As financial markets continue to experience extreme volatility, many commentators are making new comparisons between the equity markets of today and those of the Great Depression. With those comparisons come predictions that equity markets will experience a crash in which they will lose as much as 90% of their current value. Based upon these predictions, readers are encouraged to exit equity markets and, instead, hold their capital in cash or sovereign debt instruments, which were safe havens during the Depression. While anything is possible, such comparisons and predictions don’t comport with differences between today’s economy and the economy of the Depression era.
At the time of the Great Depression, governments of the world weren’t burdened with the vast debt that burdens them today. Therefore, during the Depression, cash and sovereign debt were true safe havens. Cash and bonds were made even more attractive by the Federal Reserve, which reduced the supply of money in the economy by 25%. This resulted in a deflationary environment and lower interest rates. At that time, cash and bonds were great investments. You could put your cash under the mattress and, with each passing day, it became more valuable. Bonds were even better. You could buy a bond, collect interest until maturity and then be repaid in dollars worth more than the ones used to purchase the bonds in the first place.
Of course, such deflationary pressures have significant economic ramifications, not the least of which is the hoarding of cash. Capital, that should be invested in businesses and other productive economic activities, is instead held in cash or bonds. Therefore, in addition to the reduction in the money supply, there was an equally devastating reduction in the velocity of money in the economy during the Depression. And that is precisely what caused the Great Depression. Certainly, Milton Friedman explains it far better than I can ever do, but my crude illustration provides the more important points of his monetarist ideas.
Today, we live in an economy that represents the polar opposite of the Great Depression. When the Panic of 2008 occurred, our government was already saddled with unprecedented levels of debt. Yet, the government was forced to assume the debts of the largest financial institutions in order to avoid a complete collapse of our financial system. While politicians pass the blame for the crisis to Wall Street and Greedy Bankers, nothing could be further from the truth.
In reality, the problem was created by the monetary policy of the Federal Reserve and the fiscal and political policies of the Federal Government. By maintaining artificially low interest rates for decades, the Federal Reserve believed the business cycle had been eradicated and an environment, where everyone could buy anything they wanted on credit, had replaced it. Meanwhile, the Federal Government was busy adopting policies that only Karl Marx could endorse. They created agencies, like Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB), to assure everyone could own a home they couldn't afford and every student could study any subject they chose regardless of whether the investment, in their chosen field, could ever be justified by the market after they graduated.
Accordingly, since 2008, the debt the government incurred during the Panic has increased exponentially as the government is forced to make good on mortgages and student loans, which it guaranteed during the boom years. As a result, much of the private debt that existed in 2008 has been converted to public debt. In addition, the Federal Government continues to run a budget deficit of nearly 2 trillion dollars per year as it attempts to maintain the programs and promises it made to its citizens over the past 80 years. These factors have driven the public sector to a point where its debt is no longer sustainable.
The private sector, by comparison, has fared quite well since 2008. It has, of course, benefited from the transformation of private debt into public debt. Even more, most companies have taken additional steps to reduce costs and strengthen their balance sheets. This has lead to an increase in corporate profits despite an economy that refuses to produce new jobs. So, when we compare the relative strengths of the private and public sectors of today to those of the Great Depression, we see that the real risk today exists in the public sector while the risk during the Depression came from the private sector. For these reasons, today’s economy represents the perfect antithesis of the Great Depression.
While everyone is expecting equity markets to crash in a Depression-like manner, simple common sense dictates that based on the amount of debt held in the public sector, it is far more likely that any crash will occur in the currency and bond markets. In addition to the fundamental weakness of the public sector, the bond market is also extremely overbought and is in a bubble, which may prove to be the bubble of all bubbles. Such a combination of fundamental and technical weakness makes it highly likely that the demise of the currency and bond markets could occur just as quickly as the stock market crash of 1929 or the real estate meltdown of 2008. If that happens, all people seeking safety in Great Depression era investments will be devastated.
The probability of a crash, in bond and currency markets, becomes even more pronounced when we analyze how governments are dealing with the debt crisis. Instead of balancing their budgets through reductions in spending, they continue to spend far more than their revenues. In turn, central banks expand their balance sheet and purchase government bonds on the open market to finance the shortfall. Accordingly, the problems underlying the sovereign debt crisis are not getting better but are instead continuing to worsen.
History tells us that when nations are confronted with the amount of debt currently maintained by developed countries, they resolve the problem by monetizing the debt. While quantitative easing represents the first phase of monetization, eventually the Federal Reserve will simply buy bonds that the government will never repay. This is inevitable as there is no other way out of this crisis.
Everyone knows that massive debt monetization results in inflation. And the first sign of additional quantitative easing, or increasing inflation rates, may provide the catalyst for a mass exodus of investors from bond markets. Then again, it could be brought on by the collapse of the Eurozone, a default by any member thereof or some other debt ridden sovereign entity that hasn’t yet come to the attention of investors. While timing is always an issue, there can be no doubt that these markets will eventually come crashing down.
If the current economy represents the antithesis of the Great Depression, our investment strategy should also be 180 degrees different from a prudent Depression era strategy. Rather than investing in the public sector, which provided safety during the Depression, we should invest in the private sector. In short, anything related to the government should be avoided.
As inflation accelerates, everything denominated in dollars will increase in value including equities, real estate and commodities. And that is precisely where we should put our money. As for equities, we need to focus on large cap, blue chip stocks with international exposure, a pristine balance sheet and a business model that has no reliance on government contracts or spending. Adding a healthy dividend makes it all the better.
According to these criteria, I find the following stock appealing: Procter & Gamble (PG) 3.44% yield, Wal-Mart (WMT) 2.57 yield, Arch Coal (ACI) 3.05% yield, Apache (APA) 0.65% yield, Exxon (XOM) 2.47% yield, Caterpillar (CAT) 2.04% yield, John Deere (DE) 2.28% yield, Gold ETF (GLD), 3M (MMM) 2.83% dividend yield, Silver ETF (SLV), Abbott (ABT) 3.64% yield, Lab Corp (LH), Apple (AAPL), Cisco (CSCO) 1.34% yield, International Business Machine (IBM) 1.65% yield, Intel (INTC) 3.61% yield, Hewlett Packard (HPQ) 1.8% yield, Google (GOOG), AT&T (T) 6.13% yield, Verizon (VZ) 5.53% yield.