It’s 1929, Shanghai Style: Part I

The Shanghai stock market fell about 8.5% Monday, and U.S. stocks declined as investors here got antsy about what might happen in China and markets around the world.

Let’s put the Chinese slump into perspective. First, prices on the domestic-oriented Shanghai market essentially doubled between last November and June. This was due largely to government actions, including relaxing rules on margin interest, to encourage small investors to buy shares. They obliged. In June the bubble began deflating, and since then the Shanghai market has lost about a quarter of its value. Today, it’s about where it was at the end of March — well below the peak, but also well above where it was when the climb began. So all is not lost.

On the other hand, the Shanghai slump could spell trouble. If it continues, I think it has the potential to be more like our 1929 crash in many ways than some of our other notable crashes.

Let’s compare crashes.

On Monday, October 19, 1987, stock markets around the world crashed, starting with Hong Kong, then Europe, and finally the U.S., where the Dow Industrials fell 508 points to 1,738.74, a loss of 22.61%. I was working at the now defunct investment banking firm of Drexel Burnham Lambert at the time — the home of junk bonds — and no one could believe the speed with which the Dow numbers kept sinking.

It was thought that program trading was to blame for the ’87 crash, and economists predicted that another Depression was on its way. The truth is, to this day nobody is sure of the crash’s cause or causes. And although it took two years to recoup the day’s losses, the Dow ended 1987 higher than when the year began and the economy shrugged off the slump as if nothing happened.

In retrospect, 1987 was a freak storm that just happened, a pattern that doesn’t fit Shanghai today.

It took two and a half years, not a day, but the Nasdaq crash of 2000 to 2001 — also known as the bursting of the dotcom bubble — saw the Nasdaq Composite fall from over 5,000 to just over 1,000, a loss of 78%.

The collapse was a classic speculative bubble gone nuts, much like the South Sea bubble in the 18th century and the tulip mania in 17th century Holland. In this case, the euphoria was over advances in connection with the Internet, and anything tech-related soared in value. Momentum built until enough people realized that stock prices were wildly out of whack with the earnings capacity of the underlying companies. Pffft went share values.

Again, this does not fit what’s happening in China.

The collapses of Black Monday — October 28, 1929, when the Dow Industrials lost 12.82% — and Black Tuesday — the following day, when they lost another 11.73% — not only were dramatic, but they are also seared into our collective memories as the sharply drawn dividing line between the Roaring Twenties and the Depression Thirties. On one side there were flappers, bathtub gin, and the Charleston, and on the other were breadlines, dust bowls and “Brother Can You Spare a Dime.”

While some still debate whether the Crash led inexorably to the Depression, it’s clear what led to the Crash: too much credit sloshing around in the form of margin loans, excessive levels of consumer debt, and a cultural mood where speculation seemed prudent. That seems to describe the present situation in China quite nicely.

The U.S. domestic economy in the late 1920s was similar to China today in that a decade-long growth spurt was actually coming to a close and running on debt-fueled fumes. By the late 1920s, many countries, especially those in Europe, were struggling with debt repayments. Commodity prices were coming down. The one bright spot in the world seemed to be the U.S.

Now substitute China for the U.S. Doesn’t 1929 have a familiar ring?

Next, we’ll look into what a Chinese stock market crash might mean to U.S. investors and others around the world.