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“Theory anchors” explain the 1920s NYSE Bubble

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  • Ali Kabiri
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    Abstract

    The NYSE boom of the 1920s ended with the infamous crash of October 1929 and subsequent collapse in common stock prices from 1929-1932. Most approaches have suggested an overvaluation of 100%, usually dating from mid-1927 to September 1929.Excessive speculation based on high real earnings growth rates from 1921-8, amid a euphoric “new age” for the US economy, has been given as the cause. However, the 1920s witnessed the emergence of new ideas emanating from new research on the long-term returns to common stocks (Smith, 1924). The research identified a large premium on common stocks held over the long term compared to corporate bonds. This, in turn led to the formation of new investment vehicles that aimed to hold diversified stock portfolios over the long run in order to earn the large equity risk premium. Whilst such an approach was capable of earning substantial excess returns over bonds, new ideas derived from the research led to a change in stock valuations. The paper reconstructs fundamental values of NYSE stocks from long run dividend growth and stock volatility data, and demonstrates why such a change in theoretical values was unjustified. Investors switched to valuing stocks according to a new theory, which ignored the compensation for stock return volatility, which made up the Equity Risk Premium (ERP), on the assumption that “retained earnings” were the source of the observed ERP.

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    File URL: http://www.lse.ac.uk/fmg/workingPapers/specialPapers/PDF/SP218.pdf
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    Bibliographic Info

    Paper provided by Financial Markets Group in its series FMG Special Papers with number sp218.

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    Date of creation: 2012
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    Handle: RePEc:fmg:fmgsps:sp218

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    Web page: http://www.lse.ac.uk/fmg/

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