After getting bludgeoned by Friday's job report, everybody suddenly started worrying that the state of the economy might push the market down further. There is a lot of argument of whether we are in a recession (we hadn't started as of August), a recession in confidence (yes, big time), starting a double dip recession or actively in a depression.
People are right to worry about exactly what state the economy is in as a recession inside of a depression results in much greater market declines. During normal recessions, the S&P 500 has dropped between 2% and 43%. During the Great Depression (1929-41), the S&P 500 initially dropping 85% then recovered part way but dropped back 45% during the recession of 1937.
However, there really should not be any discussion about depression: We're in one. We're in the midst of a cascade of poor government actions that have formed what Nobel Laureate Paul Krugman calls the "Lesser Depression," a time of continual high unemployment and weak or negative growth.
If we do enter another recession, it will be a recession inside of a depression like the recession of 1937, not a double dip recession like 1980 and 1981-82. The chart below shows the last double dip recession compared to today. Note that the employment today is still near its high, GDP growth has not reached it's pre-recession levels and T-Bills are hard up against the zero bound instead of high, causing the next recession like in 1981.
The chart below compares the Great Depression to the Lesser Depression with GDP indexed to 100 at the start of each to make comparisons easy. The first recession in the Great Depression lasted 43 months before goverment actions generated a strong recovery The recession that started the Lesser Depression lasted only 18 months before government actions resulted in weak economic growth. The economy today is relatively weaker than in 1937 as we have not fully recovered to the previous GDP level and have equal unemployment.
The table below shows the drop in the S&P 500 for each recession since 1919. (The values are from Robert James "Bob" Shiller’s Irrational Exuberance site, so they are by month and may not reflect the absolute high or low.) During the first stage of the Lesser Depression, the stock market drop was only 51% as increased deficits reversed the decline in corporate profits and halted the market drop.
S&P500 Drops During Recessions
March 1919 (i)
July 1921 (iii)
July 1924 (iii)
November 1927 (iv)
March 1933 (i)
June 1938 (ii)
October 1945 (iv)
October 1949 (iv)
May 1954 (ii)
April 1958 (ii)
February 1961 (i)
November 1970 (iv)
March 1975 (i)
July 1980 (iii)
November 1982 (iv)
November 2001 (iv)
December 2007 (iv)
June 2009 (ii)
-16% or more
Obviously, recessions are negative to stock values but the decrease varies due to numerous factors, which have other factors affecting them, so even guessing a range for the drop is complicated. For example, the current focus on deficit reduction in the face of a weak or non-existent recovery are a repeat of Hoover's errors of 1929-31 so the market reaction to a new recession might be a drop of greater than the 45% of 1937-38.
Based on history, the most important factor in determining the length and depth of a recession is how well the government reacts. As recently as the George Walker Bush administration the need for government action to address recessions was a given but now economic theorists try to discourage politicians from taking action by asking questions like “where was the market failure?” that justifies government action when unemployment is at 9.1% and capacity utilization at 77.5%. They then deny that there is proof that government action will work. If there is no market failure, why talk about whether government action will work?
Proof that government action used to work is pretty easy to come by. The chart below shows the unemployment rate compared to changes in the deficit. The mirror-like shape shows that unemployment used to respond to deficit spending. That is, it worked until December 2007. In 2007, we had a recession where unemployment did not seem to respond to deficit spending. How we are doing deficits today is much less effective at lowering unemployment than it used to be.
Getting to the Point
This is not about how to cure the economy, but how the stock market will react under current government programs. There will be a recession because current government actions are ineffective and not supported by any economic theory.
Currently, government actions across the developed world are concentrating on government deficit reduction as the means to improve economic performance. In reaction to slowing growth, France announced an austerity plan so that it could achieve its targets for deficit reduction. The United States has formed a deficit reduction committee tasked with reducing the deficit by $1.2 trillion. These actions are misdirected as the cause of the economic crisis in most countries was excessive private, not public, debt. The 2009 McKinsey report Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences gives a detailed analysis.
Unfortunately, there is not an economic theory (including conservative the Efficient Market Hypothesis, the Real Business Cycle Theory or Austrian economics) that supports public debt reduction as a solution to a private debt crisis. These private debts have to be cleared through bankruptcies, etc. and banks recapitalized, which has not been allowed to happen. If you believe Keynesian economics, deficit reduction during high unemployment will make things worse. Even the world's bill collector, the IMF, has stated that deficit reduction is wrong right now.
What is sure to happen in the coming recession in a depression? Earnings will drop. After tax profits vary based on aggregate investment and the government deficit so the decrease in demand from a recession will drive down private investment which, combined with current deficit reduction, will crater profits. Because corporations still remember the lessons of the recession of 2007, the cutback will be extremely rapid, similar to what happened in the recession of 1937.
Price/earnings ratios will drop. During recessions since 1918, the average 10-year price earnings ratios (PE10) has dropped by a third, from 19.5 to 12. This is to be expects as a recession will change expectations of future growth. Of course, PEs change for a number of reasons other than recessions, but we're just talking recessions.
The drop in the S&P500 will be less than the combined drop in earnings and PE10. The table below shows the drops during recessions of: the S&P500, the PE10 and annual earnings. The Great Depression recessions are highlighted in yellow as they are probably the most relevant to today. Because the bottom in PE10 and earnings occurs at different times, the drop in the S&P500 is not as bad as the combined drop would indicate -- thank heavens, or the bottom in 2009 would have been around 95.
A normal recession is more or less caused by an excess of production which has to work its way through the system before there is recovery. This will be a financial recession caused by a lack of demand due to over indebted consumers and poor job growth. This recession is more similar to the recession of 1929-33, 1937 and 2007 than later recessions.
The good news is that proper government action could limit the downside to this recession. The bad news is that there is unlikely to be any government action until the damage from the recession is well established. Political action will be taken only when the damage becomes obvious (i.e., unemployment breaches 10%) to improve election chances for incumbents before the election which is 15 months away.
Obama's job plan has been leaked and is underwhelming as usual. Totaling $300 billion including absolutely useless tax cuts, it is approximately a fourth the size needed to reduce unemployment. Republicans have already stated that they would oppose it so quick action is not going to happen. At this point, the recession will be at least 10 to 12 months long. The closer action occurs to the election, the longer the recession.
Wrapping It Up
Based on the above, a reasonable, but certainly wrong in the details, estimate of the drop in the market from a recession in the current environment of flat or declining deficits and loose monetary policy is:
- PE10 range down to 12 – based the recessions of 1937 and 2007, where monetary policy seems to have helped halt the decline.
- Profits down by 37% to 54% -- based on the recessions of 1937, 1991, and 2001 which seems to cover the range of negatives where government policy is implemented in the likely timeframe.
- S&P500 Down 40% from recent high to 820 -- basically in line with profit declines (though timing is different,) as the market anticipates turnaround at first announcement of expansive government policy.
- The market decline will be spread over a 10 to 12 month period -- this is approximately the same length as the recession. Note that we started the decline in April so this is the fourth month. The bottom should be February to April if there is some sort of real government action around this time. This is probably stimulus but there are other actions that could result in a market bottom.
- Continued perverse government action will make the recession and stock drop much worse than anticipated. The economy is relatively weaker than it was when it entered the recession of 1937 so the stock drop could exceed the 45% of 1937-38 unless corrective action is taken.
- A worldwide recession might/would force Greek default which would probably ignite another financial crisis, crushing financial stocks.
Perhaps I'm too negative. Many feel that the bad news will simply make the Fed act faster and save the economy with monetary policy. What worries me about this is that some facts are being ignored:
- The Fed cfhairman has unequivocally stated that "most of the economic policies that support robust economic growth in the long run are outside the province of the central bank."
- The Japan experience has shown that quantitative easing will not reverse a declining economy, though it may give a temporary rally.
If you are still expecting a significant rise in the market from current levels, you are probably going to be disappointed. Only QE 3 is likely to move the market upward significantly and the lack economic growth means that this will be temporary. The market has a bad habit of discounting news well in advance so we may have already experienced the QE3 rally.
Prudent investors will be totally defensive until some sign that government is taking an active role in fighting the coming recession. Preservation of capital is the name of the game until trends get clearer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.