A History of Market Violence

by: Eric Parnell, CFA

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