which is likely to be important in the
development of economics over the next decades. This discipline draws
on two fields – psychology and economics – to see how microeconomic
behaviour is influenced by human psychology. This is a complement to
more classical ideas on rational behaviour, but rather than depend on
the restrictive assumptions of rational human behaviour at all times,
aims to investigate what occurs when rational economic behaviour does
not occur, such as during asset bubbles.
A good example of the advances being made is De Martino et al.’s
paper ‘In the Mind of the Market: Theory of Mind Biases Value
Computation during Financial Bubbles’ (2013). The research aims to
measure the human brain’s activity to understand the neuronal pro-
cesses, and subsequent behavioural processes which they lead to, during
asset bubbles. In a laboratory setting, using brain-imaging techniques
normally used in the field of medicine, these tests reveal how economic
behaviour is generated. De Martino et al. find that the formation of
bubbles is linked to increased activity in an area of the brain that pro-
cesses value judgements. People who had greater activity in this area
of the brain were more likely to ride the bubble in a trading game, and
lose money by paying more for an asset than its fundamental worth.
During tests where fundamental values were no longer adhered to by
traders, they also found a strong correlation between activity in the
value processing part of the brain and another area that is responsible
for computing social signals to infer the intentions of other people and
predict their behaviour. This new and exciting work has a historical
precedent, the ‘Beauty contest’ analogy (Keynes, 2007 [1936]). In this
explanation of bubble formation and general price formation in financial
markets, the adoption of higher-order beliefs occurs where the market
price is not determined by absolute value judgements of the assets’
worth. According to this view, the best strategy is to guess what average
opinion thinks the value of a security will be. What the new research
direction shows is how complex and enigmatic ‘bubbles’ are, and also
that answers to the major questions of economics can be aided by inno-
vative techniques based in other major fields of study.
Introduction 19
Another equally vital area of research is the use of survey data to

test expectations of investors directly. In Greenwood and Shleifer’s
‘Expectations of Returns and Expected Returns’ (2013), the authors
test whether expected returns and expectations of returns diverge
and provide insight on why returns may exceed fundamentals using
multiple sources of investor surveys.
The study of financial history and historical finance has an equally,
if not more vital role to play in the resolution of whether bubbles form
in the real world. This is exemplified by the work of Yale University and
the International Centre for Finance, where detailed historical analysis
of financial markets and financial analysis of long-term financial data
have made the study of finance, and especially asset bubbles, more
viable. Having a reference point for both long-term asset returns and
economic growth enhances our knowledge of fair expected returns.
Being able also to measure realised returns over the long term provides
the reference points needed to make useful inferences about investor
behaviour and represent bubbles in the light of this fundamental expec-
tation and subsequent realisation. Our research draws heavily on such
an approach to set the benchmark, and then we analyse whether the
deviation of the benchmark displays evidence of irrationality. Seminal
work by R. J. Shiller, the joint winner of the Sveriges Riksbank Prize in
Economics in memory of Alfred Nobel with E. F. Fama and L. P. Hansen
in 2013, published in the American Economic Review (Shiller, 1981),
showed that long-term historical studies of asset prices yielded powerful
tests of market efficiency. The paper showed that in the broad market
index of stock prices the latter have deviated from their fundamental
values in long- and short-run swings of under and overvaluation over
long-term US financial market history.
Laboratory studies, where a market is created in controlled settings
(a key innovation in how bubbles are studied), have the potential to
resolve questions about economic behaviour and the formation of asset
bubbles. Smith et al. (1988) showed, in a controlled setting with live
participants, how asset prices could deviate from known fundamental
values. Smith’s work went on to earn him the Nobel Prize in Economics
in 2002 for work in experimental asset markets. From these seminal
modern thinkers and the ability of economists to assemble and ana-
lyse large amounts of data, a field in behavioural finance developed
in tandem with similar research on behavioural economics. The field
of behavioural economics became influenced heavily by the allied
social sciences, in particular psychology, with Daniel Kahneman being
awarded the Nobel Prize alongside Vernon Smith in 2002.
We focus on a particular time period and on a specific market.

Figure 1.1 represents a broad market index of US Common Stocks,
and uses data from Shiller (n.d.) taken from Cowles (1938) to show
the extent of the boom and crash. It is truly spectacular and terrify-
ing depending on where a hypothetical investor bought and sold.
Throughout the book, we use these data to look at the broad market
for US Stocks. These are the data used in Shiller (2000, n.d.) to esti-
mate the S&P 500 broad market index over long-term US financial
history. We use this measure to represent the US stock market, but
we also take direct measures from the cross-section of stocks when we
conduct our econometric tests.
The Cowles (1938) index is widely acknowledged to be a good gauge
of the US stock market (Goetzmann and Ibbotson, 2006). We use the
Cowles index throughout the book as a proxy for the US stock market,
unless otherwise stated.
The movements of the prices of Common Stocks, which rose by
400 per cent from 1921 to 1929, and collapsed from 1929 to 1932,
have been the subject of many analyses in the historical, popular, and
technical economic literature. The process has drawn interest due to
the scale of the boom and crash and its association with the largest
economic contraction in US history in the twentieth century. Perhaps
the most famous and telling account of the event remains the work of
Galbraith (1954) who was the first to provide a general account of the
boom and bust, and it has stood the test of time. The more technical
account contained in Wigmore (1985) puts numbers and much detail
to the boom and bust which Galbraith (1954) did not. In many ways,
this book and the research it reports owe these scholars a great debt
of gratitude. The works of Eugene White have also enlightened our
understanding of the period, through much econometric and historical
research on the 1920s boom. The study of the period is also indebted
to the work of R. Shiller, William N. Goetzmann, and Roger Ibbotson.
Their work on methods to detect asset bubbles, and long-term financial
data and financial history have made the insights of the future genera-
tion of researchers in these fields materially richer.
We are now in a position to conduct some further tests and borrow
from the insights of modern research in finance and economics, to
provide a picture of the boom and bust. The book follows the tradition
of a general account of the boom and crash with data on many aspects
cited in Galbraith (1954).
The focus of this book is to present new data extending well before
the Crash and data collected over the eighty years since, which allow
Introduction 21
Price index Dividend index
400
350
300
250
Index
200
150
100
50
0
Jan-13
Dec-13
Nov-14
Oct-15
Sep-16
Aug-17
Jul-18
Jun-19
May-20
Apr-21
Mar-22
Feb-23
Jan-24
Dec-24
Nov-25
Oct-26
Sep-27
Aug-28
Jul-29
Jun-30
May-31
Apr-32
Mar-33
Date
Figure 1.1 Prices and Dividend Index (Cowles) (Base = 100, Jan. 1913)
Source: Cowles (1938); Shiller (n.d.).
us to estimate, in a more technically rigorous way, the dynamics of the

boom and crash in the 1920s–1930s and answer the vital question as to
whether a deviation from fundamental values occurred.
The econometric tests and the data and methods for the tests are
also presented, so as to make the tests clear and therefore repeatable.
It is hoped that some of these techniques will improve the general
understanding of measuring asset bubbles. We use the term ‘bubble’ as
a descriptive word, which means, only, a deviation of asset prices from
their ex-post observable fundamental values. We do so with a measured
degree of caution as the word has many connotations, which we do not
want to invoke when using the term, such as a self-feeding increase in
stock prices. One of the key findings of the research was that asset bub-
bles are very hard to detect ex-ante in this period.
The main aim is to offer the reader a better understanding of the boom
and bust of the 1920s US stock market from a theoretical, historical, and
econometric perspective. A second aim is to introduce or at least confirm
to the reader the complex and enigmatic nature of asset bubbles and
hence stimulate more research on the topic of how these phenomena
actually form in the real world.
To this end it is worth introducing the reader to the history of economic

thought on ‘bubbles’ and the state of the art in the field. In Chapter 2, on
the current literature on this theme, we take a deeper look at how much
we know about them.
The subject of market efficiency is an area whose study has only
made serious headway in the last thirty years. Another aim of the book
is in part to stimulate the further study of economic and financial
history and to encourage research on bubbles, especially during new
technological eras.
The 1920s stock market boom – the rise in values from 1921 to 1929
shown in Figure 1.1 – was caused in the first instance by an underlying
monetary expansion of immense scale. The expansion is itself of great
interest to many economists as the monetary system of the 1920s was
different to today’s system. The monetary base was linked to gold, and
the USA was operating on a Gold Standard, hence the central bank
policy of the time, and its ability to sterilise international gold flows
and thus control the supply of money in the USA is of interest. Showing
how the US monetary/debt system changed to produce the boom of the
1920s is a key part of the research.
The newly formed Federal Reserve, born in 1913 to stabilise the US
economy and banking system, and the central bank’s policy during the
1920s are integral to understanding the boom. Furthermore, the central
bank’s policy towards the overvaluation, which they perceived, is also
materially important.
The dynamics of the monetary system are key to seeing how stocks,
which are nominal claims on future dividends, were affected by the mon-
etary expansion of the time. The research also shows how the housing
market’s debt system developed through the 1920s and later in the book
we look at how this may have played a role during the Great Contraction
from 1929 to 1932 via a nexus between highly leveraged home owners
and the banking system which provided the home loans. Key features
of the 1920s private and commercial property markets, which appear to
have led to a bubble in the housing market (White, 2009), include the
emergence of tradable securities in commercial real estate loans which
funded the rise of New York and Chicago’s skyscraper boom (Goetzmann
and Newman, 2012) and contributed to the crash in house prices due to
the Great Contraction in the US economy from 1929–32.
Using methods developed by Goetzmann and Ibbotson (2006), and
our own historical data set, we can estimate the level of the US stock
market, which is justified based on long-term history. This approach fol-
lows that of Shiller (1981) and what emerges from our long-run data and
Introduction 23
the Equity Risk Premium (ERP) measure from Smith (1924) and using
data from Goetzmann and Ibbotson (2006) is an estimate of how much
stock values changed relative to expectation. The scale of the change
was up to 50 per cent beyond expectation for the broad US market.
The main conclusion is that this phenomenon that we can see ex-post
was driven by both ‘high expectations’ of returns for firms, thought to be
creating or benefiting from a ‘new era’, as well as potentially lower risk
premiums. These conclusions are based on the data we have access to, as
we do not have access to expectations data from surveys of investors from
the period. Thus we cannot resolve exactly to what extent each of the two
components was responsible for the overvaluation relative to our models.
We also show how there may have been legitimate reasons for the surge
in valuation ratios for stocks by examining a technological shock occur-
ring during the 1920s and the effect this may have had on valuations.
In line with our look at technological shocks and the stock market,
we can measure realised returns to the 1920s stock market by looking
at returns over the very long run for a proxy of the market portfolio.
Using bespoke survival adjusted return data, from the 1920s to 2010 we
can derive a measure of the ex-post return to the market portfolio. This
allows us to test whether higher expectations of returns or changing
risk premiums were justified ex-post. A major finding of the research is
that the return to a diversified investor in 1925 was very similar to that
expected over the long term before 1926 and was about 3.4 per cent
in excess of the return to long-term Government Bonds based on data
from 1925 to 2010. This level of return to stocks appears to be consistent
with long-term returns prior to the 1920s. This also shows us that any
high expectations of future returns in the 1920s were not forthcoming.
This result does not, however, rule out that new technology could have
driven the boom legitimately as high uncertainty pervaded the emer-
gence of new technologies and could have legitimately increased ex-ante
valuations, even if these dissipated ex-post (Pastor and Veronesi, 2009).
What we do is provide some sobriety to investors in the modern day
who believe that stocks bought in the 1920s would have earned spectac-
ular returns if held to the present, and also caution those who think that
the Great Depression damaged long-term returns relative to historical
expectation. Considering that equity instruments, or stocks, are by their
very nature a claim on the dividends of a very long-lived asset, long-term
investors would not have been disappointed given an accurately formed
expectation if they bought in 1925.
New research from Gordon (2010) shows that the USA was on the
verge of a huge deviation from its trend productivity growth path, which
manifested from 1928 to 1950. Although the exact nature of this produc-
tivity surge is still the subject of research, acknowledging such a reality of
a ‘new era’ in the USA is important if the dynamics of the 1920s boom
and bust are to be understood. The real shift was not large enough to jus-
tify the changes seen in stock valuations. Nicholas (2008) shows patented
technologies were being revalued in the 1928–9 phase of the boom and
excess returns to these stocks remained after the crash. Janeway (2012),
by contrast, identifies a similar step-change, but ascribes the dynamics of
the post-war period to big-state capitalism and the willingness of the US
federal government to buy a range of military technologies that could be
shown fit for purpose or dangerous if developed by the enemy.
Our research points heavily towards a change in investor perceptions
of the value of Common Stocks, which had no foundation in the his-
torical or realised experience of investing. Ex-post experience of stock
returns were in line with the prediction of history, and therefore it is
hard to substantiate the claims that market prices rose to reflect a bright
future for investors. Additional cross-sectional tests reveal that naïve
extrapolation of earnings or dividends did not occur and only very weak
momentum effects can be seen in the cross-section of stock returns from
1928–9. Furthermore, there does not appear to have been a systematic
change in the ERP. These results indicate that whatever occurred in the
1920s boom was not predictable at the firm level. Our results are, how-
ever, still consistent with the idea that overvaluation could be detected
ex-ante, as exemplified by De Long and Shleifer (1991) who illustrate a
premium on financial assets whose ex-ante valuation can be calculated.
Hence the potential for a technologically driven legitimate ex-ante rise
in valuations has an upper bound.
We do challenge the conclusions of academic work on the subject
that claims no bubble existed. The research of Donaldson and Kamstra
(1996) and McGrattan and Prescott (2001) pointed to a fundamentally
justified level of the stock market at peak levels. Our results suggest
something contrary.
Investor perceptions of a ‘new era’, public involvement in stocks
via new financial products, and new data on the returns to investing
in Common Stocks may all have influenced its formation and propa-
gated the overvaluation. These factors are in addition to the very high
returns, which were a general feature of the period leading up to the
bubble forming, as stocks returned over 20 per cent per year before the
overvaluation phase.
This period also bears the hallmarks of what modern research in the
laboratory suggests are the conditions under which a ‘bubble’ is more
Introduction 25
likely to form. However, we cannot provide conclusive proof of how the

bubble formed, as this type of analysis is ‘state of the art’ and we do not
want to rely on untested theories of the boom and bust when we draw
conclusions. What we do know is that momentum was present and
there was a technology focus. Although momentum may not neces-
sarily be due to irrationality as it may also be due to the technological
shock, its presence indicates potential self-feeding bubble processes.
As the research also aimed to be set within the historical context
of the mind-set of investors and the theories of the time, rather than
to judge them by our standards alone, the book looks in detail at the
investment models, financial theory, and the evolution of equity pric-
ing theory from 1900 to 1938. We also look specifically at whether
investors were sophisticated in the 1920s, despite the overvaluation we
detect.
As we have already seen, many respected financial economists
wrote about the boom as having theoretical drivers or presented new
approaches to the equity valuation behind it. Smith’s Common Stocks
as Long-Term Investments (1924) stands out and is cited in Graham and
Dodd (1934), J. B. Williams (1938), and Fisher (1930). Although trying
to link the formation of the bubble to new ideas on valuation is diffi-
cult, the literature suggests that the latter played a role large enough to
warrant investigation. The fact that the research contributed to the for-
mation of a new type of investment vehicle in the 1920s, the closed-end
fund, and the emergence of these new funds during the 1927–9 phase
of the boom where we find the overvaluation makes the investigation
of a potential theory–pricing nexus interesting and is a key innovation
of the book from the perspective of historical finance.
Smith’s book (1924) offered the public investor of the 1920s an
insight into how equities performed well in the preceding fifty-six
years compared to bonds, providing substantial evidence for the
existence of and size of the ERP. What this book also did was to leave
an ambiguity as to the source of the premium. Some interpreted the
book as misguiding investors into thinking that stocks were too cheap
relative to their power to produce earnings which were reinvested
and went on to produce more earnings (Graham and Dodd, 1934).
Whether investors actually believed this is a subject for future research
of the accounts of investors of the time. Our research shows that what
we now know as the ERP, which Smith (1924) reported as the return
of stocks over bonds, was not labelled as a premium for risk and its
cause was left ambiguous. What makes this issue more complex is that
Smith (1924) did devote a section to explaining to investors the nature
of volatility and the protection of investors’ principal when investing

in stocks. He also observed that the degree of volatility was changing
over time and Smith’s discussion in Chapter 10 of his book indicates
that he knew investors cared about the downside volatility of a stock’s
price as a risk factor. Smith (1924) suggested that holding stocks for
between four years and fifteen years, depending on the investor’s
horizon for the volatility calculation, was enough to reduce one’s loss
of principal to zero. Hence, a quasi-metric of volatility, making stocks
more directly comparable to bonds, whose principal was safe, is also
a key insight into the 1920s theory of equity pricing. This enriches
our view of the evolution of equity theory even though the broad
market appears to have priced the volatility of returns. Therefore the
appearance of new ideas on the safety of stocks may have influenced
investors to change their assessment of the expected returns to stocks.
The institutional and investor backgrounds to the boom are also
important. The First World War, and the Liberty Bonds programme,
used by the government to finance the war effort by utilising the public
as a mass source of funding, brought with them an opportunity for
the public to handle new financial instruments. New financial innova-
tions such as closed-end funds meant that the purchase of stocks and
bonds by a larger section of society was possible and banks organised
new securities affiliates (Peach, 1941) to market and broker stocks and
bonds to investors. The emergence of a ‘mass market’ investor relative
to the pre-war period reflected rising prosperity as the economy grew
and investor demand rose for securities. Furthermore, the monetary
expansion in the 1915–21 period led to new levels in the stock market
due to the abnormally high growth of nominal earnings and dividends.
Returns of over 20 per cent per annum in the late 1920s, compared
to the usual 6–7 per cent were a direct result of the banking system’s
expansion and may have been a factor in the surge in volume of trading
and attraction to the market.
The conclusions we draw are that changes in expectations of future
returns and a bias towards new technology (Nicholas, 2008) are the
most obvious drivers of the boom.
A key conclusion is that the ‘overvaluation phase’ was not mono-causal.
Nicholas (2008) shows that both momentum effects in monthly returns
and a systematic bias towards patents were present. Extrapolations of
earnings growth rates, dividend growth rates, or the effect of (Moody’s)
risk ratings, net current assets, or market capitalisation, do not give any
correlation to the degree of overvaluation in the cross-section of stocks.
Introduction 27
Many factors have been suggested as having contributed to the over-

valuation, and our results are an important addition to research on the
topic in that we rule out many such potential causes. What we cannot
do is show, directly, why investors became exuberant, as there are likely
to be many reasons for this, which are beyond our ability to model
clearly. Investors’ expectations of returns to US Common Stocks differed
markedly during the 1927–30 period. The subsequent reversal of the
ex-post identifiable overvaluation shows that investors eventually came
to a higher degree of convergence in their expectations of returns from
Common Stocks. The ex-ante bases of the overvaluations, being irrational
speculation or due to a technology shock, are not clearly resolvable.
As patented technology effects are found in the excess returns data
from 1928–9 (Nicholas, 2008), we take a new approach to try to model
the fundamentals of a new high tech industry. In this case we can again
test expectation relative to model. This exercise not only reveals the
level of sophistication of investors in the 1920s but also how differing
beliefs can potentially be identified. This approach is also of interest for
students of the evolution of finance theory as we have direct evidence
of a generic type of two-stage industrial growth model from Moody’s
(1930). We are therefore able to add significant richness to the analysis
of investors’ use of financial tools by modelling the aviation indus-
try’s life-cycle using prices from Cowles (1938) and data from Moody’s
(1930) and an industrial growth model derived from a comparison
industry, suggested by Moody’s (1930), the automobile industry. Our
analysis reveals that investors likely used a two-stage or three-stage
model with a probability factor for industrial survival in their calcula-
tions. Furthermore, we also find that the peak of the 1920s boom saw
aviation valued at 300 per cent of the value expected, assuming the rep-
etition of the growth path of the automobile sector. Therefore, we sug-
gest that high expectations were present in the 1920s boom. On what
basis these expectations were actually formed is not clear but a large
step is taken towards understanding how stocks were valued and what
kind of fundamental values were feasible. It remains possible that the
high growth rates were ex-ante feasible due to higher growth potential
than that suggested by history, or the uncertainty about new technol-
ogy and which firms would win through led to stocks being priced at a
high level. Despite the difficulty in answering questions we are able to
provide both the theoretical context and data to support the idea that
a high tech industry rose to values beyond a contemporary benchmark
and to explain how investors saw new technology industry valuation.
Another key area of interest that we also aimed to model was the
NYSE’s credit system in the 1920s. This was a period in which the
central bank, the US Federal Reserve, was concerned about price rises
due to the credit margins available to the traders and investors active
on the NYSE. Delving into the history of the Fed since its formation in
1913/14 and how it handled the monetary expansion of the 1915–29
period, we then look at its role during the boom. The Federal Reserve
Board were concerned about credit flows to the stock market and the
valuation levels of the stock market. They believed that credit was being
diverted from the real economy to finance speculation and actively
sought a ‘bubble popping’ strategy, which failed (Bernanke, 2002). They
took two approaches to halt what they saw as a bubble: the discount
rate and the regulation of credit flows. The reasons for their policy fail-
ure are lessons for the modern day and we highlight a major source of
regulatory arbitrage as credit flowed from US companies, investment
trusts, investors, and international banks to supply the brokers’ loans to
a stock market being squeezed by the Fed’s policy to stop the boom. The
research incorporates historical material and analysis of the monetary
policy and theory used by the Federal Reserve and the US central bank’s
view of the boom through the 1920s.
What we test for is whether or not a credit crisis caused the October
1929 crash, and we investigate whether a genuine new level of the mar-
ket was disturbed by an ‘exogenous’ shock. We find that such a shock
did occur but that the New York banks intervened in time to alleviate
the credit crisis and hence the crash cannot be seen as a forced liquida-
tion of stocks. The low implied expected returns at peak valuation levels
in 1929, generated from our model, returned to historical expectation
due to something other than a credit shock to the investors and traders.
Careful examination suggests the 1930–2 crash (with stocks falling
over 80 per cent from their peak in 1929) was not due to the preceding
boom in asset prices but was instead driven largely by fundamentals
during an economic shock of unprecedented scale. In short, the 1930–2
crash appears unexpected, and should not be viewed as part of the
overvaluation of stocks in the late 1920s. What we also find is that the
bust from 1930 to 1932 was of a different nature entirely to the bubble.
In 1930, our results suggest the market was fairly valued relative to
model-based expected returns. What hit the US economy during 1929–33
and the market between 1930 and 1932 was an economic shock, which
was both unexpected and unprecedented in magnitude given the
long-run performance of the economy over at least the previous thirty
Introduction 29
years. The scale of that shock has not been repeated since. Meticulous
analysis of the economics of the depression from 1929–38 can be found
in Friedman and Schwartz (1963), Temin (1976), Eichengreen (1992),
and Bernanke (2000). However, the reader should be aware that the
dynamics of the Great Depression are still not fully understood and
hence exactly what caused the Great Depression and what remedial
policy options are the best for these mega-crises is a subject still ripe
for research. Recent events over the 2007–13 period show that such
research is still relevant.
The bust from 1930 to 1932 appears to have been driven by two major
factors: a fall in aggregate demand interwoven with a banking system
crisis. The two problems fed off one another from 1929 to 1933, with
the 1931 global banking crisis also creating severe exogenous shocks
to the USA. The credit boom we referred to earlier in the chapter is
also of material interest to those interested in the origins of the boom
and crash. The credit expansion took the form of a neutral aggregate
increase in debt levels. However, the composition of debt changed
markedly towards the consumer rather than business in the 1919–29
period. Such changes may have made the depression worse.
The bankruptcy of firms, individuals, and parts of the banking system,
the hoarding of cash, increases in the cost of bank lending, falls in price
levels, defaults on home loans, and many other factors all contributed
to the decline in output and employment of the USA (Friedman and
Schwartz, 1963; Bernanke, 2000). Although a fascinating time period for
students of economics, the effects should not be taken in abstraction from
the human suffering endured during those years. The economic disloca-
tions of those years, in the USA and Europe, led ultimately to the Second
World War. We do not delve deeper into the causal flows of economic
crisis during 1929–33 except to outline how the value of the aggregate US
stock market was affected. This limitation to our research is intentional;
it is so complex a task to model the US economy during that time period
that such analyses are better left to ongoing research efforts by others.
Understanding the processes requires a level of technical mastery of the
subject and large volumes of data collection which will likely require a
major international group-based research effort. Our analysis is therefore
directed towards aiding the reader to navigate the question of why cor-
porate earnings and stock values fell so spectacularly to the low point in
1932. In doing so we address the issue of market efficiency during the
crash and explain why it is likely that the market in 1930 was fairly valued
and that the crash of 1930–2 was unexpected and probably unforeseeable.
Our research identifies three key drivers for the falls in aggregate stock
market values. First, there was a fall in nominal earnings and dividends.
Second, there was the implied increase in the risk premium on stocks
in line with the rise on all financial asset types from 1931 to 1932.
Third, the residual unexplained by our models suggests stocks became
undervalued in 1932. These findings are corroborated by tests of book-
to-market ratio data from 1926 to 1946. The results are consistent with
Shiller (1981) suggesting extreme pessimism in 1932.
2
Literature Review and
Methodology
2.1 Modern literature related to the 1920s
The valuation of stock markets, and specifically, instances of financial

euphoria when these seem to deviate from fundamental expectations
have been of perennial interest to economic and financial academia
since the 1929 Crash and the Great Depression. Academic research into
the boom and bust of the 1920s and 1930s was conducted in the years
following, such as Cowles (1938) and Williams (1938) but has only
really developed with a specific focus on the 1920s since the 1970s.
This is due to advances in financial valuation theory and as the field
of finance generally became more developed. The advent of computer
technology has allowed the collation of data such as the CRSP database,
and testing of these data has become more accurate due to the statistical
power of the econometric tests we can use. The following sections
discuss the modern analyses of the period and the types of tests used
and inferences drawn.
Sirkin (1975) measured the growth of earnings over the 1920s for a
cross-section of stocks together with an earnings growth (DCF) model.
By using the dispersion of growth rates he was able to form a projec-
tion of expected price/earnings ratios if investors followed a simple
extrapolative rule over a five- to ten-year horizon in a two-stage model
where the growth rate reverted to a much low growth rate after the high
growth phase. This approach takes its justification from the potentially
naïve projection of rates of the high growth of earnings in the 1920s.
He concluded that the valuations in 1929 could be largely justified if
investors were using a short-run projection of five to ten years forward
from 1929 using short-run earnings growth from 1925–9. He only
noticed significant overvaluation in a small fraction of stocks and hence
31
concluded that given the rapid growth of real earnings in the 1920s, the
decade did not witness ‘an orgy of speculation’.
What this analysis (Sirkin, 1975) lacked was any solid contextual basis
and hence it was only useful in showing how valuations could have
risen to the extent they did. It never attempted to produce a full analysis
by its construction, but did pave the way for new ways of looking at the
boom and encouraged further testing of the cross-section of the stock
market.
Shiller (1981) challenged the efficient markets model, which assumed
that prices of stocks were the optimal forecast of the ex-post rational
price. Using historical data he showed that this assumption was not
consistent with these data, if the long-run trend of real dividends is
assumed given. Looking at historical time series data for the Cowles/
S&P 500 index which included the period of the 1920s and 1930s, an
ex-post rational real Common Stock price series – the present value of
subsequent de-trended real dividends – was found to be a very stable
and smooth series when compared with the actual de-trended real stock
price series. In other words, real dividend growth was nearly constant
through US stock market history and hence prices seem to have over-
reacted periodically to what was a very stable time series of dividends.
Barsky and De Long (1990) used a dividend forecasting method,
which incorporated uncertainty in the ability to forecast future divi-
dend growth rates, to show that the US stock market experienced fluctu-
ations in its dividend growth rates, which could be used to justify actual
market valuations for US stocks over the 100-year history it covered.
Their conclusion was that market prices rose and fell in an explicable
manner, namely in tandem with fair expectations under uncertain fore-
casting. They found no bubbles in the stock market over the 100 years
of data in their long-run stock price data.
De Long and Shleifer (1991) used the high valuations relative to
underlying Net Asset Values (NAVs) for ‘closed-end funds’ in the late
1920s to propose that the market was overvalued relative to funda-
mentals. The market values of these closed-end funds’ own stock
were valued at substantial premiums to the NAV of the stocks held in
the fund at market prices during the 1927–9 period. These premiums
disappeared in 1930–3 period and as there is much long-term data
to support discounts to NAV or small positive premiums through
US financial history, they attributed this deviation from the expected
value of the funds to irrational valuation of at least 30 per cent.
De Long and Shleifer concluded that the premium on funds was
excessively high and that excessive optimism is therefore detectable in
Literature Review and Methodology 33
1928–9. They also cited the large numbers of closed-end funds which
formed from 1927–9 as indicators of excessive optimism and a rush to
speculate on the value of stocks. Given that closed-end funds tend to
sell at a discount, the positive premiums are interesting as a possible
indicator of over-optimism. However, the paper was not able to resolve
a critical problem, in that generalising from a sub-sample is dangerous
and hence is not scientifically useful for assessing the value of stocks in
general. The stringency of this reasoning must be maintained, as such
a complex subject cannot be subject to ‘guilt by association’ reason-
ing for the wider market. These funds were very new at the time, only
forming in significant numbers in 1927, and may have been subject to
unobserved variable biases specific to these stocks. What the paper did
do well was introduce evidence of a deviation from fundamentals in
a robust fashion for this subset of stocks and a strong result in favour
of a potentially major behavioural basis for the overvaluation of the
wider market.
E. N. White (1990) used a Marsh–Merton model for data from
the 1920s boom and concluded that there was an overvaluation or
‘bubble component’ in prices, although this was limited in size to
about 20 per cent. The component was not found to be caused by
a self-feeding ‘greater-fool process’ or an over-optimistic perception
of the risk premium. Rappoport and White (1993) used the brokers’
loans market to assess whether lenders’ perceptions of an impend-
ing crash caused them to raise their margin requirements, to protect
against losses, which under their assumptions could be indicative of
an ‘overvaluation’ in the market. The possibility of fear of a price
crash due to a volatile credit situation and an informational asymmetry
between brokers and investors or a desire to prevent speculation are not
considered in this study. Although they acknowledged the theory and
replicate the unit root tests, which indicate that no bubble occurred,
as the paths of dividends and prices share a unit root, they conclude
that the ‘bubble component’ which they identify is still unexplained.
Donaldson and Kamstra (1996) used a ‘Monte Carlo’ simulation to
justify prices in 1929 by showing that the growth in dividends was suf-
ficient, assuming dividend forecasting uncertainty, to recreate the high
valuations seen by 1929. They used an out-of-sample calibration tech-
nique to produce an array of 10,000 possible future paths of dividend
growth based on previous dividend growth of the S&P 500. They used a
non-linear ARMA-ARCH-Artificial Neural Network model to obtain out-
of-sample dividend forecasts for 1920 and beyond, using only in-sample
dividend data. The ‘present value’ of the forecasted dividends indicated
prices that match the magnitude, timing, and time-series behaviour of

the boom and crash in 1929 prices.
McGrattan and Prescott (2001) measured the ‘fundamental’ value of
US industry by the stock of tangible and intangible capital in 1929 at
the macro level using a different approach to traditional ‘discounted
cash-flow’ (DCF) models. Using a 150 firm sample they found that the
US Industrial and Commercial Base’s value, measured as a proportion of
GDP, matched closely that produced by total stock market capitalisation
in 1929, and hence did not find that US corporations were overvalued.
The work used an innovative methodological approach by using non-
market fundamental data to measure the value of US corporations.
Data from Shiller (2000), which formed the basis of the book Irrational
Exuberance, looked at long-run aggregate Cowles and S&P 500 index
data from 1871 to 2000 to show the long-run rises and falls in US mar-
ket prices relative to dividends and earnings. These data showed that
significant peaks and troughs occurred relative to trend based on the
ex-post warranted price of the index of US stocks. The 1920s boom was
an ‘overvaluation’ according to this mean-reverting tendency of asset
prices relative to fundamentals. The trough of the 1930s also appears
as an ‘anti bubble’ where prices were too low relative to fundamentals.
Goetzmann and Ibbotson (2006) provide key data on stock returns
and the methods for estimating the ERP from 1871 to 1925 for NYSE
stocks. The large-scale data collection done at the ICF and their
multilevel research on this area are critical to gaining a handle on the
US equity market for a timeframe which lacks coverage in the main
database on US stocks, CRSP, which begins in 1926.
Recent analyses of the 1920s boom have sought new methodo-
logical approaches to the problem. Nicholas (2008) measures intangible
capital stock of US firms from a 128 firm sample, using a method of
citation-weighted patents to determine the intangible capital of firms.
The intangible capital, which was being formed by the rise in patents
developed by technologically innovative firms such as chemicals and
electrical manufacturing, new corporate structures, and other produc-
tivity enhancing technologies, was deemed sufficient to justify the
peak of the 1920s market via an adjustment for this intangible capital
factor. Nicholas (2008) illustrates that intangible capital was growing
significantly. The index of total firm patents registered by the USPTO
rose by 80 per cent from 1920 to 1929. This fact is significant because
intangible capital is thought to be responsible for the increased survival
rate of firms as well as increased productivity growth in the economy
and higher profit growth at an individual firm level.
Bierman’s The Myths of 1929 and the Lessons to be Learned (1991) used
Gordon’s (1962) Dividend Discount Model to illustrate that stocks were
not obviously overvalued in 1929. Although this approach has been
criticised as it follows the method of Sirkin (1975) in that it uses short-
term growth rates, it nonetheless reinforces the idea that the boom of
the 1920s was grounded in a fundamental or tangible basis for increas-
ing stock valuations, whether those tangible factors were actually useful
for gauging the fundamental value of stocks or not.
Bierman also focused on the political dispute between the New York
banks and the Federal Reserve regarding policy towards the NYSE boom.
This is a useful insight as it is known that this disagreement over policy,
with the board advocating a suspension of speculative credit to banks
and the New York reserve bank favouring interest rate rises, was another
key dimension in the 1920s boom. Bierman illustrated that there was
a definite concerted effort by the Federal Reserve board to stop market
speculation by a policy of ‘direct pressure’, rather than the more passive
interest rate mechanism. He also illustrated that the board, specifically
Adolf Miller, a former Harvard professor of economics and friend and
political ally of President Herbert Hoover, was keen on stopping specu-
lation on the basis that it was detrimental to the economy, seemingly
diverting funds away from the commercial centres and concentrating in
the financial, to finance speculative activity.
Miller believed that the market was overvalued due to excess specula-
tion, and had been on record as far back as 1925, criticising the desta-
bilising influence of the margined traders on the NYSE. Bierman also
details how Miller and others felt that open market operations and rate
policy were ineffective and hence moved to alter the banks’ access to
finance for speculative loans. Miller had been highly critical of the low
interest rates in 1927 used to stabilise the recession and aid the UK with
its deflationary problems. Miller was explicit in citing this low level of
rates as a primary impulse to the rise of the market that he believed
was a credit induced bubble, and was keen to deflate it (Miller, 1935).
Bierman cites exchanges in 1931 at the US Senate committee on bank-
ing and currency to illustrate these points.
Bierman dispelled some of the myths surrounding the events of the
boom and crash such as the effect of short-sellers and investment pools.
He concluded that the market was not obviously overpriced. Bierman
also devoted a chapter to the canonical bubble stock Radio Corporation
of America. In another direct reference, Bierman showed that US Steel
was showing record earnings and high earnings growth and yet the
price/earnings ratio fell substantially from 1927 to 1929. At a basic level
this could indicate that the market was not responding to short-term
earnings growth, but rather a much longer-term horizon, or it could mean
that US Steel was not thought to be a company that would generate
higher earnings over the longer term.
Wigmore (1985) is the most thorough and detailed book on the boom
and crash. It provides a systematic analysis for the 1929 market peak
through the worst of the market lows, to 1933. For each year he pro-
vides detailed data on high/low prices, earnings, dividends, and return
on equity for the prominent stocks for each major industry group such
as oil, tobacco, public utilities, and chemicals. He also provides detailed
information on gold reserves in the banking system, price levels and the
role for major firms within each of the industry groups. He illustrates that
there was a large increase in the volume of trading on both the NYSE and
the unlisted curb market in 1929 and high prices for seats on the NYSE.
He also details the high level of brokers’ loans which totalled 9.8 per
cent of the total market value of the NYSE and, added to bank loans for
speculation, totalled 18 per cent of the market cap for the whole NYSE by
the peak in October 1929. However, he notes that the ratio of loans to
market value has remained constant from 1926.
Wigmore (1985) cited the withdrawal of these loans as a key liqui-
dation pressure in the market, as short-term traders were forced out.
He also described the banking system and the sources of credit for the
brokers’ loans market, stipulating that the large industrial firms such as
General Motors were supplying funds to the brokers’ loans market and
how a series of loan calls forced borrowers into liquidation of their stock
positions. He therefore attributed the crash to a tightening of credit by
both the Fed and the banking system, which called in call loans and
forced brokers to pass on these tightening credit conditions to the mar-
ket. Critically he detailed how the brokerage community was able to
survive the initial crash as banks financed them and they reduced their
exposures and raised margin requirements. He assessed that the Fed pro-
vided an easy credit stance during the crash and after to 1931 by reduc-
ing the acceptance rate and the discount rate in response to the crash
but does not detail how or if this was effective. Hence the cause of the
crash is deemed to be systemic in nature but based on the real hypoth-
esis that stocks had become inflated or overvalued, effectively making
the calling in of speculative loans by the banks a necessary and rational
act which caused havoc in the market. He concluded that the stock mar-
ket crash and slump to 1933 was due to a series of shocks to the banking
and economic system and does not favour the monetary hypothesis
of the Great Depression. He also concluded that an overvaluation of
the market is irrefutable, although importantly he does not advance a

hypothesis as to why or how the overvaluation came about.
Summary
The literature reveals a good deal of historical research, which has borne
much fruit. These works, together with the earlier literature written in
the immediate aftermath of the crash, point to some key areas which
are ripe for testing, namely, whether it was a new technology bubble,
whether momentum played a key role, whether new pricing theories
related to the risk premium on stocks or expected growth of stocks were
a major cause, and whether credit instability was a key factor in the crash.
The motivation for our research stems from the gaps in these analyses
and the questions which extend from the earlier research. The aim was
to try and find empirical tests that would estimate the size of the bubble
and actually show whether such a bubble can be revealed in the data on
an ex-ante or ex-post basis.
The modern literature on asset bubbles, which we investigate partially
in the next section on ‘Bubble theory’, tends to support the idea that
they form. The historical evidence of particular episodes is anecdotally
and in many cases econometrically strong. However, there is also a very
large body of literature that supports the Efficient Markets Hypothesis
(EMH) in its various forms, which we also look at briefly in the next
section. The dichotomy means that research which aims to show in
an empirically testable and economically sound way that an overvalu-
ation of stocks can be proven or rejected in this historical period is a
tantalising prospect but it is extremely difficult to perform. The lack of
coverage of these additional questions, which we described earlier, was
the motivation to attempt such a complex research project. Although
Goetzmann and Ibbotson (2006), Nicholas (2008), Shiller (1981, 2000),
and Rappaport and White (1993) have provided much-needed depth to
the level of econometric sophistication used to address the topic, there
was still ample room to advance the research.
In the next section we detail the theory on asset ‘bubbles’ to inform
our methodology and provide a theoretical backdrop to the issue of
periods of overvaluation and what may cause them.
2.2 ‘Bubbles’
At the outset of this section we define a ‘bubble’ as a positive deviation

from fundamental values of a financial asset or a group of financial
assets. The term has many other connotations, which we do not imply
when we the use the term. It is an overused phrase, which deserves

deeper and more sophisticated delineation, which we hope to perform
in the next section.
The evolution of thought on the behaviour of stock market prices,
from an empirical and scientifically testable perspective, and the dis-
covery of their random nature, stems from the early research of Jules
Regnault in his Calcul des Chances et Philosophie de la Bourse (1863). In
this book, he observed that the longer you hold a security, the more
you can win or lose on its price variations: the price’s standard devia-
tion, a measure of volatility, was thought to be directly proportional
to the square root of time. The mathematician Louis Bachelier’s PhD
thesis entitled ‘Théorie de la speculation’ (1900) came to the conclu-
sion of a random nature in price movements. Holbrook Working (1934)
introduced the econometric basis for testing whether a time series of
commodity or stock prices could be generated by aggregating series
of statistically generated randomly fluctuating time series. Maurice
Kendall also examined the random nature of prices in ‘The Analysis of
Economic Time-Series, Part I: Prices’ (1953), and M. F. M. Osborne (1959)
found that the logarithm of Common Stock prices follows a ‘Brownian
motion’ and provides evidence of the ‘square root of time rule’.
These empirical tests seemed to indicate that prices were un-
forecastable over the short term and this body of research coalesced
into a school of thought in the 1970s. It is important to remember that
these were empirical observations, which grew into a much stronger
theory of what the observed nature of prices actually signified about the
informational efficiency of stock markets. Eugene Fama’s now famous
1965 article, ‘Random Walks in Stock Market Prices’, was based on his
University of Chicago PhD thesis, and developed the findings from
earlier empirical studies. Fama (1965) explained how the theory of
‘random walks’ in stock market prices challenges the proponents of
technical and fundamental analysis, that is, those who thought research
could offer a way to beat the market.
In 1970, Fama (1970) set out the ‘Efficient Markets Hypothesis’
(EMH) on the earlier basis of the three types of market efficiency first
discussed in Roberts (1967). Asset returns were theorised to have three
levels of efficiency: weak, semi-strong, and strong. The weak form
meant that no historical data could help predict tomorrow’s price, the
semi-strong that information quickly was incorporated into prices, and
the strong form that no persons(s) held an informational advantage.
The basis for the theory were the empirical observations of ran-
domness in price movements which were thought to be due to new
information impacting the prices of stocks, and hence creating

unpredictable movements of prices. Fama’s work (1970) brought a
new theory on market prices, based on empirical observation, to the
discussion. It also set out a testable set of hypotheses regarding the
zero expected return of a speculator. Although the theory suggested
that information efficiency was the reason for randomness in market
prices, this was not demonstrated by the research. It was a hypothesis
that followed the observed price behaviour. Fama (1970) found that
there were anomalies to his own theory in the data which he tested.
Firstly, evidence of serial correlation in returns, but where the sign was
random, was found. Secondly, Fama found evidence of market mak-
ers having informational advantage, but this finding was not deemed
powerful enough to refute the general conclusion that market prices
were too unpredictable for an investor to beat the market. Despite these
shortcomings, the major breakthrough was the testable hypothesis that
investors could not ‘beat the market’ and prices were following some
type of ‘random walk’.
The EMH approach stemmed from empirical observation and assumed
that because prices were not predictable, they at all times reflected all
information available on asset prices. This was enhanced by event study
research that illustrated that stock prices could respond effectively to
new information (Fama et al., 1969). What happened subsequently in
the field of market efficiency was that two major schools emerged on the
issue. The first was the EMH school and the second was the ‘Behavioural
Economics’ school. We delve into the Behavioural Economics school’s
ideas in the following section. This new school challenged the assump-
tions of the EMH.
The key difference that remained between these schools was whether
the random nature of prices precluded any potential behavioural bias
that caused stock prices to deviate from fundamental values. The
Behavioural school moved towards laboratory studies and using innova-
tive empirical techniques to resolve this issue.
The long sweep of the economic history literature is replete with
evidence of episodes of alleged deviations from fundamental prices,
when financial markets rose by large amounts and then crashed in
value over a relatively short timeframe. An investigation of such
literature would suggest that such phenomena are not common and
describe a special type of situation. However, what should be noted
is that such events seem to have been accepted as departures from
the fundamental value of assets by many sources and lengthy and
detailed research. There seems to be a clear consensus that deviations
from ex-ante knowable fundamentals most likely did occur at these

times.
The most famous of these bubbles are the South Sea Bubble (1720) and
the Mississippi Bubble (1718–20), Tulip Mania (1637), British Railroads
(1840s), Japanese Nikkei (1990s), and Dot com/NASDAQ (1998–2000).
The relative infrequency of such events in the post-war period, although
they have become more frequent in recent years, should illustrate why
policy-makers came to believe they had tamed the financial markets.
Furthermore, the identification of bubbles is not easy and many years
of careful research have allowed a deeper understanding of these phe-
nomena although there is still much more to learn. The Economic
History school, notably Kindleberger (1978), challenged the EMH on
the basis of the identification of historical periods of boom and bust
and asset price swings, which seemed to reflect behavioural elements
and credit related booms. The Behavioural Economics school began
to challenge the EMH based on long-term empirical testing using rich,
long-term financial data (Shiller, 1981). The key insight of the emerg-
ing Behavioural Finance/Economics schools was that the frequency
of episodes where behavioural effects on asset prices were thought to
have occurred is much higher than previously believed. Shiller (1981)
pointed to almost continuous under- or overvaluation of the US stock
market. Far from being only isolated historical periods of booms and
crashes due to behavioural effects, periods of overvaluation and under-
valuation were very common. These observations led to a major new
direction of thought on how prices were formed, rather than assuming
that markets always reflected all available information. The Behavioural
Finance and Economics schools led to an innovation in economics by
laboratory methods, using artificial asset markets, where numerous fac-
tors thought to create over- and undervaluation could occur, to study
the conditions of the formation of a bubble, in a controlled setting.
The testing of bubbles in the laboratory setting and the identifi-
cation of conditions under which they may emerge, added weight
to the growing challenge to the EMH (Smith et al., 1988). The new
approaches were complemented by work in Economic History and the
collation and testing of long-term data series as a bridge to the real
world. They used the laboratory tests which found that bubbles did
form, and set benchmarks for real-world tests with actual investment
return data. Subsequent research has provided much more data and
innovative methods to challenge the idea that markets are efficient
and that asset markets are free from human bias when price formation
occurs.
What we focus on in this section is explaining the theory and evi-

dence relating to research on bubbles in stocks and other financial
assets’ prices.
As we have just discussed, there have been two opposing camps in
the academic literature for a considerable length of time as to whether
asset bubbles actually exist and whether prices for assets are information
efficient, or biased by human behaviour. The crisis of 2008, and the rec-
ognition that housing in particular in the USA had become overvalued
in the earlier 2000s, coupled with the NASDAQ boom and crash of the
1998–2000 era, have led to the ascendancy of the Behavioural school.
The discussion below reviews some alternative research paths to testing
whether markets are efficient, and also looks at cutting-edge research
into asset bubbles. We survey the academic research on bubbles to
ensure that the most recent advances are captured in our methodology,
methods, and conclusions. The survey should also allow the research
we conduct to be seen in context. Due to our focus on a period which
has been alleged to have been subject to behavioural effects, we do not
survey the large amount of literature which supports the EMH school
but this bias is not intended to sway the reader towards our conclusions.
We use the term ‘bubble’ to describe a deviation of an asset’s value
from its fundamental value, on the premise that its fundamentals, in a
probabilistic sense, could have been determined, ex-ante, or a deviation
from fundamentals ex-post. In order to be able to set the results of the
research into context within the literature and to gauge the usefulness of
the conclusions, there are some key taxonomic distinctions that will be
useful for interpreting the possible causes of the 1920s boom and bust.
Although we can identify bubbles, ex-post, their identification
ex-ante, or at least in time to enact policy to mitigate them had been
regarded, in policy-making and academic circles, as a task too complex
for central banks or regulatory agencies (Bernanke, 2002). Since the
efficient allocation of capital is supposed to be the social function of
security markets, bubbles are undesirable. Furthermore, the evidence
on the tendency of bubbles to increase the cross-sectional dispersion of
wealth serves as another justification for policy intervention in markets
(Hirota and Sunder, 2007). The potential effect of bubbles on financial
stability is also a reason to be concerned about their formation. As dis-
cussed earlier, how these phenomena start and how they propagate are
of major interest. The aim of research on bubbles is now to understand
why they form and particularly how they start.
In the remainder of this section we look more deeply at the various
types of bubble generating and propagating factors, and the research
on them. We first look at the main four types and then discuss other
alternative but not mutually exclusive types related to liquidity, credit,
and monetary factors as well as the evaluation of new technology and
mass psychology.
Rational bubbles
With symmetric information
Tirole (1982) uses a general equilibrium framework to argue that bub-
bles cannot exist if it is commonly known that the initial allocation is
interim Pareto efficient. A bubble would make the seller of the bubble
asset better off, which is due to interim Pareto efficiency of the initial
allocation and has to make the buyer of the asset worse off. Hence, no
individual would be willing to buy the asset.
With asymmetric information

LeRoy and Porter (1981) and Shiller (1981) introduce variance bounds
that indicate that the stock market is too volatile to be justified by
the volatility of the discounted dividend stream. A critique of these
empirical tests is that they assume that the required expected returns,
r, are constant over time. In other words they cannot account for time-
varying risk premiums, where investors display simultaneous desires for
higher or lower reward for the volatility they assume when investing in
stocks. The concept of ‘time-varying risk premiums’ can rationalise the
long-horizon predictability of stock returns where a high price–dividend
ratio predicts low subsequent stock returns.
More recently, a new set of models has arisen which take a ‘real world’
approach based on the modelling of the behaviour of real agents in
financial markets.
Limited liability
Allen and Gale (2000), show how limited liability – the idea that a
company’s directors may be immune from losses and hence may lack
‘skin in the game’ – may induce bubbles in risky assets. The borrowers
in this model obtain investment capital from banks. Because of the
legal protection afforded by the limited liability status of the firm, the
borrowers’ risk of sustaining direct losses is limited and their maximum
losses are the Present Value (PV) of losing their future income stream
conditional upon later employment or ability to borrow from banks or
investors. However, a problem arises for the efficiency of financial mar-
kets because the managers get to keep the upside of their investment.
The pay-off structure is therefore convex, and generates a preference
for risk and for riding bubbles. Hence, these models show that the bor-
rowers’ preference for risky assets initiates a bubble and the incentives
increase with the riskiness of the asset.
Rational herding
‘Herding’ in investment decisions by investors and money managers is
an important mechanism for sustaining and propagating bubbles.
From a theoretical perspective, looking at corporate investment
managers’ behaviour and incentives, which can be applied to asset
managers if there is an elastic supply of the asset, Scharfstein and Stein
(1990), in a seminal paper following the insights of Keynes (1936), show
that managers’ herding behaviour is a direct outcome of the imposed
incentive structure and hence they may exhibit herd behaviour in the real
world based on a rational thought process, rather than an irrational one.
The ‘sharing-the-blame effect’ modelled by Scharfstein and Stein
arises because intelligent managers tend to receive correlated signals
while dumb ones do not (they simply observe uncorrelated noise).
Consequently if one manager mimics the behaviour of others, this sug-
gests to the labour market that he has received a signal that is correlated
with theirs, and is more likely to be intelligent. In contrast, a manager
who takes a contrarian position is perceived as more likely to be dumb,
all else being equal. Thus even when a manager’s private information
tells him that an investment has a negative expected value, he may
pursue it, if others do.
The authors show that in a world with two managers, there exists an
equilibrium in which the second mover always mimics the investment
choice of the first mover regardless of his own private signal. The herd-
ing incentive of the model is relaxed if managers care about investment
returns. DeMarzo et al. (2008) introduce non-standard preferences in
theoretical models to explain how bubbles propagate after formation.
If an agent’s utility depends on their relative wealth (envy), people will
prefer to participate in the bubble so that they can maintain their rela-
tive wealth level as the bubble continues.
Using empirical evidence, Frazzini and Lamont (2008) show that
mutual funds can be forced by investors to invest in high-sentiment
stocks and industries and thus perpetuate bubbles. The authors show
that investors dynamically allocate money to funds that invest in high-
sentiment stocks. As a result, managers earn higher rewards by follow-
ing the pay-off incentives to investing in a bubble. The managers may
know that a bubble exists but will not be rewarded if they refuse to obey
the sentiments of investors.
If pay for managers is based on relative performance another powerful

reason for fund managers to mimic emerges. Therefore during a bub-
ble a manager who maximises his pay over the short run would prefer
to mimic the bubble in order to maximise earnings. This is similar but
slightly different to the desire to maximise reputation as a good manager.
Shiller (2002) develops the idea that a money manager observing his
peers investing in a particular asset may conclude that his decision is
based on superior private information and may choose to buy the asset.
This is based on the rational idea that betting against the herd can be
very costly as markets enter a bubble. Managers who cannot keep up with
their peers may suffer fund outflows as investors reallocate funds to the
more successful managers who ride the bubble. An additional effect is
that managers’ reputational penalties are more severe when the manager
is wrong at the time when the rest of the investment community is right
than when everyone is wrong. Furthermore, wages of managers who bet
against the herd will suffer if performance is linked to short-term gains.
Limits to arbitrage
There is the possibility that rational agents are constrained from behaving
in a way that would return prices to fundamentals. De Long et al. (1990)
and Abreu and Brunnermeier (2003) show that under certain conditions
rational arbitrageurs may even amplify rather than eliminate mispricing.
Fundamental shocks
If the markets’ fundamentals are changing, this makes it risky to sell into
the bubble, since a subsequent positive shift in fundamentals might,
ex-post, undo the initial overpricing. For example, if there were to be a rise
in the value of a company which was not justified due to an overreaction
to an earnings announcement, which was known to be a bubble, a trade
to correct the mispricing would be subject to the risk of further upside
shock to the stock which was justified based on actual fundamentals.
Noise traders
De Long et al. (1990) present a model where traders would not want to
trade against the bubble, because the bubble itself was not stable due to
short-term ‘noise traders’. Therefore selling against the bubble is risky
even without ‘fundamental risk’, since irrational noise traders might
push up the price even further and temporarily widen the mispricing.
Rational traders with short horizons care about prices in the near future
in addition to the long-run fundamental value and are only partially
able to correct the mispricing.
Behavioural models
Differences of opinion
These models assume a setting with investor disagreement and short
sale constraints. Miller (1977) provides a simple static model for over-
valuation generated by disagreement on the fundamental value and
short sale constraints. Diether et al. (2002) show that stocks with high
forecast dispersion (as a proxy for disagreement on fundamental value)
seem to be overpriced.
Feedback or momentum trading

Lux (1995) builds a model based on a micro level mimicking action of
optimistic and pessimistic investors, which under certain conditions
amplifies to a large macro outcome following a shock to the real value
of the asset. The model shows that a small shock can propagate into a
larger one where the incentives to mimic may be determined at a short
horizon and therefore a bubble may theoretically form based on a small
shock, from a position of rational values. The bubble in the model Lux
builds collapses as the number of optimistic investors diminishes and
hence the momentum reverses and the shock then reverts to the mean
following the same process as during the upswing.
De Long et al. (1990) develop a model that contains positive feedback
traders, investors, and informed rational speculators. Traders base their
trading on past price changes. Investors’ demand depends on an asset’s
price relative to its fundamental value, and informed rational specula-
tors trade in response to news about fundamentals and in anticipation
of future price movements. In this model the rational speculators desta-
bilise prices and cause them to overshoot the asset’s fundamental value.
The reason for this overshooting is that speculators know that feedback
traders will base their future demands on the magnitude of the past
price change and hence increase demand.
Shiller (2000) argues that news media attention amplifies feedback-
trading tendencies in the market. As more investors are interested in an
asset, news media expand coverage, attracting attention from further
potential investors.
Representativeness heuristic and conservatism bias

Barberis et al. (1998) formulate a model based on these two psycho-
logical biases. They assume that earnings follow a random walk process,
and, therefore, the best forecast for the future earnings stream is the
most recent earnings realisation. Instead of using a random walk model,
investors mistakenly assume that the earnings process is captured by
either a mean-reversion model or by a trending model. When the earn-

ings innovation has the same sign in consecutive periods, investors
mistakenly see a pattern and extrapolate it into the future, thus over-
reacting to the information contained in the past sequence of earnings.
Heterogeneous belief bubbles

In these cases, even when information asymmetry does not exist and all
investors have access to the same information, the way the information
is used or factored in to their models of value can differ to a significant
extent.
A vital area of research is the use of survey data to test expectations of
investors directly so that empirical analysis of valuation in asset markets
can identify investor beliefs. Greenwood and Shleifer (2013) test whether
model-based expected returns and expectations of returns diverge and
hence can yield information on why returns may exceed fundamentals,
using multiple sources of investor surveys linked to the behaviour of stock
prices. The authors challenge a key obstacle to explaining how bubbles
may form. Time-varying risk premiums, which are commonly used to
explain deviations from standard models of asset pricing, are inconsistent
with the results. The results suggest more than one investor group must
exist as ‘expectations of returns’ derived from multiple sources of survey
data are both positively correlated with past returns and negatively
correlated with both actual returns and model-based expected returns.
Scheinkman and Xiong (2003) show heterogeneous belief bubbles are
accompanied by large trading volume and high price volatility.
Laboratory tests of bubbles

The difficulty of empirical tests for bubbles and their limited power in
showing under what conditions they may form produced an innova-
tion in how bubbles were studied and this new approach, laboratory
testing, now represents a frontier in the analysis of these phenomena.
Such freedom to conduct well-controlled tests is a major advantage to
overcome the drawbacks of the other methods, empirical testing and
theoretical models. Smith et al. (1988) use a trading game, where a
risky asset pays a uniformly distributed random dividend and partici-
pants know the fundamental value of the asset, which varies over time.
Bubbles, deviations from the ex-ante known fundamental value, were
seen to emerge during the trading game.
Lei et al. (2001) show, in another artificial market setting, that even
when investors are forced to hold the asset until the end of the trading
game, bubbles still emerge despite the fact that the buyer cannot sell it
on to another trader. The idea that investors require a ‘greater fool’ to sell
to is therefore not a necessary condition for the emergence of a bubble.
This is an important result as bubbles may form due to investor irration-
ality alone, and may not require one set of irrational traders to sell to.
Hirota and Sunder (2007) use laboratory experiments to explore how
investors’ decision horizons affect the formation of stock prices. In
their experimental markets, speculators are concerned primarily with
capital gains. They find that expectations of capital gains depend on
higher-order expectations, which are susceptible to cascading or mass
psychology of the market. In markets populated by short-term inves-
tors, prices tend to lose their dividend anchors; they can take any value
depending on such expectations, and are therefore susceptible to price
indeterminacy and bubbles.
Hirota and Sunder find that the allocative efficiency of markets is
high in long-term horizon sessions and becomes indeterminate in
short-term horizon sessions. The paper suggested several insights into
the stock market environments where bubbles are likely to occur.
First, investors’ time horizons are critical to asset pricing. The fre-
quency and impact of the failure of backward induction in a market
is greater when it is populated or dominated by short-term traders;
security prices in such markets are more likely to deviate from the
fundamental value. Long-term investors stabilise prices near the funda-
mentals through their arbitrage activity and their expectations, which
are anchored to their estimates of future dividends.
Second, securities with longer maturities are more susceptible to
deviations from fundamental values. As the duration of the security
increases, a smaller proportion of its value in the form of dividends
within their investment horizons and a greater part of their value
depends on the expectations of capital gains, which in turn depends on
higher-order expectations.
Third, bubbles are more likely to occur when the future dividends are
more uncertain. In such cases, it is difficult for the investors to conjec-
ture what others think (and what others think about what others think)
about the future prospects of dividends. It becomes more likely that
the investors fail to backward induct, and for the prices to be unhinged
from their ‘dividend anchors’.
Recent developments in the literature on laboratory tests illustrate the
advances in both the technology employed and methods used to identify
bubbles and their possible causes. De Martino et al. (2013) measure the
human brain’s activity to understand the neuronal processes and sub-
sequent behavioural processes which they lead to. They find that parts
of the brain responsible for predicting the behaviour of others become

more active during bubbles.
Credit and financial sector liquidity

Kindleberger (1978) notes the role of central bank policies of monetary
easing and tightening of bank rates as a stimulus to the formation of
booms and busts in asset prices and the real economy. Laboratory tests
of bubbles (Smith et al., 1988) also note the effect of the availability
of credit to traders as a stimulus to the formation of bubbles. Pepper
(2006) offers a theory, the ‘liquidity theory of asset prices’, and empiri-
cal data to explain how credit from the financial sector is channelled
to financial assets by investors and institutions. This factor is thought
to cause price movements above fundamental values. Congdon (2005)
stresses the effects of broad money growth, instead of the traditional
monetarist focus on narrow money. Thus with a money supply shock
in the form of strong broad money growth from financial institutions,
portfolio choices can create asset price bubbles.
Rajan (2005, 2006) argues that low interest rates could reinforce risk-
shifting, tail-risk seeking including attempts to hide tail-risk, herding, and
illiquidity seeking by fund managers. Investments then concentrate in
less and less liquid and more risky assets and potentially cause bubbles.
Mass psychology
Shiller (2000: 2) defines a ‘speculative bubble’ as ‘a situation in which
news of price increases spurs investor enthusiasm, which spreads by
psychological contagion from person to person, in the process amplify-
ing stories that might justify the price increase’. This attracts ‘a larger
and larger class of investors, who, despite doubts about the real value of
the investment, are drawn to it partly through envy of others’ successes
and partly through a gambler’s excitement’. Shiller makes a critical
innovation in the study of asset bubbles, through reference to the idea
of the phenomena as contagious social-psychological processes. What
this definition does not provide, although can be mistaken for, is an
attempt at explaining how these processes translate into asset prices.
Rather, Shiller (2000) offers some key ideas on how overvaluations can
be generated and propagated according to widespread beliefs. Drawing
from the literature in psychology and sociology as well as economics,
the empirical asset pricing research on long-term stock market prices
and the dividends, which they aim to forecast, shows excess variance –
wide deviations from expectations. These are unexplained by a host of
advanced asset pricing models. The unexplained residuals are linked to
the behaviour of the market participants and their biases and irration-
alities, which lead to the adoption of valuations frequently detached
from underlying warranted prices.
The critical point made is that under this view, the prices of stocks do
not have to violate the conditions of statistical unpredictability at the
firm or macro market level, as the EMH expects, to be seen as periods of
behaviourally driven overvaluations.
Technological growth
A relatively new strand of the literature on bubbles contends that tech-
nological innovations can legitimately cause a run up and crash in the
prices of stocks and that these are only observable ex-post. Therefore the
observed patterns are a legitimate reaction of investors to technological
uncertainty when a new innovation or technology emerges. Nicholas
(2008) examines the 1920s and finds evidence of patents being linked
strongly to excess returns over 1928–9. The effects of the changes
seemed to persist after the boom and crash indicating that investors
may have been revaluing new technology.
Pástor and Veronesi (2009) develop a general equilibrium model in
which stock prices of innovative firms exhibit bubbles during techno-
logical revolutions. In the model, the average productivity of a new
technology is uncertain and subject to learning. They find empirical
support for the model’s predictions in 1830–61 and 1992–2005 when
the railroad and Internet technologies spread in the United States.
According to the paper, during technological revolutions, the nature of
the uncertainty changes from idiosyncratic to systematic. The resulting
bubbles in stock prices are observable ex-post but unpredictable ex-ante,
and they are most pronounced for technologies characterised by high
uncertainty and fast adoption.
Application to the 1920s US stock market

The research draws on these studies to better understand what may
have caused the formation of any deviation from fundamental asset
values in the 1920s. What the preceding analysis does is prevent us from
drawing fast and easy conclusions from our results about the true nature
of the boom and crash, and also informs the tests we conduct.
2.3 Methodology
Our methodology is heavily empirical by design and follows previous

methods from Goetzmann and Ibbotson (2006), Shiller (1981, 2000)
on the long-term Equity Risk Premium, and stock market returns over
long horizons. In order to complete this research, new data not con-
tained in the standard databases such as CRSP and Cowles (1938) were
gathered. Therefore the work presents data to test the results of previ-
ous research and allows for additional variables not contained in these
sources to be tested.
Prior research has identified some factors known to influence the
formation of asset bubbles, such as:
• The presence of less well informed traders.

• Fast rising prices.
• Unclear fundamentals.
• A lack of dividend anchors for high technology or new industries.
• Credit access for leveraged investment.
• Mass media interest.
• Steep rises in IPO volumes and the volume of trading.
• Monetary easing and high liquidity.
• New investment funds.
Although we do not negate the use of such indicators, we do not use

simple identification of these factors to assert the likelihood of a bub-
ble, although we do use the results of one test for momentum as an
auxiliary test. Our main goal was to determine the dimensions and
causes of the changes of stock prices and valuations during the 1920s
and 1930s using empirical tests. We also employ historical research
of the financial literature to develop our models and considerable
research was directed at being able to reconstruct the dimensions
of the US economy during the period to avoid missing key factors,
which may have driven stock market values. In this way the assump-
tions made in our models can be benchmarked against economic
reality.
The motivation for the research as a doctoral thesis topic was the
knowledge that new data to verify or challenge previous findings would
be materially important for the study of bubbles as well as the historical
interest in how investors used financial models and estimated stock
returns in the period. We therefore approach the question of market
efficiency from a long-term asset pricing perspective using new histori-
cal data for both ex-ante expectations and ex-post realisations of the
returns to stocks. This allows us to quantify the bubble according to the
method of Shiller (1981). From this baseline, we test for potential causes
in the cross-section of the new data sources.
The joint hypothesis problem (Fama, 1970) means that a test of

market efficiency requires a model of market equilibrium, but you
cannot test models of market equilibrium without assuming market
efficiency, because most models of market equilibrium start with a
presumption that markets are efficient. The test must use an addi-
tional test(s), hence the ‘joint test’. Rejection of the test will not reveal
whether the deviation from efficiency was caused by the auxiliary
factor(s) or whether the model of equilibrium was mis-specified.
We resolved this potential criticism of our testing approach using a
historical model of the US economy and monetary system to determine
equilibrium, industry-level tests of high technology valuation, analysis
of the credit system to test for exogenous shocks to stock values, and
cross-sectional tests of drivers of the changes of valuations from the
expectation of our models. These four additional areas of analysis allow
us to have a firmer grip on whether stock prices deviated from histori-
cal expectation on a fundamentally sound basis. We then employed an
additional auxiliary test of ex-post returns to gauge whether ex-post
returns were consistent with the presence of a fundamentally legitimate
regime shift due to a technology shock. What these combined tests
cannot resolve fully and which is left for future research is the possibil-
ity that a bubble formed due to a technology shock, which could have
created a legitimate increase in valuations due to uncertainty ex-ante,
although ex-post these appear as an overvaluation. This problem aside,
our methodological design establishes a reasonably robust series of
testable hypotheses and we leave open the possibility that some legiti-
mate change to the equilibrium level of stock values did occur, even
temporary ones as information was processed by investors about new
technologies or a new economic system or new modes of valuation.
To supplement our methodology, which cannot offer conclusive
evidence of an ex-ante bubble, we provide results from other research
on the cross-section of returns during the boom phase to test the idea
that a technological shock was occurring (Nicholas, 2008) and one that
could have legitimately altered the equilibrium value of stocks. This
methodological approach to the vital question of ex-ante bubbles also
employed tests of ‘benchmark’ assets whose ex-ante values were known
(De Long and Shleifer, 1991). These are used to resolve the dichotomy of
a legitimate ex-ante rise in valuations due to uncertainty and any obser-
vation of a rise in valuations beyond ex-ante knowable fundamentals.
The first part of the approach was to analyse long-term growth and
the fairness of long-term growth expectations based on long-term
history prior to the 1920s. Further, we modelled the dynamics of the
economy and the monetary changes of the post-1915 period to adjust

for any impact these factors may have had. We then developed a valu-
ation model for the US stock market based on the long-run ERP from
multiple sources; historical estimates are taken from Goetzmann and
Ibbotson (2006) and Smith (1924). We then used a long-term constant
growth Dividend Discount Model (DDM), the inputs for which could
have been sampled by investors using available data sources. The aim
was to use historical data for a broad sample of US stocks from the earli-
est available time to produce a data set that was available in the 1920s,
to gauge fair expectations of dividend growth and survival for US stocks
forward in time from that point. The dividend growth for the DDM was
estimated using survival data and dividend growth rates over the long
run before 1929, using a new data set of 200 firms from 1900 to 1929 to
ensure that a fair model was estimated.
To ensure the accuracy of our testing, the techniques we used to
create this model needed to be evident in the 1920s. We know this
was the case from our analysis of Smith (1924). We therefore built a
model based on Smith (1924), which uses our 30-year sample growth
rate and extends this over the long-term future. We use the realised ERP
before 1926 from Goetzmann and Ibbotson (2006) and Smith (1924) as
the discount rate, which reflects an expectation that historical returns
were to be repeated in the future. The growth rate estimate follows the
technique shown in Smith (1924) and the basis of the DDM model
follows Shiller (1981).
We lack expectations data from non-market sources in any scientifi-
cally testable order, such as those from investor sentiment indicators
or surveys. Hence we cannot resolve what caused the bubble as clearly
as would be desirable. One advantage we do have is that any realised
returns can be seen ex-post as we are now far enough forward in time
to calculate the actual returns relative to the expectation. The auxiliary
hypothesis to our gauge of efficiency during the boom phase was to
use estimates of the return to investing in stocks over the long term
from the 1920s to the present. If these realised returns were different
from historical expectation formed on the basis of data from before
the 1920s, a change in true expected returns in the 1920s may have
legitimately exceeded historical expectation. In this case the boom
potentially reflected investor knowledge of a different return expecta-
tion to the historical one. This would invalidate our use of the historical
expectation as a legitimate test of fair values. By using new data on live
returns to a market tracking closed-end fund from 1925 to 2010 which
proxies for the returns to the market over the long term, we can assess
whether the historical expectation was exceeded. This approach allows

us to correct for any indexing issues or survival bias as they reflect actual
investor experience.
Although our approach still leaves the question of what caused any
potential overvaluation unanswered, we know it could have been due
to at least two factors: a lower required return or a higher expectation
of returns. This methodological approach follows Shiller (1981, 2000)
who uses the ex-post rational price by valuation of the US stock market
according to its realised dividends.
As we set out in the introduction to this section we aimed to further
reduce the problem of whether the change in valuation from 1927 to
1929 was legitimate, using a test of the cross-section of stocks. A key
component was to develop a way of looking at the cross-section to
detect any systematic causes as to why individual firms rose or fell in
value during the overvaluation phase. Detection of systematic biases
without potential theoretical justification was used to test for the weak
form of EMH. We aimed to test any common drivers causing the over-
valuation, such as a systematic change in the ERP driven by the theoret-
ical work of Smith (1924) using a new database collected from Moody’s
Manual (1930), which was available to investors at the time.
We aimed to test for a series of other drivers of valuations, such as
dividend and earnings growth and size, age, initial Price/Dividend (P/D)
ratios, and net asset effects. This approach addressed the question of
whether the boom was driven by simple extrapolation of fundamentals
or any obvious systematic biases. These tests used new hand-collected
data not present in the CRSP database using Moody’s Manual of Industrials
(1930) regarding firms’ earnings growth rates and data over a longer time
period. We use the results of tests of momentum and technology effects
of the cross-section of stocks from previous research to complement
our tests. We use Nicholas (2008) to complement our model regarding
momentum effects and technology effects and Shleifer and De Long
(1991) to act as a benchmark to detect any rise in valuation beyond
ex-ante fundamentals.
Our cross-sectional tests aimed to resolve the key issue of ex-ante
observable overvaluation and to what extent it was legitimate or con-
trary to the expectation of the EMH. We therefore are able to envisage
an ex-post bubble which occurred when there was a legitimate ex-ante
rise in valuations as described in Pástor and Veronesi (2009) but which
later breached ex-ante knowable fundamentals and also did not tech-
nically violate the expected behaviour of prices according to the weak
form of EMH.
To complement these tests, a further key angle was to develop a fair

value model for at least one sector of the US stock market. An innova-
tive sector to choose was one associated with the ‘new era’. We focused
on aviation stocks as these were most likely to have been overvalued as
they were one of the newest industries in the 1920s employing a new
technology and one which is cited as having been the subject of heavy
speculation (Galbraith, 1954).
Integral to the validity of such an approach was the ability to calibrate
other previous new technologies’ growth paths and form historical
expectations of value for a new technology. For this we required evi-
dence that such models and such data were available at the time rather
than imposing modern industrial growth and asset valuation theory
on the models we built. Although we did make one assumption in our
model, which is not found in the literature, it is likely that such knowl-
edge was easily available to investors.
Although this approach suffers from the problem of relying on his-
tory, and may ignore issues of uncertainty of technological uptake,
firm success or future growth being different from history, it offers a
historically valid benchmark. The deviation from this benchmark can
be explained by future research.
Key to our ability to understand the crash in October/November
1929, and whether there was an exogenous shock to expectations or
required returns which had risen legitimately, was to model the mar-
ket microstructure of the NYSE and identify any major new groups of
investors who may have influenced prices through increased or reduced
selling volume during the boom and crash. This approach looked at the
interaction of Federal Reserve policy with the credit system and investi-
gates their thinking regarding the overvaluation of stocks, its causes and
how to control it. We also examine the effect of their policies on the
credit market which funded traders on the NYSE.
Our tests examine the crash of October–November 1929 and whether
a credit crisis induced a crash to leave prices below fundamentals. The
question was whether a credit crisis forced investors to sell stocks and
hence increase the implied ERP or expected return to stocks, or reduce
potentially valid high growth estimates. Rejecting or accepting the credit
crisis hypothesis allows us to make further inferences about the nature of
any deviation of valuations from our model.
Finally, the research aimed to model risk premiums on comparative
assets to stocks and changes in inflation and dividends and earnings, to
determine the major drivers of stock market valuations during the Great
Contraction from 1930 to 1932. We test whether ‘market efficiency’ was
maintained following the October–November 1929 crash through to

1932. Due to the complex nature of the crash and the limits of being
able to construct accurate methods to perform these tests, we reduced the
analysis to testing our DDM using a time-varying discount factor based
on other risky financial assets. To supplement this we also used CRSP data
and book value data from K. French (2014) to assess Book/Market (B/M)
ratios from 1926 to 1945. This approach highlights whether the market
was undervalued relative to fundamentals in 1932 at the market low
using two different approaches.
Limitations of the methodology

Our approach is not without flaws, as we cannot fully ensure that we
have modelled the equilibrium levels of the economy accurately; how-
ever, we can reduce the uncertainty as to which potential causes of the
boom and crash are most likely and can provide a benchmark valuation
for the stock market. In this sense changes in expectations, as opposed
to changes in the required return, can be disentangled to a meaningful
extent, to show that high expectations were present, in the absence of
sufficiently large falls in the required returns to create the magnitude of
valuation changes seen. What we cannot exclude is the presence of non-
systematic time-varying risk premiums for stocks, as we do not test for
them. We also cannot control fully for the effect of uncertainty during a
technological shock as a justification for ex-ante feasibility of peak prices
as we use previous research results, which come from other sources.
Our main model of the fair value of the market is derived from a
data sample from 1900 to 1929 from which we reconstruct a historical
dividend growth rate, which is used as an expected growth rate for the
market over the long-run future. The construction of this growth index
will have measurement error, and its use makes some assumptions about
how investors would have constructed their estimates of the long-term
growth potential of dividends for an investor who held the market over
the long run. We use the method of Smith (1924) who used 20-year
holding periods for a live index (survival adjusted) of stock returns,
assuming that reinvestment occurred over a 20-year cycle, when he calcu-
lated total returns. We use a 30-year period using the same method, but
this difference should not affect the results to major extent, but must be
acknowledged. Our measures of the ex-post returns to a proxy for the
general market from 1925 to 2010 may also have some bias as we only
look at one fund, but the characteristic of the fund and its market track-
ing mandate, together with no debt leverage and high levels of diversifi-
cation, make its use feasible to assess a general estimate of the long-run
returns to investing in Common Stocks. Our approach to the ex-post

return as an indicator of the absence of a large increase of stock mar-
ket returns relative to history may be biased by the effect of the Great
Depression to some extent; however, given the long-term nature of the
returns and the stable trend growth rate of the US economy from before
the 1870s to 2010, we assume that no major innovation in the returns
to stocks was forthcoming. On this basis we infer that stocks were over-
valued relative to subsequent returns in the late 1920s. This does not
mean that higher levels of dividend growth rates were not feasible as an
expectation relative to history and our test should not be used to infer
that higher dividend growth rates were not plausible ex-ante.
One major criticism of the tests of the cross-section is that even
though they may not detect a technical violation of the EMH, this
should not be seen as the acceptance that markets were rational in their
behaviour or processing of information. We therefore leave aside any
micro-behavioural inferences from the tests. Furthermore, our investi-
gation and application of the theory of Pástor and Veronesi (2009) is to
show that a potential cause of a legitimate change in equilibrium values
in 1927–9 was a technological/uncertainty shock.
It remains totally plausible that another factor or series of factors trig-
gered the boom, such as market-wide increases in prices leading to an
illegitimate focus on the belief in a ‘new era’, or that no justification can
be cited for the initiation of any bubble we detect and no changes in
equilibrium values were justified in 1927–9. Taken together these limita-
tions mean that the rises in values may have been totally unjustified.
Tests at the industry level for a new technology using a historical
growth-based model cannot exclude that this particular industry did
not have higher fair expectations of growth than rates calibrated from
historical growth. In other words, we cannot know if history was a
dependable guide to the future. We also cannot discern whether the
bubble was caused by genuine technological uncertainty as to which
stocks would survive. We also do not test for momentum in this
industry-level model due to limited data and hence we cannot identify
momentum effects or reject them as an auxiliary test for this industry.
Our tests of market efficiency in 1930 from which point in time
we define the bubble to have disappeared are subject to the criticism
that the beginning of the recession in 1929 distorted the assumption
that stock prices in 1930 did not reflect a higher risk premium. We
assume that risk premiums remained the same in aggregate and time
the end of the bubble on the basis of a return to the Market Price/
Dividend ratio from 1927. This may overlook an increase in the market
risk premium due to investor caution about the future course of eco-
nomic growth in 1930. Such a critique is a fair one and it remains totally
feasible that risk premiums for stocks may have risen to a legitimate
extent from 1929 to 1930, and therefore masked a genuine change in
earnings growth during the boom.
Under this alternative view, in 1930 the market was reflecting, not
the collapse of optimistic growth expectations or a fall in the ERP, but
instead reflected new risk premiums and new expectations due to the
knowledge of the onset of the Great Contraction, which was known and
factored in to prices.
Our tests of the credit crisis in 1929 and the market microstructure of
the NYSE are limited by the power of our tests and the limited data. We
can illustrate how the credit crisis developed and offer some evidence
to suggest that a credit crisis did not cause the October crash; however,
further more advanced analysis of whether the crisis was a focal point
of the selling pressure or whether the crash was partially caused by the
forced selling is an avenue for future research.
Our tests of the market declines from 1929–32 and our use of a
time-varying risk premium may reflect our estimate of an incorrect
theoretical change in the risk premium from which we infer the values
of the stock market at the low in 1932. These tests are only intended as
a simulation of possible valuations rather than a concrete method for
identifying how prices changed during the crash.
3
The US Economy and
the Financial System
3.1 The boom and bust of the US stock market
Perhaps one of the most famous economic time series graphs of all time
is the US stock market boom and crash of the 1920s and 1930s. What
can be seen is a large run-up in prices and then a large reversal. The
temptation many have succumbed to is to see the boom and bust as
prima facie evidence of an overvaluation. Although such an interpreta-
tion would be correct to a certain extent, it does not offer explanation
as to how changes in the economy and investors’ ideas may have driven
the changes, which can be verified scientifically.
The tests and analysis that we conduct will enable the processes
behind the data in the graph to become much clearer and allow the
reader to see how the initial boom formed. We will also show that the
crash from 1930 to 1932 was not directly related to the boom, and that
this scale of crash was most likely unforeseen.
According to our tests, the boom in stock prices had two major
components:
1. A credit/debt expansion.
2. An expectation of higher future returns to Common Stocks or lower
risk premiums.
The light grey line in Figure 3.1 shows dividends from the Cowles
(1938) index and their increase in nominal terms originates in the
credit and debt expansion of the 1915–29 period. The increase in Price/
Dividend ratios, shown as the deviation of the Price Index from the
Dividend Index from 1927 to 1930 shows that investors seem to have
changed their valuations of stocks relative to their historical norm.
58
The US Economy and the Financial System 59
Price index Dividend index

400
350
300
250
Index
200
150
100
50
0
Apr-21
Apr-32
Jan-13
Dec-13
Nov-14
Oct-15
Sep-16
Aug-17
Jul-18
Jun-19
May-20
Mar-22
Dec-24
Nov-25
Feb-23
Jan-24
Oct-26
Sep-27
Aug-28
Jul-29
Jun-30
May-31
Mar-33
Date
Figure 3.1 Prices and Dividend Index (Cowles) (Base = 100, Jan. 1913)
Source: Cowles (1938); Shiller (n.d.).
Valuations crested in September 1929, having detached from their nor-

mal levels at the end of 1927, and crashed by 45 per cent in October/
November 1929. There was a subsequent rebound to a level about
20 per cent below peak values in early 1930, which quickly reversed by
mid-to-late 1930. A large overvaluation, according to our tests presented
in Chapter 4, had mostly dissipated by late 1930 and the subsequent
fall in earnings, dividends, and stock prices were due to the onset of the
‘Great Contraction’ – an economic contraction of severe and unprece-
dented magnitude. The full crash in stock values eventually culminated
in the trough in June 1932.
The exact nature of the 1929–33 ‘Great Contraction’ of the US econ-
omy is still debated in the economics and finance literature, in part due
to the extreme complexity of this period. We devote a special section to
various theories of how and why the ‘Great Contraction’ formed, but
defer that discussion until later.
What the following chapters do is set out the data and theory neces-
sary to show how we can test for the presence of an overvaluation of
the US stocks using long-term return data both ex-ante and ex-post. We
also show how we can test for the ‘fundamental’ values of a major new
technology industry. We then show how we can test the cross-section
of asset valuation changes during the 1927–9 period. Having established
the level of prices, which we think reflects fundamental values of the

stock market (see Chapter 4), we set out our view of the microstructure
of the NYSE market (Chapter 5). We examine the credit flows, volumes
of shares, and the agents active in the market. During our look at the
crash itself in October 1929 we test for a credit shock as a potential
cause. Finally (Chapter 6) we look at the real economy, assess the funda-
mental shocks during the 1929–33 period, and examine the behaviour
of stock market valuations to see whether asset values fell below funda-
mental value and on what basis this may have occurred.
Although these innovative tests, which in many cases use new hand-
collected data series, are the major innovation of the work we also
provide data on the US economic system to illustrate how we can be
assured of the strength of the tests we perform by setting them in eco-
nomic context. This historical analysis of the economy establishes the
basis for our assertion that we can reliably determine where equilibrium
was in 1927–9.
In essence, the research devoted to setting out the economic con-
text improves our chances that the tests do not exclude factors which
may negate the results. For example, if there was a step-change in the
growth path of the US economy and the market was reflecting such
knowledge, or there was a change in the equity risk premium due to
the maturation of the stock market, or a change in the risk tolerance
of the investors and traders at the time which was legitimate, we may
miss a legitimate equilibrium change. This potential for omission is the
major weakness of testing for bubbles, which the EMH school points
out. Considering the results of our tests, there does seem to have been a
fundamental change in the economy, which the stock market may have
been responding to. How we measure and control for the impact of such
legitimate changes is set out in our tests later in the work.
Bernanke (2002)1 highlights the difficulty of when to call a ‘bubble’ in
real time. The task of an ex-post identification of an overvaluation and
whether it could have been identified ex-ante in 1928–9, means we have
set ourselves the challenge of making some very accurate measurements
of the drivers, size, and timing of an alleged bubble in stock market val-
ues in the 1920s. Thus we must be sure that we can identify equilibrium
in the market and any legitimate change in this equilibrium.
The problem of exact observation of equilibrium levels of the stock
market is very important for the study of asset bubbles and deviations
from fundamentals are hard to detect if the future, which is being
expected, has not yet occurred. From the perspective of scientific analysis,
we had a target, which was much easier to pin down, as we have the
benefit of hindsight and long-term data on realised returns, and we can

control for effects, such as a legitimate increase in stock values due to
a change in productivity by measuring ex-post returns. The strength of
our analysis depends ultimately on ex-post identification of an overvalu-
ation. We are reasonably confident that we have identified something
close enough to the real equilibrium to identify a large bubble of up to
50 per cent in stock valuations, ex-post, which is detailed in Chapter 4.
Having described the outline of the boom and crash and described
the areas that we will focus on in later chapters, we turn now to focus
on the historical background of the US economy. This enables us to
gauge whether our models of long-term expectations of stock market
returns are accurate and informs the models we build in later chapters.
This helps us to judge the equilibrium level of the US market and the
justification for any changes to equilibrium.
We provide a detailed look at debt levels and compositional changes
in debt in various sectors of the US economy, the housing boom and
housing debt held in the US banking system. We also provide some
background to the Gold Standard system, the newly formed Federal
Reserve System, interest rate policy, and the effects of the credit expan-
sion on corporate earnings and the level of the US stock market. We
also measure real and nominal GDP growth, inflation expectations, and
productivity trends.
3.2 The real economy
A major component of our stock market valuation model is that we

assumed the ability of investors to expect the USA would maintain its
long-run historical economic growth rate over an eighty-year timescale,
when looking forward from 1929.
The basis on which this assumption was made is set forth in the fol-
lowing chapter. We use it to justify the use of historical dividend growth
rates in our valuation models detailed in Chapter 4. The timeframe for
projecting future growth from the 1920s may appear optimistic; how-
ever, there were sufficient historical data available then, demonstrating
that such an assumption is feasible, given the stability and longevity of
the growth path of the US economy prior to the 1920s.
W. W. Rostow (1956), an early economic growth theorist, dates the
emergence of the USA as being on a ‘self-sustained’ growth path as
early as the 1850s.2 This chapter demonstrates that the USA’s economic
growth path over the long term prior to 1929 would have rationally been
expected to continue into the long-term future from 1929 onwards.
Following the technological advances of the second industrial

revolution,3 dated from the 1870s, the USA displayed a sustained long-
term economic growth path, with real GDP growing at an annualised
geometric rate of 2.9 per cent per annum. The various sources of US
economic growth serve as a robustness check to our long-term growth
assumptions and are listed below:
Natural resources
The USA was endowed domestically with large deposits of natural
resources such as minerals and oil vital to the growth of modern indus-
trial enterprise both as raw material inputs and energy for transport and
power. The USA was also able to utilise natural resources effectively by
the application of technology. From 1900, the USA eclipsed all other
major industrial powers as a source of world industrial output, rising
from 23 per cent to 40 per cent of the total global industrial output by
1928 (Wright, 1990).
The institutional framework

The USA possessed institutional strength via good government com-
mitted to the nation’s development.4 The USA’s institutional and
legal framework facilitated economic growth via the provision of
property rights, notably patent rights to entrepreneurs and innova-
tors (Lamoreaux, 2010), thereby generating large incentives for the
development of innovations, and via the ability to enforce property
rights through the legal system with minimal threat of appropriation
by government or other entities.
A highly developed railway transportation network was also in place
to facilitate transportation of people and products, as well as telegraph
and telephony to facilitate efficient communications across the USA. The
US economy was arguably also the largest free trade zone in the world at
that time and possessed a financial system that was expanding to meet
the demands of the rise of the USA’s industrial base (Lamoreaux, 2010).
By 1930 the inventor, traditionally associated with the development
of new technologies in the USA, had moved inside the boundaries of
the firm (Schmookler, 1957) following the establishment of industrial
research labs in large firms such as Du Pont, General Motors, and
American Telephone & Telegraph (AT&T). This institutional capture
of research and technological advancement as well as the progress of
general science in the university system promoted the USA’s growth.
Much of the growth in higher education during the late nineteenth
century was funded by private sources including businesses seeking to
create local pools of expertise to meet their needs. The result was an
extensive but decentralised system of colleges and universities in which
research was often oriented towards the concerns of local industries,
for example tires in Akron and mining in Minneapolis, which gave a
larger proportion of the population access to advanced training than
anywhere else in the world at that time (Lamoreaux, 2010).
The USA had developed an advanced educational system from the
turn of the century to 1930, which was key in the development of
research laboratories for industrial firms with a strong link between
industrial research laboratories and universities. Classical examples of
these linkages are the associations between Du Pont and the University
of Delaware and Merck at Rutgers (Nicholas, 2003).
At the turn of the twentieth century, US industry experienced a large
merger wave. The period 1865–1920 witnessed a dramatic change in
the size distribution of firms in the US economy as large-scale enter-
prises emerged to dominate large segments of industry (Lamoreaux
et al., 2002). This was due to the benefits, via economies of scale and
rationalisation of production and distribution processes, resulting from
horizontal and vertical integration (Livesay and Porter, 1969) and the
adoption of new organisational structures (Chandler, 1990).
Assessments by Banerjee and Eckard (1998) concluded that these
mergers realised gains in value of 12–18 per cent, inconsistent with
the theory of monopoly behaviour and hence stressing the real
benefits of merger at that time. Those unconvinced of the benefits of
merger cite the motives for the mergers being the need for sufficient
industrial size in order to gain promotion to the NYSE which had
minimum size requirements (Hannah, 2006) and the horizontal
integration method of gaining market share dominance (Lamoreaux
et al., 2002). US Steel’s 60 per cent market share in 1913 was considered
above minimum efficient size and hence created some monopolistic
distortions.
However, the growth of firm size was to a significant extent motivated
by the needs of business to circumvent the obstacles to efficiency in
production scale and distribution, with the dominance of forward verti-
cal integration emphasised by Livesay and Porter (1969).
These larger firms which came about as a result of the merger wave,
whilst possessing monopoly power to some extent, were able to devote
large sums of money to the long-term commitment to conducting
industrial research and development and hence contributed to the
‘pushing out’ of the technological frontier by engaging in such research
(Schumpeter, 1942; Nicholas, 2004).
US foreign direct investment (FDI)

By 1930, due to the effects of the First World War, the USA’s economic
growth, and the monetary expansion in that period, the USA had
become the main capital exporter, financing the reconstruction of
Germany after the war and lending to other nations in South America
and Europe. This large outward flow reached over $5 billion, which
amounted to 60 per cent of global net capital export, with Britain and
France exporting $1.3 billion each (15 per cent of the world total) and
is testament to the growth of the USA into an economic superpower by
this time (Feinstein et al., 2008).
Summary
As stated in the methodology (Chapter 2) we use historical analysis
to help navigate the joint hypothesis problem in the identification of
asset bubbles. We use long-term growth rates of GDP and dividends
before the 1920s, so that we can be reasonably sure that the USA was on
a stable long-term growth path. The equilibrium model we seek to
establish so that we can test for an overvaluation is therefore built on
these data. By 1929, continued GDP growth over a very long timescale
would be the rationally expected course of the US economy, based on
historical experience from the 1870s to the 1920s.
Due to the steady growth rate of the US economy over long time periods
prior to 1929, although there would be a small growth component in
Multi-Factor Productivity Growth (MFPG), there would be an anticipa-
tion of a forward-looking GDP growth rate and hence the expectation
that corporate profit growth rate would be higher than its long-term
historical trend rate up to 1929, but it is not obvious whether such a
calculation was being performed by investors. To accommodate this we
allow our tests to simulate valuations based on a projected future growth
rate of dividends of up to 3 per cent, set as an upper bound, which
reflects the ex-ante long-term growth path of GDP. We are also able to
accommodate expectations of dividend growth of over 3 per cent in our
simulations, although these levels of expectation need to be set in the
context of historical expectations, which were much lower.
3.3 The Gold Standard
Examining the international monetary system of the period and its

effect on the US economy is integral to the analysis of the changes
in the US stock market. We therefore show the background to the
analysis of international gold flows into the US economy detailed in

section 3.4.
The change from the Classical Gold Standard to the interwar

Gold Exchange Standard system
The First World War was responsible for the disintegration of the
Classical Gold Standard system and the emergence of a reconstructed
international Gold Exchange Standard (GES) in the 1920s. Many coun-
tries switched to free floating exchange rates during the war and slowly
rejoined the new GES during the 1920s. This reconstructed system
was, in key respects, different from the former system and the period
of transition between the two systems, during which no international
monetary standard was present, had an influential effect on monetary
dynamics and inflation rates across the world.
Although the functioning of the pre-1914 Classical Gold Standard
system is still debated in the academic literature,5 there was a marked
change in the structure and operation of the international Gold
Standard system post-1913, with the USA at its core. Describing the
period, Mundell (2000)6 shows that US monetary policy had become
much more important with the creation of the Federal Reserve System
in the USA with its twelve regional Federal Reserve Banks presided over
by the Federal Reserve Board, and its effect on global interest rates and
price levels under the interwar Gold Standard system.
Before 1913 most countries of the world adhered to the Classical
Gold Standard system, with its commitment by monetary authorities
to convertibility of their currencies at fixed rates. The period was also
characterised by limited central bank intervention in foreign exchange
and money markets and the free mobility of capital (Bordo and
Macdonald, 2003).
The classical position on the Gold Standard era is in Goschen
(1892: 127):
money will be dear and scarce in the country which owes much to
foreign creditors, and plentiful in that which has exported much
and high interest will be attracting money to that quarter whence
specie is flowing out in the payment of foreign debt. An adverse bal-
ance of trade will … render the bills of a country which is most in
debt difficult of sale, and tend to compel it to export specie: whereas
the high rate of interest, which is generally contemporaneous of a
drain … of specie, will revive a demand for bills on this same country,
and enhance their value in other quarters, for there will be a general
desire to procure the means of remitting capital to that market where

it commands the highest value.
Thus
where there is a considerable efflux of specie taking place, the rate

of interest will rise in the natural course of things. The abstraction
caused by the bullion shipments will of itself tend to raise that rate.
(Goschen, 1892: 132)
Moreover, a country can finance a temporary balance of payments

deficit by borrowing abroad. Finally arbitrage in the securities market
will ensure that interest rates for a similar class of bills will be equal
between financial centres:
if at any time the rate of interest here falls below that which rules on
the continent, it is inevitable that the whole mass of these bills will
at once be sent to London, and be discounted there at the cheaper
rate, so that the proceeds may be remitted in gold to the continent
to be invested there in local securities at the supposed higher rate.
(Goschen, 1892: 138)
Following the outbreak of the First World War and the creation of
the Federal Reserve in 1913 the mechanics of the Gold Standard system
as an international system were altered as Great Britain, France, and
Germany suspended gold convertibility. This suspension of the com-
mitment to redeem their currencies in gold allowed the creation of
fiduciary money and the subsequent deterioration of the free floating
exchange rates of these currencies as the high costs of war necessitated
the issue of substantially increased volumes of paper currency. Austria,
Hungary, Poland, Russia, and Germany experienced uncontrolled
hyperinflation (Feinstein et al., 2008).
The post-war era of reconstruction saw a return to the Gold Standard
reconstituted as the Gold Exchange Standard, which was deemed
preferable by most major nations. Plans for reconstructing the interna-
tional Gold Standard were laid at the Genoa Conference of 1922, where
the financial commission, under British leadership, urged the world
to return to a ‘Gold Exchange Standard’7 under which member coun-
tries would make their currencies convertible to gold, but use foreign
exchange – the currencies of the key reserve countries, the UK and USA –
as a substitute for gold (Bordo and Macdonald, 2003). Viner (1937)
questioned the merits of such a system, although with the benefit of

hindsight following the disaster of the Great Depression also highlighted
that the new system was supposed to allow poorer countries to avoid
the need to hold gold reserves, which were costly.
The GES was restored worldwide in the period 1924–7. Central bank
statutes typically required a cover ratio for currencies between 30 and 40
per cent divided between gold and foreign exchange reserves. The cen-
tral reserve countries, the UK and USA, were to hold reserves only in the
form of gold. Many believed the GES was established based on incorrect
parities. It is widely held that sterling returned to gold at an overvalued
rate of between 5 and 15 per cent (Bordo and Macdonald, 2003).
The GES was in many respects different to the pre-war system, involving:
1. The transition to a higher degree of central bank management of

the currency.
2. An increasingly fractional reserve system.
3. The substitution of circulating gold coin with a promise to redeem
paper currency for gold at a fixed price.
Viner (1937) states that under a managed currency system the idea of the
Gold Standard functioning ‘automatically’ was illusory, on the grounds
that the GES system was based on a fractional reserve system and that
central bank intervention had become of overriding significance:
If a currency system could be imagined under which the specie

reserves of the banking system as a whole were always maintained
without a central bank regulation at a constant ratio to its demand
liabilities to the public, there would be only one significant differ-
ence between such a currency and a simple specie currency as far as
the international mechanism was concerned. Whereas under a simple
specie currency, fluctuations in the quantity of specie would result in
equal fluctuations, both absolutely and relatively, in the amount of
means of payment, under a fixed fractional reserve, currency fluctua-
tions in the quantity of specie would result in eqi-proportional but
absolutely greater fluctuations in the amount of means of payment.
The absolute amount of specie movement necessary for adjustment
of the balance of payments to a disturbance of a given monetary size
would be less under a fractional reserve currency than under a simple
specie currency.
Where the ratio of the amount of currency to the amount of spe-
cie is subject to the discretion of the central authority however, the
international mechanism becomes subject to the influence of the

decisions or activities of this authority and loses some, at least, of its
automatic character. (Viner, 1937: 390–1)
Viner presented his view that the managed nature of the interwar
central banking system renders analysis of the mechanisms and the
automatic nature of the system largely impossible:
Theorising about the nature of the international mechanism in so

far as it is subject to influence by the operations of central banks
cannot therefore be forthright and categorical, but must resort to
analysis of the consequences for the mechanism in different types
of situations of the particular choices which central bankers may
conceivably make among the various species of action or inaction
available to them in such situations. But whatever central banks
do or refrain from doing, and for whatever reasons or absence of
reason, their mere existence with discretionary power to act suffices
to give some phases of the international mechanism and especially
the specie-movement phase, a ‘managed’ and variable and largely
unpredictable relationship to the other phases of the mechanism.
(Viner, 1937: 391–2)
With regard to the international mechanism for balance of payments

adjustment, Viner stated:
Whatever form it takes, the international movement of short-term

funds derives its importance for the mechanism of adjustment of
international balances from the fact that these funds are highly
mobile and in the absence of financial or political disturbance
respond quickly, especially as between well developed money mar-
kets to even moderate relative fluctuations in interest rates. (Viner,
1937: 403)
A highly incisive account of the interwar GES, which corroborates

Viner (1937), comes from Gustav Cassel, a celebrated economist8 spe-
cialising in monetary economics and the originator of the Purchasing
Power Parity (PPP) theory. Cassel (1928) illustrates that the USA had
become the centre of the GES system:
It is true that even before the War the monetary demand for gold
was a factor in influencing the value of gold and therefore also the
purchasing power of every gold currency. Nevertheless the present

situation is in two aspects essentially different.
First, people now realise that a deliberate regulation of the mon-
etary demand for gold is possible and may have an important influ-
ence on the value of gold. … it is natural enough that people should
come to recognise the stabilisation of the purchasing power of gold
as against commodities to be the ultimate aim to be pursued …
Secondly, the influence on the value of gold has been concen-
trated in one country, the United States. The monetary policy of this
country, therefore, has acquired a first rate importance in regard to
the value of gold. This circumstance has, of course, accentuated the
fact that the value of gold is no independent factor of our monetary
system, but a result of monetary policy. When nowadays any other
country reconstructs its monetary system as a gold standard, it does
not in fact link it to an independent value such as that which gold
was supposed to have been before the war, but simply connects it
with the value of the dollar, the immediate practical aim always being
to keep the dollar exchange of the new currency at a fixed parity. …
Under such circumstances the United States are in a position to
exercise an independent control over the value of their currency;
the value of the dollar is simply the result of the way in which the
monetary authorities of the United States chose to regulate the gen-
eral supply of means of payment in the country. The Federal Reserve
authorities therefore control not only the general level of prices in
the United States, but also the price levels of all other gold standard
countries in the world. (Cassel, 1928: 70–3)
Keynes (1923) shared the views of Cassel (1928) and Viner (1937). He
states:
In the modern world of paper currency and bank credit there is no

escape from a ‘managed’ currency, whether we wish it or not; con-
vertibility into gold will not alter the fact that the value of gold itself
depends on the policy of the Central Banks …
But the war has effected a great change. Gold itself has become
a managed currency. Gold stands at an artificial value, the future
course of which almost entirely depends on the policy of the Federal
Reserve Board of the United States.
[Britain rejoining the Gold Standard means] that we surrender the
regulation of our price level and the handling of the credit cycle to
the Federal Reserve Board. (Keynes, 1923: 170–5)
Keynes and Cassel illustrate the critical change the GES represented
for the world monetary system. The Classical Gold Standard had
become a ‘de facto’ US Dollar Standard with the US central bank having
considerable scope to determine the price of gold. With its high degree
of autonomy in the issue of its domestic money supply, other world
countries on the GES were bound by the fixed exchange rate system to
alter their money supplies to maintain parities with the US dollar.
As highlighted above, the GES allowed the Federal Reserve to pursue a
significant degree of independence in its monetary policy. The idea that
the Fed was totally restricted by this Gold Standard seems untenable, as
there was sufficient gold in the USA to pursue to some extent all three
points of the ‘tri-lemma’, which existed for other countries on the GES.
As Cassel (1928: 72–3) noted:
The United States have accumulated a very large gold reserve which
has not been used for a corresponding credit expansion. Only part of
this accumulated gold is actually needed as a basis of the American
monetary system. The rest forms an extra reserve, from which the
United States are able to supply almost any amount of gold that
could practically be asked for by the outside world. And what is very
important, this can be done without touching the ordinary gold
cover of the currency, and therefore also without in any way affect-
ing the supply of the means of payment within the United States …
The second fact is that the United States are wealthy enough to
allow themselves the luxury of storing any amount of gold that may
be sent to them without letting such fresh gold supplies have any
effect in the way of credit expansion. Thus gold exports need not
cause a fall in the American price level.
To summarise, Cassel (1928) illustrated that the USA had by then

switched from a position of passivity in allowing gold inflows to expand
the US monetary base to one where they continued to accumulate gold
but did not allow further credit expansion. The control of the monetary
base as gold flowed in to the USA was not checked during the First
World War period and hence led to a large expansion of the monetary
base, which allowed the credit expansion which was to become highly
integral to the boom. Furthermore the work of Keynes (1923) and Cassel
(1928) highlights US control over the value of gold and the credit sys-
tems of other countries.
Although the long-term sufficiency of world gold production was
queried by Cassel (1928), who highlighted the potential long-term
dangers of inadequate gold supplies required to provide backing for the

world’s money stock, Rockoff (1984) explains that the growth in gold
discoveries, gold extraction technology, the adoption of intensive methods
of production, and the tendencies of governments to relax environ-
mental protection laws that restricted mining, would be expected in the
long term to ensure that there was no such pressure. Investors’ fears of
insufficient gold resulting in an expectation of monetary stringency do
not appear to have been a factor for valuing stocks in the late 1920s.
As we go on to demonstrate, the return to long-term Government
Bonds and the long-term US Government Bond yield of 3.7 per cent
suggest that inflation of 0.8 per cent per annum was expected over a
twenty-year horizon.
There are highly credible grounds for assuming that investors in US
Common Stocks in 1929 did not expect any form of significant near
or long-term price deflation, because the Federal Reserve System was
rationally believed to possess the policy tools and gold reserves to main-
tain the supply of money and, hence, the price level.
Summary
Research conducted at the time and more recently points to the large
dislocations of the old monetary system of the world and the emer-
gence of a more fragile new one. Central bank policy had come to play
an increasingly large role in the USA.
3.4 Monetary dynamics and the US stock market
The origin of the 1920s boom is found in the economic dislocations of

the First World War, and the expansion of the monetary base and credit
system of the USA. As gold poured in from Europe to finance the war
(Figure 3.2), the amount of lending which the US banking system could
accommodate increased substantially (for a discussion of the theoretical
foundations of how the Gold Standard system worked see Barro, 1979).
Some of this lending was used to finance the holding of US government
debt by the US public, via banking system credit to buyers of this debt
from 1917 to 1919 for the ‘Liberty Bond’ programme (Meltzer, 2003).
The new gold was also used to increase commercial lending. Gross federal
debt rose from $1.2 billion in 1914 to $24 billion in 1920, as a result of
the Liberty Bond programme and other wartime increases in expenditure.
This outstanding debt level was about 30 per cent of GDP by the end of
the war in 1918, which was soon paid down to $16 billion with a debt to
GDP ratio of 16 per cent by 1929 (NBER Macrohistory Database, 2014).
4500
4000
3500
3000
Tonnes
2500
2000
1500
1000
500
0
1895 1900 1905 1910 1915 1920 1925 1930 1935
Year
Figure 3.2 US Treasury/central bank gold reserves (metric tonnes)

Sources: Annual Report of the Director of the Mint, Washington, DC (1940); Banking and
Monetary Statistics, Board of Governors of the Federal Reserve System, Washington, DC
(1943).
The Liberty Bond sales not only increased the public’s familiarity with
securities, but also it can be argued to have been the start of the public’s
desire for and comfort with both the marketing of securities and will-
ingness to use them as investments, rather than rely on bank deposits
(Ott, 2011). The ability to generate a large-scale investor base to absorb
security issuance by the US government can be seen as a precursor to
the large-scale operations of banks and their securities affiliates (Peach,
1941), who tapped into a public with the growing wealth and confi-
dence to absorb the securities of commercial and industrial companies
in the USA.
As a consequence of this increase in gold in the US banking system,
the level of lending to the real economy via credit to households, govern-
ment, and businesses expanded on a large scale (Figure 3.3). The measure
of broad money in the economy (M2) rose from $20 to $48 billion from
1915 to 1929. Such a large change in the monetary dynamics of any econ-
omy warrants serious consideration and the discussion below looks in
detail at these dynamics, including their effect on the value of US stocks,
through changes in the earnings and dividends of these companies.
Analysis of Figure 3.4 shows that the rate of growth of the M2, M3,
and M4 indicators was marked around the 1915–19 period, rising to as
high as 17 per cent per annum, thus the major change in the growth of
monetary aggregates occurred in this time period before settling back
down to a pre-war trend rate of growth of about 5 per cent per annum.
73
M2 M3 M4
70
60
Billions of Dollars ($)
50
40
30
20
10
0
99
02
05
08
11
14
17
20
23
26
29
18
19
19
19
19
19
19
19
19
19
19
Year
Figure 3.3 US money supply (1899–1931)

Source: Friedman and Schwartz (1963).
M2 M3 M4
25%
20%
Percentage per Annum (%)
15%
10%
5%
0%
00
02
28
30
04
06
08
10
12
14
16
18
20
22
24
26
–5%
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
–10%
–15%
–20%
Year
Figure 3.4 US money supply growth (1900–1931)

Source: Friedman and Schwartz (1963).
As discussed later in this section the 1920s were not a time of high
money growth in general. This aggregate level normality in the rate of
growth of money was due to the rise of the home loan debt growth rate,
being offset by the fall in the growth rate of other debt sectors.
This growth in the monetary measures and debt in the non-
government economy was neutral, in real terms, at the aggregate level.
The ratio of national income to total private debt remained constant
and debt servicing costs remained at around 5 per cent through the
period (Kuvin, 1938). However, these aggregate measures do not show
that there was a key change in the debt structure of the US economy
through the 1920s as inflation-adjusted commercial debt growth
rates contracted but were offset by an expansion in the inflation-
adjusted growth rates of lending to the home loan sector (Kuvin, 1938;
Wheelock, 2008).
Figure 3.5 shows nominal levels of debt in five major categories: non-
farm mortgages, farm mortgages, steam railroad companies, public utili-
ties, and manufacturing and mining companies. There was one sector of
the US economy which underwent significant increases of debt growth
during the 1920s. This was the home loan sector listed as non-farm
debt. In real terms, the total private debt burden in the USA did not
increase; however, the composition of the debt changed towards home
mortgages (non-farm).
The problem of high levels of housing debt is that they can lead to prob-
lems for the real economy via the impairment of banks’ balance sheets if
very high levels of default occur. They also can produce severe negative
wealth effects, which reduce consumption if house prices fall relative to
the debt owed, and may induce behavioural changes on the part of home-
owners, who may pay down loans instead of maintaining consumption if
their debt burden relative to income is too high (Mishkin, 1978).
The 1920s and the 1930s seem to be prime candidates for such
effects, as the high levels of debt and the fall in house prices in the
1930s may have played a significant role in the severity of the Great
Depression.
The recent financial crisis of 2008 has stimulated much research on
both the dynamics and parallels between the housing bubble in the USA
in the 2000s and the 1920s. White (2009) finds that a bubble of about
20 per cent in real terms formed in the 1920s and peaked in 1926. Home
and commercial property prices in isolated pockets such as Manhattan
experienced a large boom greater than the general market in the USA
due to the concentration of higher income and limited supply in those
particular areas (Nicholas and Scherbina, 2013).
Non farm Farm

Steam railroads Public utilites
Manufacturing and mining Total
80000
70000
60000
Millions of Dollars
50000
40000
30000
20000
10000
0
00
02
04
06
08
10
12
14
16
18
20
22
24
26
28
30
32
34
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
Year
Figure 3.5 Private debt levels by sector (1900–1934)

Source: Kuvin (1938).
As suggested by White (2009)9 there was a rise in the securitisation of

mortgages, which accompanied the housing construction boom of the
1920s. Goetzmann and Newman (2012) analysed the rise of the com-
mercial mortgage-backed security market (CMS), which was used, in
part, to finance the construction of skyscrapers in major US cities, like
New York and Chicago, and a sizeable market for commercial mortgage-
backed securities emerged. Although it was much smaller than the
bank-based supply of mortgages for non-farm residential loans of about
$30 billion, it still formed a large segment of the mortgage market and
these instruments were traded on exchanges.
The commercial real estate (CRE) bond market developed when tra-
ditional lenders, including commercial banks, refused to advance funds
for risky atypical CRE projects (Wiggers and Ashcraft, 2012).10 Total
issuance of CRE securities was $4.1 billion between 1919 and 1931.
Between 1919 and 1925, total yearly issuance grew from $57.7 million
to $695.8 million, or nearly 1,106 per cent. Buildings in New York and
Chicago backed 46.2 per cent and 25.9 per cent of the issuance over
$1 million, respectively (Goetzmann and Newman, 2012).
We can therefore see that in addition to the growth in bank-based

non-farm mortgage loans there was also an active market for real estate
securities. However, bank-based lending was the dominant source of
funding for home loans and much larger in the size of increase, at an
estimated $30 billion.
The CRE sector performed poorly in the Depression. At least 80 per
cent of the outstanding mortgage securities issued between 1920
and 1929 were failing to meet their contracts in 1936. The yield on
these securities rose from 8 per cent in 1929 to 58 per cent in 1933.
Recoverable value on those same issues ranged from approximately
80 per cent for 1920-vintage bonds to less than 40 per cent for 1928-
vintage bonds (Goetzmann and Newman, 2012).
This expansion in home loans created problems for the US economy
in the 1929–33 period, primarily because the term of a mortgage was
only five years long and fixed in terms of repayments (Wheelock,
2008). Such problems meant that ‘roll-over’ risk was high, and that in a
deflation, fixed nominal payments on the mortgage were larger in real
terms and the value of the total mortgage was also larger (Fisher, 1933;
Mishkin, 1978; Wheelock, 2008). Higher levels of unemployment also
made debt default more likely. In the event of a severe recession, this
level of nominal fixed rate debt had the potential to cause an increase
in the severity of the depression by two channels:
1. Through hazards to consumer spending via wealth effects on home

values relative to debt and through a fall in nominal income relative
to fixed mortgage payments.
2. Through asset impairment in the banking sector leading to credit
contraction or even insolvency.
When combined, these effects could have created a feedback loop

where credit frictions raised the cost of refinancing and the cost of
finance for new home loans. One of the most contentious debates about
how the Great Depression formed is whether the banking system was
carrying a balance sheet that was, at a systemic level, too large relative to
capital, given that a severe macro shock could lead to rising unemploy-
ment and default (Bernanke, 2000). Another issue is that the first-order
effect of a severe macro shock could lead to a feedback between the real
economy and the banking sector through mortgage defaults which led
to credit contraction. A second-order effect reduced demand further and
increased unemployment. Exposure to such a process came into play as
a result of the economic contraction that developed during 1929–33.
Having looked at the potentially harmful effects of the debt build-

up, which we re-examine in Chapter 6, we can now inspect the impact
of these changes on the US stock markets. Consumer prices rose
(Figure 3.6), reflecting the growth of monetary aggregates as debt levels
expanded. The magnitude of the increase in prices was 70 per cent, and
120 per cent for M2. As Figure 3.7 shows, the rise in wages for unskilled
workers seems consistent with the idea that the inflation did not erode
the real wages of even the least skilled workers in the US economy, and
also reflected the same growth in monetary aggregates.
The consequences for the earnings of US firms from the monetary
expansion were large because as nominal income increased and wages
increased, we would expect the nominal earnings of companies in
aggregate to increase (Figure 3.8). The real firm level effects of these
types of changes (Figure 3.9) are not looked at in our work.
Figure 3.10 shows that such a theoretical prediction applied in the
USA in the 1920s. Real dividends and earnings for stocks as measured
by Cowles (1938) did not change in real terms following the post-1914
increase in prices. Hence we can clearly see the first part of the boom
in the 1920s was simply a reflection of nominal increases in earnings
for US companies. Whether the credit boom had any direct role in any
overvaluation up to 1929 is examined in Chapter 4.
30
25
20
Index
15
10
0
1900
1902
1904
1906
1908
1910
1912
1914
1916
1918
1920
1922
1924
1926
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
1948
1950
1952
Year
Figure 3.6 US consumer prices (1900–1952)

Source: Shiller (n.d.).
78
900
800
700
600
500
Index
400
300
200
100
0
1900
1902
1904
1906
1908
1910
1912
1914
1916
1918
1920
1922
1924
1926
1928
1930
1932
1934
1936
1938
1940
1942
1944
Year
Figure 3.7 US Unskilled Labour Wage Index (1900–1944)

120,000
100,000
Millions of Dollars
80,000
60,000
40,000
20,000
0
1900 1905 1910 1915 1920 1925 1930 1935 1940
Year
Figure 3.8 Nominal GDP (1900–1939)

Source: Williamson (2014).
79
1,400,000
Millions of chained 1999 Dollars
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945
Year
Figure 3.9 Real GDP (1895–1945)

Source: Williamson (2014).
Inflation adjusted dividend index Nominal dividend index
500
450
400
350
300
Index
250
200
150
100
50
0
Apr-05
Apr-09
Apr-13
Apr-17
Apr-21
Apr-25
Apr-29
Apr-33
Apr-01
Aug-02
Dec-03
Aug-06
Dec-07
Aug-10
Dec-11
Aug-14
Dec-15
Aug-18
Dec-19
Aug-22
Dec-23
Aug-26
Dec-27
Aug-30
Dec-31
Year
Figure 3.10 Real and Nominal Dividend Index for US stocks (1900–1933)
Sources: Cowles (1938); Shiller (n.d.).
On the surface then, the stock market boom does not seem to be that
spectacular given the monetary and debt dynamics, and the price level
changes. The market was not irrational or exuberant up to 1927 and the
index of nominal values of discounted future dividends increased passively.
In summary we can see that the 1914 increase in credit growth led
to a rise in nominal GDP and prices and hence earnings and dividends.
Hence the effect of MFPG, which was documented earlier, and the
expectation of its increase could have been a rational reason to increase
asset prices. However, barring this expectation, which we can show to
be small in magnitude and hence not able to reproduce the large jumps of
valuations in the 1920s, there is no reason for investors to have believed
that the USA was in a new era. What occurred during the 1914–29
period was a credit boom, which had no real effects other than to change
the type of sector of the economy that held the debt. This was the con-
sumer sector, which took on debt to a large degree (Wheelock, 2008).
Having seen that a monetary expansion was the cause of the first
phase of the boom we can defer measures of the expected value of US
stocks to Chapter 4.
What should be clear is that the 1920s moniker ‘the roaring twenties’
is not a wholly fair or accurate one from a real economic standpoint and
only the rise in MFPG can be assumed to be the true innovation to the
expected returns to US stocks which stock market investors should have
been concerned about.
What happened to dividends and earnings during the 1920s was
a lagged response to the growth of lending in the US system, which
later became reflected in rising nominal earnings and dividends for US
companies.
The high returns to stock market investors in the 1920s were a con-
sequence of the lending boom and the attendant rise in the price level
and, with a lag, the earnings of US companies.
Stock prices are nominal, and trade at a multiple of their underlying
nominal dividends. The returns on stock market investment changed
dramatically as the stock market rose in tandem with increasing nomi-
nal earnings and dividends. For this we use data from Shiller (n.d.).
As Figure 3.11 shows, by 1927 the average monthly return on stocks
had completed a very steep rise in its 36-month moving average from
0.5 per cent per month in 1920 to 2 per cent per month in 1927, which
was a deviation from trend of 300 per cent. This may have signalled to
investors that expected returns to the stock market were unusually high.
This may have attracted investors to the market on the basis of the
expectation of higher returns, in a general sense, and the idea that a
Monthly returns 36 per. Mov. Avg. (Monthly returns)
10
8
6
4
Percentage
2
0
–2
–4
–6
–8
–10
1915.11
1916.05
1916.11
1917.05
1917.11
1918.05
1918.11
1919.05
1919.11
1920.05
1920.11
1921.05
1921.11
1922.05
1922.11
1923.05
1923.11
1924.05
1924.11
1925.05
1925.11
1926.05
1926.11
1927.05
Date
Figure 3.11 Monthly returns (Cowles Index) (1915–1927)

Sources: Cowles (1938); Shiller (n.d.).
new trend was emerging in the returns to be expected from stocks.

What we can clearly say is that returns to investing in the latter half of
the 1920s were spectacular. Thus before even the 1927–9 phase which is
cited as a bubble, the lending-induced boom had created a large return
to stocks which would have been hard to ignore. In Chapter 4 we inves-
tigate whether momentum, a case of self-feeding increases in returns,
can be detected during the boom.
Productivity growth for the US economy

Another possible driver of the changes in valuation ratios above his-
torical trend could have occurred due to a technological shock. Despite
the clear changes in the US economy due to the nominal increases in
earnings and dividends, there was also a period of technological change
(Nicholas, 2003). Although the moniker of the ‘roaring twenties’ may
be misleading as we can see that much of the ‘roaring’ was in fact dis-
guised inflation, adding to the confusion, which investors may have
faced during this period, is the fact that the price level from 1922–9 was
highly stable. High real earnings and dividend growth were in fact due
to the changes discussed previously, but this was disguised in the 1920s
as the price level was already elevated following the 1915–19 inflation
and was stable during the 1920s, even as the lagged effect on earnings
and dividends was still catching up. As we have seen in Figure 3.10, real
earnings and dividends only reached their pre-war trend levels in 1929.
The productivity advances nascent in the new generation of US firms,
together with innovations in managerial techniques and technology,
offered higher real growth prospects for the long-term future of the USA.
A good measure of the growth in technological advances, the key
source of growth aside from the natural endowment of resources the
USA possessed, is captured in the MFPG data. From an average annual
growth rate of 0.39 per cent for 1870–91, MFPG began to climb, hitting
1.14 per cent for 1890–1913. After the First World War, it continued an
upward movement, rising to 1.42 per cent for 1913–28 before cresting at
1.9 per cent in 1928–50 (Gordon, 2000). These data from 1928–50 have
been revised upward from 1.9 per cent to 3.7 per cent (Gordon, 2010).
Gordon argued that this peak of MFPG was attributable to a clus-
ter of innovations in five areas: electricity, the internal combustion
engine, petrochemicals-plastics, pharmaceuticals, and communications-
entertainment (telegraph, telephone, radio, movies, recorded music,
and mass-circulation newspapers and magazines). These were all
well established before the Second World War, and their diffusion
and improvements thus contributed to the high MFPG of 1928–50.
Advances were also witnessed in the chemicals sector with companies
such as Du Pont in the fields of explosives, paints, and synthetic materi-
als such as rayon. Those companies with high patent counts were likely
to have performed well in the 1920s stock market and subsequently.
The mechanism for the increase in technological advances was iden-
tified through the growth of research and development (R&D) labs in
large industrial firms (Nicholas, 2003).11 By 1929, 75 per cent of all
mechanical work was electrified (Nicholas, 2003).
Given the data on MFPG, which do show the USA improving this
growth rate from the 1870s, it is likely that the 1920s witnessed the
beginning of a surge in MFPG. Technological improvement was accel-
erating in the 1920s and may have been one reason for the excitement
about some US Common Stocks. We examine these effects in Chapter 4.
Inflation expectations
The rise in consumer prices from 1915 could have led to an increase
in inflation expectations which changed investor perceptions of the
returns to stocks. Smith (1924) makes reference to investor perceptions
that inflationary times were good for stock returns. It is therefore sen-
sible to test whether high inflation expectations were present over the
long term, and if so, investigate whether this caused the surge in stock
buying in the 1920s. What we need to know is whether investors liked
stocks due to the historical experience of inflation and fear of future
inflation, which may have made stocks more attractive. We can only
test whether they were trying to protect against anticipated inflation by
measuring inflation expectations.
We can measure the expectations of inflation in the late 1920s by
two methods shown below, and see that they were low, of the order of
0.8 per cent per annum over a twenty-year forward horizon. Such low
inflation expectations could not warrant a major change in stock prices.
What we cannot prove directly is whether losses on bonds made inves-
tors look at stocks, which were inflation-protected.
For those investors who did find interest in stocks, the novelty of the
asset class or the naivety of the new investors and the unfamiliarity of
investors with these types of financial instruments are definite suscepti-
bility factors for the creation of asset bubbles which have been found in
the laboratory setting (Smith et al., 1988).
As Figure 3.12 shows, long-term Government Bond yields rose signifi-
cantly from 1919 to 1923 following the inflation of the First World War
era. Long-term inflation expectations dissipated through the post-1923
4
Percentage
0
01/1900
01/1902
01/1904
01/1906
01/1908
01/1910
01/1912
01/1914
01/1916
01/1918
01/1920
01/1922
01/1924
01/1926
01/1928
01/1930
01/1932
01/1934
01/1936
01/1938
01/1940
Date
Figure 3.12 US long-term Government Bond yield (1900–1940)

era as the Classical Gold Standard was replaced by the reconstructed

GES. However, the Government Bond market suggests that long-term
inflation expectations, having almost fully dissipated by 1927, experi-
enced a re-emergence from 1928 to 1930.
Our estimate of inflation expectations is shown below, using two
different methods:
1. Fisher’s Golden Rule.

2. Inflation-adjusted long-term US Government Bond returns.
Fisher’s Golden Rule

A useful guide to gauge long-term inflation is contained in the spread
between thirty-year US Government Bond yield and the long-term
trend real GDP. During the inflation of the First World War period
the Government Bond yield rose significantly, indicating a growth of
inflation expectations. By 1929, the yield had fallen to 3.7 per cent. By
1929, realised thirty-year inflation was 2.7 per cent as measured by the
Consumer Price Index.
Fisher’s Golden Rule (Fisher, 1930) stipulates that long-term inflation
can be calculated as the spread between real long-term trend GDP and
the long-term Government Bond yield:
Fisher’s Expected inflation (FISHER) = A – B
where,
A = L-Term Govt. Bond yield

B = Real GDP growth (1871–1929)
Therefore
FISHER = 3.7 per cent – 2.9 per cent = 0.8 per cent.
Long-term Government Bond returns (1870–1929)

Over the 59 years from 1870 to 1929 the total real return to investment
in long-term Government Bonds was 2.9 per cent.12
Long-term inflation expectations were calculated by the following
formula:
Expected inflation over 20 years (EXP) = A – C

where,
A = L-Term Govt. Bond yield (1929)

C = Real L-Term Govt. Bond return (1871–1929)
Therefore
EXP = 3.7 per cent – 2.9 per cent = 0.8 per cent.
Both measures show that there were minor inflation expectations of the
next twenty years to about 1950. These are not large enough to produce
the rise in stock market prices.
3.5 The Federal Reserve in its first fifteen years

of operation
The Federal Reserve was a new institution during the 1920s boom.
In this section we look at how it functioned in those early years and
the problems it faced. We also examine how it functioned around its
attitude towards the boom in the stock market.
The outbreak of the First World War and the 1914 crisis
In 1914, the nascent Federal Reserve System was faced with a daunting
challenge. The outbreak of the First World War had large ramifications
for the future of international trade and finance and 1914 saw a large
demand for the sale of assets in the USA. These withdrawals could have
proved hazardous for the USA’s ambitions as a reserve currency of inter-
national trade as there was a potential for the USA to come off the Gold
Standard if large gold withdrawals were met by the US banking system.
The situation placed enormous strain on the US banking system
and was remedied by unconventional and daring moves by Treasury
Secretary W. G. McAdoo. McAdoo implemented an unconventional
and imaginative solution, which involved the closure of the US Stock
Exchange, a measure which was deemed necessary to avoid a liquida-
tion of loans and investments in financial instruments, which could
have triggered a crash in values. The main aim of the action was to
prevent the outflow of capital involved in a mass liquidation of securi-
ties. Such a large-scale withdrawal would have threatened the solvency
of the banking system as gold flowed out of the USA.
The second key response enacted by McAdoo was the coordination
of the internal transfer of gold between reserve banks to make sure that
enough gold was available to ensure depositor withdrawals, as investors

withdrew currency. He also implemented the printing and distribution
of $200 million of emergency currency to ensure that banks were able
to supply enough currency to meet withdrawals from depositors.
The third action was the insurance of maritime exports from the USA
where the marine insurance market for commercial trade had broken
down in the face of the outbreak of war. By creating an insurance mar-
ket McAdoo enabled the USA to recoup gold via international trade
flows (Silber, 2007).
The outcome of these emergency measures was the sufficient stabi-
lisation of the US financial system by maintaining gold convertibility,
deemed vital to the credibility of the US dollar, and ensuring that gold
outflows were stemmed and all depositor demand was satisfied.
Silber (2007) contends that the ability of the USA to remain on the
Gold Standard was important in the development of the US dollar as a
credible currency to be used by foreign central banks as a reserve cur-
rency. The dollar therefore became as influential as sterling, which up
to the outbreak of the First World War had been the main international
currency for international commerce.
The actions in 1914 illustrate there was sufficient scope for the US
Treasury to act outside of the traditional confines of their routines in
the face of an emergency.13
Federal Reserve actions in 1919–20

During the First World War the price level increased in the US, caused
by the disruption of trade, wartime scarcity of commodities (Cassel,
1922), and increases in the money supply. Following its release from
Treasury control in 1919 due to wartime measures, the Federal Reserve
pursued a policy of increases in the base rate from 5 per cent to 7 per
cent (Figure 3.13). The proximate aim of this increase was to counteract
post-war inflation (Meltzer, 2003). The Federal Reserve succeeded in
their objectives although a severe recession and deflation followed.
The resulting shock to output due to interest rate tightening is
recorded by the NBER as a sharp and deep recession, which lasted from
1920 to 1921. Friedman and Schwartz (1963: 231–2) note:
The contraction, at first mild, became extremely severe in its later

stages when it was characterized by an unprecedented collapse in
prices. … By June 1921 they had fallen to 56 per cent of their level in
May 1920. … What was true of prices was true also of many physical
magnitudes. Industrial production, employment in manufacturing,
6
Percentage
0
Apr-22
Apr-27
Apr-32
Aug-15
Jun-16
Apr-17
Feb-18
Dec-18
Oct-19
Aug-20
Jun-21
Feb-23
Dec-23
Oct-24
Aug-25
Jun-26
Feb-28
Dec-28
Oct-29
Aug-30
Jun-31
Feb-33
Dec-33
Jun-36
Apr-37
Oct-34
Aug-35
Date
Figure 3.13 Bank rate – Federal Reserve Bank of New York (1915–1937)
and similar series show a precipitous increase in the rate of decline

in the autumn of 1920.
The total decline in the stock of money was 9 per cent. There was also
a sharp rise in bank failures as a result of the contraction rising from
63 in 1919 to 506 in 1921 (Friedman and Schwartz, 1963). The motiva-
tion for the raising of rates to such a high level was stated as due to the
low level of gold reserves in the Federal Reserve System, which stood
at 40 per cent of liabilities. According to Fed policy, this level was too
low. The discount rate was lowered when the ratio reached 56 per cent.
The Fed’s tenth annual report in 1923 indicates the switch in policy
in response to criticism for the handling of the 1921 recession. They
therefore stopped using the gold reserve ratio, which had prompted the
raising of discount rates (Friedman and Schwartz, 1963).
Price stability and gold ‘sterilisation’ post-1923

From 1921 and the quick recovery from a major post-war recession
and deflation, prices were stabilised and economic growth was robust
and consistent through the remainder of the decade. This near decade
of price stability indicated that the Fed was capable of delivering a
stable price level. This stability is credited in part to the leadership of

the New York Central Bank governor Benjamin Strong, who is widely
acknowledged to have been the dominant player in policy decisions
with respect to the discount rate at the Reserve Bank of New York. The
stability of the price level achieved under the Federal Reserve System
from 1923 to 1929 was facilitated by the adoption of a policy of ‘gold
sterilisation’. This policy was followed in order to combat the effect
of increased gold inflows passively expanding the money supply and
causing price level rises as had occurred during the First World War era.
The Federal Reserve were keenly aware of this problem, and actively
aimed to conduct ‘Open Market Operations’, selling US Treasury bonds
to offset the rises in the monetary base resulting from continued gold
inflows to the USA. Their desire to offset the potential expansion of the
lending of the banking system through this channel demonstrates that
the Federal Reserve had clear objectives and policies to maintain the
prices at an even level.
Friedman and Schwartz (1963: 282–3) stated that:
From 1923 on, gold movements were largely offset by movements

in Federal Reserve credit so that there was essentially no relation
between the movements in gold and in the total of high-powered
money. … The sterilisation of gold movements was initially jus-
tified by the System on three grounds: first, much of the gold
could be regarded as only temporarily in this country pending the
re-establishment of gold standards elsewhere; second, with most of
the world not on the gold standard, gold movements could not serve
their traditional equilibrating role; and third, with respect to sterili-
zation of the inflow, the increase in short-term foreign balances in
the United States made a larger gold stock more desirable. …
Once, however, other countries – in particular Britain in 1925 –
returned to gold, those reasons were no longer valid, though they con-
tinued to be repeated by the system. The sterilization of gold could be
justified as a means of insulating internal monetary conditions from
external changes.
The policy of ‘direct pressure’ 1927–9

In order to combat a stock market that had experienced large annual
increases from the early 1920s and the resultant identification of a
‘credit-induced asset bubble’, the Federal Reserve initiated a policy of
‘direct pressure’ and discount rate increases.14 Whether the Fed had
identified the overvaluation we identify is debatable, as their actions
seem too precise to have been feasibly identifying an overvaluation, as

prices relative to dividends were not excessive in 1927. They may have
feared that the availability of credit had influenced stock price increases.
The raising of the discount rate from 1928 to 1929 was influenced by
the belief that the stock market had been unduly inflated by the growth
in ‘credit’ (loans and investments of the Reserve System banks) and
hence the policy response was to contract ‘credit’ by increasing its cost
or preventing it reaching speculators and investors.
The eventuality the Federal Reserve Board did not account for was a
legitimate increase in ‘credit’ to the stock market reflecting the increased
demand for funds based on fundamentally sound values. The policy of
raising the discount rate had as its ultimate objective the subsequent
lowering of the rate to below the initial position. The boom was seen as
disrupting the flow of credit to the commercial or ‘real’ economy and
high levels of credit were indicative of overvaluation.
The way to get lower rates was by ‘sharp, incisive action’ involving a
rise in discount rates that would ‘quickly control the long-continued
expansion in the total volume of credit so that we might then
adopt a System policy of easing rates’.15 (Friedman and Schwartz,
1963: 257)
Writing in 1935, A. C. Miller, a key member of the Federal Reserve

Board and its only academic economist (he had earned a PhD in
Economics), illustrated the thinking on the Board:
[The] effects of cheap and abundant credit during the autumn of

1927 were not limited to stimulating business and production and
to sustaining the price level and the European exchanges. Cheap
credit gave a further great and dangerous impetus to an already over-
expanded credit situation, notably to the volume of credit used on
the stock exchanges, and to a further rapid upward flight of security
prices. In consequence, the Federal Reserve System was confronted
toward the end of the year 1927 with the problem of getting control
of the fund of credit, which it had been instrumental in placing
in the market and keeping it within the bounds of safety lest an
uncontrollable and disastrous speculative situation should develop.
In consonance with this attitude the Federal Reserve System aban-
doned the policy it had been pursuing of offsetting exports of gold
by the restoration of a similar volume of credit to the money market
through the purchase of United States government securities, and
allowed exportations of gold to exert their tightening effect on the

money market. The effect, however, in the situation then existing
was not very considerable. The stock market expansion had acquired
too much momentum. It was evident that its pull was too strong to
be counteracted by gold withdrawals. (Miller, 1935: 449)
The policy stance of the Federal Reserve Board in the late 1920s can
be recognised in the work of Ralph Snyder, a key official at the Federal
Reserve Bank of New York. He illustrates the view that dominated think-
ing in the late 1920s, namely that the level of credit in the USA had
exceeded the needs of trade and commerce. On 22 November 1929 he
stated that:
there is a fixed and in the last half century apparently unchanging

relationship between the total expansion of trade and the need of
business for credit, to carry on that expansion … now we have in
these computations pretty clear evidence that credit expansion must
go on as least as rapidly as the growth of trade; that is, at about 4 per
cent per year. Otherwise there seems to be a definite check to trade
and prosperity … we seem likewise to have clear evidence that there
is a sharp limitation to the beneficial effects of credit expansion, and
precisely as we should expect to find it, viz., that whenever prosper-
ity has reached the practical working maximum of employment for
any given period, further credit expansion can only bring about
undue speculative activity, and even mania, rising prices and all the
familiar ills attendant upon inflation or monetary depreciation. The
gambler and the speculator thrive at the expense of the rest of the
community. (Snyder, 1930: 27–9)
Currie (1934b: 57–8) also identifies the pervasiveness of the percep-

tion that ‘Credit’ had inflated the prices of Common Stocks and the
specific advocacy of the discount rate as a policy tool:
Governor Harrison [New York Federal Reserve Bank] laid it down

as a general rule that ‘if the total volume of credit of the country
is expanding at a rate and volume faster than any normal growth
of business could justify, it is incumbent upon the central bank-
ing authorities, to put pressure or restraint on that growth by an
increase in the discount rate’ … The important thing to the Board
was the growth of speculation, ‘credit’, i.e. loans were being granted
to speculators. It would appear that the attempts of various writers
to demonstrate that ‘credit’, i.e. deposits, was not being absorbed by

the stock market failed to convince the Board for the reason that its
members could see that ‘credit’, i.e. loans, were being absorbed.
With specific reference to the events of 1927–1929 he stated ‘the
report for the board for 1927 remarks upon “the rapid growth of
member bank credit”’ and cites an increase in the total loans and
investments of reporting member banks of 8.4 per cent.
It is fair to surmise that the Federal Reserve Board’s thinking was

dominated by four propositions:
1. ‘Credit’ should be directed only to the needs of commerce.

2. The stock market had been overly inflated by credit.
3. The dual policy of discount rate increases and direct pressure would
be effective tools in the restriction of this ‘credit’.
4. ‘Credit’ had been diverted from the real economy to the stock market
to finance speculation.
However, the consensus view overlooked a key distinction in the

definition of ‘credit’. Currie’s stated observation (1934b)16 in relation to
the growth of credit to fund speculation leaves open the possibility that
the stock market was thought by the Federal Reserve Board to have been
driven to levels above fundamental values by the growth of speculative
credit. Our analysis in later chapters indicates no overvaluation was
in evidence when the identification of a ‘credit-induced inflation’ in
Common Stock prices occurred.
In direct response to the Federal Reserve Board’s identification of a
credit-induced asset bubble, base rates rose from 3.5 per cent to 6 per
cent from January 1928 to September 1929.
The policy known as ‘direct pressure’ took the form of written official
warnings to the Reserve banks to restrict loans to finance stock market
equity holdings, periodically through 1928–9. There was notable dispute
as to the policy action to be taken in 1928–9, illustrated by the disagree-
ment between the Federal Reserve Board and the New York Reserve Bank
as to the pursuit of direct pressure or a rate increase from 5 per cent to
6 per cent in August 1929. Broadly defined, the Federal Reserve Board
favoured direct pressure and an avoidance of the use of the discount
rate above the 5 per cent level due to the effect it would have on the
general level of economic activity. However, the New York Reserve Bank
favoured discount rate increases to 6 per cent or above on the grounds
that direct pressure had been ineffective (Friedman and Schwartz, 1963).
However, this disagreement should not detract from the consensus

shared by both parties, namely, that Common Stock prices had been
inflated by excessive credit growth and this credit must be reduced.
A. C. Miller described the policy of direct pressure and discount rate
increases:
On February 2 the Board directed a letter to the Federal Reserve banks

and on February 7 it issued a statement to the public carrying the
substance of the letter previously addressed to the banks, in which,
after expressing its anxiety with regard to current developments, it
laid down an interpretation of the Federal Reserve act under which
it was stated:
The Federal Reserve Board neither assumes the right nor has it
any disposition to set itself up as an arbiter of security speculation
or values. It is, however, its business to see to it that the federal
reserve banks function as effectively as conditions will permit.
When it finds that conditions are arising which obstruct federal
reserve banks in the effective discharge of their function of so
managing the credit facilities of the federal reserve system as to
accommodate commerce and business, it is its duty to inquire
into them and to take such measures as may be deemed suitable
and effective in the circumstances to correct them; which, in the
immediate situation, means to restrain the use, either directly or
indirectly, of federal reserve credit facilities in aid of the growth
of speculative credit.
This interpretation was the basis of what soon came to be known as

the policy of ‘direct pressure’. It was, in brief, a method of exercising
restraint upon the speculative credit expansion then in process by
restricting the borrowings from the Federal Reserve banks by those
member banks which were increasingly disposed to lend funds for
speculative purposes. It should be particularly emphasized and noted
that not until the Board thus declared its own attitude and the posi-
tion which it deemed appropriate for the Federal Reserve System as
a whole did the Federal Reserve banks come forward with propos-
als for discount rate action looking to restraint of credit. It was on
February 14, twelve days after the Board’s warning letter, that the
Federal Reserve Bank of New York submitted to the Federal Reserve
Board its recommendation that its discount rate be raised to 6 per
cent. This was the first proposal for an advance in discount rates to
reach the Board after the 5 per cent rate was established in July of
the preceding year. Thereupon an acute controversy extending over

a period of months developed between the Federal Reserve banks and
the Federal Reserve Board. (Miller, 1935: 454–5)
The Federal Reserve were not using monetary indicators to guide

policy, although data were freely available to the governing body of
the US Reserve System, as a target variable on which to base policy
decisions,17 but instead using the ‘Burgess–Reifler (B–R) indicator’ and
the level of total credit including loans and investments as a guide to
policy (Humphrey, 2001). We investigate the dynamics of the market
and Federal Reserve Board policy in more detail in Chapter 5.
4
The Returns to US Common
Stocks from 1871 to 2010
4.1 Measuring the ‘fundamental’ value of the US

stock market
We have already examined whether the monetary expansion in the US

economy from 1914 to 1929 was neutral from the perspective of stock
market valuation ratios and real dividend growth in Chapter 3. The
second part of the boom, from 1927 to 1929, whilst controlling for the
effect of the increase in earnings and dividends due to the monetary
changes which were occurring during this period, is a topic that is much
harder to resolve. We are able to test whether a potential deviation from
rational valuations occurred from 1927–9, in three ways:
1. At the aggregate level using a DDM.

2. In the cross-section of the stock market.
3. At the industry level based on industrial growth models for a new
technology industry – aviation.
In this section we focus on point 1, and following the methodology

in Chapter 2 we measure the returns to Common Stock investing before
and following the alleged bubble period. This allows us to establish the
equilibrium level of the stock market and measure any deviation from
expectation. Later in the chapter we look at points 2 and 3 and discuss
how there may have been a legitimate change to this equilibrium due to
a technology shock and whether there is any evidence contrary to the
EMH to resolve some key questions on the 1927–9 phase of the boom.
Comprehensive data sources were available to investors in the 1920s
which enabled us to derive a total return data set for the Common Stocks
of large firms. One source was the 1900–29 data contained in Moody’s
94
Returns to US Common Stocks from 1871 to 2010 95
Manual of Investments (1930) and earlier editions of the manual, which

have continuous data on dividends and adjustments related to the issue
of bonus stock and stock splits for Common Stocks from 1900 to 1929.
Smith (1924) explains how to adjust for splits and bonus stock and
hence the ‘real’ or inflation-adjusted historical dividend growth rates
for an equal weighted holding of large firm Common Stock over the
29 years from 1900 to 1929 could have been calculated by investors.
Given that Dividend Discount Models were used at the time we use
such a model to value the US market.
Commonly used data for the long-range analysis of US financial
history comes from the work of Shiller (n.d.) using, in part, Alfred
Cowles’s (1938) data spliced to later indexes of stock prices. In order
to offer a verification of the Cowles data, which is a capitalisation
weighted index, the source data for which were lost (Goetzmann and
Ibbotson, 2006), we collected a new data set of all Common Stocks,
which were listed in the first edition of Moody’s Manual of Industrial
and Miscellaneous Securities in 1900. We therefore aimed to replicate the
experience of an investor who bought one share in each company and
held them from 1900 to 1929, to derive the dividend growth rate for
our valuation model.
As a control for our model’s assumptions, we analysed the data in
Smith (1924) of stock market returns from 1866 to 1922 to find the
Equity Risk Premium – the excess return of holding the market portfolio
of stocks over long-term Government Bonds. We estimated a premium
of 4 per cent per annum from Smith (1924). This figure is close to the
4.2 per cent estimate in Goetzmann and Ibbotson (2006) that we use in
our DDM as the discount rate.
These procedures allow us to reach a primary conclusion about the
level of prices of stocks relative to ‘fundamentals’ derived from our model
using the historically measured ERP and the growth rates of dividends.
What we can therefore show is when the bubble formed and its size.
Data, sources, and methods

1 Measuring the income return of large Common Stocks from 1900 to 1929
By measuring the total dividend return growth rates of an equal weighted
market portfolio of large stocks we can generate a feasible forward-
looking expectation of growth rates, based on historical experience, to
use in our valuation models for the stock market. We also construct our
DDM using firm survival adjusted data from 1900 to 1929, to accurately
model expected valuations, free from survivorship bias.
We exclude capital gains from our model, as our method does not
require them.
2 Data sources
We used Moody’s Manual of Industrial and Miscellaneous Securities (1900)
to form a list of stocks from five main industrial classifications:
Sector 1 Industrial companies: motive power, automobile, electric power,

compressed and liquid air, cycle, automatic, phonographic, pneumatic,
prismatic, signal, slot machine and allied industries.
Sector 2 Manufacturing companies: iron, steel, lead, zinc, brass, brick,
clay, cement, celluloid, car appliances, car manufacturers and allied
industries.
Sector 3 Food products: packing, distilling, malting, brewing compa-
nies, and so on.
Sector 4 Manufacturing companies: miscellaneous.
Sector 5 Manufacturing companies: textile and allied industries.
The categories excluded were:
6. Water and water power.

7. Financial, trusts and banks.
8. Miscellaneous corporations.
9. Mining companies: gold, silver, lead, copper, zinc, coal, and so on.
10. Guaranteed railroad stocks.
The reason for these exclusions was because our tests focus on indus-
trial, commercial, and manufacturing Common Stocks, while the other
categories use more complex pricing models (such as mining stocks or
financials) or were regulated utilities by 1929. Hence historical returns
may not be a dependable guide to valuation in 1929 and these firms
may not be amenable to the use of the DDM we use.
3 Data collection
The firms from the data sources listed above were then categorised
as ‘Large’: by the criterion of having full balance sheet data listings.
A total of 254 firms were listed using this method from which a data set
for 168 of the 254 large firms was collected. Using the available data,
annual dividends from Moody’s Manual of Industrial and Miscellaneous
Securities from 1900, Moody’s Manual of Railroad and Corporation
Securities, American and Foreign from 1908 and 1919 and Moody’s Manual
of Investments: Industrials from 1930 were collected for all years between
1900 and 1929.
Annual cash dividends data for each individual firm were adjusted to
reflect increases in the holding of the original shareholder due to bonus
stock. This method is consistent with the approach of Smith (1924) as
discussed in Chapter 1.
If a bonus dividend of 50 per cent (of Par) was paid as more stock
instead of cash, then all subsequent dividends were increased to reflect
the additional shares of the original 1900 owner of stock. The Par value
of the share was assumed as the price of the additional shares so that
original shareholders were assumed to have 50 per cent more shares.
Additional irregular cash dividends were excluded from the adjust-
ment of the total share holding which introduces a minor downward
bias in our values for dividend return growth rates.
Where data were not found for any companies, of the 254 firms
which were listed in 1900, these stocks were recorded as having no
data. Where companies were taken over or merged during the 1900–30
period, the dividend growth rate of the acquiring company or the new
merged company was used.
• Missing data from before 1912 were replaced with data from Poor’s
Manual of Industrials from 1912.
• Where data were not listed or not found they were excluded from
the data set.
• We exclude the possibility that dividends are reinvested.
4 A composite growth rate from sector-specific data

The total cash dividends for an equal-weighted holding of large firms
from each sector were tabulated for each year from 1900 to 1929. The
total cash dividends in 1900 and 1929 for each sector were then used to
derive five sector growth rates, denoted:
Ω LSEC,1. . . Ω LSEC,5
by the following formula:
∑ dividends(1900) ∗ (1 + Ω ) =∑ dividends(1929)
LSEC ,i 29
i = 1,..., 5
These five total dividend return growth rates were adjusted for inflation
using the Consumer Price Index from 1900 to 1929 from Shiller (n.d.)
to derive an inflation-adjusted geometric rate of growth per annum for
each sector.
Due to the large bias arising from the high level of cash dividends
of Sector 5 (the textile manufacturing industry) and the implicit high
weighting in the resulting unadjusted growth rate, a composite infla-
tion adjusted growth rate ΩGROWTH was calculated. We gave equal
weighting to each sector’s growth rate to form a composite growth
rate: ΩGROWTH.
5 Results: total dividend growth rates by sector

Table 4.1 shows the individual sector growth rates both adjusted for and
unadjusted for inflation and the composite growth rate. The inflation
rate was 2.7 per cent per annum for 1900–29.
The composite real dividend growth rate for sectors 1–5 was 1.3 per cent.
The Dividend Discount Model (DDM)

We use a constant growth DDM that will give us the P/D ratio we expect
for the aggregate US market, assuming a one-dollar initial dividend
grows at the rate measured from our dividend growth data set.
80
Dt
PV = ∑
t =1 (1 + k )t
Dt = (1 + ΩGROWTH )t , t = 1,..., 80
Table 4.1 Individual sector growth rates
Sector Cash Cash Nominal Inflation-adjusted

dividends dividends growth growth
(1900) (1929) (% Ann. geo.) (% Ann. geo.)
1 42.00 181.65 5.175 2.48

2 122.25 195.25 1.625 −1.08
3 111.15 632.91 6.2 3.50
4 40.00 124.00 3.98 1.28
5 317.85 244.78 −0.897 −3.60
Unweighted 633.25 1378.59 2.72 0.02
total
Composite 1.29
All inputs are inflation-adjusted values.

ΩGROWTH = Dividend growth rate (Geometric ann.)
PV = Expected P/D ratio
k = Rate of return on stocks (Geometric ann.)
The model can be used to solve for the rate of return or dividend growth
rates.
Peak valuations for Common Stocks in 1929

Method
We use the aggregate Price/Dividend ratios for the market for large firms
in 1929 as a basis for comparison to the values generated in our DDM.
We collected data from the Commercial & Financial Chronicle for the
firms in our data set, which were equal to the number of firms for which
we have growth data in the 1900–29 growth data set. The firms from
1929 represent 75 per cent of the total market value of large Common
Stocks and were therefore deemed to be representative of the market.
A data set was collected by hand for 700 of the 900 or so firms listed
in Moody’s Manual (1930) with data for 1929. The following additional
data were collected for each firm:
• Shares outstanding.
• Net current assets.
• Maximum prices reached during 1929.
• Dividends per common share.
Using the following filter, 187 large firms’ stocks were filtered from this
database:
Large firms = [Net current assets >$8m]
Price data for 146 of the 187 firms from the large firm data set were col-
lected for which data were available from the Commercial & Financial
Chronicle from 1929. The average Price/Dividend ratios (Table 4.2) in the
second week of September 1929 for firms in our filtered data were calcu-
lated as follows:
• Prices (intra-week high) from the second week of September 1929

(Commercial & Financial Chronicle, 1929) were collected.
• The dividends (annual) of these firms were collected from Moody’s
Manual (1930) for 1929 from the filtered database.
Table 4.2 Average P/D ratio for US stocks (Commercial &

Financial Chronicle), September 1929
Valuation method P/D ratio
146 Stocks average P/D ratio (1929) 30.8
The historical ERP and model: implied required return

The long-term historical return to stocks from 1870 to 1926 from
Goetzmann and Ibbotson (2006) was estimated at 3.1 per cent from
income returns and 1.1 per cent from capital gains, which gives
a return premium on stocks over long-term Government Bonds of
4.2 per cent.
Our collection and modelling of data from Smith (1924) suggests an
equity risk premium of 4.0 per cent based on the 2.5 per cent annu-
alised geometric return premium over corporate bonds from 1866 to
1922, by adding to our estimate of the Baa corporate bond premium
over Government Bonds of 1.5 per cent.
We use the P/D ratio of 19.2 from Cowles (1938) data to solve for
the required return implied in our DDM and dividend growth of
1.3 per cent, which gives a required return of 6.5 per cent or an ERP
of 3.6 per cent.
The volatility-based ERP for NYSE stocks

Method
We wanted to estimate the expected return to Common Stocks without
using the long-term observed return for NYSE stocks from before 1927.
We assumed that a larger expected return on Common Stocks than cor-
porate bonds should have been demanded due to the greater ‘riskiness’ –
measured as the Standard Deviation (S.D.) – of annual capital returns of
Common Stocks compared to corporate or Government Bonds.
We derived the excess reward for an asset over a benchmark asset,
which in this case was the US long-term Government Bond. The excess
reward per unit excess volatility was denoted γ.
We used AAA corporate Bonds as the calibration asset as it was virtu-
ally default-free. We also assumed Gamma was constant across assets
and can be used to estimate the equity risk premium:
γ = α
β
where,
α= Excess return on AAA bonds over Government Bonds

β= Excess volatility of AAA bonds over Government Bonds
Using these data, assuming that all assets have the same gamma value,
ω
ERpremium =
γ
where,
ω = Excess annual volatility of stocks (Goetzmann and Ibbotson, 2006)

ERpremium = Excess annual volatility based expectation of excess
return on stocks
We used the annual S.D. of Moody’s railroad bond index (Table 4.3),
which gives a 20-bond portfolio’s excess volatility over Government
Bonds, to impute a risk premium for bonds.
The S.D. of annual returns was calculated as before to give the excess
return to railroad bonds as:
Bondpremium = γ ∗ω railbond
where,
Bondpremium = Excess annualised geometric return on railroad bonds

ω railbond = Excess annual price volatility on railroad bonds
The results suggested that a 4.1 per cent estimate for the NYSE equity
risk premium was consistent with volatility (S.D.) of returns and a con-
stant Gamma-value across all assets.
Table 4.3 Annual S.D. of stock and bond indexes and actual and implied returns
Name Dates S.D. (%) Ann. Geo Gamma

return (%)
AAA index 1871–1926 4.87 3.6 0.373

Baa railroad index 1871–1926 7.54 4.4* 0.373
L-term Govt. Bond 1871–1918 2.99 2.9
NYSE stocks 1871–1926 14.00 7.01* 0.373
ER Premium 1871–1926 – 4.1*
Bond Premium 1871–1926 – 1.5*
* Estimate from calibration.

Estimating the fair value of the US stock market

There is no clear and easy way to try to value the US market in the
1920s, to determine what the levels of fair values were, so we restrict our
modelling to the use of a DDM with our estimate of dividend growth
rates. We need to use this procedure as the historical data from Cowles
(1938) and Goetzmann and Ibbotson (2006) assume returns to stock
market investment as a total return over the risk-free asset. Therefore
our model of dividend growth has to follow the same methodology
and assume the index was infinitely lived. We therefore use a constant
growth DDM to reflect long-term dividends and discount them using
the historically measured ERP from before 1927.
Cowles (1938) estimates real dividend growth rates of 1.25 per cent
from 1871 to 1927 and a total return of 7 per cent. Our data produced a
1.3 per cent growth rate but we do not have total return data. The levels
of growth we find are feasible and we use our growth rate with a DDM,
consistent with Cowles’s (1938) estimate of the long-term dividend
growth of the US stock market.
We use a DDM and our dividend growth estimate from 1900 to 1929 to
estimate the fair value and then compare it to a 146-firm sample from the
peak in September 1929 to identify the scale of the potential overvaluation.
Using a constant growth DDM to estimate the P/D ratio, we use
the return premium to investing in NYSE stocks from 1871 to 1926
of 4.2 per cent from Goetzmann and Ibbotson (2006) as the discount
rate; 3.1 per cent of this return premium was due to income returns and
1.1 per cent came from capital gains.
The estimates of peak prices in September 1929 are taken from a
146-firm data set, which we collected from the Commercial & Financial
Chronicle (1929). Cowles (1938) finds a January 1927 value of 19.2 for
the P/D ratio, which we use. We can also solve the DDM for the growth
rate expected from actual P/D ratios in 1927 assuming the 4.2 per cent
return to NYSE stocks.
Results
Using the DDM with a 1.3 per cent growth rate, the return expected on
stocks was 7.1 per cent and the P/D ratio was 17. Peak market values in
1929 were 30.8.
The dividend growth rate in 1927 implied from the DDM using a 4.1
per cent ERP and a P/D ratio of 19.2, was 1.9 per cent. The forward-
looking ERP, which we can extract from our DDM, with a growth rate
of 1.3 per cent was 3.6 per cent using the P/D ratio of 19 from 1927.
We cannot know which of these values was correct and the reality
of stock market pricing means these are estimates only. What we do
find is that in 1927, we assume that a 3.6 per cent to 4.1 per cent ERP
and growth rates of 1.3 to 1.9 per cent were reasonable. We therefore
assume that the market was near equilibrium in valuation levels rela-
tive to volatility of returns, historical returns, and historical growth
rates in 1927.
Sensitivity tests
Tables 4.4 and 4.5 simulate the changes in P/D ratios under various
dividend growth and risk premium assumptions. For our base, we use
the level of a P/D ratio for the market of 19.2 in 1927.
The peak levels are taken from a 146-firm data set, which we collected.
Cowles (1938) finds a January 1927 value of 19.2 for the P/D ratio,
which we use.
The clear lesson to be drawn from these simulations using our model
is that, relative to long-term historical expectation, a possible change
in required return from stocks or higher future growth rates could have
driven the boom. However, there need to be solid grounds for justify-
ing such changes in growth expectations or decreases in the required
return. We therefore also test if short-run growth expectations could
have changed valuations to the degree seen in 1929.
If no risk premium changes occurred then the long-term dividend growth
rates needed are 3.5 to 4.1 per cent, which are beyond the realm of plausibil-
ity for a long-term growth rate of dividends compared to actual experience
and the long-term growth rate of the US economy at 3 per cent. This is
because the 3 per cent long-run growth rate of the economy produced a
dividend growth rate of 1.3 per cent.
Conclusions
We do not know exactly where the equilibrium level of asset prices
was in 1927, but we can offer two models, which estimate a position
Table 4.4 P/D ratio for different risk premiums and growth rates for US stocks
146 Stocks Average P/D ratio (1929) 30.8

3.5% Risk Premium (risk-averse model) +1.3% growth 19.2
3.5% Risk Premium (risk-averse model) + 3% growth 30.0
2.0% Risk Premium (risk-averse model) + 2% div growth 30.8
2.0% Risk Premium (risk-averse model) + 1.3% div growth 26.1
1.5% Risk Premium (risk-averse model) + 1.3% growth 29.4
0% Risk Premium (risk-neutral model) + 1.3% div growth 44.7
Table 4.5 P/D ratio for different risk premiums and growth rates for US stocks
146 Stocks Average P/D ratio (1929) 30.8

from which the changes can be simulated. The first, based on historical
growth from a large data set from 1900, indicates a growth rate of 1.3
per cent per annum.
We use the method in Shiller (1981) to derive a value for the stock
market based on dividend growth rates for a market index of US stocks,
anticipating a continuous expected dividend growth rate from our sam-
ple over the long term.
A historical ERP, before 1926, calculated as the return on stocks over
the Government Bond return, of 4.0–4.2 per cent was taken from mod-
ern research, and 1920s research from Smith (1924).
These historical returns of 4 per cent per annum imply a 1.9 per cent
dividend growth rate over 80 years from our DDM, using the actual US
market P/D ratios in 1927 of 19. In 1927 our model estimates an ERP
(forward-looking) of 3.7 per cent, which is lower than expected but
within a feasible range.
In both models that we use to simulate the forward-looking ERP
implicit in prices, we can be certain that a large fall in the ERP was
needed to produce the peak values seen in 1929; in our model a fall
from 3.5 per cent to 1.3 per cent, and in the model using the historical
ERP from 4.1 per cent to 1.8 per cent. These are major deviations and
illustrate that some major change was occurring in 1927–9.
Alternatively, much higher levels of growth of 3.5–4.1 per cent also
replicate the peak values of the market in 1929. Higher growth levels of
dividends were feasible, given the long-term growth rate of the US econ-
omy of 3 per cent over the long-term before 1929, which only managed
to produce historical dividend growth rates of 1.3–1.9 per cent. Whether
the change from ratios of 19.2 to 30.8 from 1927–9 for the aggregate
market was justified, on either of these grounds, is investigated later.
The change in forward-looking dividend growth rates is large, and seems

unusual given historical expectations and standard models.
In the next section we look at realised returns from 1925 to 2010 to
test whether investors were increasing the value of stocks because of
an anticipation of future growth increases, which we can now measure,
ex-post.
4.2 The realised return on stocks from the 1920s to 2010
Having looked at growth and returns before the 1920s, the comple-
mentary analysis was to look at returns from before the boom in the
1920s to the modern day. We use two data sources to establish the
ex-post returns to the US market from 1925. The first, from Jorion and
Goetzmann (1999), was a 4.1 per cent premium from 1926 to 1999 and
the second from our own data set. The second was calculated using live
returns to a market tracking fund from the 1920s.
The performance of an investment fund with no debt leverage, which
proxies for the market portfolio, was tested to see how well the inves-
tor who bought this fund in 1925 would have fared over the very long
run. This approach allows us to produce a live return index, rather
than rely on modern methods, which may not replicate actual investor
experience.
This experiment, with live returns through the course of the 80
years, over which the fund was taken over and changed name, can
inform us of two key unknowns. We need to know whether the
realised future from the 1920s shows any signs of an upward shift in
returns, to establish whether the future was actually better than our
model of expected returns, in the previous section, and from where we
establish our ‘fair value’ calculation. If the returns were much higher
than historical expectation implied by valuations in the 1920s, using
our model of fair values in 1927 before the alleged bubble phase the
jump of P/D ratios from 19 to 30.8 could have been the product of a
rational forecast of the effect of the productivity changes which were
subsequently realised. The investment fund held over 40 Common
Stocks and therefore acts as a proxy for the market due to the level of
diversification reducing the risk in the portfolio to that of the market.
Data
Our data come from ‘Investment Trust Fund A’, a closed-end fund
whose returns can be tracked through takeover and merger and which
exists today as ‘Fundamental Investors’, a part of Capital Group LLC.

The fund was established in 1925, by E. L. Smith, to hold the market
over the long run (Table 4.6).
Net Asset Values (NAVs) and dividend pay-out data were gathered
from the New York Times for 1925–38 for Investment Fund ‘A’, known
as ‘investment trust certificates A’ using ORBIS.
NAV and dividends data for Investors Fund ‘C’ were collected from the
Commercial & Financial Chronicle at a monthly frequency for 1938–54.
Data on
• stock-splits
• dividends
• prices
• NAVs
• merger/takeover exchange ratios of shares
were supplied by Capital Group LLC – the parent of ‘Fundamental

Investors’ Fund for the entire history of the fund back to 1932.
Table 4.6 Conversion table for Investment Fund A
Date of Name of entity Into Conversion ratio

merger merging
From To
17/10/1932 Fundamental Investors

commenced operations
17/12/1934 Irving Investors Fund Investors Fund C, 1 0.48460
C, Inc. name change to Inc.
21/12/1938 Investment Trust Investors Fund C, 1 1.95121
Certificates A, Inc. Inc.
30/01/1946 Investors Fund B, Inc. Investors Fund C,
Inc.
25/04/1946 Investors Fund C, Inc. Investors
name change to Management Fund
31/03/1954 Investors Management Fundamental 1 0.87583
Fund Investors Fund,
Inc.
06/03/1969 Pitmel, Inc. Fundamental 1 1.95120
Investors Fund,
Inc.
21/07/1978 Washington National Fundamental 1 1.55271
Fund Investors Fund, Inc.
Method
We constructed a total return index for Investment Trust Fund A, assum-
ing an investor had bought in 1925 and held on to those shares until
2010. The annualised geometric return from 1925 to 2010 included
dividends and capital gains and was adjusted for merger, takeover,
and stock splits. We can therefore mimic the return to the investor in
1925 over the very long run, whilst avoiding the potential problem of
survivorship bias from using index data which may not reflect actual
returns to an investor over 1925–2010. This return was then compared
to the real return on long-dated Government Bonds, adjusted for infla-
tion from Goetzmann and Ibbotson (2006), to derive the realised equity
premium.
We use the realised premium with a constant growth DDM to derive
the dividend growth rate in 1927, which would have justified such a
return, assuming perfect foresight.
Results
The results show a 3.4 per cent premium over long-term US Government
Bonds, free from the effect of calculating returns from a continuously
updated index constructed ex-post and any survivorship bias intro-
duced by these methods. These are actual returns from 1925 to 2010
due to capital gains and income from dividends paid out, from an
investment in this fund which proxies the US market. The premium
Smith (1924) was expecting based on stock exchange history from 1866
to 1922 was remarkably close to one he would have earned by 2010. The
nominal return was 8.9 per cent, with a 5.5 per cent nominal return to
Government Bonds and inflation was 3 per cent.
The constant growth DDM, which uses actual P/D ratios from the
Cowles (1938) index in 1927 of 19.2, implies dividend growth of 1.9 per
cent. This growth rate is similar to historical growth rates from Cowles
(1938) of 1.25 per cent from 1871 to 1927.
Perfect foresight of actual realised returns implied a growth rate of 1.2
per cent with a 3.4 per cent ERP. Therefore an investor in the 1920s with
perfect foresight of these returns would have been expecting a dividend
growth rate of 1.2 per cent.
Conclusions
The data suggest that holding this fund, which is also a useful proxy for
holding the general market, could have earned an investor about 3.4 per
cent per annum over long-term US government bonds from 1925 to 2010.
The results indicate that long-term returns to the investors in the

1920s were similar to those found over the long run from 1866 to 1922
(Smith, 1924). The value is also consistent with estimates of the long-
run US ERP of about 4 per cent found by Goetzmann and Ibbotson
(2006) and Goetzmann and Jorion (1999). Had an investor bought
stocks when levels were fair in 1925, using a closed-end fund to approxi-
mate the market portfolio, they would have earned a good return over
the long run and not lost out because of the Depression from 1929 to
1938, to any major extent.
Importantly this result also shows that spectacular returns were not
forthcoming on stocks over the following 80 or so years when compared
to historical returns prior to the 1920s. The constant growth DDM,
which uses actual P/D ratios from the stock market in 1927 of 19.2,
implies dividend growth of 1.9 per cent.
The resounding conclusion is that the forecasts of those investors
who may have believed that the US economy had leapt to a new growth
trajectory, which is possible given our simulations using the DDM, and
the positive tests for patent technology in the cross-section of returns
(Nicholas, 2008), were not realistic. Had this measure of realised ERP
been 6 per cent from 1925 there may have been grounds for thinking
that the investors had been accurately forecasting a change in the US
economy and returns to stocks. In this case the realised returns would
have outperformed all of our historical ERP measures. We can be sure
that this was not the case assuming our return data are accurate.
The change of the MFPG rate identified in Gordon (2010) is an ex-post
analysis, and as stated before, we cannot be sure whether investors
understood the effect of this technologically and organisationally based
growth in MFP. However, there is some positive evidence that they did
value patents, which could have been used as a proxy for future growth
or productivity increases (Nicholas, 2008).
Another possibility is that the changes in valuations were driven by
decreased expected model-based returns; then an expected return of
4.2–4.8 per cent is implied at peak valuations or an ERP of 1.3–2 per cent
but this would require a major reduction in the required return relative
to actual returns from 1925 to 2010.
4.3 A growth model to value new technology stocks
Traditional accounts of the 1920s boom on the New York Stock Exchange
(NYSE) indicate the cause was a speculative mania in Common Stocks
(Galbraith, 1954). Aviation or ‘airplane’ Common Stocks are cited as being
amongst the most speculative and hence most overvalued. The industry
was in a nascent stage without significant dividend or earnings history.
Our investigation of this sector has two goals. One is to gauge how
investors saw industrial growth models in the period, and the second
is to use these models and our own to determine if prices for high
technology stocks were overvalued, and the degree to which they were
relative to historical models of industrial growth and, also, the general
market.
The surge in prices witnessed during the boom in these stocks in the
late 1920s and subsequent crash of 75–80 per cent from the peak by late
1930, when the broad market had only fallen by 40 per cent, is cited
as evidence for investor irrationality. The value of aviation stocks fell
further by 1932, by a total 90 per cent, using the Cowles index series
p-66 (Cowles, 1938).
These new technology stocks of the 1920s display the hallmarks of a
potential asset bubble, driven by the excitement of the age and other
new technologies, such as radio, which allegedly captured the imagi-
nation of the investing community (Galbraith, 1954). Whilst detailed
and innovative research on patent-rich new technology firms and their
stock values have been conducted by Nicholas (2008) using patents as
a proxy for intangible capital, we investigate models which we have
strong reason to believe were used by investors of the time for this sec-
tor of the market.
We are fortunate in that we made a discovery of a two-stage industry
growth model from the literature around the time of the boom and
crash, which also indicates the numerical calculations and theoretical
basis on which new technology industries were valued. We take on the
task of trying to measure the ‘fundamentals’ of a high technology indus-
try as such an industry would have been seen by investors in the 1920s.
Whilst our ability to measure the rise and crash in prices leads natu-
rally to the conclusion that aviation stock prices were the subject of a
large error on the part of investors, the size of the information asym-
metry required to produce this effect is large. The market value of the
50 aviation firms we measure rose to approximately $1000 million by
September 1929 compared with 146 large commercial and industrial
Common Stocks having a value of $38,000 million.
The aggregate index of aviation stocks fell by 75 per cent, from peak
levels to the low we use from 1930, implying an overvaluation of 300 per
cent. The alternative scenario, which we cannot test for, is the presence of
genuine uncertainty as to which firms would survive and the growth of
this new industry being different from history (Pástor and Veronesi, 2009).
Such a surge and crash in the prices of new technology stocks has
been well documented following the NASDAQ, or Dot-Com boom and
collapse of the late 1990s and early 2000s. Some authors argue that
the NASDAQ boom was due to over-optimistic forecasts of earnings
and growth from new technology stocks (Ofek and Richardson, 2003)
leading to a collective overvaluation of the NASDAQ index of 100
per cent reaching a peak in the year 2000. A large amount of research
on asset bubbles from economic historians finds numerous examples
of asset overvaluations related to new technologies (Kindleberger,
1978). Conversely, and reflecting the potential legitimacy of such
run-ups, Pástor and Veronesi (2009) develop a general equilibrium
model in which stock prices of innovative firms exhibit bubbles dur-
ing technological revolutions. In the model, the average productivity
of a new technology is uncertain and subject to learning. The new
framework that they offer is that during technological revolutions, the
nature of this uncertainty changes from idiosyncratic to systematic. The
resulting bubbles in stock prices are only observable ex-post and are
unpredictable ex-ante, and they are most pronounced for technologies
characterised by high uncertainty and fast adoption. The authors find
empirical support for 1830–61 and 1992–2005 when the railroad and
Internet technologies spread in the United States.
Given that high technology stocks are known to be subject to ex-post
observable bubbles, whether observable ex-ante or not, leads the general
need to know more about them and how they form. The modern litera-
ture on asset bubbles found in the laboratory environment shows that
deviations from fundamentals are more likely to be found where there is
no dividend anchor (Smith et al., 1988). Studies show that assets can be
mispriced due to a lack of solid basis for valuation without an underly-
ing excitement about a new technology. In essence, investors are prone
to forward-induct prices when unable to use backward induction from
dividends (Hirota and Sunder, 2007). This may make new technologies
which have low or no dividends more susceptible to bubbles, in addi-
tion to or without the effect of technological uncertainty about future
growth. The research in this area has much more to discover as to why
new technologies are actually prone to overvaluations.
The tendency of bubbles to increase the cross-sectional dispersion
of wealth serves as a reason for policy intervention to prevent such
processes emerging. Given a widespread acknowledgement that such
episodes are hard to predict ex-ante, and may be located in a single asset
class, making the use of bank rates dangerous to stop them, even if iden-
tified, led to a consensus that bubbles should not be ‘popped’ (Bernanke,
2002). Given that new technologies drive future growth, there may also
be costs for growth associated with the inhibition of technology booms.
The research therefore seeks to draw upon modern research in order
to contribute to the literature on asset deviations from fundamentals
but also to try and understand the valuation theories and market
dynamics of this historically important era.
The aviation industry of the 1920s in the USA bears all the hallmarks
of an industry likely to be at risk of being overvalued or subject to high
uncertainty, from what we now know in modern finance about technol-
ogy booms. This, coupled with common accounts of this industry being
a speculative favourite, means that it was the test most likely to provide a
good benchmark. An exciting technological area may have caused inves-
tors to miscalculate the probability of success of firms in an industry that
was likely to experience considerable ‘shakeout’, or an overvaluation
based on the probability of survival of the industry as a whole. Equally
the industry may have been subjected to high growth rate expectations
which exceeded those of past high growth industries.
Modelling a new high growth industry in the 1920s

1 Defining and measuring fundamental asset values
The approach we take to estimating fundamentals rests on our ability
to gauge the models used at the time and finding sufficiently robust
data. Whilst such a task is notoriously difficult for any asset, we were
able to gather data and evidence of modelling techniques used in the
era to infer a good estimate of fundamental values for the industry as a
whole. We therefore condition our models of fundamentals from data
and tools specific to the time period in question and do not use econo-
metric techniques or data that post-date the actual events under inves-
tigation by a major timeframe. In that sense we are remodelling rational
fundamental values from the 1920s investors’ view. Our approach also
uses price data from the 1929 crash in values to infer actual underly-
ing estimates of ex-post risk premia of market participants rather than
absolute measures of the riskiness of aviation stocks.
2 Remodelling investor valuation tools for aviation stocks

Moody’s Manual of Investments (1930) offered the following advice to
investors seeking to value the aviation industry as a whole. This pas-
sage gives a useful insight into how contemporary investors may have
viewed growth dynamics and how they may have constructed valuation
models.
Science and progress have moved forward and another great indus-
try has been born. Aviation has come into its own. There have
been many other new industries that now appear as commonplace.
Railways in 1833, petroleum in 1865, telegraphs in 1868, automo-
biles in 1903, radio in 1914, Rayon in 1917. We look for great devel-
opments in the fields of aviation and aeronautics. We have observed
from our investigations that all new industries follow similar courses
of development in arriving at maturity, and that this arrival is accom-
plished in three distinct stages. The first is the inventive stage where
the proposition is regarded as an idle dream and the public has to
be slowly convinced of its feasibility. During this time the industry
grows only a few percent per annum. The second is the boom stage
occurring after the feasibility and worth of the industry have been
demonstrated and the public mind has at last been fired with the
idea. During the second stage the typical new industry in America
expands at the rate of about 40 per cent per annum. In the third
stage after the industry has reached maturity, the rate of expansion
is reduced to an approximate equality with the rate of growth in
wealth, which here is about 5 per cent per annum. Notwithstanding
the certainty of losses in some stocks, the huge profits are to be
made in a new industry during the second stage, and for the aircraft
industry this means during the next five or ten years. However,
exceedingly keen judgment in investing is necessary at this time, and
diversification is essential. (Moody’s Manual of Investments, 1930: xvi)
Although we do not directly transfer the parameters of the model

shown above to the model we build, we aim to infer how the basic
structure and theoretical basis of such a model would have been con-
structed by a sophisticated investor given the data of the time and com-
plementary methods of valuation which were known in the 1920s. We
therefore approach aviation Common Stock valuation using a model at
an industry level using a three-stage sales growth model. However, there
are strong grounds to believe that our model is an accurate reflection
of how stocks in growth industries were valued at the time. The only
innovation we make to Moody’s model is to suggest that investors were
able to measure inflation-adjusted values and use accurate historical
data, which we know were available ex-ante to the boom in the 1920s.
We calibrate the growth factors in the model using one of the key his-
torical industries which Moody’s advocated, automobiles, and also take
Moody’s indication on which stage of development aviation was at in
1930. This date is sufficiently close to 1928–9 to be able to make judge-
ments about how this type of model could have been applied in 1928–9.
What is obvious from the timing of the publication date of the model
is that Moody’s is not responsible for the release of an inaccurate model,
which was taken up by investors and hence no connection should
be made to Moody’s for any overvaluation we detect. Furthermore, the
model described in Moody’s does not suggest any adjustment for the prob-
ability of the new technology being any riskier than previous technologies.
Their model appears to advocate an expectation of new technology firms
matching a 100 per cent probability of the growth path of previous suc-
cessful industries. In other words, the model does not control for the risk
that stocks would not repeat the historical growth seen in other success-
ful technologies even though it was then just a very young industry. The
discovery of the model enables us to understand how investors may have
been valuing Common Stocks and also indicates a potential flaw in their
reasoning based on the probability of growth in the industry as a whole
as the model assumes no probability of failure to match historical growth.
New industries such as aviation and radio are commonly cited as
having displayed overvaluation (Galbraith, 1954). The reasons for new
technologies being more vulnerable to overvaluation are primarily
twofold: first, the lack of a ‘dividend anchor’ making accurate valua-
tion more difficult using standard DDMs and second, such alternative
growth-based valuations may be susceptible to over-optimistic growth
assessments. A third possibility is that new technologies have high
levels of uncertainty regarding which firms will succeed and this may
also be a potential cause of ex-post observable bubbles which are not
irrational ex-ante (Pástor and Veronesi, 2009).
The tests of aviation stock values we develop based on Moody’s Manual
of Investments (1930), and our own inferences about the level of model-
ling skill and data available, were derived to perform three tasks:
1. Negotiate the problem of a lack of historical data for aviation firms,

as they were a new industry.
2. Value a high technology growth industry using methods and data
available to investors in the 1920s.
3. Build a model which investors should have been capable of building
given data and methods known in the 1920s.
Using the general ideas advocated by Moody’s Manual of Investments

(1930) and using a comparable industry such as the automobile indus-
try the aim was to produce a feasible growth and valuation benchmark
from historical data. The automobile industry was chosen as an industry
with similar characteristics as a high technology growth industry in the
early 1900s, with which to calibrate our models, as it has a long-term
history for which data were available to investors in the 1920s and
because Moody’s Manual of Investments (1930) makes a direct comparison
between these industries. The observation that both industries are in the
transportation area also allowed a more feasible comparison to be made.
The stage of industrial development of aviation in 1929 was, accord-
ing to Moody’s, directly comparable to the stage of development of
automobiles in 1903. Therefore, using data on the growth of the auto
industry should be a good comparison and allows us to build a growth
algorithm for valuing aviation stocks.
The next section examines the assumptions that we make in the
models, which are not taken from Moody’s but from our own historical
analysis. We deem these to be assumptions which could have been made
by investors in the 1920s. Some of these rely on other authors’ historical
research such as Klepper (2002) and Klepper and Simons (2000) relating
to the evolutionary path of an oligopolistic industry. Given the historical
data used by these authors and the sophistication of data readily avail-
able to investors, the hypothesis of the ability of investors in the 1920s to
replicate the assumptions of the survival and ‘industrial shakeout’ of firms
during industrial growth and the evolution of a new industry seems fair.
3 Automobile industry growth as a template

We follow the ideas contained in Moody’s to calibrate a growth model
using a readily available historical growth path from a similar new tech-
nology industry. An obvious choice is the automobile industry.
Klepper (2002) illustrates that the auto industry structure evolved to
form a tight oligopoly, with ‘first movers’ taking a large market share at
industrial maturity.
We use data on the growth of the automobile industry as a growth
template, as advocated by Moody’s Manual of Investments (1930), and
base assumptions on the path of the aviation industry’s evolution on
that of automobiles. It is likely that such data on industrial lifespans
and market share could have been easily derived from Moody’s manuals
and other sources which we detail later.
We use these data to calibrate the sales growth rate we would expect
from the ‘first movers’ in the aviation industry, in essence capturing
the returns to the stocks which were available for purchase in the early
days of the industry, and hence adjust our expected sales growth rates
to reflect a market share and profit estimate of our holding of aviation
firms in 1929.
We also make an estimate of industrial maturity occurring at 25 years
from the start of the high growth phase as approximated by Klepper
(2002). We use data on the expected profit/sales ratio from Moody’s Manual
of Investments (1930) for the auto industry in 1929 and the dividend/profit
ratio from Cowles (1938). Both of these ratios are used in our models to
determine profits and dividends at industrial maturity. We assume these
data were available in the 1920s and that data could be easily accessed.
Moody’s (1930) also clearly advocates a two-stage industrial growth model
to value the aviation industry and demonstrates that formulaic pricing
methods were used in the high technology area. These models can there-
fore be used to measure the values generated by contemporary financial
modelling tools by employing them with data available in the 1920s.
4 Reconstructing fundamental values for aviation Common Stocks at the

industry level
Using the growth path of the automobile industry, we build a model
to effectively model the expected growth level of aviation stocks using
data on profits from the aviation industry. We infer the degree of over-
valuation by comparing market prices at peak levels in 1929 to those
predicted by the use of our models.
5 Post-crash changes in valuations

Cowles (1938) has data for a price index of airplane manufacturing stocks
(series p-66) and airplane transportation companies (series p-67), which
we use to determine the degree of overvaluation following the crash in
prices. Using these data we are able to show the level of prices by late
1930, when the ex-post overvaluation we find with our model of the
broad market had dissipated, but critically before the full effects of the
Great Depression had made their independent effect on stock prices post-
1930. This moment was chosen as this is when Cowles’s (1938) data show
when a deviation of dividends and stock price indexes ended. This devia-
tion is the common identifier of the 1927–9 bubble used in the literature.
We assume prices in late 1930 reflected a dissipation of all compo-
nents of the overvaluation and hence offer us a chance to model values
before the onset of the severe recession of the 1931–3 period.
Method
1 Aviation Common Stock data sources
A data set of the 50 aviation firms for which data were available in
Moody’s Manual of Investments (1930) and The Commercial & Financial
Chronicle (1929) was constructed. The aim was to capture the smaller
firms as well as the larger firms in order to provide a clearer and broader
view of the industry as a whole. The firms are from the transportation
and manufacturing segments of the industry.
Due to the novelty of the industry, data were taken from three dif-
ferent listing sections of The Commercial & Financial Chronicle in 1929:
• the OTC securities section

• the NY curb exchange section
• the NYSE main listings section.
2 Data
The following data were collected for each firm for 1929 from Moody’s
(1930) and from The Commercial & Financial Chronicle from September
1929:
• earnings
• shares outstanding
• earnings per share
• price per share data (second week of September 1929).
The data were used to calculate
• Total earnings for the industry which represents the industry, includ-
ing losses.
• Total market value of industry (shares outstanding × price per share
for each firm).
3 Results
• Total market value of industry: $1020 million.
• Total earnings (net of losses): $17.6 million.
• Total earnings excluding losses: $22.9 million.
The valuation of the industry is used in later sections and compared to

the value generated by our models.
Sources for other inputs used in the model

As stated in the methodology we introduce three terms listed below
which are used in our models and which we think were available to
investors in the 1920s.
(λ ) = 75 per cent market share at maturity of industry

This value was taken from Klepper and Simons (2000) based on a rich
data set on firm ‘shakeout’ in the auto industry and is a widely acknowl-
edged source. Klepper and Simons (2000) and Klepper (2002) illustrate
that the automobile and auto tyre industries evolved according to a
pattern of high failure of the early movers, but that the first movers
would be expected to take a 75–80 per cent market share at maturity.
They show that industrial structure evolved to form tight oligopolies
with first movers taking a large share of the market at maturity. In the
case of the auto tyre industry, early moving firms captured 75 per cent
of the market with 80 per cent for autos. The first movers in the aviation
industry, that is, the ones which we are aiming to value in our model
and which investors could have bought in 1929, were assumed to reach
industrial maturity over 25 years and take a 75 per cent share of the
mature market. Whether investors actually knew this is debatable but it
is not implausible at all, given that Moody’s Manual of Investments (1930)
shows that professional investors understood industry life-cycles. The
data to make such calculations were also readily available.
(α) = 12 per cent profit/sales ratio (Moody’s data for

auto industry in 1929)
This value is taken from Moody’s Manual of Investments (1930) which

provides data for 1929 for the industry in a table in the front section
specific to autos.
(β ) = 62.5 per cent dividend/profit ratio (Cowles, 1938)
This value is taken from Cowles’s Common Stock Indices (1938) and is
acknowledged as a good and reliable source but relates to the general
market and not autos alone.
Building a growth algorithm from automobile data

from 1904 to 1929
This section details the method of construction of the growth model
using the auto industry as a template for growth. We use Moody’s
(1930) tabular data on the dollar value of auto industry output of $24.6
million, in its industrial infancy in 1904, as our base year for the growth
model. The data were then collected and growth rates at various stages
of the model were constructed using the same data table. The data are
listed in the appendix at the end of this section.
All nominal variables were adjusted for inflation using data from
Shiller (n.d.) and the NBER Macrohistory Database (2014). All values are
expressed as annualised geometric rates.
1 The stages of the growth algorithm

STAGE 1
Auto sales from 1904 to 1914 (adjusted for inflation)
Inflation: 2.0 per cent

Nominal growth rate: 34 per cent
Real growth rate: 32 per cent
The sales growth can be described by the formula:
St =10 = S0 (1 + g )10
STAGE 2
Auto sales from 1914 to 1929 (adjusted for inflation)
Inflation: 3.6 per cent

Nominal growth rate: 13.3 per cent
Real growth rate: 9.7 per cent
Sales growth can be described by the formula:
St = 25 = St =10 (1 + g )15
STAGE 3
Having generated the expected sales growth rates we then used the
assumptions discussed earlier to infer the dividends expected at indus-
trial maturity at year 25.
Dividends at year 25 can be found by the formula:
Dt = 25 = St = 25 ∗ (λ ) ∗ (α ) ∗ ( β )
where,
(λ) = 75 per cent market share at maturity of industry

(α ) = 12 per cent profit/sales ratio (Moody’s data for auto industry
in 1929)
(β ) = 62.5 per cent dividend/profit ratio (Cowles, 1938)
STAGE 4
Under the assumption that aviation Common Stocks 25 years ahead
from 1929 would be expected to have the same P/D ratio as the automo-
bile industry in 1927 or 1929, which can include or exclude the effect
of an overvaluation in auto stocks –
Vt = 25 = Dt = 25 ∗ AUTO27
– then,
Vt = 25
Vt = 0 =
(1 + k )25
where,
k = Discount rate
AUTO27 = Price/dividend ratio of auto stocks in 1927
Valuation of the aviation industry using a growth model

1 Estimating an accurate level of sales in 1904 for automobile firms
Table 4.7, from Seltzer (1928), illustrates those investors had access to
the data needed to make judgements about historical growth rates of the
auto industry and measure the level of profits relative to sales in a new
industry. Industry output was at $24.6 million in 1904 (Seltzer, 1928).
In order to check whether our sales data for autos make sense relative
to the aviation industry, we cross-check these data with the actual sales
data of $33 million for the whole aviation industry excluding military
planes from Moody’s (1930).
2 The growth model

Table 4.8 illustrates the stages of growth, which we calibrated from the
auto industry and the inputs we used to value aviation stocks as detailed
in the earlier section.
Table 4.7 1903 data on auto firms sales and profits (Seltzer, 1928)
Ford Motor Packard Reo Motor Average

Car Co. Motor Car Car Co. (%)
Co.
Sales/$m 1.3 0.5 1

Profits/$m 0.3 0.3 0.3
Profit/sales ratio 0.2 0.6 0.3 39.4
Table 4.8 Stages and inputs of the growth model
Stage 1 Stage 2 Stage 3
Time scale (years) 10 15 80

Type of input Sales Sales Dividends
‘Real’ growth rate 32 9.7
(Ann. geometric per cent)
3 The valuation of aviation stocks by the sales growth model

The sales value we use in our calculation is derived from the actual net
profits for the entire sample of 50 firms, thereby also accounting for losses,
which were used to impute the sales level using the profit/sales ratio from
Seltzer (1928).
The following tests were designed to determine what level of avia-
tion stock prices would be generated under the application of a growth
model to represent what we believe a sophisticated investor could have
inferred about asset values for aviation firms. We use profit/sales ratios
taken from historically available data from the auto industry, and an
assumption not found in the literature in the 1920s, that ‘industrial
shakeout’ of the auto industry could have been known and estimated
by investors.
4 Method
Stage 1: high growth phase. The net profits of all 50 firms from 1929 were
used with the auto industry’s ‘profit/sales’ ratio during its infant stage.
This was then used to give the series of values for sales.
An alternative value for earnings, which excluded loss-making firms,
was also used and listed in the results in Table 4.9.
STAGE 1
St =10 = S0 (1 + g )10
STAGE 2
St = 25 = St =10 (1 + g )15
where g = growth rate taken from Moody’s 1930 auto data which we
estimated in the previous section (Table 4.8).
STAGE 3: STEADY STATE PHASE
Dt = 25 = St = 25 ∗ (α ) ∗ ( β ) ∗ ( λ )
where:
(α ) = Earnings/sales ratio (12 per cent)

(β ) = Dividend pay-out ratio (62.5 per cent)
(λ) = 75 per cent market share at maturity of industry
STAGE 4
The value V of the industry was calculated as:
Vt = 25
Vt = 0 =
(1 + k )25
Vt = 25 = Dt = 25 ∗ AUTO27
where AUTO27 was the P/D ratio for auto stocks of 16 (taken from cross-
sectional data). This value was used to eliminate, in the first instance,
any bias from a potential overvaluation of stocks in 1929.
The expected value for the P/D ratio for all stocks was estimated at 19
in 1927 and at 30.8 in 1929.
Therefore the value of aviation stocks at high valuation ratios was
Vt = 25
Vt = 0 =
(1 + k )25
where a discount rate of 9 per cent was applied (k = 0.09)
Vt = 25 = Dt = 25 ∗ AUTO29
where AUTO29 was the P/D ratio for auto stocks = 27.8 (taken from
cross-sectional data).
All of the above equations assume probability = 1 of repeating the

growth path of the auto sector which is used as a calibration model.
Actual market cap was used to infer the probability of this full
growth.
Moody’s model
In order to test Moody’s model’s valuation of these stocks, we used
another model, which replicates the ideas shown in Moody’s (1930).
This is a two-stage growth model with a 40 per cent stage 1 growth
rate for 10 years and a steady state growth rate of 5 per cent.
The crash in aviation prices

1 Estimating 1930 post-crash values
Using the data on prices, the post-crash value of stocks was estimated by
taking the average of two estimates of the fall in the index of aviation
stocks from Cowles (1938) from September 1929 to July 1930.
MARKlow = % FALLCOWLES ∗ MARKhigh
where
MARKhigh = actual 1929 data for aviation stock values taken

from the CFC (1929).
MARKlow = implied aviation stock values taken from Cowles
(1938) price data from 1929 to 1930.
%FALLCOWLES = estimated per cent fall of Cowles (1938) series p-66
from peak prices in 1929 to mid-1930
2 Simulation of potential causes

The first potential component of the rise in aviation values was due to
a higher value for all stocks including automobiles, the results of which
are shown in Table 4.9, and the second from higher expected growth
than that of the automobile industry. We acknowledge the potential
role of uncertainty and increases in ex-ante values for these stocks but
do not simulate it. We use Moody’s model and our main model.
Growth: The high market value for aviation in 1929 could have been due
to higher growth expectations and these expectations, although higher
than historical growth rates, are not unfeasible. We can adjust the
growth rates from our model to simulate what kind of growth expecta-
tions would replicate the peak prices in 1929. One possible combination
was an inflation-adjusted 40 per cent stage-1 growth rate and 15 per
cent stage-2 growth rate if the P/D ratio of 16 for auto stocks in 1927
is used. With a P/D ratio of 27.8 from 1929 the growth rates for stage 1
and 2 were 40 per cent and 9.7 per cent. These growth rates are much
Table 4.9 Results of sensitivity analysis
Method of valuation Value of aviation firms / $m
Moody’s model 557

Equation (1) model – auto growth (1927 P/D) 341
Market value (September 1929) 1029
Market value (1930)*low 200
Market value (1930)*high 300
higher than history would suggest but could be feasible if the aviation
industry had the potential to grow faster than automobiles. Our results
using our most accurate model indicate that the aviation industry was
expected to grow to a size twice that expected using the growth path of
autos when using peak market values in 1929.
Uncertainty: We do not model this effect and therefore cannot exclude

the idea that a new technology could rationally cause prices to rise due
to a high level of uncertainty about which firms will succeed. This effect
could have legitimately raised ex-ante values of aviation firms.
3 Results
The results of our sensitivity analysis are presented in Table 4.9.
4 Industry price/earnings ratio in 1929

An important comparison, which can be made using the results, is the
relative valuation of the new industry when compared to the broad
stock market. The results show a price/earnings ratio in 1929 of 60 for
the industry as a whole, which can be compared to the general level for
all Common Stocks of approximately 19 in September 1929.
Conclusions
The results of the tests indicate that investors could have been using
reasonably sophisticated models in the 1920s but at peak levels the
market prices reflected an overestimate of the likely returns to invest-
ing in these firms’ Common Stock. Our discovery of these models from
1930 are a great bonus to our knowledge of the period and how inves-
tors looked at industrial growth and asset pricing for new technologies.
Using a method of valuation drawing on the actual models likely to
have been used in the 1920s, we conclude that aviation stocks were
overvalued in 1929 by a large margin, of 300 per cent relative to history
calibrated from another new technology.
There are three potential routes by which the values exceeded model-
based values: first, increased probability of survival; second, the higher
level of stocks generally which affected the terminal estimate of the
aviation firms at industrial maturity using the auto industry; third, a
high expectation of future growth could have occurred. Higher expecta-
tions of growth from this industry are not necessarily unfeasible.
The 75–85 per cent fall in values of these stocks from 1929 to 1930
could have reflected both a general change in the risk of all stocks back
to the pre-1927 norm as well as the probability of survival or growth
expectations falling. The key conclusion we make is that the model
implies that growth expectations were high relative to history. It should
be noted that changing risk premiums are not modelled.
The results indicate high growth rate expectations for the new indus-
try were grounded in the reality of technology growth in the thirty
years prior to 1929 based on data on the automobile industry but they
then overshot model-based values.
Discussion and future research

The modelling technique we develop should have application in other
instances of economic history and the results should inform the approach
to further research. The main contribution is to show a clearer picture of
the boom and crash in 1929 and also gain a handle on how investors
looked at new technologies. The results provide a benchmark for solving
the complex task of knowing what fundamentals should be. We do not
resolve whether the growth potential of aviation was higher than history
but the scale of the deviation from model suggests very high growth rela-
tive to history.
We add a level of complexity to Moody’s models, when forming
our judgements on how to reconstruct a model of what we expected
a sophisticated investor to know about when valuing stocks. Investors
were using sensible growth estimates and possibly applying a sensible
probability factor.
The conclusions we draw rest on assumptions regarding the value of
λ, the market share of first movers at industrial maturity, and hence
the dividend growth expected from our original holding through the
process of industrial shakeout. When we simulate Lambda’s value at 38
per cent, and not 75 per cent, our models give an implied 100 per cent
chance of repeating auto growth, implying less sophistication on the
part of investors. However, due to the sensitivity of our tests we cannot
make firm inferences on whether or not a probability discount was

being used relative to the path of auto growth.
Questions regarding the heterogeneity of agents’ models are also
important for our conclusions. We suggest that two components can
be identified at the aggregate level for the industry, but it should be
made clear that we do not identify how stocks were valued at the firm
level or by different investor clienteles. It may be that stocks were
priced by focusing on earnings trends or other selection criteria at the
firm level.
Natural questions emanate from the research as to why the overvalu-
ation occurred. The reasons for overvaluation are more complex than
originally thought in light of our conclusions. By invoking the litera-
ture on limits to arbitrage (Shleifer and Vishny, 1997) or incentives to
ride asset bubbles (Brunnermeier and Nagel, 2004) we can easily offer
explanations as to why we observed this level of change in valuations
in the presence of some more informed and statistically aware investors.
Another possible research avenue is to look at how new technologies
were viewed and priced at the firm level in this period and also the
perennial question of the effect of uncertainty on the valuation of new
technologies.
Information on the failure of historical new technology industries and
hence the ex-ante probability of successful growth of a new industry may
be available in advance. This would involve measuring the survival and
growth rates of all ‘new technologies’ from the USA from the dates listed
in Moody’s to determine the ‘graveyard’ and eliminate any survival bias
in realised growth paths used in expectations formation. The release of
this information during the advent of new technologies may offer a way
of preventing bubbles or mitigating their effects on the uninformed.
Data appendix
Table 4.10 Automobile industry growth data
Year Value of output Profits Profit/sales

$ millions $ millions ratio
1904 24.6 9.84 40.00

1905
1906
1907
1908
1909 165 25.697 15.57
(continued)
126
Table 4.10 Continued
Year Value of output Profits Profit/sales

$ millions $ millions ratio
1910 225 27.518 12.23

1911 246 29.347 11.93
1912 378 39.123 10.35
1913 443 48.875 11.03
1914 458 59.205 12.93
1915 701 112.621 16.07
1916 1082 158.238 14.62
1917 1274 160.075 12.56
1918 1236 159.91 12.94
1919 1885 286.537 15.20
1920 2232 222.272 9.96
1921 1261 71.442 5.67
1922 1793 218.99 12.21
1923 2592 272.094 10.50
1924 2367 206.79 8.74
1925 3015 389.902 12.93
1926 3214 427.8 13.31
1927 2700 391.864 14.51
1928 3162 473.052 14.96
1929 3567 437.573 12.27
Sources: Moody’s Manual of Investments (1930) and Seltzer (1928).
Table 4.11 Auto high prices from September (Week 2) (Commercial & Financial
Chronicle, 1929)
Name Div. per Net current Price per

share ($) assets ($m) share ($)
AUBURN AUTOMOBILE 12 Nl 499

BROCKWAY MOTOR TRUCK 3 Nl 43
CHRYSLER CORP 3 71.385 74
FEDERAL MOTOR TRUCK 1 5.112 14
GENERAL MOTORS CORP 3 251.288 80
GRAHAM PAIGE 0 11.099 24
HH FRANKLIN 1.6 17.791 13.5
HUDSON MOTOR CAR 5 26.203 86
HUPP MOTOR CAR CORP 2 17.342 42
MACK TRUCKS 6 37.084 105
MARMON MOTOR CAR 0 4.181 82
MOON MOTOR CAR 0 1.31 5
NASH MOTORS 6 44.281 87
PACKARD MOTOR CAR 3 24.876 162
PEERLESS MOTOR CAR 0 2.379 12
(continued)
Table 4.11 Continued
Name Div. per Net current Price per

share ($) assets ($m) share ($)
REO MOTOR CAR 1.4 19.972 24

STUDEBAKER CORP 5 26.04 76
WHITE MOTOR CO 2 1.578 47
WILLYS OVERLAND 1.2 21.688 24
YELLOW TRUCK AND COACH 0 19.036 37
Total 55.2 1536.5
Price / Dividend ratio 27.8
250
200
150
Index
100
50
0
6-1-28
9-1-28
12-1-28
3-1-29
6-1-29
9-1-29
12-1-29
3-1-30
6-1-30
9-1-30
12-1-30
3-1-31
6-1-31
9-1-31
12-1-31
3-1-32
6-1-32
9-1-32
12-1-32
3-1-33
6-1-33
9-1-33
12-1-33
Date
Figure 4.1 Index of airplane manufacturing stocks (1928–1933)

Source: Cowles (1938) series p-66.
4.4 The formation of closed-end funds
Although the investors who bought closed-ends funds displayed a marked

tendency to overvalue them relative to their NAVs (De Long and Shleifer,
1991) and research questions their worth as an investment vehicle due to
their problems during the crash (Rutterford, 2009), we investigate whether
they were a good financial innovation. We do this in two ways: first, by

looking at the reduction in volatility for a single stock investor which
these funds offered, and second, by investigating the realised return to
one fund over the very long run which strips out the effect of the bubble.
‘Investment trusts’ – the generic term given to corporations involved
in securities investment and trading as distinct from large traders and
investment pools – were issuers of equities and to a lesser extent deben-
tures (debt), especially in the 1927–9 period. They existed in a broad
spectrum of sizes, management style, sector focus, and leverage ratios
(Moody’s Manual of Investments, American and Foreign, 1930). Although
‘investment trusts’ had existed in the USA well before the 1920s, there
was a new type of fund with a radical new approach to investing that
formed in the 1920s – the closed-end fund. What we discover is that
investment returns had become a hot topic for investors following the
publication of E. L. Smith’s Common Stocks as Long-Term Investments
(1924) and the high returns to stocks during the 1920s.
Closed-end funds, which were designed to hold a diversified basket of
stocks, were formed en masse from 1927 and using the insights of Smith
(1924), aimed to hold a large portfolio of stocks to earn the 4 per cent
risk premium over the long term.
‘Investment trusts’ grew quickly in both number and range of assets
under management in the late 1920s and from 1928 to 1929 their assets
grew by $3.1 billion, with a new trust opening every day in 1929. The
closed-end funds, whose equity and leverage was gained by issuance of
Common Stock as well as long-term debt securities, were not critical to
the price behaviour of Common Stocks in the late 1920s.
The American style of investment trust became dominated by the
closed-end fund structure with the large growth in the number and range
of funds under management in the 1928–9 period. The total amount of
funds under management by investment companies as a whole, includ-
ing trusts, closed-end funds, and general investment companies, was
approximately $7 billion in 1929 (Bullock, 1959). Moody’s Manual of
Investments, American and Foreign (1930) states that large numbers of the
‘investment companies’ described as investment trusts operated under
varying degrees of covenant restrictions; $4 billion of the total of $7 billion
could be described as of the ‘management type’ whereby managers
decided the fund’s allocation strategy and the remaining $3 billion oper-
ated as closed-end indexed fund holdings.
The level of diversification and investment horizon

The holdings we looked at show high levels of diversification across indus-
tries and within industries and holdings, which follow a general style of
equal weighting. Grayson (1928) and Moody’s Manual of Investments,

American and Foreign (1930) also detail the level of holdings in other
investment trusts ranging from 30 to 100 Common Stocks.
Moody’s Manual of Investments (1930) details numerous other funds
using a roughly ‘equal weighted’ strategy in many cases, together with
high levels of diversification of their investments in public utilities, rail-
roads and industrial Common Stocks. Although not all funds disclosed
their holdings, those that are listed indicate the high extent of their
diversification. Other closed-end funds were known to be using this
type of strategy such as ‘Fund A’, a closed-end fund run by E. L. Smith.
This fund had approximately 40 Common Stocks, which is typical of
the average closed-end fund in Moody’s Manual of Investments (1930).
The diversification strategy within an industry reduced the risk from
failure of an individual company and diversification across industries
the risk of industrial failure or adverse shocks to a single industry. This
pattern suggests that diversification was an established concept for
closed-end funds and has direct bearing on the returns investors would
expect relative to the volatility of the fund’s assets, and by implication,
the returns they would expect from their holdings of equities, which
made up the stock market.
Closed-end funds were by design investment vehicles with an implicit
long-term investment horizon. The Equity Risk Premium, which was
earned by investors over the long-term history, of 4 per cent over the
Government Bond return does suggest that funds were intended for the
purpose of collecting this premium rather than any notion that they
were formed to defraud investors in the first instance. We look in this
section at the benefits these funds offered small and undiversified inves-
tors who intended to hold over the long term. Our data and test indicate
that such funds did buy in to the bubble as many formed during the
period of overvaluation. Some funds may have been over-leveraged and
hence did not perform well or failed subsequently (Rutterford, 2009) and
thus their formation during the bubble phase may have reflected their
managers’ understanding of investor ignorance. However, this is by no
means a test of the usefulness of the innovation that they represented.
Holding a closed-end fund that was highly diversified represented the
market portfolio and would be expected to gain the Equity Risk Premium
as a compensation for volatility of returns over the long term.
The stock market price impact of new funds

The total number of funds reached about 130, with a new fund form-
ing each day during the 1927–9 period. These investment vehicles
offered investors a way of owning a share of the US economy with the
promise of the 4 per cent risk premium over Government Bonds over
the long term.
Modern finance theory addresses the issue of the role of large invest-
ment funds and their impact on stock prices, and hence it was impor-
tant to be able to examine this possibility as one cause of the boom. The
total amount of funds from these new investment funds, over the 26
months, is estimated at about $3 billion. This figure was used to assess
any potential price impact of new funds on market prices.
Kyle’s ‘Lambda’ (Kyle, 1985) measures the market price impact of
trade volume from large buyers or sellers on market prices. Modern
studies estimate a value of Kyle’s Lambda of 1 (Gompers and Metrick,
2001). We estimate that a maximum $3 billion of new funds were
bought over the year, or about $8 million per day. This was about 4 per
cent of average value of daily market volume during 1927–9 of $200
million. On this basis we assess that a 4 per cent value of funds enter-
ing the market per day compared to the total value of the stocks traded
using NYSE data would have a 4 per cent impact on prices. Although
significant, this buying pressure from new investment vehicles is not
enough to have had a major effect on prices, and certainly did not cause
a major part of the overvaluation we detect.
The timing of the formation of such large numbers of funds from
1927 to 1929 suggests that investors were very keen to invest in stocks
at this time, and there was a surge in public interest in the returns to
Common Stocks and investment by new investors in that period.
In later chapters we demonstrate that their formation cannot be
linked to a major change of valuations during the alleged bubble phase.
The benefits of financial innovation to the small investor

We can test whether such funds were a useful financial innovation by
assuming the role of an undiversified investor in Common Stocks and
estimating the reduction in volatility from diversification. We ask and
answer the question: How much better would an investor do by investing
in these funds?
We used the old NYSE database (2012) to calculate the S.D. of capital
returns for individual stocks from 1900 to 1915 and from 1915 to 1925.
The S.D. of the total portfolio of stocks (N = 70 and N = 93) was also cal-
culated from these data. We assumed a proportional linear relationship
between the percentage change in the S.D. of returns from N = 1 to a
portfolio with N = 70 and 93, and the percentage change in the risk pre-
mium. Therefore a 20 per cent fall of excess volatility of returns as more
stocks were added would equate to a 20 per cent fall in the risk premium.
Table 4.12 Results

Source Timeframe Stocks Portfolio Single stock Factor of
(N) S.D. (%) S.D. (%) original
Goetzmann 1915–1925 93 14 32 0.44

+Ibbotson
(2006)
Goetzmann 1900–1915 70 13 28 0.46
+Ibbotson
(2006)
Cowles (1938) 1900–1920 – 17 – –
We then estimated the ‘risk premium’ (ERP) – the expected excess

return from Common Stocks over risk-free Government Bonds from
two portfolios from Goetzmann and Ibbotson (2006). The test simu-
lated a change from N = 1 to N = 93 (Table 4.12).
A change from a single-stock to a more highly diversified portfolio
implies a 55 per cent decrease in S.D. thus demonstrating the benefits
to the holder of one stock who moved to a diversified basket of stocks.
4.5 The 1927–9 phase of the boom
Tests for potential drivers of the overvaluation from 1927 to 1929

Perhaps the most elusive question in finance, economics, and economic
history is how bubbles form in the real world. Because our data and
previous long-range tests identify a large deviation from fundamentals,
ex-post, the major challenge was to devise hypotheses and tests of how
to measure what actually caused investors in the 1920s to overvalue
stocks relative to historical expectation.
Attempting to resolve such a question is extremely difficult due to the
data available and the joint hypothesis problem (Fama, 1970). However,
what we are able to do is check for some of the ‘usual suspects’ such as
dividend and earnings growth rates, size, and momentum.
We first look at aggregate data for the US stock market (Cowles, 1938),
which we use throughout the book, and test some plausible theories
using these data. In later sections we look at the cross-section of the
stock market, to see whether any factors of potential causality can be
shown at the firm level.
What we find is exciting given common ideas about the 1920s. We
do not find that any of the factors we test for caused the overvaluation
phase.
To summarise our findings, which also use prior research on the

cross-section from CRSP data (Nicholas, 2008) we are able to detect
momentum and technology effects. None of the common potential fac-
tors we test for have any explanatory power. Given these results, there
is likely to have been a series of much more complex and enigmatic
reasons for the formation of the bubble, which we are not able to model
directly. This could include a large degree of irrational behaviour.
Such a result does not rule out that we have omitted key drivers,
which investors used at the time to re-evaluate the returns to, or the
risk premiums attached to stocks. What we do find is that the likeli-
hood of high expectations is confirmed from these test results based
on heterogeneous beliefs about fundamentals, but the most optimistic
of these assessments of fundamentals pushed valuations well beyond
rational expectations. We are able, therefore, to show that simple
extrapolations of dividends or earnings were not responsible for the
1927–9 phase.
In the following sections we present and test various theories of how
the overvaluation may have formed.
Methodology
A large historical excess return to stocks over bonds and a higher annual
volatility of returns to stocks than bonds up to the 1920s indicates
investors were rewarded for this excess volatility. In this section, we
conducted three tests:
1. A test of whether Smith’s (1924) ideas on ‘zero capital loss’ prob-

abilities over longer holding periods could have caused the bubble.
2. Testing a valuation model where stocks and bonds were expected to
produce the same returns irrespective of return volatility.
3. Testing whether extrapolation of high earnings growth rates from
short-run data, projected forward using a two-stage DDM, could have
generated the valuation ratio changes for the broad market.
Test 1: Changes in investor risk preference

Smith (1924) and the new stock volatility-metrics for
longer-horizon investors
Smith (1924) shows an innovation in the estimation of risk, which is
different from how our Gamma value (1) is calculated. He estimated a
new measure of risk – ‘time hazard’. This measured the horizon over
which there was a 100 per cent probability of no capital loss. Therefore
all returns were from dividend income. This is compatible with our
DDM. Two estimates were made in Smith (1924):
1. A four-year holding period needed to eliminate capital loss from vol-

atility based on 40 years of data (1882–1922) which excluded major
crashes or recessions.
2. A fifteen-year holding period needed to eliminate capital loss, which
was based on 75 years of data (1847–1922) and included crashes and
recessions.
Method
We modelled what would happen to valuations if investors switched
from the Gamma model (1) to a new set of models (2):
α
γ = (1)
β
α = Excess return on Common Stocks

β = Excess volatility of Common Stocks
α
γ t4 = (2)
t4
β
or
α
γ t 15 =
β t 15
where,
β = 0, over the time horizon of the investment.
The data on holding periods from 1920 to 1930 were then compared to
the horizons shown above.
Results
Investors’ actual horizons were on average only for one year, in 1928.
Therefore had the use of this new volatility metric been the cause of
the bubble, it would have been adopted in error and would not reflect
the usual behaviour of investors’ holding periods in the 1920s. Even if
the average investor held for four years, the price of stocks still should not
have changed, as the risk/reward trade-off would have been better with
other assets such as corporate bonds. However, it is still possible that such
a model was adopted in error and changed valuation ratios for stocks.
A P/D ratio of over 40 was generated assuming a risk premium of 0 per
cent and the growth assumptions of our main model. We later test the
cross-section of returns to see whether changes in the valuation ratios
of stocks were linked to the risk rating of the stock given by Moody’s.
In this way we can test whether investors preferred stocks on the basis
of a systematic change in the market risk premium.
The new volatility metric seems to imply that Smith (1924) was
unaware of the reason for the Equity Risk Premium, either due to the
risk aversion of investors or because he felt that holding for short
periods eliminated risk. This is relevant because most of the gains
to Common Stock in the pre-1920s era came in the form of divi-
dends. On this basis, holding for four years and gaining the dividend
income suggests that Smith (1924) advocated a lower risk premium
on stocks.
Test 2: ‘Earnings power’ valuation: the expectation of the same

return as bonds
The second test models a method which investors could have derived
from the empirical data in Smith (1924). This model assumed that
stocks should be priced to give the same return as bonds, irrespective of
the higher volatility of stocks (Graham and Dodd, 1934). The valuation
model violates the assumption of model (1) above. By re-pricing stocks,
the risk/reward ratio for stocks falls below other assets, and hence stocks
are a bad bet relative to other assets.
The change investors may have made was to a new model (3) as
shown below.
α bonds
γ stocks =
β stocks
(3)
α Bonds = α Stocks
where,
α Bonds = Excess return on market portfolio of bonds

β Stocks = Excess volatility of stocks
Results
If the return premiums were expected to be the same for stocks and
bonds, the value of alpha for stocks would decrease to 1.5 per cent from
3–4 per cent reflecting an expected valuation ratio (P/D) of 30.4 using
our DDM. At the aggregate level the idea that stocks and bonds were
being revalued in a relative sense appears to match the results, although
the cross-sectional tests of the risk ratings of stocks are a better method
for drawing any conclusions on this potential effect.
Test 3: Expected growth of earnings or dividends

The rationale for this test comes from Sirkin (1975) and from our own
findings of a specific two-stage growth model from Moody’s (1930).
We tested whether high earnings growth rates, when projected for-
ward in time, could replicate the change in stock market values.
We used a two-stage DDM consisting of a growth rate of five or ten years
of high earnings/dividends of 12 per cent per annum from Cowles (1938)
for stocks from 1925 to 1929 and a steady state growth rate of 1.3 per cent.
The results (Table 4.13) suggest that extrapolation of trends from
1925 to 1929 could have caused a rise in the stock market. We therefore
tested earnings and dividend growth rates in the cross-sectional tests.
Changes in long-run dividend growth rates

We tested our DDM for a range of dividend growth rates to capture any
effects of higher long-run dividend growth expectations when we con-
ducted the sensitivity tests of the model in the previous section.
Optimistic real dividend growth rates of 3.5–4.5 per cent over the
long term are plausible as drivers of the boom. We discuss the feasibility
of such high growth rates in the context of the realised returns and his-
torical growth rates later in the chapter. In both cases such high growth
rates as an expectation are difficult to justify.
Discussion
The observed changes in aggregate US stock valuation ratios may have
been caused by a change to a more risk-loving pricing model (Test 1), or
Table 4.13 Results (risk premium = 3.6 per cent)
High growth (years)
5 10
P/D ratio 20.1 23.7
because investors formed the expectation that stocks and bonds should
have the same expected returns (Test 2). Extrapolation of short run divi-
dend or earnings growth rates could have justified some of the changes
in aggregate stock market values (Test 3).
These aggregate-level tests were unable to resolve the question but
inform tests of some potential cross-sectional drivers, which may be
systematic. In the next section we use various cross-sectional tests to
establish the factors or combinations of factors driving the bubble at
the firm level.
Firm-level cross-sectional data

The aggregate level tests of some theories of what caused the boom
using data from Cowles (1938) allowed some degree of insight into
potential dimensions and drivers of the boom. We then tested for the
influence of dividend growth rates and earnings growth rates, firm net
assets and age, and risk ratings on changes in valuation ratios across
individual firms in 1927–9.
As noted in Cowles (1938) and Shiller (n.d.) the return rates for the
stock market were averaging over 20 per cent per annum from 1924
to 1927. Investors may have used these extraordinarily high rates of
growth to project future returns on stocks.
We constructed tests using a 130-firm cross-sectional data set of US
stocks from a 1929 sample of large to small stocks to test primarily
whether earnings or dividend growth extrapolation could explain the
firm-level changes in valuation ratios from 1927 to 1929 and whether the
effect of momentum in asset values or risk premium changes were impor-
tant. We then added tests of the risk ratings of stocks, P/D ratios changes
before the alleged bubble phase, the age of firms, and net current assets.
These tests were conducted to complement the excess returns tests for
the 1928–9 phase of the boom, which have already been carried out by
others. The reason for the extensive testing, using hand-collected data,
is that the CRSP database does not contain earnings data, and also only
begins in 1926. Therefore, previous tests may have missed the effect of
earnings, and given the ideas of Graham and Dodd (1934) there were
significant grounds for testing earnings data. These authors blamed
investor preoccupation with short-run earnings trends for the overvalu-
ation in stocks. They asserted that this was due to a misunderstanding
of the source of excess returns of stocks over bonds in Smith (1924) as
being generated by retained earnings.
These tests complement previous research and allow us to discount
or accept three major areas of potential mispricing that we find in
the long-term DDM tests conducted in previous chapters. These are

extrapolation of earnings and dividends, or a systematic change in the
risk premium.
The tests of risk ratings, if a good proxy for the risk premium on
stocks, allow us to test for a systematic change of the return on stocks
in general, as low-risk premium stocks should have increased more in
percentage terms than higher-risk stocks. In order to test for changes in
the risk premium we assume that Moody’s risk ratings of stocks proxy
for the ‘riskiness’ of stocks.
We use the change in P/D ratio as a measure of overvaluation because
the standard excess returns method for cross-sectional data on stock
prices would be automatically significant for dividend growth and earn-
ings growth even in normal market conditions.
Data
We collected time series data for 130 stocks’ historical earnings growth
from a sample listed in Moody’s Manual of Investments (1930). We col-
lected earnings growth, shares outstanding and dividend (annual) data
using Moody’s Manual of Industrial and Miscellaneous Securities (1900),
Moody’s Manual of Railroad and Corporation Securities (1908, 1919), and
Poor’s Manual of Industrials (1912) to measure earnings and dividend
growth rates back to 1904. Data for risk ratings, size, and year of com-
pany formation were collected from Moody’s Manual of Investments
(1930) for data over the 1924–9 period.
When available, the ‘net earnings before depreciation and taxes’
figures were used although these data are not standardised in Moody’s
Manuals. Price data for 1923–9 were taken from Moody’s Manual of
Investments (1930). The 1929 price used was the peak annual price and
all other prices the high-low average for the year.
Method
We tested for a bubble in stock prices using the percentage change in
the P/D ratio from 1927–8 and 1928–9 as the indicator of a bubble on
the assumption that we can capture the firm-level overvaluation using
this method.
This method tests whether there were any abnormal drivers of these
changes and the scale of these changes at the firm level. In-sample
(1927–9) and out-of-sample (1924–7) periods were defined from earlier
results.
Earnings growth rates and dividend growth rates, calculated as
annualised geometric rates from data in Moody’s Manuals were tested
against percentage changes in P/D ratios for data from 1924–9 at annual
intervals:
Y = b0 + b1 Growthrate + e
where,
Growth rate = earnings or dividend growth rate over various horizons
To test for the potential effect of firm size, net current assets and firm
age were tested, with percentage changes in P/D ratios as the dependent
variable with the equation:
Y = β 0 + β1 log age + β2 log Mcap + β 3 log NCassets + ε
Risk ratings were tested with the equation:
Y = β 0 + β1 Risk + β2 NCassets + β 3age + ε
where,
Risk = risk ratings from Moody’s Manual of Investments (1930)

Age = age of firm from date of incorporation
MCap = market capitalisation
NCAssets = net current assets
Results
Tests of earnings growth rates are statistically significant and positive at
the 1 per cent level and have an R2 of 24 per cent (see Appendix Tables
A1–A9 for results). However, this effect only occurred ‘in-sample’ from
1927–8. Tests of dividend growth rates as causes of the bubble all show
a negative and significant correlation with P/D ratio changes for 1924–7
data and 1927–9 data. This suggests dividend growth rates were not
driving higher valuation ratios.
Another key result is that 1924–7 earnings growth had no relation-
ship to the change in P/D ratios suggesting even short-run trends in
earnings were ignored and no extrapolative effect was occurring. This
result is important, as the extremely high rates of earnings growth, of
an average 20 per cent for our sample, do not seem to have an effect on
valuations from outside the ‘bubble’ period.
The positive test we find for the year 1927–8 is not reliable enough
to ground any firm conclusions, and because it is ‘in-sample’, that is,
the data were only available ex-post as these are year-end data, the
test could be detecting some other factor correlated to earnings or that
investors favoured high earnings stocks, but that effect is only evident
ex-post.
Auxiliary tests showed no correlation between one-year earnings
growth and percentage change in P/D ratio for each year over 1923–7.
Results of tests of risk ratings of stocks using data from Moody’s,
which we assume to have captured risk premiums, were insignificant
in predicting the changes in stock valuation ratios. Reassessment of the
riskiness of stocks, in a systematic way, does not seem to have been driv-
ing the changes in valuation ratios, according to our model.
This result should not be confused with the chance of a time-varying
risk premium for individual stocks which we cannot detect using our
method.
The result that investors did not look at the trends in dividends or
earnings or other fundamental factors when reassessing the P/D ratios
out of sample from 1924–7 indicates that stocks were not being revalued
on the basis of crude extrapolation of financial indicators.
This also shows something very important about our earlier model-
ling of the monetary changes in the economy. The result implies that
investors were not led to think that earnings and dividends would
continue at the extremely high rates of the late 1920s and were also not
‘front running’ future earnings and dividends in anticipation of future
dividend increases based on trend-following behaviour.
The results should also be viewed in light of the work of Nicholas
(2008) who found significant effects from technological innovation using
excess returns, measured by citation-weighted patents and momentum.
Conclusions
All tests of age, size, historical earnings, and dividend growth cor-
roborate the EMH. The positive test for earnings from 1927–8 shows
that investors bought stocks which had higher earnings, although
the absence of this effect in 1928–9 is hard to explain. The in-sample
nature of the result also demonstrates that such a pattern was indica-
tive of a passive bias towards stocks that had higher earnings growth,
but the effect was ex-ante unidentifiable. It remains possible that some
other factor such as new technology or patents that we do not test for
was correlated with earnings or that high earnings growth stocks were
those which investors also believed were part of the new economy.
Momentum
A widely held belief about the 1920s stock market is that rising prices
led to further price rises, which drew in more and more investors,
which then subsequently made the market rise even higher. We know
that investors were attracted to the market, which was rising for funda-
mental reasons from 1921 to 1927, from evidence of the high volumes
on the NYSE and data on investor numbers. Nicholas (2008) tests these
theories using panel data from a lagged 12-month return on monthly
excess returns from 1928 to 1929. He finds a significant effect at the
5 per cent significance level, which is not present in monthly return
data from 1925 to 1928. Hence, only weak momentum effects were
present in the bubble phase according to previous research. These
effects do not represent enough of the variation in the cross-section of
returns to be the sole cause of the bubble. It is feasible that momentum
was a partial cause of the bubble and was in operation throughout the
period from 1928 to 1929. However, it should be added that such a
momentum effect could reflect a change of type described in Pástor
and Veronesi (2009) and hence its detection is not automatic confir-
mation of ex-ante irrationality or a self-feeding process on the part of
investors’ behaviour.
The cross-sectional momentum effect we refer to does not exclude
or test for a wider type of momentum effect, which could have
occurred as investors saw high returns of 24 per cent per annum in
the late 1920s, and were drawn into speculating in stocks generally.
As the graph in Figure 4.2 shows, high volume was present from 1927
160
140
120
Millions of Shares
100
80
60
40
20
0
1920.04
1920.71
1921.37
1922.04
1922.71
1923.37
1924.04
1924.71
1925.37
1926.04
1926.71
1927.37
1928.04
1928.71
1929.37
1930.04
1930.71
1931.37
1932.04
1932.71
1933.37
1934.04
1934.71
1935.37
1936.04
1936.71
1937.37
1938.04
Date Fraction
Figure 4.2 Volume of shares traded on NYSE (millions/month)

to 1929, but of itself does not show that a deviation from fundamen-
tals was occurring. However, these data are at least consistent with
the idea of non-fundamental based momentum effects and feedback
trading.
Our primary results, using very long-run data, at the aggregate level
allow us to benchmark the size of the bubble at an estimated 50 per
cent over fundamentals. Although we do find that a deviation from
model occurred, it did not form on the basis of an easy to spot statistical
anomaly using historical financial data.
As discussed before, there was a very large change in productivity
from 1929 to 1950, which was unprecedented in US history (Gordon,
2010). Nicholas (2008) shows that prices rose to some extent on the
basis of intangibles measured using patents. This finding suggests that
we cannot exclude the ideas of Pástor and Veronesi (2009) regarding
new technology shocks without further econometric tests.
Sector-level data from Cowles (1938)

To test whether there are any obvious effects at the industry level based
on the idea that the overvaluation may have been due to particular
industries which were experiencing fundamental changes in valuations,
which overshot these fundamentals on a predictable basis, we use data
from 55 individual sectors from Cowles (1938) to identify which indus-
tries had the highest percentage increases in valuation ratios from 1927
to 1929 and compared these to the residual change in valuation ratios
(P/D) by 1930. The test aims to isolate the actual bubble components
from real fundamental changes. By 1930 the aggregate P/D ratio was the
same as in 1927, at a P/D ratio of 19.2.
The graph (Figure 4.3) from Cowles (1938) shows the change in P/D
ratios at the industry level during the bubble phase from 1927 to 1929.
The grey bars show the change in P/D ratio as a percentage for each
industry, capturing the relative size of the changes. The black bars show
the change in P/D ratios from 1927 to 1930, when the collective valu-
ation of the sample had returned to the levels we find are consistent
with no bubble relative to our model existing in the market, or a P/D
ratio of 19.
This test is limited in power as we assume that no major change in
fundamentals occurred from 1929 to 1930 as a result of the October
crash and recession. There may have been signs of future changes in
the economy, which will affect our inferences. However, there does
not appear to be an obvious exaggeration of fundamentals from these
data.
% Change in P/D ratio 1927–1930 % Change in P/D ratio 1927–1929
140
120
100
80
60
Percentage
40
20
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
–20
–40
–60
–80
Cowles (1938) Sectors
Figure 4.3 Fundamental changes and non-fundamental component of P/D ratio

changes
Sources: Cowles (1938) and Shiller (n.d.).
Results
These residual components showed no statistically significant correla-
tion. The scale of the changes from 1927–9 does not have any explana-
tory power for the changes from 1927–30 at the industry level. This
shows that the overvaluation we detected in the aggregate data was not
caused by an obvious exaggeration of the fundamental changes based
on industry type.
Conclusion
The 1927–9 phase of the boom does not seem to have been based on
any of the seemingly legitimate changes that persisted to 1930, when
the overvaluation we find had dissipated.
Summary and discussion

Investment returns before the 1920s are consistent with those that were
actually realised from 1925 to 2010. An ERP of 3.5–4 per cent, which an
investor could have feasibly expected in 1926, was subsequently real-
ised. However, the overvaluation we find of about 50 per cent remains
unexplained.
Given the scale of the increase in MPFG from 1928 to 1950 recorded
by Gordon (2010), which was a 150 per cent increase from about
1.3 per cent in the preceding 50 years to over 3 per cent in the latter
timeframe, it is likely that investors had some idea that technology
was about to increase the performance of US companies to a material
extent. Thus, a ‘new era’ was feasibly on the horizon or occurring and
this was, ex-post, worthy of some change in the value of US stocks as
earnings and dividends were likely to grow at an increased rate, and
the returns to stocks increase. The degree to which and the ways in
which such a technological shock may change valuations is of interest
for future research.
The scale and dimensions of this change were tested using cross-
sectional tests. These tests from Nicholas (2008) and our own results
illustrate that patents played a role and that extrapolation of dividends
or earnings was not occurring. There was also no systematic change of
the risk premium.
Momentum effects, which are present but very weak, cannot be
shown to be unrelated to a technological shock. We must leave open the
possibility that momentum was due to a self-feeding process for future
researchers to address but the scale of the effect is not large enough to
be seen as a major factor.
The changes in stock values appear to follow a pattern consistent
with the weak form of EMH as none of our measures of financial data
are significant in the cross-section of stock valuation ratio changes.
Such a finding, together with the results of the momentum tests, is very
important and challenges the common view of this period.
Although we do find a weak bias towards stocks with high earnings
growth in 1927–8, the tests cannot establish that such an effect was
occurring ex-ante as the effect emerges ex-post. The test may capture a
variable related to earnings, which we do not test for.
We can establish that ex-post, a bubble did form. We are able to
demonstrate such an effect for airplane stocks as well as the aggregate
market using long-range data.
This leaves open the question of whether stocks were overvalued on
an ex-ante observable basis, namely that investors were irrational in
their purchases of stocks.
The most critical point to address is whether such large changes in
valuations can be justified as due to the effects of information being
limited and uncertainty being high given the nature of the economic
changes of the time and changes in investor perceptions of stocks due
to new technology or new methods of valuation.
The theoretical possibility that some of the changes from 1927–9 were
legitimately driven by such effects remains highly plausible. It is also
feasible that no technological shock was occurring and that valuations
deviated from fundamentals on the basis of the type of effect described
in Shiller (2000) where rising market values lead investors to speculate
in stocks on the basis of ideas about a new era, which were unfounded
on an ex-ante basis. In this case investors were drawn to higher
expected returns due to the aggregate extrapolation of higher returns, or
the unjustified prospect of a new technological era could have created
all of the ex-ante bubble. The results from De Long and Shleifer (1991)
indicate exuberance beyond ex-ante known fundamentals was present
on a large scale of at least 30 per cent.
5
The October Crash of 1929
and the NYSE Credit System
In this chapter we look at the crash in October 1929 – where stock prices
fell by 45 per cent over the last weeks of October – the credit system that
developed around the NYSE, and the policy of the Federal Reserve Board
towards the boom. What we will see is that an unusual credit system
developed to circumvent the Federal Reserve Board’s policy to stop the
boom, following the fears of credit growth that they had expressed in
1927 and earlier.
We will see how ‘regulatory arbitrage’ by the banking system led
to this system and how the financial stability of the NYSE was com-
promised. The chapter also shows that credit grew in line with valua-
tions during the boom, but our most important contribution is to test
whether the crash in October 1929 was due to a credit retraction from
unstable sources of finance.
This question is of great importance because being able to confirm or
rule out this possibility allows inferences about the behaviour of stock
prices during the crash. A key result from the modelling of expected
values of stocks is that prices seem to have been too high relative to
the model. Being able to discount the potential of an exogenous shock
to prices strengthens the idea that investors willingly sold stocks in
large volumes in that month, which indicates a reversal of beliefs about
future returns to stocks.
5.1 Financial stability and the NYSE credit system
Federal Reserve policy towards the boom

The stock market boom was affected by the actions of the Federal
Reserve Board on two main fronts:
145
1. The raising of the discount rate to slow the large rise in equity
prices, which simultaneously created a global rate tightening cycle
from 1928.
2. The adherence to the ‘Real Bills’ and ‘Burgess-Reifler’ doctrines as
a guide to policy which ultimately led to a mistaken identification
of a credit-induced asset overvaluation, and the policy of ‘direct
pressure’ – which forced a cessation of lending to the money mar-
kets and security loans.
During the pre-Fed days, in which the USA had not had a central
bank since 1832 (Hetzel, 2008), the US financial system was susceptible
to periodic financial crises. An example of the mechanism by which
crises arose and their wide impact on the financial system was the panic
of 1907.
There was a mechanism designed to provide liquidity in time of
financial crisis via the New York Clearing House System prior to
the establishment of the Federal Reserve System as a ‘lender of last
resort’ (Gorton and Huang, 2002).1 A key problem in 1907, but which
existed generally prior to the creation of the Federal Reserve System, was
a weakness stemming from the existence of non-bank financial inter-
mediaries (NBFIs) outside the Clearing House System or ‘outsiders’2 who
were denied routine access to the liquidity provision mechanism, which
the Clearing House System provided for its members. Hence, there
was a higher degree of potential financial instability with the increase
in the participation of ‘outsiders’ in the NYSE and money markets.
The instability arose because the banking system’s reserves were linked
to the NYSE through the New York call money market. Bank reserves
were loaned ‘on call’3 on the New York money market in order to earn
a financial return, rather than leave the reserves idle and non-interest
bearing. Call loans, in turn, were used to finance equity holdings traded
on the NYSE. This meant that banking reserves and, by extension, sys-
temic stability, were susceptible to shocks emanating from the NYSE or
the New York money market.4
In the national banking era of financial panics, the central scarcity
was the lack of high-powered money – that is, there was a scramble for
reserves. In October 1907, confronted with widespread withdrawal of
deposits and having meagre reserve holdings (their deposits at national
New York banks were considered reserves), the next source of cash for
New York’s investment trusts facing panic-induced withdrawals was the
liquidation of their call loans.
The October Crash of 1929 147
New York Clearing House Banks (NYCHBs) wanted to maintain the

liquidity of the call market to maintain values of related stock market
collateral. Insufficient call loan market liquidity could force undesired
liquidation of call loans, perhaps forcing the ‘fire sale’ pricing of assets,
which were supporting the call loans.
Such outsider threat was a sufficient motivation for the NYCHBs
to deal directly with the trusts to take over call loans from the trusts.
However, this duty was beyond their financial capacity as the call loans
market expanded outside of their control. Some of the sources of finan-
cial instability prior to the establishment of the Federal Reserve System
were therefore:
1. NYSE prices were susceptible to higher volatility than would be

expected from fundamental values, due to the volatility in the sup-
ply of call loans.5
2. The holding of reserves in the form of call loans by the banking
system was potentially dangerous for the banks as their reserve posi-
tions were vulnerable to an NYSE linked money market crisis.
3. The holding of banking system reserves as call loans could lead to a
contraction in the reserves of the US banking system. A contraction
in high-powered money as a result of a shock to the NYSE, member
bank, or NBFI would thereby create a systemic crisis with effects
reaching the wider economy.6
Moen and Tallman (2003)7 and Friedman and Schwartz (1963)8

explain that the desire to ensure liquidity provision in the form of an
organised lender of last resort, to intervene during such panics, and
prevent the conversion of deposits to currency during banking panics
was a key impetus behind the formation of the Federal Reserve.
The Federal Reserve was thus formed in 1913 as a remedy to the
periodic financial crises in the USA up to that date, and represented
an attempt to provide a strong central bank adhering to the Gold
Standard rather than the issue of a pure fiat currency (Hetzel, 2008).
The Federal Reserve comprised twelve reserve banks and a Federal
Reserve Board approved by the government to provide oversight and
policy formulation, with member banks forming part of a network
with the reserve banks. The formation of a central bank aimed to alle-
viate the problems illustrated above but with a compromise of having
twelve reserve banks to prevent centralisation of economic power in
one location.
Regulatory arbitrage and the credit flows to the NYSE

Moen and Tallman (2003) describe the role of the New York call money
market in the crisis of 1907, when outside lenders, who were not within
the emergency liquidity provision mechanism of the New York Clearing
House Banks system, became the largest lenders by volume of funds
to the NYSE, via the call money markets. This created latent systemic
instability in the US financial system.9
Moen and Tallman argue that compositional changes in lenders to
the call loan market in 1907 made the NYSE more vulnerable to a
withdrawal of these call loans, which were used to finance purchases
of securities. With a money market dominated by non-reserve mem-
bers, who critically lacked incentives to provide stability to the NYSE,
a sudden systemic shock to the New York money market was increas-
ingly likely, and could have large negative effects on market prices as a
‘liquidity panic’ took effect, in the absence of a ‘lender of last resort’ to
provide liquidity.
In times of panic, as in 1907 when the New York trusts – NBFIs
who were non-members of the Clearing House System – were in crisis,
the inability to access reserves held in form of call loans by the banks
within the Clearing House System made their reserves vulnerable and
hence made them subject to runs as they were technically insolvent.
As already discussed, NYSE prices were acknowledged by contemporary
authors such as Myers (1931) to be susceptible to shocks to the supply
of call loans. Without a ‘lender of last resort’ to take over the liquidated
positions of the non-members of the Clearing House System an external
money market shock could propagate through the banking system. The
emergence of ‘outside’ money market based lending to investors on the
NYSE increased the vulnerability of prices to falls induced by liquidity
panics, and increased systemic risk.
The two key processes relating to the relationship between NYSE
prices and the stability of call money provision were:
1. That a systemic shock leading to a mass withdrawal of call loans

could have affected prices and been part of positive feedback loop
as collateral values fell. As call loans were withdrawn, the selling of
equities to repay the loans would ensue, in the absence of liquid-
ity injections to stabilise the market. This selling, if large enough,
would trigger large price falls and impair the value of the collateral
(stocks) underlying the remaining call loans in the market. If suffi-
cient price declines occurred, a cascade of selling could be triggered.
2. The presence of ‘outside’ lenders to the money markets increased the

likelihood and severity of such a cascade developing, as risks outside
the system were less likely to be monitored, and liquidity provision
channels were not available to respond quickly to such a shock.
The Clearing House System in the era before the Federal Reserve did
have the ability to maintain liquidity and hence prevent this type of
self-feeding liquidation cycle from causing a crash in values on the
NYSE. Numerous authors discuss this liquidation mechanism such as
Haney et al. (1932) and Harris (1933).
By 1929 the US banking system had become less vulnerable to a New York
money market panic leading to a contraction of the reserve base of the US
banking system. This was because under the Federal Reserve System, the
main reserves were no longer held in the form of call loans as was the case
prior to the Federal Reserve System. However, the risk of a large-scale call
loan liquidation triggered by ‘outside’ lenders still remained, and increased
with the emergence of non-members of the Federal Reserve System. As a
consequence of the actions of the Federal Reserve Board, financial stabil-
ity was again endangered by the emergence of lenders outside the Federal
Reserve System, which led to the almost complete control of the supply of
funds to brokers on the NYSE by ‘other’ lenders.
5.2 Money market leverage for Common Stock trading
The main users of money market leverage to hold equity positions

were the investment pools, large private investors/traders, and the less
covenant-bound of the investment companies. Rappoport and White
(1994) explain the mechanics of brokers’ loans; these were loans from
the money market used by brokers to supply speculators with loans
using the securities purchased as collateral. The amount of brokers’
loans rose substantially by 1929 as traders, keen to take advantage of
the large returns available to purchase stocks as they rose to their new
equilibrium values, bought heavily. The rate on brokers’ loans rose to
high levels, as there were continual gains net of costs to be made by
speculating on the rise of Common Stocks.
The mechanics of brokers’ loans for a small account were as follows:
In order to hold a security via a broker a 40 per cent initial cash margin
of the purchase price of the security with the broker giving a 60 per cent
loan was necessary. Brokers could then call the loan when the stocks
dropped to 60 per cent of the purchase price as the cash deposited no
longer covered the remaining loan. There were also no maintenance

margins (Rappoport and White, 1994).
If the security price declined to a level of the cash margin then
additional cash would be demanded or the securities sold. Smiley and
Keehn (1988) and Rappoport and White (1994) explain that from 1928
to 1929, due to fear of an impending market crash, margin rates were
raised on these loans to an average 40 per cent with some stocks requir-
ing a 75–100 per cent cash margin.
The investment pools, large traders, and less strictly covenant-bound
investment companies were using money market leverage to trade in
and make markets in Common Stocks. The investment pools were large
($10–100 million)10 syndicates of professional traders and market mak-
ers operating on the NYSE who had ‘specialist’ knowledge of the stocks
they were trading. The size of their accounts with brokers meant levels
of margin requirement were lower than for ‘public’ investors. Wigmore
(1985) states that large investment pools had ‘no margin’ credit facili-
ties via their brokers. Large professional traders were similar to the
investment pools in their reliance on funding and leverage ratios and
also had low or no margin credit facilities.
The trading size and higher leverage ratios meant that any liquidity
shock would force large volumes of stocks onto the market in the event
of a money market disturbance via the New York brokers’ loan market.
Furthermore, their market-making activities would also be disrupted
during a liquidity shock.
The brokers’ loans market

As illustrated in Figure 5.1, the stock market boom of the 1920s
coincided with the growth of money market lending. It is vital to note
that increases in lending were not necessarily the driver of increased
Common Stock prices (Rappoport and White, 1994), but largely
reflected a demand for funds as the theoretical value of Common Stocks
listed rose during the 1920s11 due to nominal dividend increases and a
change in long-term investors’ valuation of Common Stock holdings.
The continued demand for funds during 1928–9, even as call money
rates increased significantly under Federal Reserve policy measures
designed to restrict loans to ‘traders’, suggests ‘traders’ believed that
expected returns to Common Stocks were still below the level at which
money market leverage to trade Common Stocks was demanded.
The ‘call loans’ used to provide leverage for securities holdings were
primarily in the form of brokers’ loans – loans issued from money
market lenders to brokers who in turn loaned this money to investors
VIA FEDERAL RESERVE BANKS VIA NYSE

4500
4000
3500
Millions of Dollars
3000
2500
2000
1500
1000
500
0
Jan-26
Mar-26
May-26
Jul-26
Sep-26
Nov-26
Jan-27
Mar-27
May-27
Jul-27
Sep-27
Nov-27
Jan-28
Mar-28
May-28
Jul-28
Sep-28
Nov-28
Jan-29
Mar-29
May-29
Jul-29
Sep-29
Nov-29
Jan-30
Mar-30
May-30
Jul-30
Sep-30
Nov-30
Date
Figure 5.1 Volume of lending via ‘others’

Source: Haney et al. (1932).
to purchase stocks on ‘margin’. These funds were in the form of loans

renewable at overnight notice, which could be ‘called’ or demanded
back from brokers.
The other source was in the form of call loans issued directly to inves-
tors by banks and financial institutions, thus bypassing the brokers as
intermediaries in the supply of leverage. The brokers’ loans market was
the more prominent of the two sources with a 75 per cent share of
the total. The outstanding credit in the form of brokers’ loans formed
a 10 per cent share of the total value of NYSE listed stocks in 1929
(Rappoport and White, 1993).
Figure 5.2 describes the total lending to securities investors (Haney
et al., 1932) during the 1926–30 phase of the boom using data from
member banks of the Federal Reserve System. This includes loans of
longer horizons know as ‘time loans’.
As a direct consequence of the discount policy of the Federal Reserve
and their policy of ‘direct pressure’ to stop lending via brokers’ loans
and security loans, the call money rate rose sharply in 1928–9 as in
9000
8000
7000
Millions of Dollars
6000
5000
4000
3000
2000
1000
0
Nov-26
Nov-27
Nov-28
Nov-29
Nov-30
Jan-26
Mar-26
May-26
Jul-26
Sep-26
Jan-27
Mar-27
May-27
Jul-27
Sep-27
Jan-28
Mar-28
May-28
Jul-28
Sep-28
Jan-29
Mar-29
May-29
Jul-29
Sep-29
Jan-30
Mar-30
May-30
Jul-30
Sep-30
Date
Figure 5.2 Total demand and time loans (1926–1931)

previous times of liquidity scarcity in the New York money market,

such as 1907.
As a result of Federal Reserve policy, of public opinion, and of the

Senate investigation of brokers’ loans, banks were fast becoming
unwilling lenders to brokers. This change was expressed not so much
in attempts to contract loans already made as in refusals to extend
additional loans. In other words, a supply from banks beyond the
three billion mark was not forthcoming at any price.
Consequently, as the vertical demand line approached the three
billion point, it encountered a supply curve rapidly becoming almost
as steep as itself. The result was a rise in the call money rate which,
had it not have been for a forthcoming supply from another source,
might have soared as high as 20, 50, or even 100 per cent.
The new source was of course ‘others’. As a result of new security
issues, corporations were coming into possession of a far greater
amount of money than was needed by them for production pur-
poses. This was occurring just at a time when call money rates were
rising because of the growing inelasticity of supply. A yield of 6, 7, 8,
or 9 per cent, combined with the high degree of liquidity for which
loans to brokers are known, proved to be too strong a temptation for

the corporations.
As a result the call loan supply by others began to absorb in
December, 1927, the elasticity which the Federal Reserve Board was
squeezing out of the bank supply so that after this date the funds
contributed by others became the elastic portion of total supply that
responded to changes in the market and caused some traders to sell
a part of their holdings of other securities so as to secure the funds
needed to purchase the new issues.
It is clear, therefore, that the Federal Reserve Board had no regu-
latory powers over the forces which were really responsible for the
huge increase in speculative loans. No action that they could have
taken would have been of any avail under the circumstances. Stock
prices were soaring at such a rate as to make the demand for funds
absolutely impervious to changes in the call money rate. Had the
Board not put pressure upon banks to withhold further aid, those
institutions would probably have gone on supplying the funds which
brokers demanded. As occurred, however, the Board’s attempt to cut
down on the supply of credit available to speculators merely caused
the call money rate to advance to a point where the funds demanded
were forthcoming from other sources. The Board’s failure in this
instance does not mean that brokers’ loans should go unregulated in
the future, but only illustrates the uselessness of attempting to regu-
late the supply when the demand is inelastic. (Eiteman, 1933: 461–3)
As shown in Figure 5.1 there was a surge in lending from ‘other’ lend-
ers. Had the Federal Reserve Board not embarked on this policy, ‘other’
lenders would not have entered the market as reserve bank lending
would have been sufficient to supply all the funds demanded for equity
purchases. The graph shows the inflow of ‘call money’ from January
1928, the time at which the Federal Reserve policy of direct pressure was
enacted. The net increase from lenders outside of the Federal Reserve
System from January 1928 matches the increase in total lending data
from Haney (1932) over this time period, corroborating the idea that
Federal Reserve policy caused a total halt to the flow of new funds to
investors and traders.
Roelse (1930) indicates that lending from non-reserve member banks
to ‘non NY brokers and dealers’12 and other customers amounted to
$2–3 billion, which had accumulated over the two years from 1928
to 1929. This places the total of ‘all’ US brokers’ loans at an estimated
$10.5 billion.13
The financial instability caused by the actions of the Federal

Reserve Board’s policies drew in funds from two main sources: foreign
banks/corporations and large US corporations. The next section details
the profits gained from lending to the call money market from 1928 to
1929 by these lenders. These lenders formed the majority of total lend-
ing from ‘others’.
It should be noted that ‘others’ were lending and continued to lend
to the call money markets post-crash; however, there was a large elastic
segment of the supply whose emergence coincides with the increase in
the US call money market rate spread over the US discount rate. This
elastic segment is that supplied mainly by corporations and foreign
banks. The remaining call money, which constituted ‘others’, was lent
by wealthy individuals, interior banks and investment trusts. We focus
on the two main groups in the analysis in the following section.
The changing composition of lenders in the New York

call money market
A ready supply of funds from lenders outside of the jurisdiction of the
Federal Reserve System was to change the composition of the lenders to
the money markets heavily towards outside sources. Foreign banks and
US corporations were the main suppliers.
As we have seen, there was a radical change in the composition of
lenders to the investors via the brokers’ loans market, in response to
the higher call loan rates and the ‘arbitrage’ profits available from lend-
ing in this market. The cessation of speculative lending from Federal
Reserve member banks under ‘direct pressure’ from the Federal Reserve
Board was the proximate cause of this change. ‘Others’ accounted for
about 80 per cent of the brokers’ loans market on the eve of the crash
(Haney et al., 1932) having only previously accounted for 35–40 per
cent during the 1920s. The influence of the outside banks and New York
banks occurred from around January 1928.
Smiley and Keehn (1988: 136–7) note:
the distribution of brokers loans for others as reported by the six

largest member banks in New York City was as follows: corporations
56 per cent, individuals 20 per cent, investment trusts 14 per cent
and foreign 10 per cent. This understates foreign participation since,
apparently, much of the foreign lending was through foreign banks
rather than through member banks.14
Other sources such as Roelse (1930) estimate the percentage of lending

from ‘others’ at 60 per cent of the call money market. The dominance
of ‘other’ lenders led to the emergence of a systemic vulnerability of

the NYSE to a shock emanating in the call money markets as the pos-
sibility that call money market lenders’ behaviour could induce a large
retraction of funds if the stimulus for the lending was removed or they
became fearful of a crash, became acute.
The Fed’s dual policy did not have the desired effect of causing stock
market liquidation or even slowing the stock market boom, as new
sources of funding had emerged. These sources had identified the ‘arbi-
trage’ or ‘risk-free’ profit to be gained from borrowing at a lower rate of
interest and lending to the call market and it is likely that they lent on
the basis that rewards were high. We do not calculate whether this type of
lending had a risk premium embedded in it due to the risk of a crash or
whether investors were simply benefiting from the squeeze on the market
by the Federal Reserve. This ability of the NYSE traders to access credit is a
form of regulatory arbitrage. In this sense the Fed’s actions were muted by
the availability of internationally and domestically mobile funds.
By 1929 the NYSE’s stability15 had been weakened by the effect of the
Federal Reserve’s policy because:
1. Lenders outside the reserve system dominated.

2. These lenders were sensitive to call money rates and the cost of
funds from which their profits on lending were derived.
3. A systemic shock to this lending could not be absorbed readily
by the Reserve System due to the size of the lending at over $5
billion.16
4. The outside lenders had no reason to maintain the stability of the
New York money market or the NYSE.
The mechanism of a downward spiral in stock market prices as call

loans were liquidated is documented prior to 1929 (Moen and Tallman,
2003; Myers, 1931) and an established issue regarding the prices of
Common Stocks traded on the NYSE during such liquidity crises.
US corporate lenders
H. G. Parker’s article ‘Where the Call Money Comes From’ (1929) makes
specific reference to the lending of ‘call money’ by large corporations.
Parker was the Vice-President of the Standard Statistics Company and
together with the analysis offered by I. Wright (1929) who also cites
the entrance of large US corporations to the call money market, we can
assume that some analysts were clearly aware of at least one of the main
sources of funds used by investors to hold leveraged Common Stock
positions on the NYSE during the boom.
Corporate treasurers would have been expected to seek the highest

return for surplus funds not used for business projects as well as to have
the ability to borrow funds at the commercial funds rate. The abnor-
mally high rate of return on call money and the highly liquid nature
of these financial instruments meant that lending to the call money
market provided high ‘risk-free’ returns.
Having entered the business of lending to the call money markets
in early 1928, by 1929 corporations were lending in large volumes to
investors via the brokers’ loans markets. As non-members of the Federal
Reserve System the corporations were not party to any agreement, tacit
or formal, to maintain stability on the NYSE or the call money markets.
Hence, from the perspective of financial stability, they were not ideal
sources of funding for investors, as they were likely to retract funding
when there was a higher return to be gained by investing in other
instruments, or when their cost of funds rose to the call market return.
Figure 5.3 illustrates the profit potential from lending commercial
funds ‘on call’. The profit level is derived from the difference between
the cost of commercial funds and the call money rate including
av call rate av commer rate spread
10
8
Percentage per Annum
0
j f m a m j j a s o n d j f m a m j j a s o n d
–2
1928 Year 1929
Figure 5.3 Profits from corporate lending to NYSE

transaction costs of 0.5 per cent. The difference between corporations’

cost of funds and the call money rate, net of transaction costs, was
positive from mid-1928 until October 1929.
Some of the key corporate lenders who were identified in 1928 (Parker,
1929) as large lenders to the call loan market were EI, Du Pont, De
Nemours, International Shoe, American Can, Goodyear Tire and Rubber,
American Smelting and Refining, Corn Products, International Nickel,
Standard Oil of California, Westinghouse Electric & Manufacturing, and
Eastman Kodak. The volume of these funds in 1928 was estimated at
$750 million (Parker, 1929); however, there is likely to have been a large
increase in 1929 to an estimated $1.5 billion.
The funds from corporations were made available due to the large
profits made during the 1920s, issues of new securities, commercial
loans from Federal Reserve banks and funds borrowed from other banks
and then loaned on call (Haney et al., 1932).
Figure 5.3 also shows that there is considerable change in October
1929 when the profit potential from lending to the call market disap-
pears. As we will see later in the chapter, considering the 24-hour term
of the call loans we would expect funding to be withdrawn instantan-
eously, as a result of the lack of profit from lending.
Foreign banks and corporations lending to the call loan market

Another source of funds, which supplied leverage to investors were for-
eign banks and corporations.17 The total volume of funds from ‘others’
totalled $5.5 billion and we estimated this to have comprised $2 billion
from US corporations and $1.5 billion from trusts, individuals, and
non-reserve member US banks. This leaves about $2 billion from inter-
national corporations/foreign banks.
Evidence on the flow of internationally mobile funds in the 1920s is
well documented by Einzig (1930) who cited the increasing efficiency
of international communications via telephone and telegraph and the
increasing willingness of corporations and banks to engage in interest
rate arbitrage to profit from rates of return in different money centres.
Einzig also emphasises the non-trivial scale of these flows.
International currency arbitrage and the Keynes–Einzig

conjecture
The Keynes–Einzig conjecture (Keynes, 1923; Einzig, 1937), established in
the 1920s, hypothesised that an interest rate differential of 50 basis points
or 0.5 per cent on an annualised basis, was needed in order for flows to
occur to exploit the ‘risk-free’ return between differing interest rates.
Their analysis refers specifically to ‘covered interest rate arbitrage’

between the spot and forward markets of various currencies, the
50 basis points or 0.5 per cent figure deemed necessary for these arbi-
trage trades to be entered. The conjecture has been confirmed by mod-
ern econometric tests (Peel and Taylor, 2002).
Although the type of covered interest arbitrage conducted by inter-
national investors between 1928 and 1929 took advantage of a unique
anomaly between the spot dollar, the forward dollar, and the New York
call money rate, the 0.5 per cent figure from Peel and Taylor (2002) is
used in our calculations as the necessary threshold for these flows to take
place in both uncovered and covered interest arbitrage in our analyses.
As we will see in the next section, these profits were well in excess of
the Keynes–Einzig threshold and presented an opportunity for traders.
Uncovered interest rate arbitrage

The evidence from Einzig (1937) demonstrates that a significant volume
of flows of funds from ‘other’ lenders was conducted on the basis of
‘covered interest rate arbitrage’.
This entailed borrowing in, or using existing funds in low yielding
currencies, lending these funds to the New York money markets, and
hedging the currency risk to their loans to the New York markets in the
forward US dollar market.
Another form of lending on the basis of ‘uncovered interest rate
arbitrage’ was feasible in theory, but Einzig (1937) suggests this type
of lending was not as prevalent in the 1925–31 era. This type of trade
involved lending to the New York call money market without covering
the exchange risk.
The reason for the lack of the use of uncovered interest arbitrage is
given as follows:
It may be stated that, between 1919 and 1925, practically every cur-
rency fluctuated widely in terms of every other currency …
Before the war the funds engaged in interest arbitrage were to a
large extent uncovered, for in many instances the risk of a deprecia-
tion was that the exchange within the gold points was smaller than
the difference between interest rates in the two centres concerned.
After the war however, since the gold points had ceased to oper-
ate, there was no limit to the risk involved in uncovered interest
arbitrage. Consequently, the practice of leaving arbitrage funds
uncovered was discontinued entirely … There was another reason
why interest arbitrageurs after the war systematically covered their
exchange risk. In many instances it was highly profitable to do

so. The unusually wide premium on forward rates at times yielded
abnormally large profits on interest arbitrage with the exchange rate
covered. (Einzig, 1937: 66)
During the post-war stabilisation from 1925 he goes on to explain that

the experience of instability had increased the use of forward exchange
in general because:
Confidence in the stability of currencies was not so well established

as before the war, and gold points were not relied upon to the same
extent as the extreme limits of possible exchange movements. When
on various occasions sterling or the mark [German Mark] declined
to gold export point, this did not necessarily remove the desire for
covering the risk of further depreciation. (Einzig, 1937: 70)
This observation occurred under the theoretical stability of the inter-

war Gold Exchange Standard of fixed exchange rates, as currencies were
expected to fluctuate within narrow gold import and export points of
between 1 and 2 per cent depending on the currencies involved.
As previously discussed, uncovered interest arbitrage was not being
conducted on a significant scale due to the unreliable nature of the
‘Gold Points’ as indicators of limits to exchange movements. This
restriction led to the emergence of ‘covered interest arbitrage’ as the
prevalent form of currency arbitrage and is detailed in the following
section (Einzig, 1937).
Covered interest arbitrage

Forward markets existed for major international currencies and were
actively traded having developed during the currency crises of the First
World War to 1925 and remained active. The equation below describes
the interest rate parity condition, in an efficient forward market:
⎛F −S⎞
is = ic + l ⎜ ⎟ (1 + ic )
⎝ s ⎠
where:
is is the domestic interest rate implied by debt of a given maturity

ic is the interest rate in the foreign country for debt of the same maturity
S is the spot exchange rate ($/c)

F is the forward exchange rate implied by a forward contract maturing
at the same time as the domestic and foreign debt underlying is and ic.
F is expressed in the same units as S, namely ($/c)
Taking natural logs of both sides of the interest parity condition yields:
⎛F⎞
is = ic + ln ⎜ ⎟
⎝S⎠
where ln(F/S) is the forward premium and all interest rates are now the
continuously compounded equivalents.
Covered interest parity assumes that debt instruments denominated
in domestic and foreign currency are freely traded internationally and
have similar risk. The major flow of funds to the New York call money
market from international money market investors were via ‘covered’ or
‘hedged’ positions which could be taken between lower yielding curren-
cies such as sterling/French franc/Swiss franc and thereby earning a posi-
tive return on the difference between the rates at which these funds were
borrowed and the higher rates on New York call money (Einzig, 1937).
During 1928–9 the ‘covered interest rate parity’ condition in the pricing
of the forward contract was not violated to large extent. However, due to
the existence of a large difference between call money rates in New York
and US dollar bank rates, assuming that call money and bank deposits in
US dollars were perfect or near perfect substitutes as liquid interest bearing
dollar assets18 a ‘risk-free’ profit could be earned. In this case the US dol-
lar bank rate was substituted by traders using the call money market and
hedged at a forward rate which was closely based on the IRP condition.
(1 + i ) > ⎛⎜⎝ FS ⎞⎟⎠ + (1 + i )

′
s c
where,
is = Call money rate

ic = Domestic bank rate
Figure 5.4 illustrates the profit from covered interest arbitrage between
US dollar call money and sterling bank rate borrowing costs, inclusive
of transaction costs of 1 per cent per annum, and the horizontal bar
shows the Keynes–Einzig threshold of 0.5 per cent as used in Peel and
3
Percentage per Annum
0
Se l-27
Se l-28
Se l-29
Se l-30
M -27
M -28
M -27
M -29
M -30
N -27
Ja -27
M -28
Ju -27
N -28
Ja -28
M -29
ay 0
Ju -28
N -29
Ja -29
ov 0
0
Ju -29
Ju -30
M -3
N -3
-3
n
n
ar
n
p
ov
ar
ay
p
ov
ar
ay
p
ov
ar
p
ay
–1
Ja
–2
–3
Date
Figure 5.4 Profit from covered interest arbitrage £ bank rate / $ call rate
Source: Einzig (1937) and author’s calculations.
Taylor (2002). These data are from Einzig (1937). This estimate also
includes using actual forward rate data to hedge the dollar position
with 1-month forward dollars. This type of trade, which we know was
of much smaller magnitude than the lending from domestic sources
which did not need a currency risk hedge, appears to have been fairly
lucrative.
Although we call this an arbitrage, it is not easy to see whether there
is compensation for risk in the premium of the call money market over
the bank rate, rather than a ‘free lunch’.
Einzig (1937) indicates that there is a noticeable effect on forward
dollar/sterling rates which suggests that the flows of funds to the New
York call money market forced the forward dollar/sterling rate out of
line with its ‘expected’ value under the interest rate parity condition19
of the two currencies.
The period of 1928 and 1929 is very interesting and instructive from
the point of view of the forward dollar. The Wall St boom resulted in
an all round rise in interest rates in NY. By the middle of 1928 the
bank rate parity had moved against the dollar and simultaneously
the forward dollar went to a discount.
During the autumn months the forward dollar became consider-
ably undervalued compared to the discount rate parity, and also with
its bank rate parity. This was not an unusual state of affairs. In fact,
throughout the post war period, the forward dollar, except for brief
periods had always been undervalued in relation to those parities.
On the other hand, it had usually been overvalued compared with
parities on interest rates based on call money, time money and com-
mercial paper in NY.
Consequently the theoretical interest parity, which would natu-
rally take account of these rates, must generally be more adverse to
the forward dollar than would appear from either the trend of the
discount rate parity or the bank rate parity. During the second half of
1928 the abnormally high call money rates in NY made this situation
particularly clear …
While from the middle of 1928 until the end of 1929, the forward
dollar was constantly undervalued compared with its discount rate
parity, it was very heavily overvalued compared with its call money
parities or the parity between the NY time money rate and the
London discount rate. It was highly profitable for London banks to
transfer funds to NY call money or time loans. In order to cover the
exchange risk, they had to relinquish part of the transaction, and
since during that period the spot dollar was in the vicinity of gold
import point, this measure of precaution was essential.
Throughout the second half of 1928 and the whole of 1929 there
was a material profit on covered interest arbitrage with NY funds
invested in call money and time money. (Einzig, 1937: 268)
The reason why this deviation of the forward rate from its theoretical
value was itself not arbitraged away is also given:
At the same time … it would have been profitable for New York banks
to buy sterling bills and cover the exchange. From time to time the
profit on such operations was over 1 per cent per annum, but very
few American banks availed themselves of it, owing to the much
more attractive investment facilities in the home market where inter-
est rates rose to a very high level … (Einzig, 1937: 269)
In order to demonstrate the behaviour of the actual forward rates

during the 1928–9 timeframe and the impact of the ‘covered interest
arbitrage’ trade on deviations from implied forward rates, the follow-
ing data were taken from Einzig (1937). The deviation from the US
dollar/sterling interest rate parity condition indicates that forward
US dollars were being sold to cover lending from sterling to the New
York call money and time money markets.
From the beginning of 1928 until the end of 1929 forward sterling
came strongly under the influence of the Wall St situation. The rise
in money rates in NY resulted in a premium on forward sterling from
the middle of 1928 until the end of 1929 …
… this was due to an inherent weakness of forward dollars brought
about by the Wall St boom …
Even though the forward dollar was at a discount throughout
the second half of 1928 until September 1929, this was not by any
means a sign of inherent strength in forward sterling, for through
that period the forward franc in London was almost incessantly at a
premium, showing that the premium on forward sterling was solely
due to the peculiar Wall St situation.
The discount on forward sterling in relation to the franc was fully
justified on an interest basis, for throughout 1928 and more espe-
cially in 1929, interest rates in Paris were considerably lower than
those prevailing in London … (Einzig, 1937: 257–8)
What is clear from the data and analysis of the behaviour of the
1-month forward dollar/sterling rate is that a significant deviation from
theoretically expected values (using the bank rate parity) occurred during
the 1928–9 phase of the Wall Street boom and that these lending flows
were occurring in significant volumes as they influenced the forward rate.
5.3 The October crash of 1929
The withdrawal of call loans from the New York market

There are five main points to note about the stock market in September/
October 1929:
1. The composition of lenders, operating via the brokers’ loans and call
loans market, was heavily dominated by lenders from outside the
Federal Reserve System.
2. The stock market was at a new level based on the heterogeneous
beliefs of investors.
3. Foreign centres such as London which raised its rate by 100 basis
points in September 1929, were offering 6.5 per cent and Berlin 7.5
per cent on bank deposits.
4. The New York Federal Reserve Bank had raised its discount rate to
6 per cent on 8 August.
5. The return from the call loan market fell from 8.5 to 6 per cent by
the first week of October.
In addition, investors were likely aware that instability in the money

market had already manifested itself during March 1929, when a money
market panic had forced the call money rate to 15 per cent and triggered
a sell-off in stocks as a result (The Commercial & Financial Chronicle, March
1929). The sell-off did not gain momentum as the National City Bank
in New York supplied $25 million in liquidity and offered to maintain
liquidity injections to the call money market, which stabilised the selling.
We have established in the previous sections that there was poten-
tial financial instability caused by the changing composition of the
sources of the leverage supplied to investors and traders. Critical to
the full comprehension of the huge sell-off in October 1929 is the role
played by the retraction of the funds which comprised the ‘invisible
banking system’20 which emerged as the liquidity supply mechanism
from 1928 to 1929.
The main aim of this section of the study is to identify whether the
crash in 1929 reflected a reassessment of the fundamental value of
US corporate stocks, as our modelling and tests in the earlier chapters
would indicate, or whether the crash was a result of some other ‘non-
fundamental’ cause, namely, a ‘liquidity contraction’. R. W. Burgess,
a New York Federal Reserve Bank official, illustrates a key point with
respect to the sell-off in late 1929. Namely, that the call money rate
reduction occurred before the stock market crash and thus could be
viewed as a factor in the crash itself. This is backed by data illustrat-
ing that call money rates fell from a previously high premium through
1928–9 to an equivalent rate to the US bank rate between September
and October 1929.21
The third event in the autumn series was a rapid reduction in money
rates throughout the month of October. … Call loans … 8 per cent to
6 per cent. It should be noted that much of this reduction in money
rates occurred before the stock market crash and was not the con-
sequence of any decrease in the amount of credit employed by the
stock market. … The easier position in New York had not resulted,
however, in any substantial flow from New York to the interior nor
in any easing in the interior money position. In fact, the situation
at that time may have been one of those rare instances when money
may be said to have been cheap but not easy. Rates were low but cer-
tain kinds of money were not easy to obtain. The banks were largely
out of debt at the Reserve Banks but were conservative in their lend-
ing policy, particularly as related to additional security loans, and
were putting considerable pressure upon some of their borrowers.
(Burgess, 1930: 18)
The Commercial & Financial Chronicle (5 October 1929, p. 2199) high-

lights the call money market. On 12 October 1929 (p. 2281) it notes
markedly lower rates. On 12 October it cites an excess supply of funds
due to security issuance by ‘Investment Trusts’ who lent the proceeds back
into the call money market, and were noted as a factor in the declining
money market rates. We demonstrate that call money rates fell as demand
was reduced for speculative leverage as market prices for stocks reached
equilibrium values in September, and which were unlikely to witness
rationally based price increases from those levels.
Having established the identity of ‘other’ lenders and the reasons
for their emergence as the main lenders to the call money market,
used by traders and investment pools, and the effect of the change
in the composition of lenders to a money market dominated by non-
reserve member lenders, the following section details two potential
trigger mechanisms for the crash in stock prices which ensued in
October 1929.
In October 1929, sufficient demand relative to supply did not exist
for call money leverage to sustain a significant premium above the bank
rate, and a fall in arbitrage based gains to zero for international and US
corporate call money lending. One potential cause which may have led
to very high volumes of sell trades which could not be matched with
buyers and the attendant sharp falls in prices in the last two weeks of
October, which in turn triggered the retraction of a total of $3.5 billion
call money, was a credit or liquidity crunch. In this case a fall in the
returns to lending may have caused a forced selling of stocks. The sec-
ond potential explanation for the crash was that an overvalued market
collapsed as investors realised that stocks were overvalued or that suffi-
cient information became available to reduce the uncertainty surround-
ing stock values (Figure 5.5).
Lending flows to the call and time money markets

from ‘outside’ lenders
As shown in the data on brokers’ loans (Haney, 1932; Roelse, 1930), there
is a large contraction in volume of funds coincident with the fall in the
DISCOUNT RATES (CB) London DISCOUNT RATES (CB) New York
7.0
6.0
5.0
Percentage
4.0
3.0
2.0
1.0
0.0
Jan-25
May-25
Sep-25
Jan-26
May-26
Sep-26
Jan-27
May-27
Sep-27
Jan-28
May-28
Sep-28
Jan-29
May-29
Sep-29
Jan-30
May-30
Sep-30
Date
Figure 5.5 Bank of England and NY Fed discount rates.

call money market rates. However, the time money market lending vol-
ume showed a continued increase for the month of October (Table 5.1).
This suggests that although demand for funding for stocks was falling,
the supply flows of funds were generally sensitive to this arbitrage trade.
Figure 5.6 shows how the rates on money market ‘call money and
time money’ fell over the month as well as whether the loans were
made on the ‘street’ (non-NYSE), for renewal of loans, new loans, or for
180-day time loans.
In the absence of more detailed data, these data indicate that a lack of
profitable ‘arbitrage’ based lending could have been a driver of money
market retraction. Furthermore, we also cannot rule out that lending
was retracted due to fear of losses from lending to stock market traders
as a crash in the stock market was ocurring. Figure 5.7 shows that credit
to the traders (demand loans – call money) fell substantially during the
crash and after. However, it is not possible to draw any conclusions
about which way causality flowed during this fall in credit. The scale
of the fall from these data is $2.7 billion but more comprehensive data
suggest the fall in credit was as much as $3.5 billion. These are therefore
sizeable flows of funds relative to the size of the market.
167
Table 5.1 Securities loans in 1929 (millions of dollars)
Date New York From Date New York From

banks and others banks and trust others
trust companies companies (time)
(demand)
Jan. 29 5043 939 Jan. 29 621 132

Feb. 29 5034 914 Feb. 29 584 145.9
Mar. 29 5231 979 Mar. 29 482 112.3
Apr. 29 5154 1050 Apr. 29 427 144.3
May 29 5061 1039 May 29 422 143.7
June 29 5333 1111 June 29 464 163.3
July 29 5705 1165 July 29 449 154.9
Aug. 29 5962 1200 Aug. 29 530 190
Sept. 29 6543 1289 Sept. 29 534 183
Oct. 29 4639 599 Oct. 29 674 197.1
Nov. 29 2873 424 Nov. 29 559 160.7
Dec. 29 2883 494 Dec. 29 487 126
new renew street 180 day time money

12
10
8
Percentage
0
ep
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ct
ov
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-O
-N
-S
02
04
06
08
10
12
14
16
18
20
22
24
26
28
30
30
01
Date
Figure 5.6 Money market rates (October 1929)

Source: Commercial & Financial Chronicle (Oct./Nov. 1929).
Volume/shares
18000000
16000000
14000000
12000000
Shares
10000000
8000000
6000000
4000000
2000000
0
ct
ct
ct
ct
ct
ov
ov
ov
-O
-O
-O
-O
-O
-N
-N
-N
01
08
15
22
29
05
12
19
Date
Figure 5.7 Daily NYSE volume (1929)

Source: Commercial & Financial Chronicle (Oct./Nov. 1929).
Because call money rates did not increase during the crash, as we
would expect if demand for loans were constant and supply was quickly
retracted, the money market rates shown in Figure 5.6 imply that no
forced retraction ever occurred in 1929. We see no spike in rates around
the time of the crash. This indicates, on the surface, that adequate credit
was reaching investors and traders during the crash. However, a deeper
examination of the market’s credit supply shows that there was a forced
retraction of credit on a very large scale, amounting to $1 billion, but
that the New York banks stepped in to fill this void by taking over the
leveraged positions of traders to avert a crisis. We discuss the entire
question of whether the credit retraction caused the crash in the next
section.
Did a liquidity crisis cause the October crash?

It is plausible to argue that the reason why stocks went up so much in
the 1920s, beyond the level justified by the growth in nominal divi-
dends, which we have documented throughout the book, was due to a
fall in the required return on stocks, and by extension, a fall in the ERP.
Alternatively, high expectations of future returns may have increased
stock prices.
As we already know from earlier tests, there was no risk premium

based, systematic change in valuation ratios from 1927 to 1929, the
period of the boom, which cannot be explained in our simulations of
feasible growth and the historical ERP.
The tests conducted earlier point towards an overvaluation of stocks.
As set out in the methodology, we wanted to establish if the market
crashed from potentially feasible values due to some other factor. If we
can prove that a shock to the credit system caused the market to fall,
there may be grounds for thinking the market was at a feasible level in
1929. In the opposite case, we can exclude the ‘credit shock’ hypothesis
from our list of potential causes of the crash.
We therefore take an innovative look at whether an exogenous shock
to credit caused the crash which would potentially have disturbed legiti-
mate changes in the valuations for stocks.
Ivan Wright’s ‘Loans to Brokers and Dealers for Account of Others’
(1929) makes explicit reference to the idea that outside lenders, spe-
cifically corporations would be quick to withdraw funds from the call
money market when the cost of funds equalled the call money return.22
Such a threat may have been the motivation behind the raising of the
margin requirements by brokers before the crash (Rappoport and White,
1994), on the understanding that there was a threat of a ‘liquidity
shock’ or an overvaluation of stocks. Haney et al. (1932: 165) find that
in late 1929, when the market declined, non banking and out of
town lenders hastily withdrew their funds, forcing the NY banks
to expand their loans to brokers in order to prevent an utter credit
debacle. Whether their withdrawals were chiefly the cause or result
of the decline in the stock market cannot perhaps be determined
statistically. During the market decline their withdrawals apparently
coincided with the decline in the call loan rate.
On the other hand it should be observed that during the weeks end-
ing Nov 4 and 12, the rate (call money) was at 6 per cent, while loans
for ‘the account of others’ and total brokers loans declined steadily.
This tends to indicate that at such times as this, fear, coupled with a
declining stock market, is more potent in determining a withdrawal
of loans by others than is a decline in the call loan rate. European
lenders in our market were made very nervous by critical conditions
on their own stock exchanges and other occurrences at home.
Haney et al.’s insight is valid in its injection of a note of caution into

determining the flow of causality from the fall in the call loan rate to
the withdrawal of funds and the collapse of the value of shares. The
Commercial & Financial Chronicle (November, 1929), the main financial
publication of its day in New York, made specific reference to the cause
of the collapse in prices in October 1929:
At the end of September the market was exceedingly weak, and this
weakness extended into October. The market now suffered numerous
bad spells, and they came with increased frequency as the month
advanced. But the great mass of the general public still held on and
showed little inclination to get rid of its holdings. There was not the
slightest inclination of mob selling or mob desire to sell. But after the
decline had been going for several weeks there came an entirely new
development, namely the calling of loans on a huge scale, not by the
banks themselves but by the mongrel crowd of outside lenders. The
statement of brokers’ loans issued by the federal reserve for the week
ending Oct 30 furnishes absolute conclusive proof that the flood of
stock which came on the market in a perfect torrent the last ten days
of the month was forced out by the calling of loans on a scale which
itself spelled disaster. This calling of loans, as stated, was entirely by
outside lenders.
In 1931, writing in Wall Street and Lombard Street, Hirst stated:
after the crash several writers, including no less than Prof Irving
Fisher of Yale sought to explain the heavy fall, which had falsified
their predictions of a continued rise, by the theory of mob psychol-
ogy. The price level they declared was not too high, the long bull
market was justifiable and ought to have been extended. Prices fell
simply because a mob of stupid and ignorant speculators all over the
US suddenly took fright and began to sell. This explanation will not
hold water. As a matter of fact the mob of small speculators held on
till the last moment whereas many of the big speculators, being bet-
ter informed and impressed by the selling movements from London
and the continent, began to liquidate in September and unloaded
their holdings in the market, which was consequently weakened.
This weakness was intensified towards the end of September. …
What brought about the final collapse was a new development – the
calling in of loans by the outside lenders. The total amount called in
during the last week of October was computed by The Commercial &
Financial Chronicle at over 2 thousand million dollars. This forced
upon the market a torrent of stocks in the last days of October and so
ruined many thousands of speculators who, having bought on mar-

gin to the limits of their credit, lost everything when their margins
were swept away in this flood of liquidation. (Hirst, 1931: 12–13)
During the large-scale liquidation that occurred in late October 1929

only $1 billion of the total liquidation of $3 billion was taken over by
the large New York banks (Haney et al., 1932). This suggests that stocks
were being sold voluntarily and the credit used to hold them was being
repaid. The New York banks’ ‘taking over’ of leveraged stock market
positions was used by investors who did not want to relinquish their
positions. These traders and investors could not get their desired level
of leverage from non-Federal Reserve System sources, who as we have
seen were not bound by any obligation to maintain financial stability.
The large scale of the liquidity injection by New York banks denotes
a liquidity crisis was occurring. Taken together, the high level of credit
not required by investors shows that they may have been selling stocks
which they realised were overvalued and hence no longer wished to
hold at the high prices in the first two weeks of October 1929.
The offer of liquidity support by the New York banks is indicative that
the banks feared the consequences for financial stability of a large-scale
retraction of lending to investors and traders. The subsequent actions of
the New York Federal Reserve did supply funds to the New York banks,
which had taken over the call loans (Stern, 1988)23 to the extent that
liquidity was needed by investors.
Our data and testing show that the market was overvalued by about
50 per cent and some $4 billion in funds entered the brokers’ loans
market from ‘outside’ or ‘other’ lenders during the overvaluation phase
from 1927 to 1929.
The volume data show a surge in daily trading volumes in the last two
weeks of October, which reflect the crash weeks. As stock prices fell by
40 per cent during the crash, the high volumes reflect selling pressure,
which could not be absorbed by buyers at the prevailing high prices
before the crash began.
In order to test whether the market crash was caused by a retraction
of liquidity or a fundamental reassessment of the value of stocks, we
conducted some simple tests of the ratio of stock prices to credit using
data from Haney et al. (1932).
The total fall in this type of credit was at least $3 billion with aggre-
gate levels of money supply in the economy of $50 billion. To give a
comparison of the scale of the actual fall in the level of credit, as of
2007 reconstructed M3 in the USA was $11 trillion, thus a 5 per cent
Price/Credit Ratio without NY Bank Injection Price/Credit Ratio Index
1.4
1.2
0.8
Ratio
0.6
0.4
0.2
0
1926.01
1926.03
1926.05
1926.07
1926.09
1926.11
1927.01
1927.03
1927.05
1927.07
1927.09
1927.11
1928.01
1928.03
1928.05
1928.07
1928.09
1928.11
1929.01
1929.03
1929.05
1929.07
1929.09
1929.11
Date
Figure 5.8 Ratio of Cowles (1938) Index to Credit Index

Sources: Cowles (1938), Haney et al. (1932), and author’s calculations.
contraction of this magnitude would equate to $550 billion in nominal

2007 dollars.24 This volume if ‘forced out’ of the market by panicking
money market lenders could have triggered a crash, as the magnitude
is large.
Figure 5.8 shows the ratio of stock prices to credit from the NYSE
and both Reserve and non-Reserve member banks and shows both the
ratio of prices to credit when we exclude the injection of call money by
the New York banks for their own account in October 1929. This rescue
was organised because of the potential effects of the instability of credit
and their concern about the effects of a credit crisis on market values.
Adding the measure of the New York bank injection in October 1929
reduces the change in the ratio seen during the crash. This indicates
that ample credit was supplied by the New York banks to investors who
desired liquidity via the New York banks’ own accounts. The ratio does
increase by 25–30 per cent from October to November even with the
New York banks’ injection, which indicates some forced selling could
have occurred but this is within our tolerance range given the ratio’s
historical levels. Investors may simply have been becoming less aggres-
sive. The ratio change is 50 per cent higher when the New York bank
liquidity support is not included and we therefore do not see a major
credit-induced shock occurring.
Although the credit panic may have become a focal point for selling
and the money market was a clear source of instability for the market,
the New York banks were able to allow investors to maintain their
desired levels of credit. Hence the crash appears to have been driven
by a fundamental re-evaluation of the worth of stocks, or at least not
an exogenous credit shock that forced the crash. The analysis suggests
investors were, for the most part, selling overvalued stocks on a deliber-
ate basis. One area that cannot be ruled out entirely is that the crisis was
a focal point for sellers in a market which they thought was overvalued
and may explain the scale of the sell-off, despite the overvaluation
we find.
Summary
The boom occurred in tandem with a rise in the level of credit to inves-
tors and traders, but this rise seems to have reflected the normal level
of desired leverage by investors. The Federal Reserve Board were very
concerned about the level of the stock market and believed that ‘credit’
had become excessive. We know that credit availability increases the
tendency for bubbles to form in the laboratory and hence the availabil-
ity of credit in general may have propagated the formation of a bubble.
It is worth remembering that credit costs were high in the late 1920s, at
an average of 200 basis points over the central bank rate.
The Federal Reserve restricted banks from lending to traders and
sources of unstable lending developed as a type of regulatory arbitrage.
The flow of credit was from investment trusts, investors, and foreign
banks facilitating covered interest arbitrage, but a large percentage came
from US corporations. The key question is whether the crash was caused
by a credit retraction from these unregulated sources.
The data suggest that although these funds were unstable and the
withdrawal of funds was based on high profits to lending, the crash was
a function of the desire of investors to sell, rather than being forced to
sell as the funds, which were retracted by these ‘others’, were offset by
the actions of the New York banks. Such an observation leads to the
conclusion that the crash was not generated by an exogenous shock
and the crash is consistent with the reversal of a bubble in stock prices.
6
The Great Contraction of
1929–1932 and the Value of Stocks
The Great Depression, and what caused it, was famously dubbed ‘the
holy grail of macroeconomics’ by Ben S. Bernanke, the former Chairman
of the Federal Reserve Board (Bernanke, 1995). This period is of great
interest to economic historians and financial economists due to the scale
of the crises which occurred at that time, the global dimensions, and the
complexity of understanding how the Depression developed.
Although we have found that the levels of stock prices were excessive
ex-post, given the data available to investors, the results of the exten-
sive theoretical modelling and econometric testing we conduct show
that the Crash from 1929 to 1930 was a return to the level expected in
our models. The broad market appears to have been up to 50 per cent
overvalued.
The subsequent crash in stock values from 1930 to 1932 is probably
why the period has become infamous. In this section we look at how
and why stocks fell to the lows in 1932. The fall in stock prices is linked
to the severe recession known as the ‘Great Contraction’ and the scale
of the collapse was over 80 per cent from 1929 to 1932.
The period from 1930 to 1933 reflected an economic shock of unprec-
edented magnitude that has not been repeated in US history, and as
we can illustrate about twice the size of anything the US economy had
faced in the 30 years before (Figure 6.1). Our focus is on the behaviour
of the US stock market during this period and we leave to one side
explanations of how the Depression formed, although we provide an
outline of some drivers thought to have been at work. We need to
answer three major questions about the valuation of stocks:
1. Were valuations feasible in 1930, given the ex-post returns we have

collected on the long-term ERP, and the ex-ante models we have built?
174
The Great Contraction 1929–1932 175
140.0
120.0
100.0
80.0
Index
60.0
40.0
20.0
0.0
1899-01-01
1900-09-01
1902-05-01
1904-01-01
1905-09-01
1907-05-01
1909-01-01
1910-09-01
1912-05-01
1914-01-01
1915-09-01
1917-05-01
1919-01-01
1920-09-01
1922-05-01
1924-01-01
1925-09-01
1927-05-01
1929-01-01
1930-09-01
1932-05-01
1934-01-01
1935-09-01
1937-05-01
Date
Figure 6.1 Index of US business activity (1899–1937)

Source: NBER Macrohistory Database (1938).
2. Why did stock values fall during this period?

3. Was the market undervalued at the trough of the market in 1932?
We know that by middle to late 1930, eight to twelve months post-

crash, the overvaluation in the aggregate data is no longer apparent.
Tests of the long-term ex-ante and ex-post risk premium imply that
valuations were feasible in 1930.
From our perspective the market seems valued at levels pre-1927
which are consistent with our model from Chapter 4. This level of valu-
ation was again reached in 1930, and the valuations seem consistent
with our model on the assumption that no forecast of the impending
Great Contraction was lowering valuations in a major way. An implied
ERP of 4 per cent using the aggregate market level suggests fair values in
1930. The events of 1930–2 were not easy to predict and there is much
to suggest investors were not irrational to have valued the market at the
levels we find in 1930. Dominguez et al. (1988) illustrate that econo-
mists did not forecast the Great Contraction.
The Great Contraction was of an order of magnitude twice that of
other large recessions in the previous 30 years. There is much debate
on whether the shock was avoidable by central bank intervention and
what actually caused the shock – the credit/monetary hypothesis of
Bernanke (2000) and Friedman and Schwartz (1963) is that credit and

monetary contraction due to the failure of banks and eventually the
entire banking system, which could have been saved by prompt action
to provide liquidity or organised closure, and by maintaining price
stability, led to credit frictions and deflation. Thus, the view offered by
Friedman and Schwartz (1963) was that a recession of a common variety
evolved to become a Great Depression.
The alternative view, led by Temin (1976), argues that there was a
pronounced recession before the monetary/credit effects had become
apparent and that causality flowed from the real economy to nominal
income rather than from money to the real economy. This is a theory of
a demand-led contraction, which was severe and was later exacerbated
by the 1931 crisis. The 1931 crisis forced the raising of interest rates in
the USA and a banking system contraction due to an exogenous shock
from Europe as the UK was forced off the Gold Standard.
Eichengreen (1992) argues that the Federal Reserve was bound by the
‘fetters’ of the Gold Standard to prevent the effects of the international
crisis in 1931 when the UK left the Gold Standard. This interpretation
suggests the Federal Reserve was constrained by the Gold Standard and
that real factors plus an inability to prevent the contraction brought
about the severity of the Great Contraction.
The difference of interpretation between the demand side and money/
credit arguments stems from the role of the central bank. Friedman and
Schwartz (1963) argued that the central bank could have stopped the
Great Contraction by liquidity support, bailouts, and timely resolution of
insolvent banks, to prevent a problem for the US banking system becom-
ing systemic. This analysis extends to the 1931 crisis, which was thought
to have been preventable due to the existence of sufficient gold reserves
and an ability to prevent the effects of the 1931 crisis reaching the USA.
Much subsequent and ongoing research on the Depression suggests
that both schools of thought have merit and those interested in the
mechanics of severe recessions accompanied by banking crises should
consider both approaches together.
The research does not challenge any of these views directly as our aim
was to focus on the valuation of the stock market. The actual causes of
the Great Contraction are therefore better thought of, at this stage of our
knowledge, as the interaction of both monetary, credit, and real factors.
What seems to emerge as a consensus, taking the current research into
account, is that high levels of debt in the consumer sector, deflation,
and banking problems all played key roles in the period. The idea that
the real economy contained so much debt in the hands of consumers,
who were vulnerable to an economic downturn and the potential crea-

tion of a ‘doom loop’, between consumer mortgages and the banking
system, has merit. Such a feedback process between a demand shock
and subsequent increases in unemployment and economic contrac-
tion, which led to debt default and a banking system crisis generated
internally, is worthy of further investigation. However, the scale of
contraction, even under such a process, seems unusually large for this
demand-led explanation alone. For both schools of thought, the global
banking crisis of 1931 seems to be a key driver of the scale of the Great
Contraction although they differ in how the shock was transmitted to
the real economy in the USA.
In the following sections we investigate the downswing in stock
prices and the underlying drivers of these changes.
Real and nominal earnings and dividends

Nominal dividends appear to have been one major driver of lower stock
prices (Figure 6.2). However, the Great Contraction also produced P/D
ratios that were lower than the fall of dividends would suggest. Therefore,
what we must also account for is another driver of the fall in stock prices.
Valuation ratios were at a level of 19.2 in 1927, where we have already
Prices Dividends
400
350
300
250
Index
200
150
100
50
0
1922.12
1923.06
1923.12
1924.06
1924.12
1925.06
1925.12
1926.06
1926.12
1927.06
1927.12
1928.06
1928.12
1929.06
1929.12
1930.06
1930.12
1931.06
1931.12
1932.06
1932.12
1933.06
1933.12
1934.06
1934.12
1935.06
Date
Figure 6.2 Nominal dividends and prices

Real Dividends Real Earnings
25.00
20.00
Dividends/Earnings
15.00
10.00
5.00
0.00
9-1-29
1-1-30
5-1-30
9-1-30
1-1-31
5-1-31
9-1-31
1-1-32
5-1-32
9-1-32
1-1-33
5-1-33
9-1-33
1-1-34
5-1-34
9-1-34
1-1-35
5-1-35
Date
Figure 6.3 Real dividends and earnings (1929–1935)

Note: The y axis shows dollar values accruing to the index of US stocks from Cowles (1938).
established fair valuation according to our models. This level was again
reached in mid-to-late 1930. The rise in the riskiness of stocks, which is
captured in the DDM, or a lower expectation of future growth rates are
potential causes, which we look at using a sensitivity test of our model.
As can be seen in Figure 6.3 the 1929 crash predates the fall in real
earnings and dividends. As the economy contracted, real earnings and
dividends show the market slump reflected a severe real economic con-
traction in the USA. The decline was marked for the 1929–32 period.
The graph shows the behaviour of the Cowles (1938) Index adjusted for
the decline in the Consumer Price Index. The Real Dividend Index fell
by approximately 35 per cent by 1933. The market trough in June 1932
occurred before the real and nominal dividend indexes had reached their
lows. Nominal dividends fell by approximately 60 per cent by 1933.
The implied return on stocks and growth

at the market low in 1932
The rise of the Yield To Maturity (YTM) for Baa rated bonds in 1932 to
8 per cent reflected increased default risk due to the Great Contraction
LONG TERM US T-BONDS AAA CORPORATE BONDS

A CORPORATE BONDS BAA CORPORATE BONDS
6
Yield to Maturity %
0
9-30-20
9-30-21
9-30-22
9-30-23
9-30-24
9-30-25
9-30-26
9-30-27
9-30-28
9-30-29
9-30-30
9-30-31
9-30-32
9-30-33
9-30-34
9-30-35
9-30-36
DATE
Figure 6.4 Long-term bond yields (1920–1936)

Source: Global Financial Data (2009).
(Figure 6.4). The expected return on stocks could potentially have risen
to reflect higher bond risk premiums during 1931–2. Although we do
not perform cross-sectional tests we can model the market low in 1932
in terms of this higher risk premium on stocks.
The expected return on stocks, which we can derive from our con-
stant growth DDM, and which assumes dividend growth expectations of
1.3 per cent measured in our earlier tests in Chapter 4, was 15.5 per cent
in 1932 based on a P/D ratio of 7 at the trough of the market (Figure 6.5).
Although we do not test for the causes of the rises in the Government
and Corporate Bond yields, they imply that financial assets were riskier
across all asset groups due to the ongoing recession and the impact of
35
30
25
20
Ratio
15
10
0
1926.01
1926.05
1926.09
1927.01
1927.05
1927.09
1928.01
1928.05
1928.09
1929.01
1929.05
1929.09
1930.01
1930.05
1930.09
1931.01
1931.05
1931.09
1932.01
1932.05
1932.09
1933.01
1933.05
1933.09
1934.01
1934.05
1934.09
1935.01
Date
Figure 6.5 P/D ratio (1926–1935)

the 1931 crisis on the US banking system. The rise in the risk of other
financial assets appears to have driven the P/D ratio of the aggregate
stock market to lower levels. Assuming that the expected return on stocks
would have risen from between 6.5 and 7 per cent, by the same amount
as the Baa bond yield from 1927 to 1932, we can estimate an expected
return on stocks which was 3 per cent higher, at 9.5–10 per cent.
Therefore we can see one potentially rational model that would
generate large falls in valuation ratios to a level of 11.6–12.4 in 1932.
This model does imply, by design, that investors did not, or could not,
forecast long-term trend levels of dividends.
Alternatively, a contraction in dividends from the level they had
fallen to in 1932, implied by a P/D ratio of 7, was a dividend growth
expectation in 1932 of minus 4 per cent per annum, using our DDM and
an expected return on stocks of 10 per cent that reflects the rise in the
yield on other assets. This is a forecast of a level of real dividends of
zero per cent of the original level over an 80-year horizon. Such a pes-
simistic forecast implicit in prices potentially reflected an ‘Armageddon
scenario’ for the USA, which we cannot assess, ex-ante, but seems exces-
sively negative.
These tests revealed that the low in 1932 was some type of ‘anti-bubble’
or extreme pessimism about stocks, which appears to be the product
of irrational fear but which persisted for a period of three to six months.
However, it may also be the case that credit flows were disrupted during
the 1931–2 period and that stocks were sold due to a credit crunch and
therefore not due to fear but rather lack of access to finance.
Using these assumptions we can show that the model we built, if used
by investors, cannot replicate the fall in the market index from Cowles
(1938) to a level of 7 (P/D) on the basis of the higher risk implicit in all
financial asset prices. We would expect a P/D ratio of 12 in June 1932
assuming that the expected return on stocks rose in line with Baa rated
bonds.
To provide an alternative perspective to questions of undervaluation
of stocks relative to fundamentals we employed a method that looked
at book to market ratios for a broad sample of US stocks from the CRSP
database.
Figure 6.6 shows the book to market capitalisation ratio for the entire
sample of CRSP data on US Common Stock prices and shares outstand-
ing that have corresponding data on book values from French (2014).
We derive an aggregate market value and an aggregate book value to
test the time series behaviour of ‘book to market ratio’ for the US stock
market. These simple time series data from 1926–46 illustrate the degree
to which the market changed before, during, and after the boom and
crash. The very high values during the crash in 1932 reflect stocks in
2
1.8
1.6
1.4
1.2
Ratio
1
0.8
0.6
0.4
0.2
0
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
1942
1943
1944
1945
1946
Year
Figure 6.6 Book to market ratio of CRSP stocks (1926–1946)

Sources: CRSP and Book Value Data (French, 2014).
the USA collectively trading at well below their values at liquidation

and point to an undervaluation of these firms. What these data mean
theoretically is that selling these companies off would have generated a
return in excess of the market value.
These data corroborate the undervaluation we find using our DDM
where we used time-varying risk premiums estimates, which find a 35 per
cent undervaluation. Our book to market values appear to deviate heavily
from their mean values during the crash. Our data are taken using year-
end values and hence do not fully capture the true book to market value
in mid-1932. Nonetheless, we can see that stocks traded well below their
book values during the 1931–2 period. Using our data we can see that
stocks appear to have been undervalued by at least 45 per cent.
These data suggest that markets for Common Stocks appear to have
been functioning partially during the 1930–2 period based on the
assumptions of a DDM and no perfect foresight of the actual trend level
of dividends for stocks. Investors therefore seem to have been updat-
ing their valuations on the basis of current levels of dividends, using a
growth expectation from that level of dividends, rather than forecasting
the long-term trend position or mean reversion of dividends to the long-
term trend position. We cannot know whether assuming that dividends
would revert to their mean path was feasible or not. Therefore we can
only offer an explanation as to why the valuations of stocks fell to the
extent they did, and also show that the low in 1932 seems unjustified.
The fall of prices of stocks most likely reflected the fall in nominal
dividends, caused by the economic contraction, and a higher ERP due
to risk perception increasing for all financial assets. The residual fall
cannot be accounted for in our model. Whether investors should have
known that stocks would ‘mean revert’ to their long run historical divi-
dend growth path over the very long term is not obvious, as this would
imply knowledge of the future path of dividends rather than the esti-
mate of the growth of dividends from a particular point. We therefore
base our model on growth of 1.3 per cent from the level of dividends
in 1932. Even using this assumption our model finds a 35 per cent
undervaluation of stocks in 1932 that is consistent with the apparent
undervaluation shown in the book value data.
The recovery in the yields on bonds from 1932–5 in Figure 6.4 seems
to match the fall in the required return on stocks, back to levels con-
sistent with our models of the long-term ERP. The book value data also
indicate a return to pre-boom levels by 1935.
We cannot resolve clearly whether the final phase of the 1930–2
crash should be seen as abject pessimism in stocks, or in the modern
terminology on ‘bubbles’ as an ‘anti-bubble’. Using the discount factor
linked to the yield on other financial assets, although rational, may not
have been the best way to value stocks in the 1930s but this and the
data on book to market ratios suggest that investors were unduly pes-
simistic about stocks.
The real economy

In this section we investigate some of the salient features of the 1929–33
period. As stated earlier, we do not aim to explain the causal flows of
the Great Contraction. What we do offer is the current explanations
for the processes, which led to dramatic contraction over such a short
timeframe. The Federal Reserve Board’s policy, the deflation, and a
banking system crisis in 1931 are all interesting features of this period
and are relevant to understanding why the contraction was so severe
(Fisher, 1933; Bernanke, 2000). We suggest that a large recession which
was already underway in the USA turned into a mega crisis due to an
exogenous shock in 1931.
The real economy from 1929 to 1933 was affected to some degree by
the stock market’s fall in value. This is likely from two major channels.
These direct factors were:
1. The October crash’s impact on demand in 1929–30 where investors

delayed purchases of consumer durables due to a shock factor and
the signal of impending recession.
2. Losses to investors which suppressed consumption through a
wealth effect over 1929–32.
We do not delve deeper into these areas but these are important areas
for future research. Our focus has been the fall of stock prices and in the
discussion below we show the fall in real earnings and dividends and
extract some estimates of an increase in the ERP at the market low in
1932. We attempt to offer the reader some important key data on the
Great Contraction from 1929 to 1932.
During the 1929–30 recession real GDP fell by 8 per cent. The cause of
the fall in prices was initially due to a fall in aggregate demand. In total,
real GDP fell by 24 per cent by 1933. Romer (1993) suggests that the
crash itself played a major role in the initial downturn in demand due
to high levels of uncertainty generated by stock market volatility. This
is a pattern noted through the pre-war era and relates the stock market
shock to real economic declines. Unemployment rose dramatically from
2 per cent in October 1929 to 11 per cent in December 1930, reflecting
a real economic downturn that was severe. In total, unemployment
reached 25 per cent in 1933 (Federal Reserve Bank of St. Louis, 2014).
Figure 6.7 shows the monthly change in the Consumer Price Index
from 1929 to 1937. It is worth noting that deflation of 1 per cent per
month is large enough to have major effects on real activity. The deflation
can clearly be seen and was of the order of 25 per cent from 1929 to 1933.
Price falls can have real effects. As the price level fell there were three
real effects:
1. Debt deflation – existing debt grows in real terms during a deflation.

2. Real interest rates are positive at the zero nominal rate bound and
borrowing is more difficult as the real cost of borrowing is high for
companies and consumers.
3. Consumers delay purchases due to anticipated future falls in price.
Analysis of the real earnings decrease of companies must include

these factors as well as the fall in demand and credit frictions. Key links
between the real economy and the financial system, which affected the
severity of the crisis, were the high levels of mortgage debt concentrated
in the consumer sector and the concentration of these assets in the
hands of the banking system. In this way the real downturn in demand
lowered earnings, and also created problems in the banking system, as
distressed borrowers had problems servicing the interest on their loans,
4.00
3.00
Monthly Percentage Change
2.00
1.00
0.00
–1.00
–2.00
–3.00
1929.04
1929.37
1929.71
1930.04
1930.37
1930.71
1931.04
1931.37
1931.71
1932.04
1932.37
1932.71
1933.04
1933.37
1933.71
1934.04
1934.37
1934.71
1935.04
1935.37
1935.71
1936.04
1936.37
1936.71
1937.04
1937.37
1937.71
Date Fraction
Figure 6.7 Monthly change in Consumer Price Index

which increased credit frictions due to bank stress and the outright fail-
ure of many banks (Bernanke, 2000).
White (2009) uses an improved House Price Index to show a bubble of
20 per cent in the 1920s which peaked before the stock market, which
is significant for the effects of the downturn on aggregate demand.
Figure 6.8, which uses older data than White (2009), indicates that
prices, in aggregate, were generally stable through the 1920s but fell
during the crash.
These data are corroborated by the House Price Indexes from
Wheelock (2008). Non-farm residential mortgage debt increased sharply
relative to non-farm residential wealth during the 1920s and continued
to rise until 1932. The Great Contraction from 1929 to 1933 resulted in
very high levels of default by 1934. One estimate places arrears at over
40 per cent of all residential home loans in 1934 (Wheelock, 2008).
Indebtedness of consumers and a deflation, which lowered collat-
eral to loan ratios for borrowers, known more commonly as ‘negative
equity’, may have created a strong negative effect on demand through a
wealth effect and a desire to reduce debt by using income. What we do
know from previous research (Mishkin, 1978) is that the scale of the
‘real’ debt burden on households rose to very high levels during the
period, via increased real debt servicing costs, as mortgage repayments
5
index 2008=100
0
Ja 00
Ja 02
Ja 04
Ja 06
Ja 08
Ja 10
Ja 12
Ja 14
Ja 16
Ja 18
Ja 20
Ja 22
Ja 24
Ja 26
Ja 28
Ja 30
Ja 32
34
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
Ja
Date
Figure 6.8 US House Price Index (1900–1935)

were fixed in nominal terms, and the total real debt liabilities of US
households increased.
For our research we are purely concerned with looking at what hap-
pened to the value of US stocks and whether the shock was expected,
and hence whether the market was rationally priced. What we can see
from the data is that the fall in prices of Common Stocks had two major
components:
1. The fall of nominal dividends.

2. An increase in the riskiness of stocks (ERP) or fall of the expected
dividend growth rate.
Conclusions
The Great Contraction phase produced a large fall in stock prices and
valuation ratios. It is not clear whether these changes were justified. One
plausible cause was the rise in the risk premiums on other financial assets.
Another was the fall in nominal dividends.
Assuming that our assumptions of fundamentals are correct, this still
leaves a residual component that cannot be explained by the factors in
our tests. There appears to have been an ‘anti-bubble’ – or undervaluation
of stocks relative to fundamentals. This can be seen using both the DDM
we build and Book to Market data from CRSP and French (2014). In both
cases an undervaluation of 35–40 per cent appears as a feasible conclusion
regarding the market trough in June 1932. Whether the observed under-
valuation was due to pessimism, and hence a behavioural phenomenon
cannot be firmly established but similarly the data do strengthen the
possibility that such a behavioural effect was present.
7
Conclusions
The research was designed to answer an enduring question in eco-

nomic and financial history and was motivated by a desire to provide
additional data to Cowles (1938), the raw data for which were stored
on Hollerith cards, which were lost (Goetzmann and Ibbotson, 2006).
We also wanted to test theories not amenable to the use of the CRSP
database, which lacks earnings data and begins in 1926 and find new
measures of Common Stock returns from the 1920s over the long run.
We relied heavily on the approaches of Shiller (1981) and Goetzmann
and Ibbotson (2006) to build our valuation models but we use new data,
which act as a confirmation of the results of these approaches to testing
for market efficiency in the 1920s.
The 1920s should be seen in the first instance as a boom generated
by the credit expansion of the post-1915 period, which caused large
and legitimate rises in nominal earnings and dividends. This change
occurred at a time before the USA leapt into a new high productivity
phase from 1928 to 1950 (Gordon, 2010). There cannot be much doubt
that there was an underlying productivity surge in the making in the
1920s and this was a potential source of legitimate enthusiasm for the
expected returns to stocks. Another question the research aimed to
resolve was whether this productivity change and the new innovations
of the 1920s actually increased the returns to Common Stock investing
from 1925 to 2010. We conclude that an obvious change did not occur
and further, that an investor in 1925 would have earned an Equity Risk
Premium which was very similar to that expected based on long-term
history from the 1870s to 1926. Our major conclusion is that an ex-post
bubble can be seen according to long-run dividend growth rates and
long-run returns to Common Stocks. Furthermore, there appears to be
no systematic bias in the bubble phase. Whether an ex-ante observable
187
bubble formed relies on the results of Shleifer and De Long (1991) who
find evidence that valuations were too high. We also find evidence from
Nicholas (2008) which combined with our additional tests indicate that
a legitimate ex-ante change in stock values could have occurred. We also
do not reject Shiller’s (2000) idea that rises in prices led to an ex-ante
observable bubble as investors came to expect higher future returns at
the aggregate level.
The first stage of the research was to look at the effects of the monetary
and debt dynamics of the 1900–29 period on the earnings, dividends,
and prices of US stocks. We explain the reasons for the underlying boom
as a debt expansion of a large magnitude, as a result of the gold flows
into the US banking system during the First World War, which created
a significant expansion of the monetary base and hence the amount
of lending possible. The banking system was required by the Federal
Reserve to have a certain level of gold relative to its deposits and in this
period of passive monetary base expansion, the Federal Reserve Board
did not sterilise the flows of gold.
This expansion in the monetary system was, overall, neutral in terms
of the debt to income ratio of the private sector; however, this aggregate
identity hides a definite shift in the composition of private debt towards
the household sector and the commercial real estate sector, due to a
nationwide house building, and commercial real estate construction
boom. There was a net rural–urban migration of 8 million people from
the farming areas to urban centres following the First World War, from
a total population of 120 million. A localized bubble in major centres
such as New York (Nicholas and Scherbina, 2013) and a general bubble
in real house prices of 20 per cent (White, 2009) seem to have formed
during a large increase in commercial and residential construction
across the USA (Kuvin, 1938; Goetzmann and Newman, 2012).
The concentration of debt in the consumer sector led to problems
from 1929 to 1934 as nominal house prices fell substantially and unem-
ployment rose, which led to a high rate of default. Wheelock (2008)
estimates 40 per cent of non-farm mortgages were in arrears in 1934.
Fixed nominal debt relative to falling nominal income created problems
of debt servicing and wealth effects.
In addition to the effects on the housing market, the credit and price
level increases raised the nominal earnings of companies. The economic
dynamics of the time meant that price level increases raised nominal
profits of firms, although this full effect had a time lag of about ten
years due to a severe deflationary recession in 1920–1. The 1920s were
a time of low and stable prices following the price level surge of the
Conclusions 189
1915–20 period. During the 1920s the delayed effect of this wartime
inflation on nominal earnings appeared as a surge in the growth of
earnings and dividends of stocks.
The increased earnings of US companies led to a perfectly normal
increase in the prices of stocks from 1921 to 1927. In inflation-adjusted
terms the earnings and dividends of US stocks did not show any ten-
dency to deviate from their expected real growth path and can be
seen as a reaction of stock prices to nominal changes in earnings and
dividends. The large rise in nominal stock values during the 1920s,
where returns were 24 per cent per annum before the 1927–9 phase,
reflected the genuine underlying changes of the economy, which were
monetary in nature. Such large increases in values may have encour-
aged investors.
Our methodological approach consisted of the use of long-term
equity return data to calibrate a DDM to value the stock market in the
1920s. A major part of the research involved testing the long-run ERP
both before and after the 1920s. We find that investors seem to have
demanded compensation for the excess volatility of returns over the
risk-free asset for stocks of about 4 per cent, which is close to the esti-
mates for the long-run realized ERP of 4.2 per cent over the long run
before 1926, and the 4 per cent ERP we calculated from Smith (1924) for
his data from 1866 to 1922.
In order to replicate the dividend growth rate expectation of inves-
tors over the long term before 1929 we measured dividend growth
rates over 1900–29 for a large cross-section of commercial and indus-
trial firms using data that were available to investors in the 1920s, and
methods of valuation known to be in use at the time (Smith, 1924).
We used the new database of dividend growth rates in the constant
growth DDM to estimate fair values in 1927–32. This model used the
historical ERP before 1926 and the dividend growth rate from our
database. The growth rate we found was 1.3 per cent per annum over
the 30-year sample and we assume this rate can be expected over
the long term as a dividend growth rate for the market index of US
Common Stocks.
This assumption is derived from the methods used in Smith (1924)
and follows the method of Shiller (1981). We used the DDM to find the
expected level of the stock market via its Price/Dividend ratio generated
from the DDM.
We compared the expected level of stock valuations to the actual P/D
ratios at the market peak to quantify the scale of the overvaluation, using
a 200-firm cross-section from The Commercial & Financial Chronicle and
using Cowles’s (1938) data. Having established fair values for the aggre-
gate market of US Common Stocks, and the levels reached in 1929, we
find an overvaluation of 50 per cent.
We were also able to measure the growth rates of dividends expected
in 1927, from before the alleged bubble, by taking the P/D ratio of the
market and solving for the growth levels implied from the DDM. We
needed to test whether the changes from 1927 to 1929 were due to a
rational forecast of the future growth of dividends due to some factor
unobserved in our model. We collected new data on live returns to
an investment fund, which mimics the market portfolio from 1925 to
2010. We constructed a total return rate, which was 3.4 per cent on a
geometric annualised growth rate basis. Such a return is close to the
expected level of the historical ERP of about 4 per cent. The 3.4 per cent
realised return for the market, which we measured from the returns
from 1925 to 2010 suggests that investors were savvy in the 1920s
before the boom, but in 1929 they seem to have over-predicted the
growth of dividends in the future.
Any fundamental changes to the returns to stocks that may have
occurred must be seen in the light of the realised returns data which
showed no such exceptional growth was forthcoming that could justify
the high valuation ratios in 1929. The sensitivity analysis of the DDM
showed that peak market valuations implied dividend growth rates of
3–4 per cent, which were not feasible given both measures of return
expectation and realised returns.
The ‘perfect foresight’ valuation test of our DDM, assuming the realised
returns were used to price the market in 1927, required a 1.2 per cent
dividend growth rate. Our estimate based on dividend growth history
was 1.3 per cent from 1900 to 1929. Cowles’s (1938) data measure a
1.25 per cent growth rate over the long run from 1871 to 1927. Therefore
by all our measures the growth expectation implied by 1929 valuation
ratios of 3–4 per cent was very high relative to ex-ante and ex-post meas-
ures using a variety of assumptions.
Previous research, which has tested for a momentum effect (Nicholas,
2008), seems to indicate the possibility of a weak self-feeding bubble
in the cross-section of stocks, which does not appear consistent with
rational valuation methods. However, this view cannot exclude the
possibility of a technological shock as described in Pástor and Veronesi
(2009) where momentum effects would occur during such a shock.
The data on stock market volumes show trading volumes surged in
the 1927–9 phase and fell back sharply after the crash. However, these
data in themselves, although consistent with ex-post overvaluation,
Conclusions 191
could technically reflect a rush to participate in potentially high yield-

ing growth stocks.
The aggregate market was up to 50 per cent overvalued based on our
historical model and subsequent long-term returns to Common Stock
investment. It is very hard to suggest that a deviation from model did
not form in the 1927–9 period, based on long-term ex-ante expecta-
tions, and feasible simulations of expected growth and both the ERP
before the 1927–9 phase and the realised returns. Our results are there-
fore consistent with Shiller (1981, 2000).
The 1920s did precede a new technological era for the USA, and
MPFG did show a marked change in the 20 years following the late
1920s (Gordon, 2010). This was not a large enough fundamental shock
to justify the full amount of the price changes seen based on an ex-post
returns basis. Realised returns do not reflect any major change from
long-term expectation.
Nicholas (2008) finds strong evidence of technological basis for the
excess returns from 1928–9 using patent data. Therefore, there may
have been a legitimate focus on new technology and uncertainty sur-
rounding it, but in terms of realised returns to stocks, does not justify
the prices reached. There is a real possibility that Nicholas (2008) identi-
fies a reason for the boom being initiated as a shock to the equilibrium
value of the stock market as new technologies emerged in the period.
This shock would have had two possible effects. The first effect could
induce a change in the growth potential of the aggregate market, which
was feasible ex-ante. The second was to introduce uncertainty as to
which firms would benefit the most and hence create dispersion in fore-
casts of expected returns to individual stocks. Such effects could have
driven some part of the boom.
To complement the long-run DDM, we also tested one sector which
had potential to be overvalued ex-post but was also a new technology.
The aviation industry was new in the 1920s and has a direct histori-
cal precedent in the auto industry, as indicated by Moody’s Manual of
Investments (1930). We used the models from Moody’s to construct
our own innovative tests of the expected value of aviation stocks
using a large sample of price and earnings data from The Commercial &
Financial Chronicle and Moody’s Manual of Investments (1930). We
calibrated an industrial growth model using the path of the auto
industry as a template for the future growth of aviation stocks, and
compared fundamentals to actual peak market capitalisations. Moody’s
Manual of Investments (1930) showed that investors knew how to
value high-growth new technologies using a two-stage growth model.
Moody’s Manual of Investments (1930) also gave indications as to how

to calibrate the models numerically and estimated the relative stage of
the industry life-cycle, which the new technology aviation industry
was at in 1929.
Peak values were $1 billion in 1929, and our model suggested inves-
tors should have valued the industry at $350 million using our model.
Actual post-crash values in 1930, from which we estimate the rational
valuation of investors, were $200–300 million. We therefore concluded
that there was a large overvaluation of aviation stocks relative to histori-
cal growth and the scale of the overvaluation was 300 per cent. Such a
large deviation indicated that very high expectations could have been
driving valuations.
Our conclusions can be challenged by the idea that this new tech-
nology may have been different from historical expectations, making
our model mis-specified, as an ex-ante test of fundamentals. We have
no substantial basis to reject the idea that aviation stocks could have
had higher growth than history or faced high uncertainty (Pástor and
Veronesi, 2009), and that this caused the boom and crash. For the pur-
pose of our conclusions, individual firms in this industry would have
been difficult to assess and their success uncertain. Without a certain
basis for valuation, it is likely that an ex-ante bubble could form. A key
question emerging from tests of this industry and the aggregate market
is to what degree can uncertainty at the firm, industry, or economy
level, feasibly generate the high levels of valuations seen?
The results of these first two major tests of the broad market and one
industry are new and draw on data not featured in CRSP. To complement
these we also designed a test to look for drivers of the potential overvalu-
ations we found. We tested the cross-section of the market, taken from
a 130-firm sample for drivers of the change in P/D ratios using age, net
current assets, 1927 P/D ratios, risk ratings, and market capitalisation.
We also used earnings and dividend growth rates from 1924 to 1929.
We found one anomaly from 1927–8 where there was a 24 per cent R2
and 1 per cent statistical significance for one-year earnings growth from
1927–8. From 1928–9 there is no detectable effect. Dividend growth rates
were negatively related to the changes in P/D ratio. Although the more
powerful econometric approach to testing for deviations from funda-
mentals is to use the cross-sectional excess returns approach, exempli-
fied by Nicholas (2008), our questions required a non-standard test. The
analysis of the cross-sectional data shows that high dividend growth or
high earnings growth stocks did not achieve the highest changes in P/D
ratios, which excludes naïve extrapolation of these values as a cause of
Conclusions 193
the changes of stocks’ valuations. The conclusion we come to is that

whatever the cause of the overvaluations, they were not due to simple
extrapolation of financial data on stocks. This is a vital result for simplis-
tic interpretation of the overvaluation to be rejected.
We can also exclude the idea that fundamental based investors were
making rational forecasts on the basis of dividends or earnings caused
by the uncertainty of when the underlying expansion would stop.
Therefore, investors were not projecting higher earnings or dividends
on the basis of the trend of earnings or dividends.
Our cross-sectional tests also show that a systematic change in the
ERP was not driving the overvaluation, which contradicts parts of the
accounts of Graham and Dodd (1934).
The sector-level tests showed that the change in P/D ratio during the
overvaluation relative to the change by 1930, when the aggregate over-
valuation had dissipated, showed no correlation. The bubble was not
then a systematic exaggeration of fundamental changes in the value
of stocks assessed by industry type. This illustrates the non-simplistic
nature of the overvaluation.
It appears that our tests of the cross-section of the US stock market
reveal that the weak form of the EMH cannot be rejected and that the
formation of the bubble that we observe ex-post did not follow any
systematic bias that can be clearly seen. The overvaluations we see
may have been the product of a genuine change in the US economy.
However, previous studies such as De Long and Shleifer (1991) seem
to demonstrate that valuations became exuberant when tested against
benchmarks that appear to be highly robust ex-ante.
Following our extensive look at the literature around the 1920s and
1930s and before, relating to asset valuations, we can trace the emer-
gence of a new idea in the 1920s on the returns to stocks over the long
term. Smith (1924) was a revelation to the public about the long-term
return to stocks and may have influenced investors to hold stocks
(Graham and Dodd, 1934; Williams, 1938).
A new asset class based on the ideas of Smith (1924) emerged. Closed-
end funds themselves became subject to overvaluations (De Long and
Shleifer, 1991). They formed rapidly in 1927–9 to satisfy the demand for
holding stocks in a way that reduced the risk profile, or compensation
for volatility, for smaller investors.
Our models indicate these funds were a useful, risk mitigating, theoreti-
cal and practical innovation. We tested whether the emergence of this new
investor group during the boom phase caused the overvaluation. These
funds and other investment trusts did form contemporaneously to the
bubble, increasing in number and funds under management exponen-

tially over the bubble phase to about $7 billion in 1929.
The scale of the funds invested relative to the NYSE volumes in 1929
was about 4 per cent of the total value of shares traded and were not
enough to cause a major impact on prices and therefore we do not see
this source as a major contributor to the boom.
These new funds were a financial innovation, which were potentially
beneficial for investors in spreading risk and earning a long-run ERP
that was estimated to be 4 per cent, a value that has been corroborated
by subsequent studies (Cowles, 1938; Goetzmann and Ibbotson, 2006).
Our estimate of ex-ante ERP was derived from the actual market values
and constant expectation of return per unit excess volatility over
Government Bonds. Closed-end funds were not all good investments
and many performed poorly due to leverage having a severe effect on
them during the crash. Therefore some funds led to large losses for some
investors.
In order to test whether an exogenous shock caused valuations to
fall from 1929 to 1930, assuming the counterfactual scenario of fair
expectations or lower required returns in 1929, we conducted a major
analysis of the credit system in the 1920s. We found some interesting
facts about the emergence of a ‘shadow banking system’ that supplied
funds to traders as Fed policy squeezed liquidity from the market, due to
fears of a credit-induced bubble. This was a good example of regulatory
arbitrage and we find that financial stability was compromised, neces-
sitating the injection of $1 billion during the crash week. By analysis
of the ratio of credit to prices in the 1920s, we set a level of expected
ratios and tested whether the ratio deviated from expectation. We did
this to ensure that a potential source of an exogenous shock was not
the cause of the reversal of a potentially genuine change in valuations.
We found that credit was unlikely to have been the cause of the crash
in prices due to a credit crisis where investors and traders were forced to
liquidate their holdings.
We reject the idea that the crash in 1929 was induced by credit con-
traction by analysis of the Cowles (1938) Index price to credit ratio
when accounting for the injections by the New York banks during the
crash.
The crash in October 1929 was not the direct result of a credit crisis
although the New York banks were forced to provide liquidity on a large
scale and the financial stability of the NYSE was therefore compromised
by the flow of credit from unstable ‘outside’ lenders. We therefore
Conclusions 195
concluded that regulatory arbitrage occurred and was a source of insta-

bility to the NYSE, which required intervention.
The final part of our approach to determining the dynamics of the
boom and bust was to investigate the 1929–32 crash. By 1930, the over-
valuation we found had deflated and 1927 levels of valuation ratios for
the aggregate market had been restored. The 1930–2 crash was a phe-
nomenon which does not directly follow from the overvaluation. The
market appears to have been fairly valued in mid-1930.
The ‘Great Contraction’ from 1929 to 1933 affected the value of
stocks in two ways – falls in nominal earnings and increases in the riski-
ness of all financial assets – which seems to coincide with the increase
in the required return on stocks. We used the Cowles (1938) Index to
measure the fall in earnings and dividends and measure the valuation
ratios of the aggregate stock market.
The value of the aggregate market remained logical to a partial degree,
as dividends fell and P/D ratios fell to reflect higher risk premiums on
financial assets. This fall in the P/D ratio to a level of 7 in 1932 could
not be justified on the basis of our expected real dividend growth rate
of 1.3 per cent or the increase in the ERP due to the increased riskiness
of all financial assets. The ERP could have risen to a level of 7 per cent,
but valuation in 1932 indicates this ERP was 12 per cent. Whether the
fall was actually rational given the long-term return to stocks and trend
levels of dividends is not clear. Shiller (1981, 2000) suggests that there
was an undervaluation of stocks in 1932 based on the ex-post warranted
price. Our models, which assume very little could be actually known
about the future of the stock market and the US economy, estimate a
level P/D ratio of 12 due to higher risk premiums across other financial
assets. Our data on book to market ratios during the trough in 1932
suggest that stocks traded well below their book values at around
35 per cent.
The difference between the actual level of P/D ratios of 7 and the
expected level of 12 in our models cannot replicate the lows in 1932 even
when we assume that dividend growth rate expectations also fell. The
expectation derived from our DDM was a minus 4 per cent per annum
fall in dividends. This would mean no dividends would be paid on the US
stock market over an 80-year horizon, which is unfeasible. This indicates
that the market low in 1932 cannot be explained using rational forecasts
and implies that irrational pessimism may have been present.
A major factor, which needs to be emphasised, is that the scale of the
crash exaggerates what the fair expectation of stock prices were. The
degree of the economic collapse during the 1929–32 period was unprec-
edented, and hence an investor in 1926 was not acting irrationally in
buying stocks, given the subsequent returns they would have enjoyed
through 2010.
The conclusion that we reach regarding the boom has already been
established to a certain degree by academic researchers who are experts in
the field, notably Robert J. Shiller, Eugene N. White, William Goetzmann,
and Roger Ibbotson. Their trail-blazing work demonstrated that the 1920s
stock market was overvalued by a significant margin using historical and
financial econometric methods of substantial power. Our results build
on their insights that such phenomena did occur. These analyses rightly
encourage the further study of what are perhaps the least understood
areas of economics and areas which present future academics with many
interesting questions regarding the true nature of asset bubbles.
Our conclusion is not to condemn the investors of the time by label-
ling them as irrational, as we do not offer enough systematic evidence
to draw that conclusion. We also do not rule out that investors were
irrational. Some non-fundamental beliefs about very high future returns
were potentially driving market prices higher although uncertainty
about which firms would perform well in the new economic era may
have made legitimate ex-ante changes to valuations of stocks.
What we offer at the aggregate stock market level are both rigorous
and long-term tests of the large deviations of stocks from their ex-post
‘fundamentals’. Expectations of returns at the market level were higher
than those observed over the long run before the 1920s and those that
were realized over the long run from the 1920s to 2010. The scale of
the overvaluation relative to these measures was 50 per cent for the
broad market and our simulations of potential growth suggest a bubble
formed on an ex-post basis.
The stock market boom bears all the hallmarks which have been iden-
tified by the modern literature as indicative of ‘bubbles’:
• the presence of less well informed traders

• fast rising prices
• unclear fundamentals
• a lack of dividend anchors (aviation industry)
• credit access for leveraged investment
• mass media interest
• increases in the volume of trading
• credit expansions on a large scale.
Conclusions 197
These can ex-post lend some credence to the idea that a deviation
from fundamentals occurred in 1927–9 based on the findings of other
research on the conditions under which bubbles may form and general
factors which indicate their formation. Full resolution of whether an ex-
ante ‘bubble’ formed, its magnitude, and its causal factors is dependent
on future research.
Discussion: policy implications

There are two key findings, one related to financial stability and the
other to asset bubbles, which have potential implications for current
policy-makers.
Regulatory arbitrage and the shadow banking system

Alternative credit systems, which are outside of the regulatory purview,
may also need to be investigated more deeply in light of this research
and also in light of their role in the 2008 crisis during a freeze in lending
from money markets (Gorton and Metrick, 2012) which forced the guar-
antee of all money market funds during the crisis by the Federal Reserve.
In the 1920s, the Federal Reserve became, via the New York banks, the
liquidity provider of last resort, which is the original conception of the
function of a central bank in a liquidity crisis (Bagehot, 1873). Such
systems posed a threat to financial stability in 1929, and required large-
scale liquidity support by the New York banks who were later supported
by the Federal Reserve’s open market operations.
Regulatory arbitrage is a process that occurs as regulators are either
‘captured’ or entirely circumnavigated by those whom they seek to reg-
ulate, which in the pursuit of a legitimate desire to generate profit may
lead to excessive risk for the financial system in the event of a panic, as
the transactions conducted are not within the remit of the regulators or
central bank to correct, except in the last resort.
As we have seen, credit flows could not be stopped by the Federal
Reserve Board. The Federal Reserve sought to squeeze the investors’ and
traders’ funding from the call money markets. Their policy failed and
new lenders in the international money markets and from domestic
corporations and investment trusts stepped in to fill the void. This is
what is known now as regulatory arbitrage and occurs when regulations
are seen by investors to be obstructing their business, and channels are
found to escape the regulation. In 1929, this led to the need for liquid-
ity support from the Federal Reserve System during the crash as lenders
withdrew funds and investors repaid loans to the outside lenders during
the collapse of what in retrospect was an overvaluation. In the 1920s,

the credit system that was built up around the NYSE was known as the
‘invisible banking system’ (Ayres, 1929), but today it exists by a differ-
ent name – the ‘shadow banking system’.
The recent crisis of 2008 has shown that regulatory arbitrage is
dangerous as it places the control of the financial system, and the risk
within it, outside of the purview of financial regulators or at least out-
side of their professed ability to take direct remedial action. In the case
of subprime mortgage instruments, many banks took their risks ‘off
balance sheet’ to escape regulation (Milne, 2009). They funded their
investments through the money markets, which comprised a complex
network of funding sources (Adrian and Ashcraft, 2012). These sources
suffer from the potential to become unstable and lead to panics and
runs on those institutions which rely on the funds (Gorton and Metrick,
2012). The research therefore suggests that modern policy-makers
should be interested in regulatory arbitrage and the attendant increase
in systemic risk that this brings. The level of credit and its sources and
their stability, as well as the overall effect on systemic stability should
be considered at all times.
Asset booms and busts

The research does not possess high enough statistical power to make
any inferences about asset bubbles in general, other than the fact that
we detect a major deviation from fundamentals. Given that bubbles
are relatively infrequent on the scale that we find in 1927–9, what the
research does do is add another historical example to other instances,
with a higher degree of certainty.
However, there are some obvious positive results of the research,
in particular the growth of the monetary system and the price level,
and the research shows that monetary expansions can be harmful to
financial market efficiency. Bordo and Jeanne (2002a) used mechani-
cal rules to identify booms in stock and residential property prices
since 1970 in fifteen industrial countries. They defined a ‘boom’ as a
situation in which asset-price growth over a three-year period lies sig-
nificantly above its long-run average and a ‘bust’ to be a situation in
which the three-year asset-price growth is correspondingly lower than
normal. Out of 24 boom episodes that they identified for stock prices,
busts followed only three. Bordo and Jeanne found more evidence
for boom–bust cycles in residential property: busts followed ten of
nineteen property booms. However, none of these instances was in
the United States.
Conclusions 199
As we have seen, there are many common factors between the 1929
boom and those factors known to influence asset bubble formation
either via laboratory experiments or other ex-post analysis of these
situations.
The paradox remains that stocks cannot be said to always form bub-
bles given the presence of the criteria such as:
• less well-informed traders

• fast rising prices
• unclear fundamentals
• a lack of dividend anchors
• credit access for leveraged investment
• mass media interest
• steep rises in IPO volumes
• increases in the volume of trading
• credit expansions on a large scale
• low interest rates and deviations from the Taylor rule
• new economic or technological eras.
The challenge that emerges is the question: Should we stop looking for
them or can other indicators be used?
The inherited response to bubbles, which are known to have formed,
is to leave them alone on the basis that statistically, in the cross-section
of firms, they do not have detectable causes and that policy action is
not timely or directed enough even once identified (Bernanke, 2002).
However, this finding is paradoxical in that we can identify an asset
bubble ex-post and this may offer some way of improving policy as it
currently stands towards bubbles.
We now have a large body of evidence based on academic research
since the 1970s to predict when a bubble is likely to be forming and the
conditions under which the statistical probability of them forming is
high. In the 1920s both monetary expansion and a technology shock
can be detected as drivers. Ex-post, there are other anecdotal factors,
which conform to the findings of laboratory tests. This is based on
ex-post reasoning but nonetheless may provide an edge to their early
detection or the causal mechanisms of their formation, which may be
controlled or prevented.
Early warning and prevention

We leave to one side the later proposition we make regarding further
research into whether some types of bubbles are desirable, or may have
hidden benefits, such as the promotion of technological advancement.

We consider how new research on bubbles and behavioural finance may
aid policy.
The next step would be to design policy to prevent or limit the forma-
tion using what we know about what causes them and how they work.
Alternatively a good outcome would be to have early warning systems
to allow prompt action via flexible regulation, once detected. For exam-
ple, it may be the case that low central bank rates, which deviate from
the Taylor rule, may induce excessive credit creation and risk taking
and inflate asset prices in general. Thus, more serious attention would
be paid to such obvious conditions of monetary easing if they can be
linked to previous bubbles.
These suggestions highlight a critical point. The difference between
policy-makers’ considerations and academic research is that we had to
be reasonably certain that a bubble formed in 1929 and test it beyond
reasonable doubt. Policy-makers are, fortunately, not constrained by
these considerations to the same extent. Their concern should be the
cost–benefit calculation of such an event occurring. The true cost is that
which is borne by society as a whole, whether looking from a static or
the more logical, dynamic perspective on welfare.
Welfare effects of bubbles

What the crisis of 2008 has done is to serve as a timely reminder that
bubbles, or overvaluations of assets, may have welfare consequences,
both directly to the holder and indirectly via financial institutions los-
ing wealth and the creation of credit crunches. These effects need not
be restricted to those actually active in financial markets, but via an
increased risk of a banking crisis can lead to global effects for people
totally unconnected to the assets in question.
A very important question is: who loses from bubbles? Are they detri-
mental, statistically speaking, to the welfare of society? This is not very
clearly defined and hence further research is needed. There is evidence
to suggest that those at the lower end of the income distribution lose
from asset bubbles (Hirota and Sunder, 2007). If bubbles represent a net
transfer to the higher income strata, then this is not a major considera-
tion unless this has an asymmetric effect on growth and the dynamic
welfare of the society in question. Some may argue that such considera-
tions of income distribution are important, but a much deeper, rigorous
analysis is needed to determine whether those in lower income strata
who buy inflated assets should be protected as they enjoy the potential
upside of their gains. Care must be taken to fully analyse why people
Conclusions 201
engage in speculative or excessive risk taking which may be detrimental

to the wealth of a particular income group. To regulate them would
mean restriction of freedom to transact on the most basic level and is
a hard sell in a free democratic system. We therefore focus on dynamic
welfare of the whole society as our yardstick for guiding policy.
It may be that some type of education on the dangers of bubbles
should be offered to investors. Of course, the aim of investment is to
make profit, and those with greater access to financial advice should
perform better. Those at the lower end of the income distribution are
likely to have less information and therefore the provision of simple
guides to realistic returns through financial history and risk awareness
of the volatility of investments would provide a level playing field to all
investors. The conclusions we reach are that investment over the long
run is a good idea, if an investor diversifies.
The communication of how to invest safely should be the function
of a government seeking to prevent asymmetric welfare effects. As the
case of the US housing bubble has shown, there may not be a direct link
from house price bubbles to severe outcomes for welfare. It is highly
probable that the Federal Reserve Board believed that the housing bub-
ble of the 2000s in the USA could be contained by their actions. In the
case of the USA, the housing bubble, whose effects on growth could
have been reduced by decreasing bank rates to stimulate the economy
when the bubble deflated, became a much larger problem due to the
miscalculation of risk of certain mortgage products by banks. The
problem of a bubble in housing was transmitted to areas of the global
economy unrelated to the housing market. How do we therefore calcu-
late the effect of the housing bubble on welfare losses? It can be argued
that all bubbles create some kind of financial instability and therefore
all are worthy of more detailed study to eliminate their formation.
Although generally seen as detrimental to welfare, an area which
remains of potential interest and a potential reason to allow their forma-
tion is that they spur technological innovation. Without investigation of
whether technology bubbles lead to gains in overall dynamic welfare, as
we over-invest in new technology thereby stimulating further research
and the proliferation of the technology, we cannot be certain that we
can apply the same analysis of their negative welfare effects. What this
type of analysis may show is that we can differentiate between other
types of overvaluations, which seem to serve no dynamic benefit.
Welfare considerations in the dynamic sense need to be considered
rather than just the static case of observed losses or changes in the dis-
tribution of income in a single time period.
Future research
As we have seen earlier in the book, the three main approaches to asset
bubble research are likely to prove fruitful. All are needed to further our
understanding of these complex phenomena.
Historical cases of asset bubbles and long-range empirical research

The research has shown that history and long-range empirical studies,
which follow the tradition of Goetzmann and Ibbotson (2006), Cowles
(1938), and Smith (1924) and others, can yield useful knowledge about
the behaviour of financial markets and asset prices. Their importance
has been neglected given that such work is not easy to conduct due to
the added dimension of the location and collation of data by hand,
from old and sometimes incomplete sources over hundreds of years.
There are many other cases of historical asset bubbles and crises that
have not been fully documented in the detail which this study has
aimed to provide. One area of particular interest is technology bubbles.
Studies of the NASDAQ boom and crash of the 1998–2000 period and
other international cases of potential bubbles would benefit future
generations.
Laboratory tests of bubbles

These new types of tests have provided many valuable insights (Smith et al.,
1988), and opened new frontiers in our understanding of asset bubbles.
Furthermore these new approaches have overcome the problem faced by
traditional empirical analysis, namely that some factors are extremely dif-
ficult to control for in the analysis of real-world data.
In addition to the ongoing work in this area a focus on remodelling
of historical episodes in the laboratory would be very interesting, most
notably for the economic and financial history community, who would
gain from being able to see history through the lens of laboratory
behaviour. Behavioural economics would also gain from this innova-
tion to their approach to see to what extent social and institutional fac-
tors unrelated to finance, which are historically specific, may influence
bubbles. Of course, there are limits to these approaches but they offer
an interesting alternative research path for the laboratory method. The
1920s market could be remodelled to some degree and the bubbles that
formed may be compared.
The laboratory method should be extended to focus more on the effect
of technological shocks and uncertainty on the formation of bubbles.
One key area that remains unresolved is the behaviour of investors in
Conclusions 203
times of new technologies and whether bubbles form due to a rational

reaction to not being able to identify who the winners will be.
Theoretical work
New theoretical work on technology bubbles will enhance our knowl-
edge a great deal, not only about how technological shocks may affect
the patterns of investment in the economy but also how we respond
to them and perceive their benefits. How we respond to technological
shocks due to radical uncertainty, or due to the inability to determine
who will win from a new technology at the firm level, needs further
work. This research should aim to resolve whether there is a way of
making the distinction between effects under technological change
from irrational exuberance and those based on more complex consid-
erations. Being able to test this is probably the most important question
to emerge from the research on the new technology we looked at.
The impact of crashes on demand and interest rate policy

The crash of 1929 may have increased the severity of the recession
in 1929–30 (Romer, 1993) and the fall in values over 1929–32 may
have had an impact on consumer spending through loss of wealth.
These effects deserve to be investigated further. The NASDAQ crash
has been suggested as a reason for the series of emergency rate cuts by
the Federal Reserve Board and the lack of concern about the emerging
housing market boom in 2001–3, which saw US central bank rates fall
to 1 per cent to mitigate the effects of the economic slowdown. This
stimulus from the Federal Reserve may have caused an over-stimulus of
credit in the US housing sector, stoking another boom which led to a
sizeable overvaluation of property in the USA.
Therefore, the effects of crashes on wealth, investment, and spend-
ing could produce useful insights as they may have knock-on effects
on required monetary easing to dampen their effect on consumption.
Another area which has relevance for the crisis of 2008 and the 1920s
is how property price falls, whether due to bubbles deflating or price
instability, can affect consumers’ consumption behaviour and their
behaviour towards paying off debt.
Credit expansions and asset bubbles

Both monetary and credit expansions have been investigated and evi-
dence found to the effect that monetary factors can stoke bubbles in the
housing market (Bordo and Jeanne, 2002a). The evidence is less clear for
the stock market. Our research suggests monetary factors played a role
in the 1920s, but may be specific to that era.
Credit expansion in the financial sector or financial sector liquidity is
also an area of concern for stoking bubbles in the financial or housing
sector. This is an area of research that has generally been neglected as
monetary economics has been overlooked to a certain extent by central
banks and economics generally as the assumption of money as a neu-
tral variable in the real economy has gained credence. Even without
challenging the idea that money grows passively as the demand for it
increases, such a transmission mechanism need not exclude the pos-
sibility that bubbles can be detected when money growth is very high
relative to expectation. The recent financial crisis, although not prov-
ing that credit growth is a danger, has rekindled the need for research
to investigate both over the long sweep of history and via theoretical
models how credit growth or credit availability may influence bubble
formation in housing and stock markets.
Mental pathology, herd behaviour, and higher-order beliefs

One area of research where there is much room for further analysis
stems from the possibility that we have missed a critical part of the
reason for the formation of the asset bubble in the 1920s. The idea that
investors may be irrational or at least driven by behavioural forces to
start bubbles is feasible. How investors become behaviourally driven
may be due to the fact that they have expectations based on illusion
or fantasy about the real world. Rather than seek the explanations of
‘rational irrationality’ where growth is overestimated within normal
bounds, it may be that bubbles form due to some type of collective
euphoria. This could take the form of any of the types we discussed in
Chapter 2 in the literature review of bubbles. It may be that bubbles
are the result of herd behaviour as investors follow others in the belief
that others know more or people are aiming to predict how others will
behave (Keynes, 1936), or there may be a large role for chaotic and
unstructured thinking based on an individual’s own thoughts, a type of
pathology best described as humans being a ‘little bit crazy’. One recent
area of research on this subject has been dubbed ‘Emotional Finance’
by its practitioners, David Tuckett and Richard Taffler. Tuckett’s Minding
the Markets (2011) explores the role of emotions in trading. Prices in the
late 1920s moved far from the fundamentals indicated in our models;
new approaches to identifying how we generate fantastical thinking or
via people anticipating the fantasy of others is an area ripe for research.
Conclusions 205
Investor surveys of expectations and behaviour

Perhaps the most obvious and interesting frontier in research into
bubbles and economic behaviour generally is being able to know in a
scientifically rigorous way what investors’ expected returns from assets
are, and the reasons for their expectations. Furthermore, how expecta-
tions can be influenced by other factors is also an area ripe for further
research. These studies could use data collection methods that harness
the power of the Internet or instant messaging to collect large data
samples at low cost.
Appendix: Results of
cross-sectional tests
Table A.1 Results of regression of percentage change in P/D ratio from 1927–9
(DEP) with earnings growth rates from 1927–9
Constant 0.556
(0.081)
Earnings growth 0.412**
(0.203)
R-squared 0.053
No. observations 72
Sample period 1927–1929
with annual earnings growth rates from 1928–9
Constant 0.3
(0.052)
Earnings growth 0.026
(0.039)
R-squared 0.006
No. observations 74
(DEP) and annual earnings growth rates from 1927–8
Constant 0.179
(0.03)
Earnings growth 0.253***
(0.048)
R-squared 0.274
No. observations 74
206
Appendix 207
(DEP) with annual dividend growth rates from 1927–8
Constant 0.248
(0.038)
Dividend growth 0.131
(0.034)
R-squared 0.017
No. observations 70
on dividend growth rates from 1927–9
Constant 0.248
(0.079)
Dividend growth – 0.328**
(0.164)
R-squared 0.054
No. observations 72
with dividend growth rates from 1924–7
Constant 0.211
(0.041)
Dividend growth – 0.634***
(0.120)
R-squared 0.286
No. observations 72
208 Appendix
on earnings growth rates from 1924–7
Constant 0.571
(0.082)
Earnings growth 0.286
(0.281)
R-squared 0.013
No. observations 81
with age, net current assets, market capitalisation (size) in 1927 and percentage
change in P/D ratio in 1926–7
Multivariate
Constant 0.194
(0.257)
Log size (net current assets) – 0.373
(0.0495)
Log age – 0.0055
(0.063)
Log market CAP (27) 0.0468
(0.0353)
PD 1926–7 – 0.161
(0.117)
R-squared 0.0448
No. observations 71
Table A.9 Results of regression of percentage change in market capitalisation

from 1927–9 on net current assets, age, and risk rating
Constant 0.242
(0.344)
Net current assets 0.000
(0.001)
Age 0.004
(0.003)
(continued)
Appendix 209
Table A.9 Continued
Aa – 1.127
(0.413)
A – 0.168
(0.316)
B – 0.088
(0.350)
Ba 0.033
(0.350)
Baa 0.001
(0.349)
Ca – 0.581
(0.484)
Caa – 0.047
(0.393)
R-squared 0.113
No. of observations 72
Notes
Prologue
1. ‘Some time ago intrinsic value was thought to be about the same thing as
book value, i.e. it was equal to the net asset value of the business, fairly priced.
This view of intrinsic value was quite definite, but it proved almost worthless
as a practical matter because neither the average earnings nor the average
market price evinced any tendency to be governed by the book value. Hence
the idea was superseded by a newer view … that the intrinsic value of a busi-
ness was determined by its earning power. But the phrase “earning power”
must imply a fairly confident expectation of certain future results. It is not
sufficient to know what the past earnings have averaged, or even that they
disclose a definite line of growth or decline. There must be plausible grounds
for believing this average or this trend is a dependable guide to the future. …
There was however, a radical fallacy involved in the new era application
of this historical fact [referring to Smith’s discovery of the Equity Return
Premium]. This should be apparent from even a superficial examination of
the data contained in the small and rather sketchy volume from which the
new era theory may be said to have sprung. The book is entitled COMMON
STOCKS AS LONG-TERM INVESTMENTS, by Edgar Lawrence Smith, pub-
lished in 1924. Common stocks were shown to have a tendency to increase
in value with the years, for the simple reason that they earned more than
they paid out in dividends, and thus the reinvested earnings added to their
worth. … The attractiveness of common stocks for the long pull thus lay
essentially in the fact that they earned more than the bond interest rate upon
their cost … but as soon as the price was advanced to much higher price in
relation to earnings, this advantage disappeared, and with it disappeared the
entire theoretical basis for investment purchases of common stocks … Hence
in using the past performances of common stocks as the reason for paying
prices 20 to 40 times their earnings, the new era exponents were starting
with a sound premise and twisting it into a woefully unsound conclusion’
(Graham and Dodd, 1934: 64–5, 312–13).
2. ‘[A] potent reason for the long bull market rising to the plateau of stock prices
1923–1930 is that there has been a material change during this period in the
estimate of the public as to the risk of investing in common stock. Whether
this change is justified or not, the change has occurred. … Amoung [sic] sev-
eral important books which emphasise the important role of changes in the
value of the dollar, none has impressed the investing public so profoundly as
certain events that gave rise to investment counsel and investment trusts in
America, including especially the publication of Edgar Lawrence Smith’s book
[Common Stocks as Long-Term Investments].
‘The series of writers on the subject have proved, statistically that bonds are
not, as compared with well selected and diversified stocks, what they have
been cracked up to be; that they are especially deceptive during rising prices
210
Notes 211
and that even when prices are falling they are not all that superior to stocks …
they show that whatever truth there is in the “risk” carried by the stockholder
as compared with the bondholder, this risk can be partly neutralised by diver-
sification … both Smith and Van Strum show how this diversification does
neutralise the risk and correct the unsteadiness of the stockholders income’
(Fisher, 1930: 198).
3. This is a key research database for financial historians and can be accessed via
the ICF at Yale University.
4. This refers to the monetary expansion from 1915 to 1920, which eroded the
‘real returns’ to corporate and Government Bonds.
5. This refers to the effect of price stabilisation in the 1920s when near zero
inflation/deflation increased the ‘real’ returns to corporate bonds.
3 The US Economy and the Financial System

1. ‘In December 1996, before my time at the Board, John Campbell of Harvard
and Robert Shiller of Yale made a presentation at the Fed, in which they
used dividend-price ratios and related measures to argue that the stock
market was overvalued. (A version of their presentation was later published
in the Journal of Portfolio Management, which is the source for all my com-
ments here.) Campbell and Shiller, whom I know well and respect greatly
as preeminent financial economists, rightly deserve credit for calling the
possibility of a bubble to people’s attention, at a time when (lest we forget)
there was significant diversity of opinion about which way the market would
go. Shiller, of course, has gone on to write a best-selling book about stock
market manias. Though Campbell and Shiller were among those warning of
a bubble in stock prices, and deserve credit for doing so, we should not lose
sight of a simple quantitative point: According to their published article,
their analysis of dividend-price ratios implied that, as of the beginning of
1997, the broad stock market was priced at three times its fundamental value
(Campbell and Shiller, 1998, p. 13). At that time the Standard & Poor’s 500
index was about 750, compared with a close of 842 on October 1 of this year.
‘I do not know, of course, where the stock market will go tomorrow, much
less in the longer run (that’s really my whole point). But I suspect that
Campbell and Shiller’s implicit estimate of the long-run value of the market
was too pessimistic and that, in any case, an attempt to use this assessment
to make monetary policy in early 1997 (presumably, a severe tightening
would have been called for) might have done much more harm than good’
(Bernanke, 2002).
2. See Rostow (1956).
3. By 1900 the USA was the world’s main producer of natural gas, copper, petro-
leum, iron ore, zinc, phosphate, molybdenum, lead, tungsten, and many
other minerals (Wright, 1990).
4. A good example of this development commitment is the provision of educa-
tion for agricultural development.
5. See Bordo and Schwartz (1984).
6. ‘The importance of the United States in the international monetary system
would have been recognized much earlier had the United States possessed a
212 Notes
central bank in the 19th century. Upon its creation in 1913, it was instantly
the most powerful central bank in the world, this despite the much-vaunted
prestige of the Bank of England, the acknowledged importance of sterling
and the London financial market. The creation of the Federal Reserve System
in 1913 was one of the most important events of the 20th century. It was
the Federal Reserve System that enabled the paper dollar to become the
most important currency in the world. The primacy of the dollar can be
said to have begun in 1915, the second year of World War I, when the dollar
took over from the pound sterling the role of most important currency in
the world. The whole future of the gold standard came to depend on the
policy of the US with regard to gold. During World War I, the value of gold
had fallen in half as the US dollar, which remained more or less on the
gold standard, experienced a doubling of its price level between 1914 and
1920. In 1921 the Federal Reserve liquidated assets and tightened credit.
Prices then fell precipitously, from an index of 200 (1914 = 100) in 1920 to
140 in 1921. The Federal Reserve then shifted to a policy of stabilizing the
price level and it remained more or less constant until 1929. Thus, during
the 1920s, the US price level was about 40 per cent above the pre-war gold-
standard equilibrium’ (Mundell, 2000).
7. The Gold Exchange Standard in the UK practically involved the withdrawal
of gold coin from circulation, thus economising on its use, and the promise
to buy gold bars at a fixed sterling price
8. Cassel had testified before the Senate Banking Committee in the USA,
the Genoa conference in 1922, and had authored a ‘Memorandum on
the world’s monetary problems’ at the invitation of the League of Nations
in 1920.
9. ‘The nationwide “bubble” that appeared in the early 1920s and burst in
1926 was similar in magnitude to the recent real estate boom and bust.
Fundamentals, including a post-war construction catch-up, low interest
rates and a “Greenspan put”, helped to ignite the boom in the twenties, but
alternative monetary policies would have only dampened not eliminated
it. Both booms were accompanied by securitization, a reduction in lending
standards, and weaker supervision. Yet, the bust in the twenties, which drove
up foreclosures, did not induce a collapse of the banking system’ (White,
2009: abstract).
10. After the war, there was a general population migration into urban areas,
mostly to the larger cities (migration of 9 million individuals to urban
areas with populations over 30,000). Returning soldiers felt they had better
employment opportunities in urban areas and an agricultural depres-
sion caused by falling commodity prices spurred ‘millions of people from
farms . . . [to] large cities’ (Simpson, 1933: 163).
11. Nicholas (2008) finds evidence of correlation between patents and excess
stock returns in the 1920s. Notable examples in the data are Westinghouse,
General Electric, and Du Pont, who feature prominently in the chemicals
and electrical industries.
12. Our estimate uses a 4 per cent long-term return under the Refunding Act
of 1870 and Consumer Prices data from the NBER Macrohistory Database.
Our estimate of 2.9 per cent was found by taking the L-Term Govt. Bond
yield in 1870 (4.0 per cent) and deflating by the Consumer Price Index from
Notes 213
1871 to 1900 = 5.5 per cent return. For 1900–29, we took the 3 per cent L-Term
Govt. Bond yield in 1900, and deflating by the CPI = 0.3 per cent return.
13. This observation bears directly on our assessments of the Federal Reserve’s
ability to abrogate the effects of the monetary contraction and lends support
to the counterfactual scenarios tested by McCallum (1990) and Bordo et al.
(2002).
14. Chapter 5 deals specifically with the operation of the policies and their
effects on the NYSE and New York money market.
15. The quoted words are those of New York Federal Reserve Bank governor
Harrison.
16. ‘[S]ince with leading monetary writers, credit has come to mean demand
deposits, an abnormal expansion of credit has been held to cause inflation.
Some writers understanding credit to mean loans and investments, have
been led to maintain that it is a rapid expansion of loans which causes infla-
tion, without attempting to work out a relation between loans and the value
of money. It has become almost a fashion to refer to the post-war period up
to 1929 as one of inflation due not to increased velocity but to excessive
expansion in the volume of credit. These opinions must have been based on
the movements of loans and investments; actual figures of demand deposits
can harldy be said to warrant such a conclusion … since the reserve admin-
istration understands “credit” to mean loans and investments it has been led
to distinguish between the qualitative and quantitative aspects of “credit”,
stressing the former most heavily. Unfortunately, by taking credit to mean
loans and investments, the banking authorities have completely misunder-
stood the theorists’ arguments and have therefore misapplied them’ (Currie,
1934b: 51–4).
17. This was not an official Fed measure until 1941 (Humphrey, 2001).
5 The October Crash of 1929 and the NYSE Credit System

1. Gorton and Huang (2002: 1–14) describe the method that ‘clearinghouses
developed to turn illiquid loan portfolios into money, private money that
could be handed out to depositors in exchange for their demand deposits
during their times of panic. Clearing house loan certificates originated in the
inter-bank clearing system as a way to economise on cash during a panic.
During a banking panic member banks were allowed to apply to a clearing-
house committee, submitting assets as collateral in exchange for certificates.
If the committee approved the submitted assets offered in exchange, then
certificates would be issued only up to a percentage of the face value of the
assets. The bank borrowing against its illiquid assets would have to pay inter-
est on the certificates to the clearinghouse. The certificates could then be
used to honor inter-bank obligations where they replaced cash, which instead
could be used to pay out to depositors … during the panic of 1907 about
$500m was issued (4.5 per cent of the money stock).’
2. In 1907 trust companies were outside the jurisdiction of the Clearing House
System.
3. Call loans were money market instruments, which could be called at one day’s
notice and were deemed highly liquid when compared to real estate loans.
214 Notes
4. ‘In the Pre Fed era, New York Clearing House Banks were the predominant
source of funds for call loans on the NYSE. New York Clearing House Banks
(NYCHBs) were able to maintain liquidity on the call loan market in prior
panics despite disruptions to intermediation, because they monopolised the
funding of the market. The growth of trust companies in New York (not
members of the NYCHB system) along with the increasing sophistication
of the interior banks led to an increasing proportion of call loan volume
outside the control of the NYCHB. At that time NY banks still held about
40 per cent of their loans as call loans. Hence a substantial devaluation of
call loan assets would seriously weaken their balance sheets and threaten
their solvency. Any widespread liquidation of call loans by the trusts or
interior banks might trigger a rapid loss of stock market value. As the call
market share of NY National Banks fell relative to “outsiders” the probability
of observing a collapsing value/price scenario increased’ (Moen and Tallman,
2003: 1–2).
5. Myers (1931) notes that seasonal demands for reserves would contract call
loans and cause price falls on the NYSE. Moen and Tallman (2003) also note
that interior banks and trusts were lending directly to the call loan market
making the supply of funds more erratic.
6. A contraction in reserves would be expected to contract loans to non-
financial businesses and hence effect an economic contraction.
7. ‘That is why the key reformers of the banking system J. L. Laughlin and
P. Warburg agreed that the development of a rediscount market comprised
of self liquidating loans would be a promising alternative to the call loan
market as the basis for liquid bank assets. Even if these assets had bad
outcomes – e.g. claims could not be paid off – the loans are claims to inher-
ently less volatile assets and the correlation across these real assets is less
likely than the correlation across stocks. … perhaps most importantly, the
reformers aimed at repairing the underlying flaw in the financial system – no
reliable and rapid method to increase base money. One solution, a central
banking institution would be willing to hold self liquidating real assets
through the discount function, essentially exchanging private claims (the
assets to be discounted) and public claims (currency)’ (Moen and Tallman,
2003: 9–10).
8. ‘The Federal Reserve was created by men whose outlook on the goals of cen-
tral banking were formed by their experiences during the national banking
era panics. The basic problem seemed to them to be banking crises produced
by or resulting in an attempted shift by the public from deposits into cur-
rency. In order to prevent such shifts from producing either widespread
bank failures, some means was required for converting deposits into cur-
rency without a reduction in the total of the two. This in turn required the
existence of some form of currency that could be rapidly expanded – to be
provided by the Federal Reserve note – and some means of enabling banks to
convert their assets readily to such currency – to be the role of discounting’
(Friedman and Schwartz, 1963).
9. ‘Changes in the identity of the intermediaries providing those funds help
explain why the movement to establishment of a central bank in the
USA took hold only after the panic of 1907. The growing significance of
non clearinghouse creditors to the call money market diluted the relative
Notes 215
financial influence of the NYC bankers and compromised the apparent coin-
surance arrangement between brokers and the NY clearinghouse lenders’
(Moen and Tallman, 2003: Abstract).
10. This is an estimated figure based on Wigmore (1985).
11. Rappoport and White (1994) note that the ratio of security loans to total
market value of stocks remained fairly constant through the 1920s boom
and demonstrate effectively that the brokers’ loans market was not driving
the stock price rises.
12. These loans are both call and time money loans to brokers and dealers in
securities providing leverage to investors.
13. Assuming non-member security loans were divided between brokers and
other customers in the same ratio as Reserve member banks as detailed in
Roelse (1930).
14. Smiley and Keehn (1988) highlight the fact that our figures are only for the
reporting member banks and the NYSE and there may have been a large
pool of funds for which we have inadequate data. Nonetheless, there are
sufficient data to determine that there was substantial selling pressure caused
by a large reduction in the supply of call loans in October 1929.
15. The exposure to a call loan contraction.
16. The New York banks’ liquidity injection totalled only $1 billion. Whether
the inadequate size of this injection was due to policy, resources, or organ-
isational restrictions is unclear but indicates that the Reserve System did not
have the capacity to supply liquidity to offset the external liquidity shock.
17. The identity of these banks or other entities engaged in currency arbitrage-
based lending to the NYSE call money markets is beyond the scope of this
study.
18. Call money, being a highly liquid instrument, was in effect the same as a US
dollar bank balance paying interest and was unlikely to suffer from signifi-
cant credit risk premiums as the loan could be liquidated within a 24-hour
timeframe.
19. We use bank interest rate parity between dollar/sterling to determine the
theoretical value of the forward rate.
20. Ayres (1929) described the suppliers of call loans the ‘invisible banking
system’.
21. Global Financial Data (2009) and The Commercial & Financial Chronicle
(1929).
22. ‘If “others” have lent their surplus funds to brokers on call because it is more
profitable than to invest or use these funds in business … Accordingly these
funds will be withdrawn and invested or used in the most profitable way
when the call rates decline … The withdrawal of the funds in the market
by only a few lenders will bring pressure on the market and liquidation of
securities wholly out of proportion to the amount of money taken out of the
market’ (Wright, 1929: 132–3).
23. ‘The increase in required reserves, which necessarily accompanied the bulge
in the money supply resulting from the surge in bank lending to securities
firms, was met in part by sizable open market purchases of U.S. government
securities by the New York Federal Reserve Bank and by discount window
borrowing by New York commercial banks. According to a senior official
of the New York Fed at the time, that bank kept its “discount window wide
216 Notes
open and let it be known that member banks might borrow freely to estab-
lish the reserves required against the large increase in deposits resulting
from the taking over of loans called by others”. As a consequence, the sharp
run-up in short-term interest rates that had characterized previous financial
crises was avoided in this case. Money market rates generally declined in the
first few months following October 1929’ (Stern, 1988).
24. This sum is equivalent to 5 per cent of the total supply of money in the
entire United States at that time.
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Index
Numbers in bold refer to figures and tables.
Abreu, D. and M. K. Brunnermeier, 44 Babson, Roger, 4

aeronautics industry, 14 Babson Statistical Organisation, 4
Allen, F. and D. Gale, 42 Bachelier, Louis, 7, 38
American Telephone & Telegraph Banerjee, A. and W. E. Eckard, 63
(AT&T), 62 Barberis, N., 45
arbitrage, 7, 28, 125, 155, 157–63 Barsky, R. B. and J. B. De Long, 32
covered/uncovered interest rate Behavioural Economics, 19, 39,
arbitrage, 158–63, 161 40–57, 23
interest rate parity, 159–63 see also economic behaviour;
Keynes–Einzig conjecture, 157–8, neuro-economics
160–1 Bernanke, Ben S., 60, 174, 176, 211n1
ARMA-ARCH-Artificial Neural Bierman, J., 35
Network model, 33 boom and bust, 1, 3–7, 20–1, 58–61,
asset pricing, 2, 37, 46–8, 50, 123 197–9
see also bubbles; Common Stocks; literature review and methodology,
Dividend Discount Model; 31–7
dividend growth rates; equity see also bubbles; economic
returns; overvaluation; prices; behaviour; fundamental values;
risk; stock value collapse; valuing Great Contraction; Great
stocks Depression; overvaluation; stock
assets market; valuing stocks; volatility
commercial real estate bonds, 75–6 Bordo, M. D. and O. Jeanne, 198
fixed income, 15 broad/narrow money growth, 48
lifespan, 3, 8 brokers’ loans market, 33, 36, 149–57,
mortgage-backed securities, 75 152
prices, 1, 2, 19, 21, 28, 34, 39, see also call money markets
40, 48, 80, 103–4, 181 bubbles
railroad bonds, 101 behavioural models, 44–6
risk-free, 3, 10, 102, 155, 156 British Railroads (1840), 40
see also closed-end funds; credit induced, 35, 88, 91, 146, 194
Common Stocks; corporate definition, 1, 21, 37–8
bonds; Government Bonds; Dot com/NASDAQ (1998–2000), 40,
high-technology stocks; 41, 110
investment trust funds early warning and prevention,
automobile industry, 14, 27, 113–15, 199–200
117–24, 119, 123 effects on social welfare, 200–1
aviation industry, 4, 13–14, 27, fundamental shocks, 44
54, 84 herding behaviour, 43–4, 204
case study, 94, 108–27, 119, heterogeneous belief bubbles, 46
120, 123, 125–7, 131, historical analysis, 19, 202
191–2 impact on financial policy, 203
229
230 Index
bubbles – continued excess returns and volatility, 13

laboratory studies, 19, 46–8, 202 long-term returns, 2
limited liability factors, 42–3 overestimating risk, 10–13
limits to arbitrage, 44 price data, 4
liquidity factors, 48 prices and dividend index,
Mississippi Bubble (1718–20), 40 20–1, 21
momentum effects, 24–6, 37, 45, speculative investment, 6, 35
81, 140–1, 141 time hazard investment horizon,
Nikkei (1989), 40 12, 133–4
noise traders, 44 valuation of, 7–8
over-optimism, 6–7 volatility reduction, 12–13
psychological factors, 48–9 zero capital loss estimation, 12, 26,
rational bubbles, 42–4 132, 133–4
role of symmetric/asymmetric see also corporate bonds; Dividend
information, 42 Discount Model; dividend growth
self-feeding processes, 25, 81 rates; equity returns; Equity Risk
South Sea Bubble (1720), 40 Premium; fundamental values;
speculative bubbles, 48–9, 108 Government Bonds; investment;
technological growth, 49 overvaluation; prices; risk; stock
theory of, 37–57, 203 market; valuing stocks
time horizons, 47 Congdon, T., 48
Tulip Mania (1637), 40 corporate bonds, 2, 10–12, 134
see also economic behaviour; AAA (high grade) bond index, 11,
fundamental values; Great 100–1
Contraction; Great Depression; Baa bonds, 11, 100
house price bubbles; neuro- risk factors, 7–8
economics; overvaluation; stock valuation of, 7
market; valuing stocks; volatility see also government bonds
Burgess, R. W., 164–5 corporate lenders, 155–8, 156
see also non-bank financial
call money market, 7, 36, 146–73, intermediaries
151, 156, 161, 166, 167 Cowles, Alfred
Cassel, Gustav, 68–9, 70, 212n8 Common Stock Indices, 1871–1937,
closed-end funds, 3, 25, 26, 32–3, 6, 20, 27, 95, 102, 107, 115, 141–2
105–8, 127–31, 131, 193–4 credit instability and crisis, 28, 29,
Commercial & Financial Chronicle, 4, 37, 48, 54, 145–73
99, 115–16, 165 credit, loans, and debt, 58–9, 70,
Common Stocks 71–7, 73, 80, 145–73, 151, 152,
analysis of returns, 94–144 167, 168, 176–7, 187, 188, 203–4
buy-and-hold strategy, 2, 26 speculative loans/credit, 35, 36,
calculating returns, 10–16 91, 92
changes in values relative to stock prices to credit ratio, 172
expectation, 23 CRSP (Center for Research in Security
cross-sectional tests of stock values, Prices) database, 31, 34, 50, 132,
53, 56, 133–40, 189–97, 206–9 136, 181
diversified, 10 Currie, L., 90–1, 213n16
dividend discount modelling, 7–8
effect of asset lifespan on value, 8 De Long, J. B. 44, 45
excess return over bonds, 2–3, De Long, J. B. and A. Shleifer, 24,
10–11, 25 32–3, 144, 193
Index 231
De Martino, B., 18, 47 realised, 2, 19, 23, 55–6,

DeMarzo, P. M., 43 105–8, 190
Dice, C. A., 3 Smith’s return premium
Diether, K. B., 45 estimates, 13
Dividend Discount Model (DDM), Standard Deviations (S.D.), 100–1,
3, 5, 35, 52, 55, 94–108, 135–9, 101, 131
189–90 see also valuing stocks
see also dividend growth rates; Equity Risk Premium (ERP), 2, 3,
valuing stocks 10–11, 23, 25, 50, 129–30,
dividend growth rates, 27, 55–6, 64, 131, 189
81, 124, 135–9, 189–90, 192–3 calculation of, 10–16, 95, 100–1,
dividend forecasting, 32–4 104
dividend growth index, 55, 102 retained earnings, 6, 137
fair expectations, 32, 52, 56, volatility-based, 100–1
179–80, 194, 195 see also fundamental values
see also equity returns; productivity exogenous economic shock, 28–30,
growth; valuing stocks 54, 145, 173, 183, 194
Dodd, David, 5–6
Donaldson, R. G. and M. Kamstra, Fama, Eugene F., 19, 38–9
24, 33 Federal Reserve, 22, 65, 71, 85–93,
Du Pont, 62, 63, 82 145–73, 197
bank rate, 86–7, 87, 91
earnings growth rates, 6, 27, 35–6, ‘bubble popping strategy’, 28
53, 57, 132, 135–40, 143, 192, discount rate adjustment, 28, 88–9,
206, 208 91, 92, 146, 151–2
earnings growth (discounted cash interest rate mechanisms, 35
flow – DCF) model, 31, 34 price stability policy, 87–8
econometric tests, 2, 10, 21, 31 regulation of credit flow, 28, 35, 54,
economic behaviour, 14, 17–18 89–92, 146
herding, 43–4, 204 see also financial markets;
historical context, 18 regulatory arbitrage
irrationality, 6, 17, 19, 25, 27, 32, 47, financial crisis (2008), 17, 41, 74,
49, 109, 132, 140, 144, 195–6, 204 197–8
laboratory studies, 19, 41–57, 202 financial history, 17–18, 145–73
risk aversion, 3, 134 financial markets
see also neuro-economics curb market, 36
Economic History school, 40, 48 discount rates, 166
Eichengreen, B. J., 176 instability, 145–73
Einzig, P., 157–9, 161–2 ‘marginal opinion’, 5
emotional finance, 204 money market leverage, 149–64
equity returns money market rates, 167
Book/Market (B/M) ratio, 55, price setting and volatility, 5
181–2, 181 securities loans, 167
calculating, 10–16, 37–57 see also brokers’ loans market; call
efficiency, 38–9 money market; market efficiency
expected, 2, 3, 19 financial modelling, 1, 3–4, 50, 115
Market Price/Dividend ratio, 55 time series data, 6, 32, 34, 38, 58,
Price/Dividend (P/D) ratio, 10, 53, 137, 181–2
58–9, 59, 98–9, 100, 102–4, 103, financial theory and analysis, 2–5,
104, 108, 141–2, 142, 180, 189–90 7–16, 31–57
232 Index
First World War, 26, 65, 71, 85–6 exogenous shock, 183
Fisher, Irving real economy, 183–6, 184
The Nature of Capital and Income see also stock value collapse
(1906), 7 Great Depression (1930s), 4, 6, 17, 23,
The Stock Market Crash and After 29, 36, 67, 74, 76, 174
(1930), 2, 6, 25, 210–11n2 Greenwood, R. and A. Schleifer, 19, 46
Fisher’s Golden Rule, 84
Frazzini, A. and O. A. Lamont, 43 Haney, L. H., 153, 169
Friedman, M. and A. J. Schwartz, Hansen, L. P., 19
86–7, 88, 89, 147, 176, 214n8 high-technology growth, 4, 113–14
French, K., 55 high-technology stocks, 27
fund managers, see investment trust valuation of, 13–14
funds see also aviation industry; new
fundamental value technology; technological
deviation from, 19, 21, innovation; technological shock;
33, 39–40 technology
discounted cash flow (DCF) Hirota, S. and S. Sunder, 47
model, 34 Hirst, F. W., 170–1
ex-ante observable, 40 Hoover, Herbert, 35
ex-post observable, 1, 21 horizontal and vertical
measurement of, 94–105 integration, 63
house price bubbles, 1, 22, 41, 74,
Galbraith, J. K. 185, 188, 203
The Great Crash (1954), 6–7, 20 housing market debt, 22, 74–5,
General Motors, 36, 62 184–6
global banking system, 17, 177
Goetzmann, William N. and Roger industrial growth model, 3–4,
Ibbotson, 20, 22–3, 34 13–14, 27
Goetzmann, William N. and Frank industry life-cycles, 5, 13–14,
Newman, 75 27, 117
gold, 22, 65, 36, 70–2, 72, investment
85–6, 188 diversification, 3, 7, 10, 13, 14, 55,
Gold Standard/Gold Exchange 105, 112, 128–31
Standard, 22, 64–71, 86, 147, 159, long-term, 2
176, 212n7 search for ‘intrinsic value’, 5–6
Gordon, M. J., 35 speculative, 6, 35
Gordon, R. J., 23, 82, 108, 143 theory, 5, 14
Goschen, G. J., 65–6 see also closed-end funds; Dividend
Government Bonds Discount Model; equity returns;
calculating returns, 12, 16, 23, 71, investment pools; investment
83–4, 83, 95, 100–1, 104, 107, science; investment trust funds;
129–31, 194 investors; risk; valuing stocks
long-term inflation expectations, investment pools, 35, 149–50, 165
84–5 investment science, 7–16
Graham, Benjamin and David Dodd investment trust funds, 105–8, 106
Security Analysis (1934), 5–6, 25, fund managers, 7, 43–4, 48, 129
137, 210n1 portfolio diversification, 3, 7, 10,
Great Contraction (1929–32), 22, 13, 14, 55, 105, 112, 128–31
54–5, 59, 174–86, 194 see also closed-end funds
Index 233
investors, 1, 3, 4 ‘Monte Carlo’ simulation, 33

access to financial data, 11 Moody’s AAA Corporate Bond
distinguished from speculators, 5 Index, 11
expectations, 19, 32, 52, 56, Moody’s Investors Service, 4
179–80, 194, 195 Moody’s Manual of Industrial and
herding behaviour, 43–4, 204 Miscellaneous Securities (1900), 4,
irrationality, 6, 17, 19, 25, 27, 95, 96
32, 47, 49, 109, 132, 140, Moody’s Manual of Investments (1930),
144, 195–6, 204 3–4, 13–14, 27, 53, 94–5, 97, 99,
risk aversion, 3, 134 111–14, 129
Moody’s Manual of Investments,
Janeway, W. H., 24 American and Foreign (1930), 129
Mundell, R. A., 65, 211–12n6
Kahneman, Daniel, 19 Myers, M. G., 148
Kendall, Maurice, 38
Keynes, John Maynard, 9–10, 43, 69 Net Asset Values (NAVs), 32,
Kindleberger, C. P., 40, 48 106, 128
Klepper, S., 114, 117 neuro-economics
Knight, Frank brain activity during asset bubbles,
Risk, Uncertainty, and Profit (1921), 17, 18, 47–8
8–10 irrationality, 17, 19
Kyle, A., 130 psychology and economic
behaviour, 14, 17–18
Lei, V., 46 new technology, 23, 37, 54
LeRoy, S. F. and R. D. Porter, 42 growth model valuation, 108–27,
Liberty Bonds programme, 26, 71–2 119, 120
Lowenfeld, H., 7 valuation of, 14
Lux, T., 45 see also aviation industry;
technological innovation;
Macaulay’s High Grade Rails technological shock; technology
Index, 11 New York Clearing House Banks
market efficiency, 19, 22, 30, 32 (NYCHBs), 147, 148, 214n4
Behavioural Economics, 39, 40, New York Stock Exchange (NYSE), 2,
41–57 35, 36, 54, 108
Efficient Markets Hypothesis credit system, 28, 29, 145–73
(EMH), 37, 38–9, 40, 139, 143 microstructure, 60, 145–73
joint hypothesis problem, 51, 64, 131 volume of credit (1929), 168
testing methods, 41–57 see also stock market
Marsh–Merton model, 33 Nicholas, T., 24, 26, 34, 49, 139, 140
McAdoo, W. G., 85–6 non-bank financial intermediaries
McGrattan, E. R. and E. C. Prescott, (NBFIs), 146, 147, 148
24, 34
Miller, Adolf C., 35, 89–90, 92–3 Osborne, M. F. M., 38
Miller, E. M., 45 overvaluation, 4, 17
Modern Portfolio Theory (MPT), 3 analysis of stock market returns,
Moen, J. R. and E. W. Tallman, 147, 94–144
148, 214n4, 214n7, 214–15n9 aviation industry case study, 94,
monetary expansion, 1, 4, 22, 26, 70, 108–27, 119, 120, 123, 125–7,
73, 80, 188 131, 191–2
234 Index
overvaluation – continued Rajan, R. G., 48

cross-sectional tests of stock values, Rappoport, P. and E. N. White, 33, 149
53, 56, 136–9, 189–97, 206–9 rayon, 14, 82
high expectations, 23, 55, 122–3, Regnault, Jules, 38
132, 135–6 regulatory arbitrage, 145, 148–9, 173,
long-term inflation expectations, 197–8
82–5 shadow banking system, 194, 197–8
lower risk premiums, 23 returns on investment, see equity
momentum effects, 24–6, 37, 81, returns
140–1, 141 risk
new financial products and diversifiable, 3, 10
investment vehicles, 24, 25, 26 effect of economic growth on
over-optimism and exuberance, investment risk, 12–13
6–7, 26, 32–3, 144 measure of, 2
perception of a ‘new era’, 24, 56, 143 overestimation of long-term risk,
tests for potential drivers, 131–43, 10–11, 12
135, 141, 142 quantifiable/unquantifiable, 9
reduction of, by diversification, 3
Pareto efficiency, 42 roll-over, 76
Parker, H. G., 155 systemic, 17
Pástor, L. and P. Veronesi, 49, 110, time hazard investment horizon, 12
140–1 time-varying risk premium, 42, 46,
Pepper, G. T., 48 55, 57
petroleum industry, 14 uncertainty and risk, 1, 8–16
Poor’s Manual of Industrials (1912), 97 see also closed-end funds; Equity
Price/Dividend (P/D) ratio, see equity Risk Premium; Modern Portfolio
returns Theory; uncertainty; valuing
prices stocks; volatility
drivers of price rises, 1, 53 Roberts, H. V., 38
Efficient Markets Hypothesis Rockoff, H., 71
(EMH), 37, 38–9, 40, 53 Roelse, H. V., 153, 154
legitimacy of price rises, 1 Romer, C. D., 183
liquidity theory, 48 Rostow, W. W., 61
‘marginal opinion’ as cause of
fluctuation, 5 Scharfstein, D. S. and J. C. Stein, 43
random nature of, 38–9 Scheinkman, J. A. and W. Xiong, 46
prices and dividend index, 20–1, 21 Second World War, 29
square root of time rule, 38 Seltzer, L. H., 119
standard deviations, 38 Shiller, Robert J., 6, 19, 22, 32, 34, 40,
probability theory, 9–10 42, 44, 45, 48, 95
see also risk; uncertainty short selling, 35
productivity growth, 3, 12–13, 81–2 Silber, W. L., 86
Multi-Factor Productivity Growth Sirkin, G., 31–2, 35, 135
(MFPG), 64, 80, 82, 108, 143, 191 skyscraper building boom, 22, 75
sector growth rates, 98 Smiley, G. and R. H. Keehn, 154
Purchasing Power Parity, 68 Smith, Edgar L., 106
Common Stocks as Long-Term
radio, 14 Investments (1924), 2–3, 5, 6,
Radio Corporation of America, 35 10–12, 23, 25–6, 55, 82, 95,
railways, 14, 62 107, 132–4
Index 235
Smith, Vernon L., 19, 46 technology

Snyder, Ralph, 90 aviation industry case study, 94,
stock market (USA) 108–27, 119, 120, 123, 125–7,
analysis of returns, 94–144 131, 191–2
boom (1920s), 3, 4, 6, 7–16, 20–6, boom and growth, 1, 4, 6
58–61, 131–44, 151 growth model for new technology
crash (1929), 4, 6–7, 20–1, 54, stocks, 108–27, 119, 120
58–61, 145–73 Multi-Factor Productivity Growth
crash (1930–2), 28–30, 58 (MFPG), 64, 80, 82
credit system, 145–73 telegraph, 14, 62
equilibrium level 60–1, 94–105 Temin, P., 176
fair value, 52, 54, 55, 102, 105, Tirole, J., 42
189–90 Tuckett, David, 204
liquidity crisis, 168–73,
172, 215n16 uncertainty, 1, 33, 123
microstructure, 145–73 distinct from risk, 9–10
monetary dynamics, 71–81 dividend forecasting, 32–4
money market retraction, 163–8 USA
prices and dividend index, business activity index (1899–1937),
20–1, 21 175
realised returns, 2, 19, 23, 55–6, construction industry
105–8 boom, 188
stock valuation and the real consumer prices, 77, 184
economy, 174–86 debt levels, 71, 74–7, 75
see also Great Contraction; Great dividend index, 79
Depression; overvaluation; stock economic dynamics, 2
value collapse economic growth, 3, 12–13, 81–2
stock value collapse, 174–86 economy and financial system,
extreme pessimism (anti-bubble), 58–93
180–1, 182–3, 186 foreign direct investment
fall in nominal earnings and (FDI), 64
dividends, 30, 177–8, 177, 182, gross domestic product (GDP), 78,
186 79, 183
fall in real dividends and earnings, growth path, 23–4, 62–4
178 higher education, 62–3
increase in risk premiums, 30, inflation, 15–16, 15, 82–5, 188–9
178–80, 179, 180, 182, 186 institutional framework, 62–3
stock undervaluation, 30, 180–2, long-term government bond
181, 186 yield, 83
Strong, Benjamin, 88 money supply and growth,
72–4, 73
Taffler, Richard, 204 natural resources, 62
tangible/intangible capital, 34 recession, 183
technological innovation returns on stocks, 80–1, 81
asset bubbles, 49, 109, 110, 202 rural–urban migration,
patents, 3, 26, 34, 49, 109, 143 188, 212n10
research & development (R&D) stock ownership, 14–15
labs, 3, 62–3, 82 stock valuation and the real
technological shock, 1, 23, 27, 51, 56, economy, 174–86
81, 143, 191 unemployment, 76, 183
236 Index
USA – continued scientific theory, 5

wages/wage index, 77, 78 utilities, 5
see also Federal Reserve; Great value investment approach, 5
Contraction; Great Depression; Viner, J., 66–8
New York Stock Exchange; stock volatility, 3, 7, 26, 42
market compensation for, 10
US Steel, 35–6, 63 effect of diversification, 13
measurement of, 26, 38
valuing stocks US economic growth, 12–13
balance sheet analysis, 5
Dividend Discount Model (DDM), Wheelock, D., 188
3, 5, 35, 52, 55, 94–108, 135–9, White, Eugene N., 20, 33, 75, 212n9
189–90 Wigmore, B. A., 20, 36–7, 150
dividend discount modelling, 3, Williams, John Burr
7–8, 42 The Theory of Investment Value
industrial growth model, 3–4, (1938), 5, 25
108–27, 119, 120 Working, Holbrook, 38
industry life-cycles, 5, 13–14 Wright, Ivan, 169, 215n22

(Palgrave Studies in The History of Finance) Ali Kabiri (Auth.) - The Great Crash of 1929 - A Reconciliation of Theory and Evidence-Palgrave Macmillan UK (2014)

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(Palgrave Studies in The History of Finance) Ali Kabiri (Auth.) - The Great Crash of 1929 - A Reconciliation of Theory and Evidence-Palgrave Macmillan UK (2014)

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The Great Crash of 1929

Palgrave Studies in the History of Finance

Palgrave Studies in the History of Finance series

Typeset by MPS Limited, Chennai, India.

6 The Great Contraction of 1929–1932 and

Appendix: Results of cross-sectional tests 206

0.1 Consumer Price Index (1825–1929) 15

5.8 Ratio of Cowles (1938) Index to Credit Index 172

0.1 Smith (1924) estimates of return premium on stocks 13

A.4 Results of regression of percentage change in P/D ratio

This book aims to produce in as detailed a way as possible a guide to

The author would like to thank Professor Geoffrey E. Wood, Professor

order to develop a clearer understanding of the causes of boom and

of Investments (1930). This model was intended for investors to value

participation in the boom, and mass media coverage. Galbraith’s book is

The 1920s US stock market and the evolution of finance

In 1900 Louis Bachelier (Bachelier, 1900) was already investigating the

1. The ‘probability’ of these income payments.

Therefore the value of the bond would be lowered by a ‘probability fac-

The estimation of the longevity of dividend income

New ideas on risk and uncertainty

(1921) first conceived of an explicit distinction between quantifiable

ideas on what cannot be truly known show to what extent academic

tests of the comparative investment value of bonds and of Common

Although Smith focused initially on changes in the returns to

The usual data and charts representing market fluctuations of

Data from Moody’s investors’ manuals provided detailed informa-

We have, then, data relating to four separate stock holdings covering

Table 0.1 Smith (1924) estimates of return premium on stocks

Timeframe Investment Total return Capital Income ($) Premium

1901–1922 10 000 16 400 5420 10 980 5.2%

• Over time as the US economy became more stable.

been many other new industries that now appear as commonplace.

Our modelling of the automobile industry, which we do when

Figure 0.1 Consumer Price Index (1825–1929)

Another equally vital area of research is the use of survey data to

We focus on a particular time period and on a specific market.

Price index Dividend index

us to estimate, in a more technically rigorous way, the dynamics of the

To this end it is worth introducing the reader to the history of economic

likely to form. However, we cannot provide conclusive proof of how the

of volatility and the protection of investors’ principal when investing

Many factors have been suggested as having contributed to the over-

2.1 Modern literature related to the 1920s

The valuation of stock markets, and specifically, instances of financial

prices that match the magnitude, timing, and time-series behaviour of

the market is irrefutable, although importantly he does not advance a

At the outset of this section we define a ‘bubble’ as a positive deviation

when we the use the term. It is an overused phrase, which deserves

information impacting the prices of stocks, and hence creating

from ex-ante knowable fundamentals most likely did occur at these

What we focus on in this section is explaining the theory and evi-

With asymmetric information

If pay for managers is based on relative performance another powerful

Feedback or momentum trading

Representativeness heuristic and conservatism bias

either a mean-reversion model or by a trending model. When the earn-

Heterogeneous belief bubbles

Laboratory tests of bubbles

of the brain responsible for predicting the behaviour of others become

Credit and financial sector liquidity

Application to the 1920s US stock market

Our methodology is heavily empirical by design and follows previous