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This is the third article in this series. The first one was written in the end of March 2009. The market switched to a bull mode then and the future seemed to be rosy. The next one was written in November of the last year. The future still seemed rosy, although a little bit darker. May of 2010 changed everything.

What happened in May? Europe woke up to the depression. They call it a "liquidity crisis", "bank crisis", "sovereign debt crisis". Wrong! This is a full blown financial crisis, part of the Great Worldwide Depression of 2008-?

Inflation and Stagnation = Stagflation

After last May, there is no possibility for this scenario. Inflation does not happen when banks don't lend. You can get inflation during a crisis, but you still need banks to lend money for that to happen. Now banks in US and EU and many other countries just do not lend money. Worse, there are multiple reports from both the US and the EU that in many areas demand for loans is low, which means that banks can't lend more money even if they wanted to.

Probability of stagflation any time soon: 0.

Great Recession

I wanted to believe it. Almost everybody wanted to believe it. The US economy grew nicely in the second half of 2009 and in the first quarter of 2010. And in this scenario, we should be out of the woods already. But, again, May changed everything. The economy might still grew for a couple more quarters. But a deep recession in Europe, which will definitely follow the current financial turmoil, cancels the possibility. The EU economy is as big as the US's and when it goes down, it pulls down everybody, just like US. There might be tiny possibility that a quick response from European governments and central banks can trigger a quick recovery there, but I just don't see it. Instead of emergency spending, governments are cutting budgets. It's OK for Greece, with its bloated government sector, or maybe for Spain, but Germany, with relatively small sovereign debt, should not cut. They need emergency spending. There is always a way to spend money for a good reason. There are always roads to build and repair, bridges to rebuild, schools to improve.

Probability: Around 5%, if we are lucky.

Great Depression 2.0

Here we are. This is just too much like version 1.0. Started in US, becomes full blown when Europe goes to pieces. The current scenario is different on one account only: neither the US nor Europe is in the mood for trade wars. Which is great, because any kind of trade war between the EU and the US will make the situation very bad very fast. The main problem: both regions are in deflation. And deflation was the main problem during Great Depression in 1930s. Latest information about M3 money aggregate in the eurozone and the US is awful. The ECB and the Fed have failed. The last thing they should allow is falling money supply. Remember what Bernanke said? That the Fed can always increase money supply with fiat money and a printing press. So, where is the printing press when we need it? Or, as it happened during GD v1.0, every dollar coming from printing press goes directly to the mattresses?

Probability: About 60%

Japanese disease (Zero growth with zero inflation or low deflation)

I still think this scenario has lower probability than GD 2.0. Maybe it's just my wishful thinking. Arguments against this scenario: the US and even Europe are more dynamic societies than Japan, there is no habit of sweeping problems under the carpet and keeping them there for many years, voters kick out governments much faster etc. But there are arguments for this scenario as well. Demography: The population is not growing in Europe, it's falling in many countries, just like in Japan. The government sector is way too big in Europe, and government employees are not enterprising enough to pull countries from depression. The US is different, our population is still growing, but mostly because of immigration.

Probability: About 35%

Conclusion

Most probably, we are in GD 2.0. It will last several more years. I hope that it will not end in a big war, like the Great Depression did. In this case, and in the case of ended Great Recession, the right investment behavior would be to buy stocks. The question is: which stocks? In the case of Great Depression, the best stocks are high yielders with a relatively safe market. Tobacco, entertainment, food, cheap retail. In the case of ended recession, it's fast growing companies, high tech first of all. The worst case scenario would be Japanese. In this case, the best investment is in cash.


I am going to change my portfolio this summer. I will reduce or eliminate bond funds, leaving only bank bonds, because governments will not let the majority of the banks fail. I will add more high yield companies. Reduce the weight of tech. And keep large cash reserves to play with opportunities.

Source: 4 Possible Market Scenarios: Part III