I am a classical value investor, but many readers might have noticed that my writings have focused increasingly on macro issues in the past year. There's a reason for that. While value investing is an extremely effective long-term wealth creation strategy, there are assumptions underlining it. When one of those assumptions gets undermined, what once looked like "value" can suddenly become very expensive. This can happen on a micro level, with a company hitting a growth cliff (what we typically call a "value trap"). Or it can even happen on a macro level, with an entire economy falling off a cliff.
The Great Depression is undoubtedly one of the greatest examples of value destruction on a macro level. It showcases how poor monetary and political policy decisions can decimate "value" in an entire economy. It also provides hints as to macroeconomic issues that may be brewing today.
There's surprisingly little evidence to suggest the market was greatly "overvalued" in 1929 prior to the Great Depression, if one believes that corporate earnings and cash flows are indicative of valuation. Research from New Low Observer shows P/E ratios for the S&P Industrials ranging from around 14x - 20x range in 1929; perhaps slightly on the high-end, but certainly far from what we might see as "bubble" territory.
Likewise, a quick glance at the S&P 500 P/E ratios shows a market P/E ratio of around 14 to 16 during 1929, right near the long-term historical average. In case you're wondering, from 1900 - 2013, the average P/E ratio was around 15.7. Based on this, the 1929 market looks "fairly valued" and a far cry from the late 90's tech bubble, where the P/E ratio of the S&P 500 ascended to over 45x.
To take this even further, P/E ratios stayed in a relatively "normal" range of about 10x to 20x from 1929 to 1932, even while the stock market was plunging. The real problem during this timeframe was that corporate earnings were getting obliterated due to macro factors. Once the E's began to drop, the P's quickly followed.
The Great Depression shows how dependent valuations are upon larger forces. Buying a "cheap" market where earnings get rapidly undermined can be devastating to investors. Conversely, buying an "expensive" market where earnings rapidly expand can result in spectacular returns. This is why the macro environment should still be very important to value investors.
The Reasons for the Great Depression
The reasons for the Great Depression have been debated for decades by economists. There are three consistent themes we see in the predominant schools of economic thought (i.e. the Austrian School, Monetarism, and Keynesianism).
(1) Monetary policies by the Federal Reserve,
(2) Protectionist trade policies including the Smoot-Hawley Tariff, and
(3) Large tax increases in the 1930s
The Great Contraction
In the 1960s, Milton Friedman, alongside Anna Schwartz, authored A Monetary History of the United States. Friedman argued that the policies of the Federal Reserve Bank kept credit artificially tight in the early Great Depression years, which triggered a massive contraction in money supply. This, he argued, was the primary cause of the depression. In fact, Friedman termed the event "The Great Contraction" as opposed to the "Great Depression."
While tight monetary policies might have been responsible for the Great Depression, Friedman also viewed loose monetary policies as an equally unbeneficial. Friedman has argued that when money supply growth exceeds output growth, inflation is created, and inflation is a stealth tax on the economy.
Trade and Smoot-Hawley
Another common explanation for the Great Depression focuses on trade policies. In 1930, signed into the law the Smoot-Hawley Tariff, which many economists have blamed for the depression. There's evidence to support this explanation, too. From 1929 to 1933, US exports declined 61% and imports declined 66%. It wasn't until 1944 that US exports would again reach 1929 levels, even in nominal terms (and 1946 in real terms).
While economists might debate whether Smoot-Hawley was the biggest cause of the Depression, at the very least, it exacerbated the crisis. It's also difficult to deny that increased world trade after World War II was one of the primary factors driving America's post-war growth.
The chart below shows imports and exports in terms of real GDP from 1934 to 1966. What we can see from this is that the real growth in exports was over 500% for that 38 year time frame; compare that to 1929 to 1945, a period that saw zero growth in real exports.
(click to enlarge) The real shift came right at the end of the war, as exports increased over 116% in real terms in 1946, the beginning of a long-running trend of increased trade. When economist Adam Smith penned "The Wealth of Nations", he laid out the reasons why greater trade helped make everyone wealthier. The Great Depression and the Post-War Boom provide two of the most dramatic illustrations of this effect. Smoot-Hawley promoted a destruction of wealth on a grand scale, while policies that fostered increased trade after World War II resulted in worldwide wealth creation.
Taxes and the Austrian School
President Herbert Hoover signed the Revenue Act of 1932, which implemented arguably the largest peacetime tax increase in American history. It's often noted that it raised the top rate from 25% to 63%, but more broadly, it raised taxes significantly on every single American, even doubling the rates for many middle income individuals and introducing a bundle of new excise taxes. To make matters worse, the tax was implemented immediately for the 1932 tax year, rather than being phased in for future years.
(click to enlarge) Hoover's tax increases were necessary to fund his surge in government spending. Federal spending as a % of GDP increased from 3.7% to 9.1% during the Hoover Administration. I view total spending as a % of GDP as a more pertinent figure for the "true tax burden", since spending will emphasize future debt, anticipated tax increases, and / or future inflation (a stealth tax).
Hoover's tax increases were an almost immediate disaster. The most critical indictment of the tax increase comes from a dramatic fall in gross private domestic investment ["PDI"], a key component of GDP. After the Hoover tax increases, PDI fell 78% in one year; the single largest decline in the data series, which dates back to 1929.
In spite of the disastrous results of the 1932 tax increases, Roosevelt implemented several more tax increases between 1935 and 1938, with more of an eye on "soaking the rich." The result: in 1938 consumer spending fell 3.7%. While much less dramatic than the 20% fall in 1932, it's still one of the largest declines in the data series. More ominously, PDI fell 34% in one year and was the main driver pushing the US back into recession.
The charts above might be ugly, but the two charts below make this look even uglier when put in context. In real terms, private domestic investment did not hit its 1929 levels again until World War II, and even that was fleeting. It took till 1946 till PDI sustainably stayed above the 1929 mark. In essence, we had something close to a 17 year black hole for investment. No wonder unemployment was so astronomically high in the Great Depression.
To show this in yet another form, take a look at PDI as a percentage of GDP. From 1946 to 2007, we can see a "normal range" of 13% to 20% emerge. In 1932, PDI as a % of GDP had fallen all the way to under 2.2%. In 1938, after slowly improving to 13.3%, it plunged to 8.2%.
Thus it seems very clear that tax and spending policies greatly hampered domestic private investment in the Great Depression. This plunge in PDI led to an immense rise in unemployment and a stagnant economy.
Takeaways from the Depression
While economists will continue to debate the Great Depression, my personal view is that all three main schools of thought are partly correct. The three primary causes of the Great Depression were:
(1) Policies of the Federal Reserve Bank that created severe monetary contraction,
(2) Trade restrictions including the Smoot-Hawley Tariff of 1930, and
(3) Large tax and spending increases implemented by Presidents Hoover and Roosevelt
Ultimately, these interventions coalesced to create a massive drop in investment, trade, credit, and corporate earnings, which decimated the stock market and led to sky-high unemployment.
Unfortunately, I worry that we're entering another "economic dark age". Several major governments are manufacturing similar flawed policies right now that have the potential to undermine value. I'm not predicting another Great Depression, but there are several major macro themes I believe will make markets very vulnerable to a crash in the upcoming years:
(1) Trade distortions within the eurozone,
(2) Malinvestment in China, resulting from currency distortions and non-market interest rates,
(3) Japan's attempts to artificially weaken its currency,
(4) Excess money growth in the US, fueled by large budget deficits and loose monetary policy,
(5) Entitlement program issues in the United States (Medicare / Medicaid) and Europe, and
(6) The US Affordable Care Act ("Obamacare")
I've written about the Affordable Care Act in my recent series (Part I, Part II, Part III, and Part IV). My thesis is that the ACA will harm economic growth in 2014 and beyond, but I'm not necessarily convinced that the impact will be enough to result in recession or "value destruction" on a grand scale. Rather, I think the negative impact will be focused on a few particular sectors of the economy, including restaurants, retail, construction, and farming.
I've also written to some extent about the eurozone's problems (Italian exit, trade imbalances, Greece is merely the first domino, and German bonds), as well as malinvestment in China (trade subsidies, China's Catch-22, Yuan devaluation risk rising). Also, a few more excellent articles on China here: Is China the Biggest Malinvestment Case of All-Time and By 2015, Hard Commodity Prices Will Have Crashed. In regards to China, I'd also recommend reading anything by Michael Pettis or Patrick Chovanec.
US Corporate Profit Bubble?
Here in the US, I'd argue we can see the affect of distortive spending and monetary policies in corporate profits. Cullen Roche at Orcam Financial Group recently posted a chart showcasing the breakdown of US corporate profits. The chart shows how an increasingly large percentage of this is being fueled by government deficits. This is particularly critical, because corporate profit margins are now at record highs in the US, and have particularly skyrocketed since 2000.
Only problem is that eventually we have to hit a brick wall. We can't fuel corporate profit growth through government deficits forever. Eventually, those deficits tend to manifest themselves in a negative way, either through higher taxes (which lower private domestic investment and consumer spending), inflation (a stealth tax of sorts) which also creates more pressure on the Federal Reserve to raise interest rates, or via attempts to lower government spending. The latter, while beneficial in the long term, will likely be painful in the short term.
Conclusions and How to Invest
The issues I've listed out are just a few very major economic issues I see lingering in the background. Many of these macro currents have the potential to destroy value for shareholders, so that what might look like a fairly valued market, could turn into an expensive one rather quickly.
The most difficult part of this exercise is to determine how to use this information. While I've shown in this article and previous articles that there are lots of reasons to believe the stock market and economy are vulnerable, we could have made a similar argument in 2004 or 2005, and it took until around 2008 before we saw the devastating consequences manifest themselves in the markets. For this reason, I'm not necessarily bearish on the US stock market (SPY) right now. Rather, I'd simply proceed with much more caution than I would have since late 2008.
I view real estate, insurance, and banking as the best US sectors to invest in. In many major metropolitan areas, price-to-rent ratios are still at historic lows, suggesting that housing prices need to "catch up" with rents at the very least. This will ultimately benefit banks and insurers, as well, both of which can benefit from potentially higher interest rates. Companies that I like in these sectors include Howard Hughes Corp (HHC), Genworth (GNW), Popular Inc (BPOP), and Pacific Continental Bank (PCBK).
Sectors I'd eschew or am actively betting against: copper, Chinese real estate / banks, Canadian banks, the Eurozone, and some US restaurants (which I think will get hit by Obamacare). I'd also keep a close eye on US retail, as several new tax increases go into affect over the next few years and the Affordable Care Act could also hamper consumer spending somewhat.
Overall, my outlook is a mixed one and I believe it's prudent to hedge one's bets over the next few years due to both increasing global and US-specific macro risks.
Additional disclosure: I am short on a few Canadian banks, copper producers, and US restaurant chains.