Revisiting March 2009: Over Two Years Later and Nothing's Changed

by: Eric Parnell, CFA

I posted an article on Seeking Alpha entitled “A History of Market Violence” on March 5, 2009. This, of course, was the day before the market bottomed on March 6, 2009 at 666.79 on the S&P 500 Index. Much time has passed since I posted this article, so I hadn’t read it for quite a while. But a comment from a reader in one of the posts over the weekend caused me to revisit it, and it was striking what I found. Even though nearly two and a half years have passed with the market rallying +105% from its March 6, 2009 trough to its May 2, 2011 peak, virtually nothing has changed. All of the same underlying problems that were plaguing the economy and markets at its very bottom are still festering today, over two years later. And in some cases, they’ve become quite a bit worse. Given where we are now in the cycle, this suggests potential downside for stocks in the months ahead.

The following is an excerpt from the above mentioned article published on March 5, 2009:

“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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.”

Returning to July 2011, it is worthwhile to revisit each of these items point by point.

First, the discards. Point number 2 warrants no further discussion, as monetary policy prior to the downturn remains what it was. Point number 6 on protectionism has also not surfaced as a problem to this point, short of a few minor rumblings along the way.

But the remaining items are notable. Here is where we stand today over two years later.

1. Excess debt and leverage – It has been several years since the outbreak of the financial crisis, and little progress has been made in the deleveraging process. And while the financial system managed to stabilize, lending activity by the banks remains languid.

3. Monetary policy during the downturn – We are over two years on now, and the Fed has endured wilting criticism over QE2 and seen its independence come under attack over concerns that its monetary policy has been both excessively easy and far too accommodative. And we have seen speculative bubbles appear to form in asset markets as a result, particularly in stocks and commodities. One has to look no further than recent geopolitical events around the world to see the fallout effects from such sharply increasing prices for items such as food.

4. Fixed Currencies – The potential demise of the euro was a concern then, it is quickly becoming a reality now with Greece on the brink and Ireland, Portugal, Spain and Italy all under mounting pressure.

5. Taxes – It was Hoover and Congress in 1932 -- three years after the 1929 market crash in 1932 -- that raised taxes in an attempt to balance the budget. It is Obama and Congress today -- three years after the 2008 market crash in 2011 -- that are heatedly debating raising taxes and reducing spending to achieve a balanced budget. And just like last time around, the fallout effects, if any, will not be known until well after the fact.

7. Global Credit – One of the biggest concerns we face today in this country is our ability to borrow using Treasuries going forward. And in recent months, we’ve seen increasing signals that our primary foreign lenders are looking to place their money elsewhere. This is a story that is not only far from resolved, but it still remains in its early stages.

The aggressive fiscal and monetary policies enacted worldwide were supposed to buy us time. But clearly, we are no further along than we were nearly three years ago in addressing the major dilemmas facing us at the depths of the crisis.

This raises an important issue. On March 5, 2009, when I wrote my original article, the S&P 500 stood at 682.55 and was hours from bottoming at 666.79 the next day. Over two years later it peaked at 1370.58 on May 2, 2011 and still stands at 1316.14 as of July 15. Thus, the stock market more than doubled along the way since I wrote my original article, but virtually none of the underlying problems have been solved. So if many of the issues that were prevalent when the market was trading at 682 on the S&P 500 on March 5, 2009 are still problems today, in an already sluggish global economy that is showing signs of slowing further, is the market rally that we have achieved all along the way sustainable? Has the economy truly achieved what the market has so unflinchingly priced in to this point? Or are we at risk for considerable downside in the months ahead?

Over the last several months, I have discussed in a variety of posts the likelihood that the stock rally from the March 2009 lows has been largely built on stimulus, including most importantly quantitative easing (QE) from the Federal Reserve. For if the rally is built on the sand of QE, we could see a repeat once again of the scenarios outlined in my closing paragraph from my original article on March 5, 2009:

"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."

Today, the stock market gained +105% in roughly 26 months after the March 2009 lows. While then is then and now is now, today’s rally bears a striking resemblance both in magnitude and duration to the +137% rally from June 1932 to January 1934 (19 months) and the +101% gain from February 1935 to January 1937 (23 months) mentioned above.

The Great Depression showed us that major bull market rallies occur within ongoing secular bear markets. And the last two plus years for stocks have clearly been a great ride. But the fact that virtually none of the major underlying issues that got us into this mess in the first place are resolved suggests that the risks to the downside outweigh the risks to the upside going forward. This is particularly true today, with QE off the table, a rapidly deteriorating situation in Europe and a still unresolved debt ceiling debate in Washington. And given the similar underlying problems still at work today, it will be much harder for stocks to hold their ground at 1319 on the S&P 500 today than it was at 682 a few years ago.

Taking some gains of the table and dialing back exposures to stocks may be worthwhile as a result. And as I've previously mentioned, other asset classes including Treasuries, TIPS, Gold, Silver and selected Investment Grade Corporate Bond issues along with Non-Financial Preferred Stocks all continue to offer attractive alternatives.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long GLD, LQD, ALM, FGE, XCJ, DRU, IEI, IEF, TLT, LNT, WR, PG, CL, KMB, GIS, CPB, TAP, XLU.