As originally published on April 22, 2009 at SeekingAlpha & DividendInc
After considerable pondering on the subject, I have come to the conclusion that the 89% decline in the Dow Industrials from 1929 to 1932 had little to do with the economic state of the nation. In fact, a simpler explanation lies behind the cause of the decline in the Dow which was thankfully never repeated since. A good portion of the blame should rest squarely on the shoulders of Dow Jones, now a subsidiary of News Corp. (NWS).
First, this is not an article to explain away the various levels of overvaluation in the market of 1929. It was clear then, as it is clear now, that the stock market was extremely overvalued. Also, the explanation that follows isn't the only reason for the decline of '29 to '32. We all know that various economic and political events pushed our economy and stock market to the known limits in the shortest period of time. In this article, I'm trying to point out or explain the reason for the extent of the decline in the stock market. I am hopeful that readers of this article will be open to a "different" perspective on this reasonably unique period which might broaden the minds of the reader rather than convince the reader to buy or sell their stocks.
As a person who tries to examine the Dow Jones Industrial Average from every angle, I have often wondered what the impact of the changes to the index would be if the changes to the index were never made. For example, where would the index be if AIG wasn't added to the index on April 2004? How about if Bank of America (BAC) was never part of the index? Bank of America was added to the Dow on February 2008. What about if Microsoft (MSFT), Intel (INTC), and Home Depot (HD) weren't added to the index in November of 1999? Where would we be if Citigroup (C) and Hewlett-Packard (HPQ) weren't added to the index in March 1997.
These questions have significant bearing on why the index has fallen so much in the last year and a half. It is worth noting that the selection of these stocks were at or near the peak in the respective industry groups that these companies are members. As an example, when Bank of America was added to the index in 2008 it replaced Altria (MO) and/or Honeywell (HON). Both of these companies, when compared to BAC, fared much better in the time after being taken out of the index. In fact, Kraft (KFT), a successful spinoff of MO when it was taken out of the index, was added back into the index on September 22, 2008 replacing AIG. Unfortunately, once KFT was added to the index it promptly fell from its relatively high price of $34.97 to the current level of $22.55.
The decision to take AIG out of the index and put KFT into the index couldn't have happened at a worse time. After all, the Dow Jones Industrial Average is a price weighted index. This means that the higher the stock price, the greater the impact the stock would have on the overall movement of the index. Essentially, the people at Dow-Jones traded a low priced stock with little impact on the index for a high priced stock that was susceptible to falling during a crummy economy. Furthermore, by choosing KFT, Dow-Jones ensured that the index would fall further because high quality stocks like KFT are the last to go when the market hits the skids. And so, KFT promptly fell 33% after being added to the index. Being a relatively high priced stock in the index, KFT had a much more significant impact on the Dow Industrials than the 90% decline in AIG over the same period.
Effectively, what I am describing is a "buy high and sell low" strategy that Dow-Jones exhibited in recent years. Which got me wondering, how did they manage during the "Great" Crash of 1929? Well, the results were what I would consider to be astonishing. The untimely inclusion of companies like KFT, C, HPQ, INTC, MSFT, AIG, BAC and HD were nothing new. However, what was unique about the period of 1929 to 1932 was the number of changes to the index that took place in such a short period of time. A total of 18 companies were taken in and taken out of the Dow.
Never before and never since has the Dow had so many companies added and dropped as constituents of the index. The only other period that came close was the period from 1899 to 1901, when the index had 9 companies added and dropped from the index. As demonstrated earlier, the timing of the selections were not the most optimal. As one company was added at a relatively high price the outgoing company with a low price, which would have had little impact on the downside, was given the boot. This resulted in a vicious cycle which propelled the index much lower than was otherwise necessary.
I contrasted the period of 1929 to 1932 with other known bear markets like 1906 to 1924, when the Dow languished around the 100 level, and the period from 1966 to 1982, when the Dow traded at or below 1000. In each case, the number of changes to the index was marginal, at best. The 18 year period from 1906 to 1924 had only 13 changes or 1.38 changes per year. The 16 year period from 1966 to 1982 had only 4 changes or 0.25 changes per year. This is contrasted with the 1929 to 1932 period which had 6 changes per year.
If looked at from the perspective that Dow-Jones is always going to "buy high and sell low" then we can reasonably assume that much of the decline in the Dow from 1929 to 1932 was due primarily to the constant changes to the index. Frequent changes to the index causes "the market" to grope about for a bottom (no pun intended) that doesn't exist. It appears that Dow-Jones learned the lesson that "buy and hold" works better than trading in and out. However, the timing of their changes to the index has caused more pain to last much longer than if they just let sleeping dogs lie.
See also:
