[00:04:53] Shawn O’Malley: So as mentioned at the top of the show, I want to break down today two of the four episodes of financial history covered in Napier’s book, and I’ll be relying on his research for much of that. I’ll share some big picture takeaways from the book and then zoom in on the two bear markets I found most interesting to study.

[00:05:11] Shawn O’Malley: Napier found generally that market bottoms yield the greatest amount of bargain price stocks when market prices fail to keep pace with economic and earnings growth. Using the example of the market’s low in 1921, the Dow Jones Industrial Average, which was stock index most widely referenced then, which is sort of similar to the S& P 500 today, Had fallen to the same price level as 22 years earlier in 1899, despite nominal GDP having grown 383 percent since then.

[00:05:44] Shawn O’Malley: The economy had made two decades worth of progress, yet stock prices were stuck in the 19th century. That was a telltale sign that the stock market was hugely undervalued. Something similar happened in 1982, when the Dow Index was at the same nominal level it hit in 1964, yet it was down 70 percent in real inflation adjusted terms.

[00:06:06] Shawn O’Malley: By Napier’s count, this represented the fourth best buying opportunity in stocks during the 20th century. One of the key takeaways Napier offers is that while we can find specific points that mark a bottom in stock prices, the actual process for stocks to travel from their peaks of to the depths of undervaluation.

[00:06:27] Shawn O’Malley: It can take about 14 years in the bear markets that he studied. Not a quarter, not six months, not a year, but 14 years. That’s a huge chunk of an investor’s adult life to be trapped in such a peak to trough cycle. Another key lesson is to learn to think in real terms. If you just look at a chart of the Dow Jones Index, the bottom came in December 1974 at a low of 570.

[00:06:53] Shawn O’Malley: But between 1974 and 1982, there was a tremendous amount of inflation, and at a price level of 760 in mid-1982, the Dow was actually down 15 percent from 1974 in inflation adjusted terms. Meaning, if the stock market doesn’t keep up with inflation, the point of most undervaluation in a market bottom isn’t necessarily the lowest nominal price point.

[00:07:17] Shawn O’Malley: If markets tread water for a few years, even with some gains, the market may get even cheaper after accounting for inflation. In researching his book, The Anatomy of the Bear, Napier dug through 70, 000 articles from the Wall Street Journal to better understand the context and mood surrounding the four major bottoms of the 20th century.

[00:07:38] Shawn O’Malley: He found that while many believe market despair, panic, and bankruptcies mark a bottom, economic gains and improving media sentiment lead market recoveries by several months. He also finds that across these four episodes, the minimum period of subsequently high returns was eight years after a bottom, but these recoveries usually lasted much longer than that.

[00:08:00] Shawn O’Malley: The challenge with financial history is that we have very limited modern precedence to go off of. A sample size of four is incredibly small, but it’s really all we have. You can find a handful of other relevant examples, but the point still remains. We must make the most of the limited examples we have to learn from.

[00:08:20] Shawn O’Malley: Before we dive into the 1921 bottom, I want to continue to share some of the big picture takeaways from studying market bottoms. One of Napier’s fundamental findings is that stock valuations are mean reverting. As in, they resist the extremes over long periods of valuation metrics. Thanks. That point is really nothing new, but more interesting is his realization that the catalyst for such reversions is often linked to swings in inflation.

[00:08:51] Shawn O’Malley: Inflation is fundamentally destabilizing for financial asset prices. It shortens investment time horizons because when inflation is high and unpredictable, no one wants to be caught taking longer term risks that could burn them if inflation is even higher in the future. This is seen most obviously with bond prices, which sell off the most when expectations for future inflation rise.

[00:09:13] Shawn O’Malley: Bonds pay back fixed sums of principal and interest, so there’s a real risk that you could buy a bond today and get repaid with dollars that are significantly less valuable in 20 or 30 years. Bond prices tend to sell off until they become cheap enough that the returns offered exceed investors’ concerns about long term inflation.

[00:09:32] Shawn O’Malley: Something very similar happens with stocks. When inflation is high or rapidly rising, companies future earnings and profitability become increasingly difficult to predict. As you become less confident in a business’s prospects, you’d naturally pay less to own it. So, big multi decade trends and inflation can drive which direction stock valuations move in over time.

[00:09:56] Shawn O’Malley: As Napier highlights, import prices rose just 1. 6 percent from 1981 to 2001. This apparent death of inflation coincides almost exactly with the great 1982 2000 equity bull market. Meanwhile, one of the worst periods for owning stocks from 1969 1981 coincided with a 370 percent increase in import prices.

[00:10:22] Shawn O’Malley: Understanding the trends driving inflation is quite consequential to understanding the environment for stocks. Fortunately, according to Professor Jeremy Siegel’s analysis, anyone who has been able to hold on to stocks for at least 17 years has never lost money in the stock market. The downside is that few of us have such patience.

[00:10:41] Shawn O’Malley: The average holding period for stock investors is around 10 months now, down from as long as 5 years in the 1970s. In the 20th century, 35 out of those 100 years delivered negative returns for US stocks, and in 8 of those years, there were negative returns of more than 20%. So as Napier puts it, quote, the average investor will likely encounter a bear market every three years or so.

[00:11:05] Shawn O’Malley: And every 13 years, the bear will be particularly mean. We saw one as recently as 2022 when the S and P 500 delivered a negative return of 18%. So bear markets will come and go. And Napier acknowledges that by writing quote, Bears, however, can be beautiful in their own way, and an alternative title for this book might have been, How I Learned to Stop Worrying and Love the Bear.

[00:11:30] Shawn O’Malley: Bear markets give us price discounts on our favorite stocks, and therefore we should come to appreciate them. I’ll also add that in the book, Napier determines whether markets are roughly over or undervalued by comparing a company’s market valuation with the cost to replace its assets. So a company trading below fair value is one, at least in Napier’s definition, that trades at a price below the replacement value of its assets.

[00:11:56] Shawn O’Malley: And with that, let’s take a look at the great market bottom outlined in the book in August 1921. While the U. S. stock market boomed in the early years of World War I, by August 1921, the Dow Jones Index of industrial companies sat at the same price level it had reached 22 years prior. While this new sector of industrial companies was seen as risky, those who had stuck with blue chip railroad stocks fared even worse, with prices sitting at the same levels as in 1881.

[00:12:26] Shawn O’Malley: With stocks in 1921 trading at a 70 percent discount to the replacement value of their assets, the outlook for future returns couldn’t have been better. The next eight years would be the best in the New York Stock Exchange’s nearly 140 year history. But just a few months earlier in September 1920, an attack on America’s center of capitalism left Wall Street rattled.

[00:12:48] Shawn O’Malley: Right outside of J. P. Morgan’s offices on Wall Street, an explosion rocked lower Manhattan, sending stockbrokers at the New York Stock Exchange running to flee flying glass and killing 40 people. As Napier writes, the bomb was not the only disturbance on Wall Street, a vicious bear market was also wreaking havoc.

[00:13:08] Shawn O’Malley: Buying at the bottom is an investor’s goal, and there was arguably no more profitable time to do so than in the summer of 1921. That wasn’t as obvious at the time as you might think for the simple reason that no stock index accurately captured the entire stock market at the time. In the same way that the S& P 500 and NASDAQ 100 indexes can tell conflicting stories about the market, the same was true in 1921, but leading indexes were even less representative of the big picture.

[00:13:39] Shawn O’Malley: To gauge what was happening in markets, one had to watch both the Dow Jones Industrial Average and the Dow Jones Railroad Stock Average. Let’s go a bit further back in time to understand the lead up to the Great Bottom of 1921. In 1896, trading of industrial stocks accounted for 48 percent of the trading volume on the New York Stock Exchange, with the other 52 percent of the volume going toward railroad stocks.

[00:14:06] Shawn O’Malley: But volume in general was in decline as the market recovered from the panic of 1893 to 1895. In that period, the original J. P. Morgan, the namesake for the bank, helped breathe new life into the distressed railroad sector by spearheading a number of mergers. As Napier writes, a merger mania soon followed after, and the number of business mergers in the United States rose from 69 in 1897 to more than 1, 200 in 1899.

[00:14:36] Shawn O’Malley: The merger boom benefited railroad companies the most, as the industry’s profitability had been crushed by excess capacity. A six year bull market in the railroad index delivered returns well beyond what the industrials offered at that same time. It was only the assassination of President William McKinley in 1901 that cooled the enthusiasm for railroad stocks as the great trust buster Theodore Roosevelt took office.

[00:15:03] Shawn O’Malley: Roosevelt had little sympathy for the many businesses that had combined together into monopolies and oligopolies across the U. S., especially those that had effectively unified to control pricing in their industries. Naturally, the mature railroad industry was a larger target for trust busting than the burgeoning industrial sector.

[00:15:24] Shawn O’Malley: And by 1911, trading in industrial stocks exceeded railroad stocks for the first time in over 15 years. From there, with a roughly 50 50 share of total market capitalization, prices for railroad and industrial stocks would diverge hugely, beginning 3 years later, at the start of World War I. By 1921, railroad stocks fell from representing half of the stock market’s value to just over 10%.

[00:15:51] Shawn O’Malley: While industrial companies shares rocketed to almost 90 percent, World War I had transformed the U. S. stock market and many railroad companies had been nationalized. The seeming inevitability of war after Archduke Franz Ferdinand was assassinated in June 1914 Since U. S. stock prices spiraling, with many fearing that gold would flow out of the U.

[00:16:13] Shawn O’Malley: S. to finance a European war, which would drastically reduce the supply of money available in the U. S. to facilitate economic growth. This was, of course, a different time, when currency values were tied to gold, and a nation’s holdings of gold could quite literally determine its potential for growth. When Austria declared war on Serbia on July 28th, stock exchanges around the world promptly closed down the next day, from Montreal to Madrid and Berlin.

[00:16:42] Shawn O’Malley: With London’s exchange shutting down on July 31st, the New York Stock Exchange was left with little choice but to follow suit. The NYSE, which is the acronym I’ll use for the New York Stock Exchange, didn’t reopen for six months, and when it did, there were a number of restrictions on trading in place.

[00:17:01] Shawn O’Malley: While the exchange had been closed over fears that global investors would liquidate all their U. S. investments to fund the war. The opposite actually happened. Funds flowed into U. S. stocks, reflecting how American companies had benefited from being a neutral industrial powerhouse selling goods to both sides.

[00:17:18] Shawn O’Malley: It was a boom in profits per share unlike any other since. In nominal terms, profits for US stocks in 1916 would not be surpassed until 1949, some 33 years later. In real terms, adjusting for inflation, US corporate earnings wouldn’t beat the mark set in 1916 until 1955, according to Napier. U. S. industrial companies quickly were recognized as the biggest beneficiaries of the war in Europe and earned the nickname War Bridges.

[00:17:48] Shawn O’Malley: That momentum would shift though in 1917 when the U. S. joined the war itself, which sent the market lower. Measures to support the war effort, like governmental controls on commodity prices, Plus the failure of the railroads to secure approvals for rate increases from the Interstate Commerce Commission, rising costs, and new taxes on excess profits to fund new government debt all weighed on U.

[00:18:11] Shawn O’Malley: S. stocks. It was not until the stalemated war in Europe finally came to an end in 1919 that the Industrial Index would enjoy another bull market when it hit a new all-time high in November 1919. As mentioned, the divergence between the performance of railroad and industrial stocks up until this point couldn’t have been any bigger, primarily because so many railroad companies had been nationalized by the government.

[00:18:36] Shawn O’Malley: For shareholders, their equity in these companies effectively turned into bonds, where the government paid them, fixed dividends based on the average earnings of their companies prior to nationalization. Possible returns for railroad shareholders then were quite constrained, and many were optimistic that railroad stocks would recover with the end of nationalization, which came in March 1920.

[00:19:00] Shawn O’Malley: Meanwhile, the Federal Reserve, which has become a very powerful force in today’s financial markets, was still in its infancy, and with that, its actions were unpredictable to investors. As gold flowed into the U. S., as countries paid off wartime debts, the money supply ballooned. Yet, the Federal Reserve, which was formed in just 1913, had not accumulated enough assets in its short history to fend off this inflationary surge.

[00:19:27] Shawn O’Malley: If it had more financial assets on its balance sheet, the Fed could have sold them to the public and pulled money out of circulation. This is similar to what we call quantitative tightening today. As Napier writes, quote, in more simple terms, the Fed could stretch the elastic currency in its early years, but until it had first been stretched, it could not be an instrument for monetary tightening.

[00:19:50] Shawn O’Malley: While the Federal Reserve had little impact on investors up until when the U. S. entered the war, everything changed from there on. America began to sell goods to its allies on credit rather than in return for gold, and the flow of gold to the U. S. fell off in 1917. Additionally, with the U. S. government adopting large spending deficits during the war, the Federal Reserve embraced the role of helping finance those deficits.

[00:20:16] Shawn O’Malley: Commercial banks would lend funds to Americans who wanted to buy Liberty Bonds to support the war effort and then commercial banks would turn around and essentially sell those loans back to the Federal Reserve. Investors hurried to try and wrap their heads around what the Fed’s growing role in the financial system would mean exactly for the dollar’s value and inflation, both during and after the war.

[00:20:38] Shawn O’Malley: America’s last major war at this point was the Civil War, and during that time, the gold standard had been suspended, but investors that used that as a reference point would have been misled. With the Federal Reserve now in place, there was a lot more short term flexibility in the money supply, and that enabled the country to remain on the gold standard through World War I.

[00:20:58] Shawn O’Malley: Investors who had bet on the gold standard being suspended again had failed to understand how the recently formed Federal Reserve had already changed the structure of the financial system. As the war wound down in 1918, economic decline hit the U. S. as demand for America’s manufactured goods fell off.

[00:21:16] Shawn O’Malley: The Fed would try its hand for the first time at using monetary policy to stimulate the economy, keeping interest rates significantly below what they otherwise would be to preserve the value of government bonds issued during the war. If that last part is a little confusing, I’ll just clarify that bond prices have an inverse relationship with interest rates, so by keeping rates low, the Fed was helping to prevent a wave of paper losses on bonds from rippling across the financial system.

[00:21:44] Shawn O’Malley: With interest rates so low, it was believed that the system could distinguish between legitimate borrowing for useful economic purposes and speculative borrowing where people exploited the low rates for high risk but high reward endeavors. As has happened several times in the last century and in more recent memory though, society did not have the collective restraint necessary to keep borrowing toward only legitimate purposes.

[00:22:09] Shawn O’Malley: Instead, a speculative mania kicked off and a bull market in industrial stocks and commodities raged through 1919, according to Napier. While it had long been an accepted principle that wartime inflation would lead to post war deflation during the gold standard, the aftermath of World War I did not follow that same blueprint thanks to the Federal Reserve.

[00:22:30] Shawn O’Malley: The Fed stretched the money supply even further to assist with funding the government, and as the money supply increased, so did inflation. Markets were playing by new rules, and investors following the old rules missed the 1919 bull market. On the flip side, some extrapolated the Fed’s role too much, and actually thought interest rates might never rise again, which was, of course, also wrong.

[00:22:54] Shawn O’Malley: Still, where the Fed had never provided credit into the financial system before November 1914, by the end of 1919, it was providing a sum of credit equivalent to 4 percent of GDP. With the Fed helping to provide more credit and increase the money supply, which works to keep interest rates low, if you can recall back to your econ 101 days, many investors at the time reportedly embraced the idea that borrowing low interest loans for speculative bets was inherently less risky now.

[00:23:23] Shawn O’Malley: Thanks to the Federal Reserve’s new role in the economy, they all too willingly loaded up on speculative debts that fueled a substantial rise in asset prices only for a more painful hangover to hit from 1920 into 1921. This all paints a picture of what was going on at the time, but it doesn’t fully explain why stocks were so exceptionally cheap in 1921.

[00:23:47] Shawn O’Malley: And why this was arguably the biggest bottom in US stocks during the 20th century. Big questions surrounding the Fed’s continued role in markets after the war and how Europe would recover weighed on investors’ minds, but there were simpler challenges that could also set the stage for stocks to be hugely mispriced.

[00:24:05] Shawn O’Malley: We take for granted today the plethora of economic data available at our fingertips and the standardization processes that governmental agencies and private organizations go through to clean up those numbers and make them useful for us, but it goes without saying that that hasn’t always been the case.

[00:24:23] Shawn O’Malley: Official calculations of GDP, for example, didn’t start until 1929. It’s hard for us, even in hindsight, to know exactly how much the economy grew between 1914 and 1919 in both real and nominal terms. Determining whether you think prices of stocks offer fair value is very much connected to one’s outlook for and understanding of inflation and economic growth.

[00:24:46] Shawn O’Malley: Yet, if there were no widely accepted calculations of economic growth or methods for measuring inflation, then investors may be making decisions with wildly different sets of data. The fog of war was also quite disruptive, too. By 1919, any available economic data was hugely distorted by World War I, so investors had the not so easy task of trying to reconcile corporate earnings and stock valuations from before the war with after the war.

[00:25:13] Shawn O’Malley: If you were an investor in industrial companies, you have to ask yourself whether the good times of substantial profits were likely to increase or whether those companies’ earnings would revert to prewar levels. It’s not so different from today with the pandemic. You might look at a house’s price and say, well, it’s cheap compared to 2021, but expensive compared to 2019, even after accounting for inflation.

[00:25:36] Shawn O’Malley: So what are you to do in that situation? The same thing happens with stocks as well. What? Companies hit unprecedented valuations during the pandemic bull market and when trying to discern whether those same stocks offer good value today, investors have to ask themselves whether they’re comfortable making comparisons to the pandemic era or whether it’s better to make comparisons with only pre pandemic numbers.

[00:25:59] Shawn O’Malley: And the same goes for earnings. Zoom was a huge COVID beneficiary and investors in the company spent much of the last two or so years trying to figure out whether those exceptional financial results would continue after the pandemic was largely considered over. While it’s tempting to say that you should throw out COVID error evaluations and results and reference only more normal pre COVID times, Doing so doesn’t account for the fact that we live in a different world now than in 2019.

[00:26:27] Shawn O’Malley: COVID has changed the world, and we can’t ignore that. Using the Zoom example again, remote work is obviously not as common today as it was in 2020, but it still is considerably more popular than in 2019. COVID changed the way we work, and that fundamentally changed Zoom’s outlook as a company. Investors in 1920 faced the same challenge.

[00:26:48] Shawn O’Malley: Markets were thrown out of whack by World War I, but investors had to make their own decisions about how relevant trends in markets during that same period were going forward. For example, it wasn’t clear whether the US’s surge in economic growth and trade, as it sold supplies to both sides during the war and the first two years, represented a one off gain, or whether it was indicative of the US taking on a more lasting and growing role in global trade, which could offer a more permanent boost to American companies profits.

[00:27:17] Shawn O’Malley: Just imagine yourself at this time. You’d be debating the future of the gold standard, the federal reserve’s impact on the financial system, and whether America was truly a rising manufacturing superpower or just a temporary winner during the war. The questions are clearly different from the ones we asked today, but their essence is similar.

[00:27:37] Shawn O’Malley: Over a hundred years later, you’ll hear just as much debate about the Fed on CNBC. After wholesale prices had risen 147 percent from 1914 to 1919, there was tremendous fear that those higher prices would have to work their way out of the system during a period of deflation where prices fall. This is very much a consequence of the gold standard, which operates differently from the prevailing fiat based financial system around the globe today.

[00:28:04] Shawn O’Malley: We rarely see deflation now. Instead, the rate of inflation usually just decelerates during downturns. But during the gold standard, sharp deflations could occur after a boom period. While most people think of the Great Depression as being America’s most severe bout of deflation, the annual rates of deflation in 1921 were actually even sharper.

[00:28:25] Shawn O’Malley: Wages for unskilled workers fell from their peak by more than half in 1921. By 1921, the alternatives to the gold standard were becoming more clear as well. Countries like Germany, Poland, Russia, and Hungary had largely abandoned the gold standard, leaving authorities with the discretion to print money as they saw fit to stimulate the economy.

[00:28:46] Shawn O’Malley: By ditching the gold standard, these countries did succeed in a way in dodging the expected post war deflation. In 1921, Germany’s economy experienced roughly 30 percent inflation off the gold standard, while France, which had a currency still anchored to gold, saw a 24 percent collapse in prices. And as the inflation took off, so did the Frankfurt Stock Exchange, which increased 40 percent in 1921.

[00:29:13] Shawn O’Malley: In part, the stock market rise is attributable to many in Germany realizing that their savings were being destroyed by inflation, which pushed them to convert as much of their cash as possible into stocks they thought might better hold their value. Meanwhile, as inflation took hold, the German mark depreciated in foreign exchange markets, actually making Germany’s economy more competitive.

[00:29:34] Shawn O’Malley: Since its exports were becoming cheaper for foreign countries. For Americans, with the Germans off the gold standard and taking manufacturing market share away from them, it began to look like the recession in the US could even be worse than first feared, as European countries off the gold standard more than reclaimed their market shares in areas that had been lost during the war.

[00:29:54] Shawn O’Malley: And anyone familiar with Weimar Germany will know what happened next. Abandoning the gold standard and haphazardly printing money ultimately led the country into hyperinflation, but of course in 1921 that outcome wasn’t so clear. Going back to the US stock market in the summer of 1921, there were only 382 listed stocks on the New York Stock Exchange compared with over 2200 today.

[00:30:20] Shawn O’Malley: While railroad stocks made up just 1 percent of newly issued stock at the time, an emerging sector was rapidly gaining importance, automobiles. Other key growth businesses were rubber and cigarettes, which were gaining popularity over forms of loose tobacco. There were some other recognizable names at the time, too, like American Express, AT& T, Coca Cola, General Electric, and Nabisco.

[00:30:44] Shawn O’Malley: Intensifying the bear market in stocks was a long bear market in bonds that lasted over two decades. The drought in bond returns worsened during World War I as the government issued more and more debt, increasing the supply of bonds in the market and thus lowering their price. Federal debt rose from an extremely modest 2.

[00:31:03] Shawn O’Malley: 7 percent of GDP in 1916 to 32. 9 percent by 1921. A 15 fold increase in public debt in five years is enough to even make today’s politicians blush. Investors had to absorb those bond increases, but they did so at equities expense. They only had so much money to allocate to both asset classes, and with more and more bonds floating around in markets, funds available for stock investing got squeezed out.

[00:31:30] Shawn O’Malley: World Peace didn’t offer bond investors a break either. Mounting inflation after the war drove further selling pressure on bonds, with 80 percent of the original holders of Liberty Bonds issued to finance the war selling out across 1920 and 1921. Uncertainty around all the different factors we’ve discussed so far fed into the great bear market bottom of 1921.

[00:31:53] Shawn O’Malley: As Russell Napier concludes, almost every bear market in U. S. stock market history was preceded by a period when stock prices ran up in excess of economic fundamentals. Same was true in 1921, but the lows were equally incompatible with economic fundamentals. As the Dow Jones Industrial Average sat in 1921 at the same level it had reached in 1899, the economy was vastly different.

[00:32:18] Shawn O’Malley: In those 22 years, the population had grown 41%, the working age population had grown 45%, nominal GDP had nearly quadrupled, and real GDP had nearly doubled, yet the leading stock index at the time was flat in nominal terms. Part of the problem for stock investors over the four decades leading up to 1921 was that corporate earnings per share gross significantly trailed economic growth.

[00:32:43] Shawn O’Malley: Publicly traded companies increased earnings by only 130 percent from 1881, whereas nominal GDP grew by over 700%. As Napier puts it, quote, In this remarkable period of growth for the U. S. economy, shareholders clearly failed to benefit to the extent one would have expected. The failure of corporate earnings to keep pace with economic growth is one key reason why equities had disappointed investors even prior to the bear market of 1919 to 1921.

[00:33:12] Shawn O’Malley: Using normalized earnings for 1921, Napier estimates that stock market price to earnings ratio valuations fell to as low as seven times. For context, companies in the S& P 500 today trade at P E ratios of more than 21. 5 on average, which is three times higher than valuations in 1921. As one banker told the Wall Street Journal in September 1921, scores of companies were selling below working capital.

[00:33:40] Shawn O’Malley: In the case of many companies, the shares are selling for less than the value of the plants. There are shares of copper mines that are selling below what it would cost to equip these respective mines. One of the most common bear market aphorisms is that investors should buy when the news is all bad, at the point of maximum pessimism.

[00:33:59] Shawn O’Malley: Anyone following that advice in 1921, though, would have missed out on the bull market of the roaring 20s. As Napier says, quote, The Wall Street Journal in the summer of 1921 was teeming with news and well informed opinion that the economic contraction and, with it, the bear market and stocks, was ending.

[00:34:17] Shawn O’Malley: At one of the greatest market bottoms, sentiment was generally optimistic or at least not entirely dominated by fear. Many saw the outlook for companies improving and still chose to sell, ignoring the positive implications of an economic recovery. That sort of irrationality encapsulates the type of behavior that drives markets towards such a generational bottom.

[00:34:38] Shawn O’Malley: In looking at newspaper reports from the time, Napier found that one of the driving explanations for why sentiment shifted in the stock market was simply because bears had reached a stage where they refused to regard any development as constructive. As the Wall Street Journal at the time wrote, anyone who even intimates that a stock may go up is looked up with suspicion.

[00:34:59] Shawn O’Malley: Such a condition usually marks the end of a bear market. The timing for that quote couldn’t have been better. It was published just two days before the bottom. News flow became incrementally more positive around the bottom, and more tangibly, the supply of socks available for lending was decreasing, and thus the cost of borrowing socks was rising.

[00:35:18] Shawn O’Malley: What that means, essentially, is that short sellers were running out of shares to sell in their bets against companies. In fact, while probably a coincidence, the exact day that the market bottomed was also the day that the number of stocks being lent at a premium peaked. Naturally, as short sellers ran out of ammunition, So did the biggest headwind to stocks recovering.

[00:35:40] Shawn O’Malley: Another indication people used at the time I found interesting relates to trying to assess whether ownership of companies was being concentrated in the hands of institutional investors on Wall Street or among the general public. One such bellwether was the company U. S. Steel. U. S. Steel was something of a safe haven for the general public.

[00:35:59] Shawn O’Malley: In good times, like the market boom of 1916, Wall Street ownership of the stock reached as high as 58 percent as the masses piled into more exciting names. In 1921, as the general public loaded up on shares of U. S. Steel during the bear market, institutional investors stake in the company fell to 23%. So it was popular to try and measure whether U.

[00:36:21] Shawn O’Malley: S. Steel’s shareholder base was shrinking, which would mean investors and the general public were no longer hiding in safe haven assets and were diving into riskier opportunities. AT& T came to fill a similar role in this period as well. And with public participation in both companies at abnormally high levels in the summer of 1921, that would have been as good an indicator as any that the market was hitting its bottom.

[00:36:45] Shawn O’Malley: What’s also interesting is that while stock market prices bottomed in August 1921, corporate earnings still had another 37 percent to decline before they hit a bottom in December. The recovery in earnings lagged considerably behind the recovery in the stock market. In conclusion, when reflecting on the 1921 bottom, Napier remarks that U.

[00:37:06] Shawn O’Malley: S. stocks traded below fair value from 1917 to 1926. So how is one to know that 1921 marked the opportune moment to buy in? He says growing demand for select goods like automobiles, commodity price stabilization, improving economic news being ignored by the stock market, higher trading volumes on days when the market rallied, reductions in interest rates as set by the Fed, and a rally in the bond market all overlapped together for discerning investors to recognize that the tides were turning.

[00:37:37] Shawn O’Malley: The bad news for investors at this time is that the next bear market would be very different and more vicious. That brings us to the Great Market Bottom of 1932, which is arguably the most famous chapter in American financial history. Nearly 100 years later, the stock market crash of 1929 and the Great Depression are still widely remembered for their devastating effects.

[00:38:01] Shawn O’Malley: From 1921 to 1929, the Dow Jones Industrial Average rose nearly 500 percent before plunging 89 percent from 1929 to the bottom in 1932. 89 percent in 3 years. That is just breathtaking. Not to fearmonger but imagine checking your portfolio again in 2027 and being down 90 percent from today. It’s not likely, but it has happened before.

[00:38:30] Shawn O’Malley: I also think this period is just so interesting to people because it really marked a shift in American society. It was a major step from the 19th century and earlier values into a world that more closely resembles our modern one today. Really for the first time in the 1920s, America unequivocally embraced consumerism.

[00:38:49] Shawn O’Malley: Americans piled into cities, advertising went mainstream, and automobiles unleashed a new wave of productivity and possibility. It was a time of radical transformation, and because of that, Napier argues the 1929 1932 period disproportionately lingers in people’s minds. He writes, quote, Undue focus on this one period has created a misleading impression of bear markets.

[00:39:14] Shawn O’Malley: While often cited as the classic example of a bear market, it may be more the exception than the rule and thus have misled a generation of investors. While we know that the market also bottomed in 1921, it took about three years for a great bull market to form. By 1925, stocks had risen 87%, with an average dividend yield of 6.

[00:39:35] Shawn O’Malley: 4 percent since 1921. However, this was just the beginning. Trading volumes would start to go through the roof in 1925 and onwards as stock investing went mainstream. Prices for a seat on the NYSE Surged in 1924, A seat cost as much as $115,000, but just five years later, demand to trade on the floor of the NYSE had pushed the cost of a seat to as high as $625,000.

[00:40:03] Shawn O’Malley: While Calvin Coolidge’s 1924 election victory to become president provided a catalyst for this epic bull market thanks to his reluctance to break up monopolies and his sustain for taxes. Coolidge’s election was not the underlying cause of the bull run between 1925 and 1929. As is common with all major bull markets, says Napier, this one can also trace its roots to two key factors, technological breakthrough and the increased availability of credit.

[00:40:32] Shawn O’Malley: On the technology front, rapidly expanding access to electricity was changing daily life for Americans. Adoption was slow for several decades before picking up steam in the 1920s. From 1921 to 1929, the percentage of American homes with wired electricity rose from 37. 8 percent to 67. 9%. Here is an incredible stat.

[00:40:56] Shawn O’Malley: By 1929, the US produced more electric power than the rest of the world combined. Electricity hugely boosted productivity, which dampened the effects of inflation, while also creating a surge in spending as Americans bought up new electrical products. America’s electrification was a major boon to corporate earnings and therefore a fundamental reason stock prices rose so high in the 1920s.

[00:41:21] Shawn O’Malley: As electricity enabled machinery to become far more efficient, corporate America accrued a growing slice of national wealth during this decade. Napier estimates that earnings per share for listed companies rose something like 455 percent over the course of the 1920s. The gains in productivity during this decade were so huge, in fact, that we could produce so much more of everything from textiles to household furnishings, food, and building materials that aggregate price indexes largely fell.

[00:41:50] Shawn O’Malley: That’s right, despite undergoing one of America’s biggest economic booms, which would normally be thought to be inflationary for prices. The 1920s were a deflationary decade. The supply of goods more than outpace the considerable growth and consumer demand. One of the most notable growth products enabled by electricity was the radio sales of radios.

[00:42:12] Shawn O’Malley: Over the decade rose, almost 30 fold. As Americans bought up radios and other appliances, consumer credit played a more important role in driving the economy and the 1920s bull market. Installment credit went mainstream in 1919, in part thanks to General Motors, which began offering financing options to help middle class families afford cars.

[00:42:32] Shawn O’Malley: The percentage of households buying cars on credit more than tripled from 1919 to 1929. By 1927, 85 percent of all furniture sales were made on credit, 80 percent of phonograph sales, 75 percent of washing machine sales, and more than half of sales for things like radios, pianos, sewing machines, vacuum cleaners, and refrigerators.

[00:42:53] Shawn O’Malley: Sales on credit, especially for consumer Magnified the economic upturn by increasing spending, but also increased the risk of greater than normal defaults during a recession. Even though interest rates were not particularly low during the 1920s boom, new forms of credit still emerged to capitalize on the major changes occurring in society.

[00:43:14] Shawn O’Malley: The point being, bubbles and excesses can still occur under moderate monetary conditions. That is not to say the Federal Reserve wasn’t active, though. World War I invigorated the Fed to take a greater role in economic management, and through the 1920s, investors came to see it as a more permanent fixture intervening in markets.

[00:43:33] Shawn O’Malley: As gold flowed in from abroad into America’s booming economy, the Fed sought to raise interest rates and tighten monetary policy, hoping to curb some of the excessive speculation that was taking place in the second half of the decade. The challenge the Fed was grappling with was that although the U. S.

[00:43:49] Shawn O’Malley: stayed on the gold standard after World War I, Most of the world temporarily abandoned it. By 1925, the US held 43 percent of the world’s gold reserves, and managing outflows back to the rest of the world was of critical importance. As countries eventually resumed the gold standard, the decision on which exchange rate to use when re pegging their currency to gold would ultimately be political, and the Fed worried that countries might intentionally undervalue their currencies to give their exports an advantage.

[00:44:17] Shawn O’Malley: That would disadvantage American companies in selling their goods on the global stage and potentially lead to major outflows of gold from the U. S. The Fed’s contingency plan to prevent major gold outflows as countries return to the gold standard was to proactively tighten monetary conditions, as I say, which effectively means raising interest rates.

[00:44:36] Shawn O’Malley: If not for the Fed’s interventions, credit would have been even cheaper in the 1920s and could have fueled an even bigger boom and bust, or a bust may have come several years earlier at least. You could also argue that the Fed’s efforts to stem the outflow of gold from the U. S. to countries in desperate need of gold helped create the international economic crisis we know as the Great Depression.

[00:44:58] Shawn O’Malley: During this time, the Fed also sought to crack down on loans deemed to be more speculative than productive. That is, loans on Wall Street to enable the purchase and sale of financial assets rather than lending toward producing real things in the economy. A split developed among Federal Reserve board members over whether to try and directly punish banks making too many loans to Wall Street.

[00:45:19] Shawn O’Malley: By 1928, unrelenting surges in the stock market made it clear that some sort of action was needed. And as of 1929, 20 percent of all loans in the U. S. banking system were to stockbrokers. That is actually one of the craziest statistics I’ve ever heard. A truly unprecedented amount of money was being channeled into buying stocks on credit.

[00:45:40] Shawn O’Malley: The number of Americans who own stocks jumped 40 fold from 1913 to 1929, increasing from half a million to 20 million. The Fed drew up a list of 100 banks it wanted to pressure for making excessive loans to brokers on Wall Street, but in reality, funds were flowing in from all over the world to fund the lending boom on Wall Street, and plenty of non-banks were lending funds too.

[00:46:02] Shawn O’Malley: The Fed’s efforts to stem speculative lending were too little, too late. By July 1929, the upward climb in interest rates was showing its first signs of affecting the economy, but stocks would not respond for another few months. To the extent that higher interest rates were slowing speculative activity on Wall Street, it was only because the real economy was feeling the effects.

[00:46:24] Shawn O’Malley: Where the Fed had started as an organization meant to serve as the lender of last resort, its policies were now making and breaking Wall Street’s ups and downs. Elsewhere around the world, countries slipped into economic decline earlier than the US. That happened in Australia and the Netherlands as early as 1927, and in 1928, countries like Germany and Brazil were slumping too.

[00:46:47] Shawn O’Malley: While much of the world tried to adhere to the gold standard still, America’s grip on the world’s gold reserves and the seemingly never ending flow of capital to Wall Street from abroad was like a chokehold on the global economy. Through 1929, it became increasingly clear that either the gold standard would break or the US economy would have to fall off, as foreign countries could no longer afford to buy American goods.

[00:47:10] Shawn O’Malley: Either outcome looked problematic, and violent gyrations hit stocks in September and October of 1929. The Dow Jones Industrial Average peaked on September 3rd, 1929, and fell 32 percent by October 28th. By November, stocks had fallen by nearly 50%. What sparked the decline in markets remains up for debate, but there is agreement on why the selloff was so fierce.

[00:47:34] Shawn O’Malley: The unwinding of such spectacular bull market excesses would inevitably have resulted in a painful hangover. For example, a boom in early versions of the first mutual funds was never going to be sustainable. 700 investment trusts were created over a three year period, managing over 3 billion at the time.

[00:47:53] Shawn O’Malley: Many of the investors managing these funds indulged in a variety of manipulative practices, like making concentrated bets on illiquid stocks to significantly bid prices higher. The decline in stocks wasn’t a straight line. By April 1930, you could have been forgiven for thinking that the market might recover just as quickly as it had sold off.

[00:48:13] Shawn O’Malley: Stocks had recovered around 52 percent of their losses and were back at levels seen in early 1929. Unfortunately, anyone who had believed the market had regained its footing would have been subjected to a further 86 percent decline in the Dow Jones Industrial Average before it bottomed in July 1932.

[00:48:31] Shawn O’Malley: What made this bear market unique was that it all coincided with a collapse in the banking system. The Panic of 1907 saw a number of bank failures that eventually led to the creation of the Federal Reserve, but the Fed could not stop the wave of bank failures that would come between 1929 and 1932. By early 1931, the stock market selloff wasn’t hugely worse than in 1907 or between 1919 and 1921, so it was plausible that the worst may have been over.

[00:49:00] Shawn O’Malley: As bank failures piled up though, so did the damage to the economy. In November and December of 1930, over 600 banks had been suspended. And one of the more crucial bank failures, what you might call this generation’s Lehman Brothers moment, came with the Bank of the United States going under. This was a bank founded in 1791 with over 400, 000 depositors concentrated in New York City, which made for the largest bank failure in American history up until that point in time.

[00:49:29] Shawn O’Malley: While failures at small banks focused on lending to farmers didn’t really raise systemic concerns, the Bank of the United States collapse did. Americans raced to withdraw money from banks, which is what turned the recession of 1930 the Depression of 1931 and 1932. On the other side of the pond, a collapse in Austria’s largest private bank spurred a panic in Hungary which created a run on banks in both that country and Germany shortly thereafter.

[00:49:56] Shawn O’Malley: With U. S. banks assets in Austria, Hungary, and Germany frozen, this put further strain on American banks balance sheets. Total deposits in the U. S. banking system declined some 15%, reducing deposits to nationwide levels not seen since 1924. The U. S. was hit by two separate banking crises in the same year, which was all the more painful after many had come to believe that such banking crises were no longer possible thanks to the creation of the Federal Reserve.

[00:50:24] Shawn O’Malley: For context on that, here’s a quote from the U. S. Secretary of the Treasury in 1928. He says, There is no longer any fear on the part of the banks or the business community that some sudden and temporary business crisis may develop and precipitate a financial panic. We are no longer the victims of the vagaries of the business cycles.

[00:50:44] Shawn O’Malley: The Federal Reserve System is the antidote for money contraction and credit shortage. So prominent government officials believed we had defeated the business cycle, and beliefs like that made the opposite inevitable. For generations, people have looked for and wrongly embraced methods for supposedly taming the business cycle.

[00:51:01] Shawn O’Malley: 2008 was our 21st century reminder that this is just not possible. As other countries, like the United Kingdom, abandoned the gold standard, fear spread that the US could do the same, prompting depositors to try and withdraw as much gold out of the banking system as they could. In the six months from August 1931 to January 1932, over 1, 800 banks would fail and suspend operations.

[00:51:26] Shawn O’Malley: In six months, that was as many banks as had failed in the entire decade before. A handful of approaches were taken to try and turn things around. The National Credit Corporation was launched to provide loans to banks whose assets were deemed to be too low quality to be collateral at the Federal Reserve.

[00:51:44] Shawn O’Malley: And in early 1932, the Reconstruction Finance Corporation was created to provide loans to banks and railroads. While there was some reason for optimism in early 1932, the stock market would still decline another 54 percent before bottoming in July. Reflecting on the 1932 bottom, Napier says there are many ways that 1921 stands out from other major bear market bottoms.

[00:52:07] Shawn O’Malley: The most important difference is the pace at which equities moved from overvalued to undervalued. In 1921, equity prices became extremely cheap, primarily because stock prices moved sideways while the economy and corporate earnings had grown considerably. In 1929, stocks were heavily overvalued, and in 1932, And only a sharp correction could bring prices back into line.

[00:52:29] Shawn O’Malley: Yet such a sharp correction to undervalued is the outlier in most of the bear markets Napier has studied across the past few hundred years of financial history. Most bear markets, he suggests, are more similar to the 1921 example, where long periods of downward drifting inflation adjusted valuations give way to a final slump that marks the bottom.

[00:52:49] Shawn O’Malley: He writes, quote, because the 1929 to 1932 bear market looms so large in the investment psyche, we still assume that this is the model for all bear markets. However, this bear market is very much the exception in terms of the development of real value for investors in the stock market. Bear markets, where three year price declines make overvalued equities cheap, are the exception and not the rule.

[00:53:14] Shawn O’Malley: At its peak in 1929, U. S. stocks were trading at a normalized price to earnings ratio of roughly 31. 6 times and fell to as low as 10 times in 1932. Calculated using a 10 year rolling average for earnings. The market’s price to earnings ratio in July 1932 was almost 70% below its average from 1881 to 1932, where investors had placed a premium on owning stocks in 1929.

[00:53:40] Shawn O’Malley: Given the infinite possibilities of the future, by mid-1932, many stocks are trading at a 50% discount to their hard assets. Evidence that the market had bottomed came when a third banking crisis hit the country in 1933, yet stocks did not fall below their mid 1932 levels. Improving conditions were a false dawn for bulls in 1932, yet this was still the best time to buy.

[00:54:04] Shawn O’Malley: 1933’s low was 22 percent above 1932’s low even as the economy fell into an even deeper crevice. Stock’s failure to fall further in this third crisis reveals, in hindsight, that prices were so beaten down that even the biggest bears could hardly justify continuing to sell. Napier finds that in 1932, like in 1921, the end of a bear market is not characterized by investors learning to ignore bad news.

[00:54:32] Shawn O’Malley: Instead, it’s when sentiment becomes so pessimistic that markets shrug off good economic news. In the same way, stocks failing to sell off further on bad news signaled that a subtle shift had begun to develop. While the Fed worked to inject liquidity into banks, hoping that they would turn around and start making more loans, something of a chicken and egg problem developed.

[00:54:52] Shawn O’Malley: Bankers wouldn’t lend until they felt the economy was recovering, and without more lending to facilitate consumption and investment, a recovery couldn’t happen. Credit expansion in the U. S. economy would not truly resume again until 1935, but stock investors waiting for that to happen would have missed the bottom in 1932.

[00:55:09] Shawn O’Malley: Instead, a better indicator of the bottom was to follow trading volumes. Throughout 1932, on days that the market was down, trading volumes were weak and falling, suggesting that lower prices were spurring less and less action from investors. Similar to 1921, the re-emergence of financial professionals and wealthy individuals piling back into stocks at the bottom in 1932 signaled the pivot at the bottom, not some huge upswing in sentiment throughout the general public.

[00:55:37] Shawn O’Malley: The market’s biggest players returned to kickstart the next bull market. Ultimately, the bear market and depression from 1929 into 1932 would set the stage for FDR’s New Deal and America’s abandonment of the gold standard, but that story is for another day. With that, that wraps up today’s discussion of early 20th century financial history, which saw two of the greatest bottoms in stock market history when stocks reached deeply undervalued levels in very different ways.

[00:56:06] Shawn O’Malley: What stands out to me the most from digging through these chapters is that doing so really fills in a lot of context for the world we live in today. Maybe you don’t think it’s all that valuable to try and accurately identify the bottom of a bear market. I think that’s fair, but I still find it valuable to understand how we got to where we are today.

[00:56:23] Shawn O’Malley: How early stock indexes were formed, why we have certain regulations in the banking system and FDIC insurance to protect against bank failures, what the world was like during the gold standard, and really just what was going on through investors’ minds during turbulent periods, including world wars and massive booms powered by automobiles and electrification.

[00:56:43] Shawn O’Malley: There’s a lot more to be said about understanding both the bottom of 1929 and 1932, but I’ve painted a pretty decent picture here of it for you. If you’re interested in diving deeper into these two bear markets for investing lessons and context on financial history, I’d really encourage you to check out Russell Napier’s book, the anatomy of the bear, which I’ve linked to in the show notes below.

[00:57:04] Shawn O’Malley: With that, you can also dive into his explanations of the great market bottoms in 1949 and 1982, which I didn’t have time to get to today. I’ll leave you with the following quote from the famed stock trader, Jesse Livermore, who lived from 1877 to 1940, quote, markets are never wrong. Opinions often are. That’s all for today, folks. I’ll see you back here next week.

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