Financial Advisors Rob McClelland and Mike Connon discuss the global history of stock market crashes and review “A History of the United States in Five Crashes: Stock Market Meltdowns That Defined a Nation” by Scott Nations. What do all these crashes have in common, and how can leverage be detrimental to an economy? Find out this and more.
Transcription
Rob (00:00):
Hello, this is Rob and Mike, from The McClelland Financial Group of Assante Capital Management, and this is Think Smart with TMFG. Today on Think Smart with TMFG, Mike and I are going to be discussing the history of market crashes in the United States, and globally. Mike, an interesting book that I just finished reading, it’s called The History of the United States in Five Crashes, and it’s written by a gentleman by the name of Scott Nations. And what he did is, he went back and looked at all the major stock market crashes that have taken place, since the early 1900s. He made an interesting observation right off the top of the book, where he said, “Every modern stock market crash has an external catalyst. Each collapse has been fueled by a new, poorly understood, financial contraption that introduces leverage into a system that is already a little bit unstable.”
Mike (01:05):
It’s funny what you consider modern, what we think of now, as in modern, back in the day, there were some pretty simple things were really new ideas coming out at the time, weren’t they?
Rob (01:16):
Definitely. Let’s go back to 1907. The contraption that was created was called trust companies. And they were essentially a type of company that you could invest in. It was similar to a bank, but it wasn’t a bank. They were ungoverned.
Mike (01:38):
They have a very safe sound name, don’t they? Trust companies.
Rob (01:40):
They do, right? And they’re still called trust companies today.
Mike (01:44):
What could possibly go wrong in a trust company?
Rob (01:46):
Well, I’ll tell you what went wrong. It was leverage. How leverage works is, if you put in, let’s say, $100,000, and you use leverage, you could borrow $200,000, so that you have $300,000 working for you. Now if that investment goes up 10%, just 10%, your 100,000 has gone to 130,000. That’s a 30% increase, even though the investment only went up 10%. But Mike, what happens if that investment goes down 10%? What do you have left?
Mike (02:24):
Exactly the opposite.
Rob (02:26):
You started with 300,000, you only put in 100,000. Now you’re down 10%, you’re down to 270,000, but you still owe $200,000. So, you’ve lost 30%. And that’s what got these investment trusts into trouble. And so many people were making so much quick money, everybody got excited about it, and started putting more and more money in, which, when that demand is there, then the supply happened. So, investment trusts were literally created overnight. And this is what fueled the 1907 crash. By the end of the year of 1907, the stock market was down 38%.
Mike (03:10):
And think about this, go back to that time. Now, we go through leverage, and do all these complicated transactions using heavy-duty computers. In 1907, it was ledgers. There wasn’t even calculator, right? I don’t even know if they had adding machines back then to do that. So, think of how this stuff had to be tracked. And when people got odd positions, there wasn’t a phone to call them, right? What do you do? You send them… You have a horse deliver a letter to them? Like, that your margin call has come in it. It’s very amazing that all this stuff even existed at that time. But yeah, you can see all the problems that would come with it.
Rob (03:48):
Let’s move on to the next one, 1929. What was the instrument that no one understood? They were called investment trusts. Interesting, Mike, there’s that word again. And in the late 1920s, hundreds of new investment trusts were created every year. The sponsor of the trust would not only receive a management fee for the money inside the trust, and they would earn that fee in perpetuity, but they could also earn commissions from the buying of selling of stocks inside the trusts. And all of that went into their pocket. What happens next? Leverage. Just like happened in 1907, the money looks too easy to make.
(04:31):
So people say, “Well, I’m going to borrow money to get into these things.” And that’s what happened. They would, in 1927, they’d pour $50 million from many small investors. And instead of buying the securities, they would put the 50 million in, but they’d go out and borrow $100 million dollars, and it would all go into stocks. And then when things started to get a little unstable, the investors couldn’t get out. The crash of 1929 would actually lead to the Security Act of 1933, that required these companies to do proper disclosure, and that was the issue. There weren’t any rules around how these things happened.
Mike (05:13):
At that time they even had, I believe it at that time, was even up to 90% leverage on buying stocks. There’s limitations now, I think it’s around 50%. Otherwise there’s, depending on the type of stock you’re buying, but there’s a lot of limitations as to how much you can leverage into an account. Back then it was… They didn’t have those rules. And a lot of amateurs were getting in the stock market. And we always hear the famous story. It’s always, whether it was Joe Kennedy, or Rockefeller, when they went to get their shoes shined, and the guy shined the shoes gave them advice on the stock market, they pulled all their money the day before it crashed because it was just going right across the whole board. Everyone was giving stock advice, without any knowledge.
Rob (05:53):
What was interesting is those that got impacted the most financially, and in dollar sense, were the 1%, the wealthy 1%, because they were the ones that were extremely leveraged. Unfortunately, the collateral damage was the unemployment rate, and that’s what followed. And so, even those who weren’t invested in the stock market, they lost their jobs, which is even worse. And that went on and on, for a number of years.
Mike (06:19):
The people with the money lost their money, and that led to the Great Depression afterwards, because they couldn’t hire anyone.
Rob (06:24):
Let’s go forward now to 1987. Now, what’s interesting about 1987, I was actually buying my… A house at the time, and I owned stock, and I had submitted it. I was with Hudson’s Bay Company and I had submitted an order to sell $30,000 worth of stock so I could put this down payment on the house. The only problem is it was a real manual system. There was only one person that would sell your stock, and that person was away for a month. So, my stock didn’t get sold until November ’87, after the market had crashed. I remember this one very painfully because I didn’t have nearly enough money for the down payment, and I had to reach out to my parents for a loan for $20,000 to do the down payment. What caused the 1987 crash? Well, there were two things. It was called portfolio insurance.
(07:19):
Think of that. You can have a portfolio, and you can buy insurance to protect your portfolio. What happens when the market crashes though, is the insurance can’t cover everyone’s portfolio. Kind of like what happened in Florida with the hurricane, now they’re saying we can’t get insurance on a hurricane, which makes sense, right? Because these disasters seem to happen, time and time again. So, what caused the crash in ’87 was, number one, portfolio insurance, was number two, lower than investment grade, or junk bonds. It was another complicated financial product called portfolio insurance, and that’s what helped to stimulate the crash.
Mike (08:03):
And I think we forget how bad 1987 was because it recovered so quickly. But how much was it down in that short period of time?
Rob (08:12):
Believe it or not, the Dow lost 508 points, which doesn’t sound like a lot because the Dow is so much higher today.
Mike (08:18):
That’s an average day today.
Rob (08:19):
That’s an average day. But that was 22.6% in one day. And that’s where we heard stories of people jumping off rooftops, and everything. Whereas the biggest one day correction before that, had been in 1929, where it was only down 12.8. So, you go from 12.8, in a day down, to 22.6%, that’s a huge drop.
Mike (08:42):
When you look back on Black Monday, it doesn’t seem as obvious as a problem because it recovered within… Literally within six months it was back to normal again, something like that.
Rob (08:51):
The year finished positive. But if you had bought before the run up, and then bailed out after the correction, you lost a lot of money. So let’s now go to 2000, and to 2002. It’s called the tech rec, it’s called the dot-com bubble. You and I were working together as financial advisors at the time, and it was crazy. We had, literally, clients leaving us every single day. Every day we would get a transfer out from a client and the response was, “You don’t know what you’re doing. My son is smarter than you, and I’m going to give him all the money to manage, and we’re going to be billionaires.” And we know what happened. And so what happened? Everyone was chasing growth stocks. The internet was just becoming… It had been in existence, but suddenly now people had realized how to capitalize on the internet.
Mike (09:48):
They saw the potential, they just didn’t quite understand the mathematics behind it.
Rob (09:52):
Not dramatically different than what we’ve just been through with the FANG stocks, and the second tech boom. But retail investors, at the time, were looking for hot stocks to invest in. And anything, any new company that came out that had technology in its name would go up, regardless of whether it was a good company, regardless of whether it made a profit, that stock would just take off, and go through the roof.
Mike (10:19):
I had friends when I was in my 20s that all of a sudden had places downtown. They were these gorgeous penthouse apartments, and they were just graduates. They were like myself, but I was envious, I must say, because they all of a sudden were worth $10-20 million, on paper. But the problem is as they try to realize their gains, whenever they got purchased by anyone, they got purchased with stock of another dot-com company. So, what would happen is, they thought it because they got the company bought, they had a price set based on the value of the other stock, but the other stock was worthless too, at the end of the two years.
Rob (10:52):
And again, leverage played a role, because if you’ve invested $100,000 and you’ve already turned it into 150,000, why not go borrow $200,000 thinking you can turn that into $300,000? That’s what again, caused 2000-2002. And the correction that happened therewith. And again, that was a big one, that was a 40-45% correction depending on which market you’re looking at. Now we’ll go to the more recent one, 2008, the financial crisis. Okay, what’s the cause again? Mortgage-backed securities. There was a couple things that started. In 1970, the US government created the National Mortgage Association, and it was called Ginnie Mae, and they created the first mortgage-backed security. And so, imagine what this is. You’re basically not just taking your mortgage, you’re taking… Mike, we’ll include your mortgage, we’ll include all of our employees mortgages, and then we’re going to sell it as a package with a guaranteed return. Interest rates were low, these mortgage-backed securities were paying 6%, interest rates were 4%. Everyone started to buy them.
Mike (12:05):
It’s almost like the stock index. Every individual company’s risky, but the index with all the companies together is a lot less risky because there’s a lot more companies involved in it. I guess to take that theory and put it out to mortgages, where an individual mortgage is risky because one person could certainly default, but the chance of a thousand people-
Rob (12:24):
There’s a hundred mortgages in, less chance of default, except this is where the engineering comes in, they see an opportunity. And what happened in, if we go back a little bit in history, in 1985, the Clinton administration launched the National Home Ownership Strategy, which is an initiative to get 8 million American families to buy their own homes over the next six years.
Mike (12:49):
Whether they could afford it or not.
Rob (12:51):
Whether they could afford it or not. So, you had in these packages of mortgages, say you had a hundred mortgages, you probably had 20 really good ones, 20 okay ones, 20 in the middle, and then 40 that were pretty bad, and the bottom 20 were horrible mortgages. What did they do? They started selling them off individually, and the credit rating companies came in and gave them all good ratings.
Mike (13:16):
It’s what they’d call tranches, at the time of mortgages. If you ever want to watch a good movie, many people probably watch it, but if you ever watch The Big Short, it’s a fantastic movie. And it’s about all the problems that happened in 2008. And there’s one scene where they go into neighborhood of all newly-built houses, and they realized no one’s living to them. They’ve just been built on leverage.
Rob (13:36):
And unfortunately, these people had bad credit history. Their income didn’t justify the value of the home they were buying. Housing prices were going through the roof. They could put as little as 3% down payment to get a house. So, tons of people were owning homes, they just couldn’t afford those homes.
Mike (13:53):
And the other thing, the salesman that were selling the mortgages were being paid on a sale happen, and they weren’t being paid on the success of the mortgage being paid off. Their main goal of their salesman person, they got the commission right up front if they got someone to sign on that line.
Rob (14:05):
So, then what happened? It all started to collapse. Some of the banks realized the risk that they had taken on, and they started to write it off. And the more they wrote it off, what they realized is they were all interconnected. They had bought some of the mortgages from other banks.
Mike (14:21):
Governments.
Rob (14:22):
They had sold the mortgages, they had bought them, and it became totally intertwined.
Mike (14:26):
Government pension plans were buying the mortgages. I mean, full countries had their whole social security systems based on these mortgage-backed securities.
Rob (14:34):
The crash really started in 2007. It then went into all of 2008, and it really didn’t end till the beginning of 2009. March 2009’s when things started to recover. So, we’ve covered a lot of big crashes, a lot of bad news. What can we learn from this, Mike? What are some of the lessons that we need to remember?
Mike (14:54):
I guess we can see the signs of danger, right? Low interest rates always create that push toward leverage. And when you get particularly low interest rates, it’s too easy. And so, that’s a big sign. We see people borrowing a lot of money. Government action and interaction. When government gets involved in things, you think the government always knows what they’re doing, but sometimes they cause more problems than they solve along the way.
Rob (15:17):
They’re often slow to react, and globally, they kept CERB going on too long.
Mike (15:23):
I think Bill Clinton was a great president. Everyone loved Bill Clinton, right? He did a great job with the economy and stuff. And the idea that everyone should own their home seems like a great idea. From the point of view, looking at it like every American should own their own house, seems like a fantastic thing to push for, but he didn’t realize the problems that would come from that.
Rob (15:42):
Home ownership is extremely expensive. So, what are some other things? We’ve had the bubble in Bitcoin, and there’s a financial instrument that no one really understands. It sounds really cool, and it may have some qualities that provide some great technology in the future, but people were buying this and bidding up the price, and borrowing money to bid up the price, to get more coins.
Mike (16:06):
What do they call it? Everything you don’t know about finance, mixed with everything you don’t know about computers, and the people that were buying it knew nothing about either one of those, in the most part.
Rob (16:15):
So when you look at these things, all of these were bubbles, and bubbles happen. We probably went through, certainly, a crypto bubble. We went through a technology bubble. Some of these companies were ridiculous values. And again, you had a ton of dot-com’s that came out and created billionaires overnight, who were serving the work-from-home market. And those companies have all crashed dramatically. That brings us to the end of another week. Thank you for joining us. This is Rob and Mike, with Think Smart from The McClelland Financial Group of Assante Capital Management, reminding you to live the life that makes you happy.
Assante Capital Management (17:16):
You’ve been listening to The McClelland Financial Group of Assante Capital Management Limited. Assante Capital Management Limited is a member of the Canadian Investor Protection Fund, and the Investment Industry Regulatory Organization of Canada. Insurance products and services are provided through Assante Estate and Insurance Services Incorporated. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources. However, no warranty can be made as to its accuracy or completeness. Before acting on any of the previous information, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. The opinions expressed are those of the authors, and not necessarily those of Assante Capital Management Limited.
