This is my second installment in this series examining bubbles, earnings crashes, and market corrections in US history. I began this examination after publishing an article titled, "Now Is the Time To Be Fearful", in which I observed that full-on stock market bubbles were extraordinarily rare in the US. Rather, market corrections tend to be caused by unexpected earnings crashes, triggered by macroeconomic factors, rather than excessive valuations.
Valuations have looked reasonable before nearly every market crash (with the exception of the Tech Bubble), so long as one assumed that positive earnings growth would continue. Those of us who have been taught valuation know that our models are heavily reliant upon a few assumptions, such as a terminal growth rate. This is where investors often get in trouble, as they fail to account for the "lumpiness" and volatility in earnings growth. The false scientific precision in modern valuation models brings comfort, but leads to frequent error.
The problem is that there is no realistic way to numerically account for huge macro factors that can swing the market. Instead, to be successful, investors simply have to run their models and mentally adjust for risk. This is the great benefit of "margin of safety" investing; we know that our own models are imprecise, which is why having a "margin of safety" provides us more room to be "wrong", without losing money.
Of course, it's instructive to look to the past to get a better understanding of risk. That's why I've embarked upon this exploration of prior earnings crashes. My first article in this series examined the earnings crashes from 1871 - 1900. This article will look at the first quarter of the 20th Century.
Earnings Crashes: 1900 - 1925
Let's jump right into the meat. The chart below shows estimated S&P (SPY) earnings from 1900 - 1925.
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Comparing it to our prior period (1871 - 1900), this period seems to have less volatility, particularly in the first 15 years. At that point, we see a huge jump in earnings (1914 - 1916), followed by a prolonged decline (1916 - 1921), which is eventually followed by more rapid growth (1921 - 1925).
I counted four noteworthy crashes during this 25-year timeframe. The first three earnings crashes could be described as "moderate", including (rather surprisingly) the one associated with the Panic of 1907. The next crash, on the other hand, is one of the worst in American history, running all the way from late 1916 all the way to the end of 1921, and culminating with the Depression of 1920 - 21. Earnings plunged 81% during this 5-year timeframe and this is the second largest decline in recorded in the entire 142 year data series.
(click to enlarge)You can see the market reaction to these earnings crashes below. Note that the last two columns, simply labeled "A" and "B" measure how many months prior the stock market reacted to the EPS peak and the EPS trough. With all four of these crashes, the stock market peaked about 1-3 months ahead of time. Unfortunately, as we'll find out in the later articles, this does not hold steady throughout history, and fluctuates wildly, so the predictability in this era may be an aberration.
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The market reaction to the first three crashes was rather moderate. Even the prolonged 81% 5-year contraction in earnings from 1916 - 1921 only resulted in a 37% decline in the market. However, this may be, in part, due to the fact that the market did not fully follow earnings upwards in the 1914 - 1916 time period.
The chart below looks at the P/E ratio of the market, compared to earnings, during the period. From 1914 - 1916, earnings surged from a low of $0.52 in December 1914 to a high of $1.53 in December 1916. That's a 194% increase in just 24 months. Conversely, the P/E ratio in the same time period fell from 14.1 down to 6.4.
How do we explain the subdued multiples? One response might be that investors fully expected the earnings surge not to last. After all, it's difficult to find too many 2-year stretches were earnings catapulted upwards at a 72% annualized rate. In fact, I can only find two other examples of this, and both came after massive earnings crashes: 1921 - 1923 and 2009 - 2011. So perhaps investors didn't fully buy into the idea that this was going to last.
Also, keep in mind the context here. 1914 was the beginning of World War I and the United States did not enter the war until three years later. The first few years of the war were very beneficial to the American economy, as European agricultural capacity was decimated, which caused prices for agricultural goods to skyrocket. The US was still heavily dependent on agriculture at the time, and these events were beneficially economically for American farmers, with many dramatically expanding their output.
Expectations and the unique economic circumstances of World War I likely played a huge role here, but there's an alternative explanation, as well. The US Federal income tax was put into place in 1913. The initial rates from 1913 - 1915 were quite modest, ranging from 1% to 7%. The vast majority of Americans paid less than 1%, with $20,000 being the limit for that rate. In inflation-adjusted terms, the equivalent would be that everyone making under $450,000 would pay a max 1% income tax.
From 1916 to 1918, the income tax underwent a dramatic transformation, with what might be considered either the 1st or 2nd largest series of tax increases in American history (Herbert Hoover's 1932 tax increases would be the main competition). The chart below, with data provided from the Tax Foundation, shows how the income tax changed from 1913 - 1918.
During the 1910's, I'd surmise that wealthy investors owned the bulk of shares in the stock market. Also keep in mind that there were no distinctions between "income" and "capital gains" during this time period. So a wealthy investor who made $100,000 per year would have been taxed at 4% on investments in 1915, and 60% in 1918; a rather steep increase.
Suffice it to say, the rapidly changing tax situation might partly explain why investors were reluctant to pay high multiples for stocks. It also likely led to dramatically lower investment in the American economy, outside of a few industries that heavily benefited from the war.
Given all this, there appear to be an abundance of reasons why investors may have been paying suppressed earnings multiples from 1914 - 1918, including skepticism about the sustainability of the earnings surge, the uncertainty and distortions of World War I, and one of the largest tax increases (and likely the single largest on capital) in American history.
Earnings Growth Rates
Next, let's jump over to forward earnings growth rates. The first chart looks at the 5-yr forward compounded annual growth rates ["CAGR"] for S&P earnings.
(click to enlarge) There's a ton of volatility, just as there was in the chart examining the same metric for 1871 - 1900. I've also included the 10-yr version of this for comparison purposes.
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Please note the scale in both charts. The 10-yr might initially look more volatile, but it's actually a case of the 5-yr chart being so wild, that the terrible -30% and outstanding +35% growth rates masks some of the other figures. The 10-yr chart actually smoothes this volatility out quite a bit.
(click to enlarge)When I ran this analysis for 1871 - 1900, the correlation was high, with the correlation coefficient at +0.795. This data set has a correlation much weaker than the first. The correlation coefficient here is +0.433. However, once again, this may be the result of the market anticipating certain policy moves ahead of time, as well as concerns about World War I.
Now that I've finished bombarding you with charts, let's look at some of the causes for the two most important crashes in this era: The Panic of 1907 and the Depression of 1920 - 21.
The Panic of 1907
The Panic of 1907 is one of the most noted events during this timeframe. This recession occurred after the 1906 San Francisco earthquake, which was one of the worst natural disasters in US history. The total damage was equal to about 1.5% of Gross National Product. The closest modern parallel would be Hurricane Katrina in 2005, which caused $81 billion in property damage, equal to about 0.6% of GNP. In other words, the San Francisco earthquake caused a hit to the economy 2 ½ times as large as Katrina.
This 1906 earthquake resulted in New York banks sending a lot of capital to the San Francisco region; it also likely resulted in a major strain on the West's most important economic hub. On the other side of the pond, interest rates were rapidly climbing in the UK, making US investment less appealing, which likely led to tightening capital in the US.
While some accounts point to the Heinze Brothers' attempt to corner the stock of United Copper as a significant cause for the recession, I don't fully buy this explanation. The Heinze scheme began in October 1907, after several months of declining money supply (also see Milton Friedman's Monetary History of the United States), suggesting that the Heinze scheme was more of a symptom than a cause of the distress. If it had occurred during a stronger economic period, it'd likely be no more than a minor footnote in history.
Therefore, I'd pinpoint the major causes of the Panic of 1907 as being the San Francisco earthquake, rising interest rates in the UK (leading to some capital flight from the US), and a moderate monetary contraction that may have resulted from both of these events.
That said, while the Panic is considered one of the more notable ones in US history, the impact on corporate earnings was surprisingly subdued compared to other banking panics, causing only a very moderate 24% decline from peak (1906) to trough (1908).
The Depression of 1920 - 21
While the first decade and a half of the 20th Century resulted in no major earnings crashes according to the Shiller data (i.e. no crashes of 40% or greater), the period from 1917 - 1940 gets downright ugly. It starts with the Depression of 1920 - 21, which I'd consider the second worst in post-Civil War American history.
The period from 1916 - 1920 was marked by an extremely sharp rise in US government spending, followed by a significant reversal. Government spending as a percentage of GDP rose from 8.2% in 1916 to 29.3% by 1919, and then back to 12.8% in 1920.
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The US budget deficit also soared, rising from 0.3% of GDP in 1917, all the way to 11.9% in 1918 and 16.8% in 1919. After that, it plunged again in 1920, and the US ran small fiscal surpluses the next 11 years.
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This massive spending surge was obviously an effect of World War I and it likely had a huge shock on the US economy. Also note that Consumer Price Index inflation soared during the war and the immediate years afterwards, peaking at 23.7% in June 1920.
The next year would see a complete reversal of this trend, as extremely high inflation shifted into extreme deflation, with CPI plunging 15.8% YOY by June 1921. The deflation ended up being beneficial for the economy (and short-lived) if the next several years were any indication.
We should also look at the labor market shift. In 1918, the US Armed Forces employed 2.8 million people. The total population of the US at that time: 103 million. That means that roughly 2.7% of the population was employed by the military. If you were only to count working-age men, that number would probably jump into the 7% - 10% range. One has to imagine that this would have a huge impact on the economy.
The trend obviously reversed and the number of Americans employed by the military fell from 2.8 million in 1918 down to 380,000 in 1920. In other words, much of that 7% - 10% of the American workforce that was removed from the economy for the war, was suddenly reinserted back into it by 1920. It's obvious how this could create a bit of an economic dislocation.
Yet, there are also forgotten shifts from WWI. I already alluded to the shift in agricultural production that had benefited US farmers immensely. As a result, US agricultural supply was greatly increased during the 1914 - 1919 timeframe. Once the war ended and Europe's agriculture industry slowly started to return to "normalcy", prices began falling, and US farmers who had overexpanded were struggling. Indeed, the booming economy is what we tend to think of when we talk about the 1920's, but while most of the nation was in a boom, the agriculture sector was in a major depression. This boom to bust was likely one of the causes behind the Depression of 1920 - 21.
Monetary policy was also a factor. In A Monetary History of the United States, Milton Friedman documents how the Federal Reserve dramatically raised interest rates in 1919 and 1920, going from 4.75% in late 1919, all the way up to 7% about six months later.
In spite of the severity of the Depression of 1920 - 21, the economy recovered rather quickly, as the Harding, and eventually, Coolidge Administration favored policies of dramatically government spending and reducing taxes, which led to major private sector growth.
General themes in this period for the Depression of 1920 - 1
1. War and war inflation,
2. War-time labor market shifts,
3. Large tax increases,
4. Dramatic increase in government spending,
5. Massive budget deficit,
6. Agricultural boom / bust cycle,
7. Rapid monetary tightening
Examining the period from 1900 - 1925 and comparing with the period from 1871 - 1900, we see a few common themes. Once again, wars end up playing a huge role in the most major depressions. We saw how the end of the Franco-Prussian War may have helped trigger the Long Depression of 1873 - 1879, while World War I definitely played a major role in the Depression of 1920 - 21.
There's another interesting development here. The Depression of 1920 - 21 was more severe than virtually any other economic dislocation in the developed world since 1870. World War I also created more negative long-term issues, as the destruction of Europe's agricultural capacity, would lead to massive overcapacity issues in the US after 1919. These issues lingered on right through the 1920's boom and into the Great Depression.
We also find that natural disasters can have a major impact on the economy, with the San Francisco earthquake destroying 1.5% of GNP. Monetary contraction is another theme that manifests itself frequently, as rising interest rates in the UK and the San Francisco quake, may have helped led to a lending slowdown and the Panic of 1907. Additionally, rapid monetary tightening may have exacerbated the Depression of 1920.
Overall, the dramatic surges in government spending and huge tax increases may be the most instructive parts of this era, as it appears the huge income and capital tax increases from 1915 - 1918 may have played a role in undermining US economic growth, and leading to too low investment in vital industries. This view may be re-confirmed due to the rapid recovery of the US economy after 1921, once government spending and tax rates were reduced.
For Part 3 of this series, I will examine the 1926 - 1950 time period, which will primarily focus on the Great Depression (1929 - 1933), as well as the Recession of 1937 - 38.