20 Feb 2009

The Stock Market in 1929 Was Undervalued??

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So argue McGrattan and Prescott in this 2003 Fed paper (pdf). Here’s the abstract:

Many stock market analysts think that in 1929, at the time of the crash, stocks were overvalued. Irving Fisher argued just before the crash that fundamentals were strong and the stock market was undervalued. In this paper, we use growth theory to estimate the fundamental value of corporate equity and compare it to actual stock valuations. Our estimate is based on values of productive corporate capital, both tangible and intangible, and tax rates on corporate income and distributions. The evidence strongly suggests that Fisher was right. Even at the 1929 peak, stocks were undervalued relative to the prediction of theory.

Hmm. I think if your model predicts that stocks were undervalued in 1929, then your model is wrong. Forget the fact that the Dow didn’t surpass its 1929 peak until the 1950s (according to Amity Schlaes)–after all, one could plausibly argue that the New Deal and World War II totally changed the underlying fundamentals that prevailed in 1929. Fine.

But still, how do our authors explain the huge rise in the stock market during the late 1920s? In other words, if stocks were undervalued at the 1929 peak, then they must have been ludicrously undervalued in 1927, since I don’t think there were any major changes in the “fundamentals” during the two years.

I haven’t read the paper so maybe they give an answer. They do address the issue of the crash itself–they follow Friedman and blame it on the Fed tightening. I think this theory that the tightwad Fed caused the crash may be Friedman’s worst contribution, surpassing his role in creating tax withholding.

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