What caused the stock market to crash in the 1920s?

Capital is the tools needed to produce things of value out of raw materials. Buildings and machines are common examples of capital. A factory is a building with machines for making valued goods. Throughout the twentieth century, most of the capital in the United States was represented by stocks. A corporation owned capital. Ownership of the corporation in turn took the form of shares of stock. Each share of stock represented a proportionate share of the corporation. The stocks were bought and sold on stock exchanges, of which the most important was the New York Stock Exchange located on Wall Street in Manhattan. 

Throughout the 1920s a long boom took stock prices to peaks never before seen. From 1920 to 1929 stocks more than quadrupled in value. Many investors became convinced that stocks were a sure thing and borrowed heavily to invest more money in the market. 

But in 1929, the bubble burst and stocks started down an even more precipitous cliff. In 1932 and 1933, they hit bottom, down about 80% from their highs in the late 1920s. This had sharp effects on the economy. Demand for goods declined because people felt poor because of their losses in the stock market. New investment could not be financed through the sale of stock, because no one would buy the new stock. 

But perhaps the most important effect was chaos in the banking system as banks tried to collect on loans made to stockmarket investors whose holdings were now worth little or nothing at all. Worse, many banks had themselves invested depositors' money in the stockmarket. When word spread that banks' assets contained huge uncollectable loans and almost worthless stock certificates, depositors rushed to withdraw their savings. Unable to raise fresh funds from the Federal Reserve System, banks began failing by the hundreds in 1932 and 1933. 

By the inauguration of Franklin D. Roosevelt as president in March 1933, the banking system of the United States had largely ceased to function. Depositors had seen $140 billion disappear when their banks failed. Businesses could not get credit for inventory. Checks could not be used for payments because no one knew which checks were worthless and which were sound. 

Roosevelt closed all the banks in the United States for three days - a "bank holiday." Some banks were then cautiously re-opened with strict limits on withdrawals. Eventually, confidence returned to the system and banks were able to perform their economic function again. To prevent similar disasters, the federal government set up the Federal Deposit Insurance Corporation, which eliminated the rationale for bank "runs" - to get one's money before the bank "runs out." Backed by the FDIC, the bank could fail and go out of business, but then the government would reimburse depositors. Another crucial mechanism insulated commercial banks from stock market panics by banning banks from investing depositors' money in stocks.

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• The stock market crash of 1929 was a major stock market crash and was the single worst financial event in the history of the US.
• The crash was a result of a myriad of factors including investor behavior, weak regulations, and international trade relations.
• The stock market would not recover from the crash until nearly 20 years later.

The stock market crash of 1929 is known as the most catastrophic event in the history of the US stock market. On Thursday, October 24, 1929, the stock market fell 11%. The losses continued on Monday, October 28, when the market fell another 13%.

Then, on, what became known as "Black Tuesday," October 29, the market fell another 12% and provided a spark for what would be known as the Great Depression. From that point, the stock market would not bottom out until the summer of 1932 and would not reach the peak of 1929 levels until the 1950s. 

In the years preceding the crash, much of the US was in the throes of the "Roaring Twenties." From 1920 to 1929, total wealth in the US more than doubled, and the unemployment rate averaged 3.7%. The economy was in a period of expansion, but consumers and companies were taking on debt and engaged in more speculative financial behavior, setting the stage for the crash and the Great Depression. 

What caused the stock market crash of 1929?  Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

The stock market crash of 1929 was not caused by one single factor but a collection of events on the part of investors, regulators, and international relations. Here's a quick rundown on some of the major causes: 

1. Overconfidence and oversupply: Investors and institutions were piling into the stock market during the early 1920s as the economy expanded. But what went unnoticed by most investors is the fact that many businesses were overproducing and the growth of the stock market did not accurately reflect the business reality at the time as many businesses were selling their goods at a loss.
2. Buying on margin: Margin is the practice of taking a loan to buy stocks which can amplify gains and losses. This gave investors more buying power to further inflate prices when the market was up, but put several in debt once the crash began. "Borrowing money from your stock broker back then was a common occurrence, and with as little as 10% down during those times. This 'overconfidence' also extended to industries who overproduced, which led to surpluses, which ultimately drove supply prices and share prices down," says Joshua Lutkemuller, CFA, head of investment strategy at Strongside Asset Management, LLC.
3. Bad moves made by the Fed: The Federal Reserve is charged with the job of creating a safe and stable financial system. One way that the Fed accomplishes this is by raising or lowering interest rates. Throughout the 1920s the Fed kept interest rates low and when the crash hit, it actually raised interest rates, which is the opposite of what economists would recommend today, making the situation much worse.
4. Bad moves made by Congress: In an effort to increase demand for domestic goods and offset some of the overproduction issues, Congress passed the United States Tariff Act of 1930 also known as the Smoot-Hawley bill. The impact of this bill backfired as multiple countries retaliated with their own tariffs on US goods and imports fell 40%. With demand lacking domestically and now abroad, the losses on Wall Street continued.

Quick tip: Generally, the Federal Reserve will raise interest rates to prevent the economy from overheating and keep inflation in check and it will cut interest rates to encourage saving and investing to boost the economy.

What are the effects of the 1929 stock market crash?  Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

The stock market would continue to fall through 1932, hitting the bottom at 89% below its peak in 1929 and then the Great Depression began. "By 1933, almost half of America's banks had failed and unemployment rates were around 30% or 15 million people," Lutkemuller adds. 

For African Americans, it was even worse, as approximately half were out of work and racial violence would increase in parts of the South. It wouldn't be until 1954 that the Dow Jones would reach pre-crash levels. In an effort to put the US back on track, a series of moves were made in 1933 under President Franklin D. Roosevelt's New Deal.

The New Deal was an expansive series of programs put in place, with several of the original protections and agencies that are still used today. The New Deal created the Federal Deposit Insurance Corporation (FDIC) to ensure the funds held in US banks up to a certain limit.

It also created the Securities and Exchange Commission (SEC) to protect investors and oversee the stock market. The FDIC was created because as the stock market fell, thousands of people began withdrawing their money from banks. "Banks didn't have adequate reserves to meet these demands, due to the funds being invested in the market. This sent the market into even more of a spiral," adds Lutkemuller.

Quick tip: During the 2008 recession, this limit was raised from $100,000 to $250,000. By 2010 the $250,000 FDIC limit was made permanent as a part of the Dodd-Frank legislation. 

The bottom line

Because the economy and the stock market are linked to so many complex and fluid factors like international relations, consumer behavior, and regulations there was no single cause for the crash. But these factors are even more complex today, due to the rise of cryptocurrencies and investment opportunities and technology. Lutkemuller says that market crashes are not as easy to forecast as you might think. "Hindsight bias is very common when looking back at previous market crashes, but it is very hard to predict in real-time." 

It is also important to point out that while buying and holding for the long term is generally considered solid financial advice today, it may not have been the best idea in the years directly after the crash in 1929. "We have been blessed with an extraordinary bull market the past decade," Lutkemuller said. "But let's not forget that it took almost 25 years for the stock market to fully recover to its September 1929 peak."