What Caused the Great Depression?

There’s whispers in the financial market stating that we’re in a 1929 setting.

But what does that mean?

We know that 1929 was start of a prolonged bear market but why did it have to occur? How did the roaring twenties end up in the depressing 30s?

Let’s find out.

The Events Leading Up to The Depression

According to History.com, the crisis occurred on October 24, 1929. The reality is that a variety of interconnected events led to October 24, 1929. Fear replaced greed. Traders were scared and weak hands were everywhere. The Dow Jones declined more than 10% on October 28th, 1929 and fell another ten percent on the next day. People started to see and slowly feel the effects of a period of “irrational exuberance.”

The prior decade was one for the history books.

The U.S economy saw significant growth and the stock market got high.

Real high.

The air was filled with great expectations for the future.

The Dow went on tear from the latter half of 1921 to the latter half of 1929. Investors saw significant gains in their portfolios, more than a five-fold increase.

Everyone thought that the stock market and the economy would continue to grow at a breakneck speed.

But the joy would soon come to an end as the Dow finally reached its peak at 381. Studies of this time show that more general people and laymen started to enter into the speculative stock markets, quite likely on the thought that their investments could only head in one direction, up. They were so confident in the economy, their horoscopes, and the soothsayers of Wall Street that they would start to get their feet wet and buy more stocks with leverage. An increase in average working class people with a low tolerance for risk started to take on more than they could afford.

It is hard to blame them. Everything looked great in the 20s. The United States economy was growing at a rapid clip, jobs were aplenty and key sectors looked quite robust.

There were many different reasons as to why the roaring 1920’s turned into the depressing 30’s, a few key factors are listed below.

Risk Appetite, Leverage, Extrapolation and Extremes

Everyone thought that today’s rapid expansion would continue to last well into the future. They lived and speculated accordingly. The stock market is based on capturing and investing in future cash flows. Growth can only happen at a certain level, then regress, before plateauing over time and slowly trudging forward.

As reflected by stock prices, expectations were pretty high for the future. But this growth could not last. “In 1932 the DJIA reached a low of just 11% of its high in 1929, or a loss of roughly 89%.” A steep correction like that indicates that asset values were overpriced. Investors weren’t necessarily looking at the fundamentals. They were buying for a variety of reasons that might not have been tied to reality. Reasons such as buying in hopes of selling to someone else for a greater price.

The three main causes of the great depression likely stem from an increase in the average person’s appetite for risk, their love for debt, and excess confidence in the economy.

Consumers and investors weren’t the only one’s taken with the good times, businesses also ramped up production based on extrapolations of the present. Businesses took significant losses when they saw that their supply, their purchasing, and way of operating were not tied with the realities of the times.

The Federal Reserve saw that the economy was rising quickly and decided that it was time to slow it down by raising interest rates. It simply raised it by 100 basis points a few weeks later, the first signs of distress would appear in the stock markets.

Once the asset declines started to take place, fear gripped the hearts and souls of Wall Street and Main Street, they started to started to make plans to pull cash from the financial system. Bank runs, further stock declines, and other fear related activities exacerbated the situation.

It went from 200% confidence in the financial market and the future to zero confidence.

Remember this as you make your investment allocations.