A History of Market Violence

Investors are potentially standing on the precipice of another Great Depression. Conventional wisdom has long held that the Great Depression would not happen again. Behind this notion was the belief that much was learned from the mistakes made during this difficult period in history and policy makers would know how best to intervene to keep the economy from tumbling back into another abyss. But this conviction is now being put to the test after three-quarters of a century, as the events that are unfolding today have some alarming similarities to the Great Depression of the 1930s. As a result, it is worthwhile to consider how one might best navigate an investment portfolio through such a treacherous market backdrop.

The causes of the Great Depression were not necessarily so clear-cut. For decades, economists were broadly divided over the events and actions that led to the financial collapse of the 1930s. It was not until recent years that a consensus view began to form behind the research of leading experts on the subject, including Federal Reserve Chairman Ben Bernanke. The fact that it took some of the world’s top academic minds over fifty years to begin developing a cohesive explanation for the Great Depression indicates the deep complexity of this past crisis. But more importantly, it also suggests how challenging it may be working in real time to prevent a similar outcome today given the completely new set of driving circumstances and fundamental risks, some of which may not be well understood or even recognized by policy makers at the present time.

Many parallels may be drawn between the events surrounding the Great Depression and today. The following list represents the consensus view of the causes of the Great Depression and their correlations to today.

1. Excessive debt and leverage – This is the root fundamental cause behind the Great Depression and today’s episode that ultimately led to a banking crisis and a breakdown in the financial system. Banks reduced lending activity dramatically during the early 1930s in order to preserve capital and maintain survival. Banks today have also retrenched sharply, as the collapse of several major global financial institutions and the proliferation of toxic assets in the banking system has greatly undermined confidence, which has crippled financial intermediation and investment markets as a result.
2. Monetary policy prior to the downturn – Despite minimal inflationary pressures, the Fed raised interest rates starting in early 1928 until the market crash in October 1929 in an effort to thwart speculative bank lending. This policy action ultimately helped start the downturn. Although the Fed did not raise interest rates leading up to the current downturn, it has been suggested that the Fed may have begun easing too late and lowered interest rates too slowly once it was clear that the financial crisis was getting underway in early 2007.
3. Monetary policy during the downturn – The Fed tightened monetary policy far too soon during the Great Depression, leading to compounding deflationary effects. The risk today appears to be the opposite. The Fed has openly stated its commitment to maintain easy monetary policy for an extended period in order to combat prevailing deflationary pressures. As a result, it is likely that policy may stay too loose for too long, leading to the potential for compounding inflationary effects down the road and the development of new speculative bubbles.
4. Fixed Currencies – The global commitment to the gold standard in the early 1930s and the need to maintain fixed exchange rates ultimately forced many countries to assume tightening monetary policies even if local conditions warranted a decidedly different policy response. This helped compound weakening economic activity worldwide. While the gold standard does not exist today, many of the world’s largest economies in Europe share the euro currency, with many countries essentially maintaining a fixed exchange rate and taking on the same monetary policy despite vastly different individual economic circumstances. The potential economic instability of several countries in the Euro Zone not to mention the spillover effects of a mounting financial crisis in Eastern Europe may lead to more pronounced economic weakness from the region with subsequent feedback effects filtering through to the entire global economy.
5. Taxes – Two years into the Great Depression, the Hoover administration and Congress instituted a tax increase in 1932 in an attempt to balance the budget. This included a major tax increase on top wage earners. This tax increase ultimately resulted in a reduction in disposable income and a further contraction in consumer spending and economic activity. Roughly two years into the current episode, the Obama administration recently delivered a budget that included numerous tax increases in an effort to bring the now ballooning budget deficit back down to the $500 billion range by 2013. This budget proposal includes a major tax hike on top wage earners with income of $250,000 per year or more. While the ultimate impact of these policies today remain to be seen, characteristics of the recommended tax increases share some perilous similarities to those of the Depression and may serve to dampen economic activity once again this time around.
6. Protectionism – During the Great Depression, many countries engaged in protectionist trade policies such as tariffs and quotas in an attempt to promote domestic economic activity. This included the United States and the notorious Smoot-Hawley Tariff Act of 1930 and the Buy American Act of 1933. Such protectionist measures had decidedly negative consequences on global economic growth including massive contraction in global trade and foreign demand. Despite these past lessons, the protectionist instinct is building today in many countries across the globe. This once again includes the United States, which engaged in rhetoric opposing NAFTA during the Presidential election campaign, has been increasingly reluctant to approve new free trade deals and included “Buy American” provisions in the recently approved $787 billion stimulus package.
7. Global Credit – Following World War I, the United States was the main creditor to Europe. Once the flow of capital to Europe began to slow following the onset of the Great Depression, many European economies came under additional stress. Today, Asian economies including China are major creditors to the United States. If the flow of capital from China to the United States were to abate or reverse, our ability to adequately finance our own recovery efforts may come under significant strain.

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Stock market performance during the Depression and today are also strikingly similar. Although it began to crash in October 1929, the stock market as measured by the S&P 500 Index officially peaked in August 1929. In today’s episode, stocks reached their peak in October 2007 and drifted lower before finally cascading down in September 2008. As a result, we are now 16 months removed from the market peak in the current episode. When comparing today’s market to that of the Great Depression after 16 months, we are virtually in the same place (see chart). By December 1930 and February 2008, the stock market in both instances had declined by roughly –50% from its respective peaks. It is worth noting that after 33 months from the August 1929 peak during the Great Depression, stocks had declined by nearly –85%. Whether stocks continue to follow the same path today over the next 17 months between now and mid 2010 will depend largely on whether policy makers can unlock the financial system while also avoiding the types of mistakes listed above that compounded the economic and market damage during the Great Depression. Unfortunately, today’s risks remain elevated and a clear direction for resolving the current crisis is still far from established.

Fortunately, other asset classes have proved resilient during such difficult economic times. Despite the risks associated with investing in stocks during the Great Depression, several other asset classes performed well and provided relatively stable returns throughout the period (see table). Leading among these was Investment Grade Corporate Bonds, which generated a positive annualized return of roughly +6% during the peak Depression years from 1930 to 1932 and +7% during the decade of the 1930s. These corporate bond returns jump to +16% and +9%, respectively, when adjusted for inflation/deflation during these time periods. The same can be said of both long-term and short-term U.S. Treasuries. From 1930 to 1932, long-term Treasury Bonds returned an annualized +5% both from 1930 to 1932 and during the decade of the 1930s (+15% and +7%, respectively, when adjusted for inflation/deflation), while short-term T-Bills provided an annualized +1.5% from 1930 to 1932 and an annualized +0.6% for the decade overall (+11% and +3%, respectively, when adjusted for inflation/deflation). While the outcome for these asset classes may be different during the current episode, at a minimum it implies that meaningful opportunities exist to add value in relatively more stable asset classes outside of stocks during times of extreme economic stress. Encouragingly, results thus far suggest that similar trends may already be developing for these asset classes once again today.

Additional asset classes also merit consideration. One concern surrounding current monetary policy is that in contrast to the Great Depression, Fed policy may stay too loose for too long, leading to a potential inflation outbreak down the road. Treasury Inflation Protected Securities, or TIPS, would help provide portfolio protection against such an outcome. Precious metals such as gold and silver would also be suitable in this context for a variety of reasons. While gold was washed out during the Great Depression once global economies abandoned the gold standard, today it provides a store of value against risks of both inflation and deflation. Moreover, gold and silver are increasingly being viewed as potential back up reserve currencies given fears that global currency printing presses may ultimately overheat.

Even stocks may offer periods of opportunity along the way, but with considerable risk. As discussed, stocks declined from their August 1929 peak by roughly –85% over 33 months before bottoming in May 1932. But while it took decades after the Great Depression before stocks returned to their previous peak, it is worth noting that some healthy bear market rallies occurred along the way during the 1930s once stocks finally bottomed. This included a +137% rally from June 1932 to January 1934 and a +101% rally from February 1935 to January 1937. Of course, these rallies were accompanied by violent aftershocks, including a –21% correction from February 1934 to January 1935 and a long grinding –57% stock decline from February 1937 to March 1942. As for today, exactly when the current market will finally bottom remains unknown. And the driving forces behind any subsequent bear market rallies and corrections will be unique to the events surrounding today’s episode. But the key takeaway from the Great Depression for an investment strategy today is that while opportunities in stocks may exist in the coming years, any such allocations should be undertaken carefully and with a potentially short time horizon in mind.

Conclusion: We are potentially standing on the brink of a new Great Depression, and striking parallels exist between this past episode and today. A carefully managed investment strategy provides the opportunity to navigate such a treacherous market environment with controlled risk and the potential to add meaningful value along the way.

Disclosure: Long LQD, TIP, MBB and GLD

Comments

[cash:]

The graphic looks ominous. May indicate S&P 400-300 if the same script plays out. Civil unrest, and nuclear strikes on wall street are in order

Mar 05 08:01 AM

[Conan the B...:]

Nice Article, but disagree with "Monetary Policy" prior to the Downturn. In early 2007, Greenspan warned of a Recession if Monetary Policy remained tight, Bernanke ignored his wisdom.

The other question I have is the TIP aspect, wouldn't you buy them when it looked like the New GD had been averted?

Gold should be held regardless, just in case a Run on The Treasury occurs overseas while US markets are Closed. imho

Mar 05 08:45 AM

[kruser53:]

Eric, great article.

Any discussion like this would be better served by a book, rather than an article, but you have done a good job of getting many of the issues on the table. One area that could use some more discussion is taxes. In 1932, Hoover raised the top tax bracket from 25% to 63%. We now know that such drastic tax changes produce severe dislocations in economic activity. Obama has proposed raising the top bracket from 35% to 39.6%, the top bracket that was in effect before 2001. What evidence is there for the effects on economic activity for this smaller change in tax rates? There may be some changes on the margins, but will economic behavior be changed in the same way as larger changes? I don't know if there are any answers, but I think there is a lot of room for discussion.

Please don't take my comment as criticism of your fine article. I just think it is the beginning of the topic, not the culmination, which would take a book to cover.

Mar 05 09:19 AM

[investor88:]

Well, potentially in the jaws of depression. Reasons why not are fair enough, equally there are reasons why we are worse off than in 1930. Let the markets decide, see which way the guillotine will fall. It is not a situation for betting the farm.

Mar 05 09:43 AM

[Chris B:]

1)
Interesting thesis about how the Euro shackles monetary policy in Europe just as the gold standard shackled monetary policy in the depression era. However, I'm not sure if the analogy is sound, as conditions across the various countries vary little, and free cross-border trade can arbritage any differences that emerge. It's like saying the US states are shackled by a common currency that doesn't react to local conditions. Nonetheless I would say that the EU is doing a horrible job right now of preventing a deflationary credit crunch.

2)
What predictive value do overlapping charts have when today's expansionist monetary policies are the exact opposite of the contractionary policies pursued in the early depression? Today's proposals - which is all they are - on taxes and protectionism are merely symbolic gestures compared to what was done during the depression. Moreover, they face massive public opposition this time.

I saw simple chart overlaps like this in 2002 predicting another 50% downside. However, history doesn't repeat if you do things differently.

3)
Why mention that treasuries performed well during the depression? Interest rates were set too high back then. Do we really think that 20 year treasuries yielding <3% will yield double-digit gains? How exactly would that work? Interest rates are different this time, and treasuries are dogs. TIPs might offer some moderate gains and insurance against an inflationary disaster. Corporate bonds are offering OK, but not great, real yields but would decline in the case of the inflationary disaster your TIPs insure against.

4)
The general advice to this article is to withdraw from equities into bonds, TIPs, and precious metals. That advice would have been absolutely correct 5 years ago and the author's point is that it will be correct for the next 5 years because history is repeating itself.

The stakes are high. If history repeats and you stay in equities, the market price of your assets may not recover for years. If history does not repeat and you sell at the bottom and move into bearish assets, you'll never recover. Those "safe" bonds will fall in value in a recovery, while you miss out on double-digit stock price gains.

So evaluating this claim - that history will repeat - is the critical question. We should all have a set of historical criteria that will serve as a sell signal. Mine are:

-a wave of real protectionist legislation
-the govt. allowing all the big banks to collapse as occurred in the depression (I seriously doubt it)
-an inexplicable increase in interest rates within the next year (doubtful)
-poorly thought out legislation (e.g. mortgage rate ceilings, tariffs, restrictions on layoffs, budget cuts, etc.)

If these things happen, history will repeat. If not, then recovery in stock prices could start this year, and now is the time to buy even more equities. Just don't invest any money you'll need in the next 10 years in stocks. That should have been the advice all along.

Mar 05 09:45 AM

[sleepless_o...:]

Chris B, outstanding comment.

I have been thinking about the differences between 1928-1931 and 2006-09. You have been very thorough in suggesting some of the differences. This could be worth a lot more discussion.

For example, had Roosevelt been elected two years earlier and the New Deal was started in 1931 instead of 1933, would the depression have been shortened or made worse? I don't know the answer, but I'd sure like to hear a discussion from more knowledgable people. (Or even from more opinionated people.)

Again, Chris, thanks for opening a subject I have been wondering about. Your comment definitely adds to the value of this good article.

Mar 05 10:20 AM

[svosavvy:]

I have the same question as paultaut on TIPS,

The best time to buy is on the cusp of the turn from deflation to inflation right? Kind of like buying the bottom? From what I understand this will increase the value of the underlying bond?

Chris B
on tenet number 3 treasuries carried into the depression will have performed great because as the great deflation I mean depression roared on it killed yields as the dollar strengthened so you could fetch a nice price for your treasury as people were willing to buy an issue that paid a fair yield, and they knew there wasn't a call risk from the fed. A good example of this is look at the long treasuries issued from around 2005. If you bought the long bond in 2005 the par value has increased significantly. Now would be a nice time to sell your treauries into strength if you feel deflation is over.

Mar 05 10:51 AM

[GMiki1:]

Yes, be very careful of Treasuries. Short term if you want to hold cash. TIPs don't give real inflation rates, so why bother.

Louise Yamada, a highly respected Wall Street investment advisor, was on CNBC the other day saying that 400 S&P and 4,000 DOW are possible.

Mar 05 11:13 AM

[AdamsConsult:]

While the author's list of similarities is certainly evocative and in times like these we would be foolish to ignore history altogether. But the author has overdrawn some comparisons that warrant comment. Individual state governments comprised the bulk of tax revenu collected until 1934. The Federal government's tax burden on individulas was miniscule in comparison. Today's IRS is inflicting a much more serious tax burden on the American tax-payer than was ever levied in the 1930s. Although the Smoot-Hawley protectionism of the 1930s deserves serious criticism for its unabashed pork-barrel politics, the fact is that global trade had collapsed long before the law came into effect. Like now, the scamble for cash in the the global financial system lodged gold in state coffers--the UK left the gold standard since it was unable to meet its gold payments to the US. No gold, no capital, no financing, and no demand mean that there was little trade to be controlled by Smoot-Hawley. There is good evidence to suggest that the commodity exporting nations--Latin America in particular, actually enjoyed an increase in the standard of living during the "protectionist" 1930s. Local capital was deployed to meet local demands rather than finance export ventures. At present, China and Brazil look like they could do quite well, even with rising "technical" protectionism around the world.

Mar 05 04:08 PM

[CJJ:]

Can we stop calling the RETURN to tax rates on the RICH as a terrible thing. They are going to 39%. The RICH get more tax breaks than anyone. There is no way they are going to ever pay 39% of their income in taxes.

Who pushes this agenda other than people who make over $250,000/year.
Out of all the issues in the world today this should be the least of anyones worries.

Can this guy write an artical about how the widening gap between the rich and poor is a good thing and how well trickle down economics has worked lately? Should I hold my breath?

Mar 05 06:46 PM

[CJJ:]

Oh yea, after my last comment I guess I must be a socialist for wanting millionaires to pay more taxes in % to those who have no money.

I guess food, home and gas prices aren't taxes on the poor while being mere pittances for the rich.

I can read 100 ARTICLES about Greedy bankers every day, but I can read 1000s of COMMENTS by greedy citizens every hour.

Mar 05 06:49 PM

[Fred Voetsch:]

All we really need to know is the first: "Excessive debt and leverage"

All else follows because once we have the leverage/debt we must get rid of it and there is no way to get around that.

Until we see that the deleveraging has slowed we will not begin to see an economic recovery.

Mar 06 02:04 PM