Stock Market Swings and the Value of Innovation, 1908–1929

Abstract

This article investigates whether the run-up in stock market prices during the 1920s was related to the accumulation of intangible capital by firms. I use a matched data set of company financials and historical patent citations for 121 publicly traded firms between 1908 and 1929. I show that the returns to intangible capital were approximately three times larger during the 1920s compared to the 1910s reflecting significant changes in the configuration of company assets between these decades. Intangible capital growth was substantial in 1920s America, investors realized it, and they integrated this information into their market pricing decisions. There appears to have been a major shift in investor psychology towards intangibles during the stock market boom. One implication of the findings is that investors were not only more responsive to intangible capital at this time, but through triggering large stock market payoffs for innovation they also encouraged its growth. Introduction A recurrent theme in the modern literature on the economics of financial markets is the extent to which stock market swings reflect changes in the present discounted value of expected future earnings or the ‘animal spirits’ of investors. For example, the rapid acceleration in stock prices during the 1990s can be explained both by changes in expected investor payoffs in response to the accumulation of intangible capital by firms (e.g., Hall, 2001), and by behavioral phenomenon that caused a speculative bubble (e.g., Shiller, 2001). Whether swings in the stock market are driven by the diffusion of new technologies or by periods of irrational exuberance is an important question in the economics of innovation and finance. While this question is central to the debate over the causes of the recent stock market boom and bust it is also important to a fuller understanding of another major event in the American stock market – the run-up in equity prices during the 1920s and the Great Crash of 1929. While Irving Fisher famously reported on the eve of the Crash that stock prices would remain permanently higher than in past years due to the arrival of new technologies and advances in managerial organization that created positive expectations about future profits and dividend growth, retrospective analysis has indicated the presence of a ‘bubble’ (DeLong and Shleifer, 1991; Rappoport and White 1993, 1994). The speculative bubble hypothesis has become orthodox in the literature given that the S&P Composite Index fell by more than 80 percent from its September 1929 peak to its level in June 1932. The Great Crash is the canonical example in American financial history of market prices diverging significantly from fundamentals. Despite the conventional wisdom that stock market prices were unrealistically high during the 1920s, we know little about the types of assets that investors are said to have been