almost 3 years ago • 5 mins
In his book “Rainbow's End: The Crash of 1929”, Maury Klein provides a detailed autopsy of the biggest, most devastating stock market crash in US history. And given how uncanny the similarities are between the lead-up to the Wall Street Crash and markets today, you might want to start working out an exit strategy in case history repeats itself.
There are a lot of stock market debuts
The number of initial public offerings (IPOs) reached record levels in 1929, as companies rushed to ride the market euphoria and sell new shares to investors. Fast forward to 2020, and the number of IPOs was around the highest in history – despite a pandemic that wreaked havoc on the global economy. That was soon followed by a blockbuster start to the year in 2021, with the number of first-quarter IPOs hitting a new record.
Loads of new, inexperienced speculators are entering the market
In the late 1920s, the number of new investors – attracted by fast-rising prices – ballooned to record numbers. To meet the demand, the number of brokerage houses in New York more than doubled from 1925 to 1929.
The modern-day equivalent is commission-free trading apps like Robinhood and Freetrade – and they’re booming like never before. At the same time, Reddit's r/wallstreetbets – a home for retail traders that shows signs of the same type of speculative attitude seen in the late 1920's – has seen its ranks swell to over 10 million members.
There’s record amounts of leverage
Buyers who draw heavily on margin (borrowed money) or leveraged products like options are more vulnerable to being forced to sell in a downturn. Record levels of borrowing to invest and trade, then, are rarely a good sign.
Brokers in the 1920s took out loans to fund margin accounts for clients like there was no tomorrow. It was a great business – or it was until it all came crashing down. In 2021, brokers are again giving out record levels of debt to investors and traders, with the amount of margin debt hitting a record-high $813 billion in February – nearly double last year’s $545 billion.
The US central bank is boosting the economy
Back in the 1920s, the US Federal Reserve (the Fed) kept interest rates very low for far longer than many economists back then had hoped, and it was stocking up on US government bonds too. If that sounds familiar, it’s because it’s exactly what the Fed’s doing today: interest rates are at virtually zero percent, and it’s buying up a massive $120 billion worth of bonds a month.
The fear is that all this cheap money provided by the central bank is inflating market prices and creating bubbles everywhere you look. That’s what happened back in the 1920s – only for the bubble to violently burst in the 1929 market crash.
Stock valuations are as high as ever
There’s a widely followed valuation metric known as the cyclically-adjusted price-to-earnings (CAPE) ratio, which aims to even out the highs and lows across an entire ten-year economic cycle. And if you use it these days, you’ll see it hovering at 37x. To put that into context, the historical average of the ratio is around 17x.
The CAPE ratio has proved essential in identifying potential bubbles and market crashes in the past. A CAPE above 30x has only occurred four times in history: before the coronavirus-induced stock market crash in 2020, before the 2007-08 financial crisis, before the dotcom bubble burst in the late 1990s, and, of course, just before the great market crash in 1929.
No one can say when a stock market crash will happen, or how much higher markets could grind before then. But when it does, you’re essentially left with three exit strategies:
1️⃣ Get out early
If the eventual market dip turns out to be significant, it may be a good idea to get out straight away, even if that means missing out on some gains in the interim. Exiting early doesn’t necessarily involve cashing everything in at once: you could instead gradually reduce your portfolio’s exposure to stocks.
2️⃣ Get out late
An alternative approach is to ride markets past their peak and exit after the crash has already started. You could time that withdrawal using a technical indicator like 12-month price momentum, which measures an investment’s performance over the preceding 12 months. Once the stock market’s 12-month price momentum signal turns negative, make your exit.
3️⃣ … Do nothing
Markets have always risen in the long term, and since timing the market is hard, it might not be a bad idea just to make an investment and forget about it. A crash could leave you looking at years before your returns turn positive, but you might be skeptical that any correction will be that significant – or that one will even happen in the first place.
As for which strategy to take, there’s no right answer: it all depends on who you are as an investor. Just as long as you have some kind of strategy in place in case everything goes topsy turvy – even if that strategy is “sit back and ride it out.”
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.