New stock market crash inevitable

Every production phase or society or other human invention goes through a so-called transformation process. Transitions are social transformation processes that cover at least one generation. In this article I will use one such transition to demonstrate the position of our present civilization and that a new stock market crash is inevitable.

When we consider the characteristics of the phases of a social transformation we may find ourselves at the end of what might be called the third industrial revolution. Transitions are social transformation processes that cover at least one generation (= 25 years). A transition has the following characteristics:

• it involves a structural change of civilization or a complex subsystem of our civilization
• it shows technological, economical, ecological, socio cultural and institutional changes at different levels that influence and enhance each other
• it is the result of slow changes (changes in supplies) and fast dynamics (flows)

A transition process is not fixed from the start because during the transition processes will adapt to the new situation. A transition is not dogmatic.

Four transition phases

When we consider the characteristics of the phases of a social transformation we may find ourselves at the end of what might be called the third industrial revolution.

The S curve of a transition

Figure: Four phases in a transition best visualized by means of an S – curve: Pre-development, Take off, Acceleration, Stabilization.

In general, transitions can be seen to go through the S curve and we can distinguish four phases (see fig. 1):

1. a pre-development phase of a dynamic balance in which the status does not visibly change
2. a take-off phase in which the process of change starts because of changes in the system
3. an acceleration phase in which visible structural changes take place through an accumulation of socio cultural, economical, ecological and institutional changes influencing each other; in this phase we see collective learning processes, diffusion and processes of embedding
4. a stabilization phase in which the speed of sociological change slows down and a new dynamic balance is achieved through learning

A product life cycle also goes through an S curve. In that case there is a fifth phase:

       5. the degeneration phase in which cost rises because of over capacity and the producer will finally withdraw from the market.

When we look back into the past we see three transitions, also called industrial revolutions, taking place with far-reaching effect:

1. The first industrial revolution (1780 until circa 1850); the steam engine
2. The second industrial revolution (1870 until circa 1930); electricity, oil and the car
3. The third industrial revolution (1950 until ....); computer and microprocessor

The emergence of a stock market boom

In the development and take-off phases of the industrial revolution many new companies emerged. All these companies went through more or less the same cycle simulataneously. During the second industrial revolution these new companies emerged in the steel, oil, automotive and electrical industries, and during the third industrial revolution the new companies emerged in the hardware, software, consulting and communications industries. During the acceleration phase of a new industrial revolution many of these businesses tend to be in the acceleration phase of their life cycle, more or less in parallel.

Figure: Typical course of market development:  Introduction, Growth, Flourishing and Decline

There is an enormous increase in expected value of the shares of companies in the acceleration phase of their existence. This is the reason why shares become very expensive in the acceleration phase of a revolution.

There was also an enormous increase in price-earnings ratio of shares between 1920 – 1930, the acceleration phase of the second revolution, and between 1990 – 2000, the acceleration phase of the third revolution.

Figure:  Two industrial revolutions: Shiller PE Ratio (price / income)

Splitting shares fuels price-earnings ratio

The increase in the price-earnings ratio is amplified because many companies decide to split their shares during the acceleration phase of their existence. A stock split is required if the market value of a share has grown too large, rendering the marketability insufficient. A split increases the value of the shares because there are more potential investors when they are cheaper. Between 1920 - 1930 and 1990 – 2000 there have been huge amount of stock splits that impacted the price-earnings ratio positively.

Table 1: Share Splits before the stock market crash of 1929

Table 2: Share Splits during the period 1990-2000

Share Splits keep letting the Dow Jones Index explode

The Dow Jones Index was first published on May 26, 1896. The index was calculated by dividing the sum of all the shares of 12 companies by 12:

Dow12_May_26_1896 = (S1 + S2 + .......... + S12) / 12

On October 4, 1916, the Dow was expanded to 20 companies; 4 companies were removed and 12 were added.

Dow20_Oct_4_1916 = (S1 + S2 + .......... + S20) / 20

On December 31, 1927, two years before the stock market crash in October 1929, for the first time a number of companies split their shares. With each change in the composition of the Dow Jones and with each share split, the formula to calculate the Dow Jones is adjusted. This happens because the index, the outcome of the two formulas of the two baskets, must stay the same at the moment of change, because there can not be a gap in the graph. At first a weighted average was calculated for the shares that were split on December 31, 1927.

The formula looks like this: (American Can, split 6 to 1 is multiplied by 6, General Electric, split 4 to 1 is multiplied by 4, etc.)

Dow20_dec_31_1927 = (6.AC + 4.GE+ ..........+S20) / 20

On October 1st, 1928, the Dow Jones grows to 30 companies.

Calculating the index had to be simplified at this point because all the calculations were still done by hand. The weighted average for the split shares is removed and the Dow Divisor is introduced. The index is now calculated by dividing the sum of the share values by the Dow Divisor. Because the index for October 1^st, 1928, cannot suddenly change, the Dow Divisor is initially set to 16.67. After all, the index graph for the two time periods (before and after the Dow Divisor was introduced) should still look like a single continuous line.  The calculation is now as follows:

Dow30_oct_1_1928 = (S1 + S2+ ..........+S30) / 16.67

In the fall of 1928 and the spring of 1929 (see Table 1) 8 more stock splits occur, causing the Dow Divisor to drop to 10.77.

Dow30_jun_25_1929 = (S1 + S2+ ..........+S30) / 10.77

From October 1^st, 1928 onward an increase in value of the 30 shares means the index value almost doubles. From June 25th, 1929 onward it almost triples compared to a similar increase before stock splitting was introduced. Using the old formula the sum of the 30 shares would simply be divided by 30.

Figure: Dow Jones Index before and after Black Tuesday

The extreme rise in the Dow Jones in the period 1920 - 1929 and especially between 1927 - 1929, was primarily caused because the expected value of the shares of companies that are in the acceleration phase of their existence, was increasing enormously. The value of the shares is strengthened further by stock splits and as icing on the cake this value of the shares was  enlarged again in the Dow Jones Index, because behind the scenes the formula of the Dow Jones was adjusted due to stock splits.

During the acceleration phase of the third industrial revolution, 1990 - 2000, history has repeated itself. In this period there have again been many stock splits, particularly in the years 1997 and 1999.

Table 3: Summary DJIA, Dow Divisor and amount share splits between 1990-2000

The formula that was used on January 1, 1990 to calculate the Dow Jones:

Dow30_jan_1_1990 = (S1 + S2+ ..........+S30) / 0.586

The formula that was used on December 31, 1999 was to calculate the Dow Jones:

Dow30_dec_31_1999 = (S1 + S2+ ..........+S30) / 0.20145268

On December 31, 1999 on an increase of the 30 stocks again nearly three times as many index points, the same value increase on January 1, 1990.

>> Read Part II: New Stock Market Crash Inevitable