Three years ago, 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. Exactly three years have now passed since this market bottom. And on its anniversary, I thought it would be worthwhile to revisit this article once again to assess how far we've come in fixing the problems that ailed the system three years ago.
Many of the same underlying problems that were plaguing the economy and markets at its very bottom are still festering today. And in some cases, they have become vastly worse. This does not bode well for a stock market (SPY) that has risen so far over the same time period. Fortunately, the stock market is just one of the many ways we can allocate capital to capitalize in investment markets.
The following is an excerpt from my post "A History of Market Violence" from 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.
- 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.
- 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.
- 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.
- 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 eurozone 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.
- 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.
- 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.
- 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."
Given that we are now at the third anniversary since the stock market bottom, it is worthwhile to revisit each of these items point by point.
Here is where we stand today exactly three years later since the market bottom on many of these points.
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. Instead, we've seen a great deal of leverage transferred from the private sector to the public sector. And while the financial system managed to stabilize, lending activity by the banks remains tepid at best.
3. Monetary policy during the downturn - We are three years on now, and the Fed along with other global central banks have flooded financial markets with liquidity in an attempt to solve a solvency problem. Today's announcement that the European Central Bank's balance sheet has now ballooned to $4 trillion (gulp) is the latest data point highlighting the extent of these monetary stimulus efforts. Global central banks including the Fed are now facing increasing criticism that monetary policy has become far too excessive, is leading to major market distortions and may ultimately lead to vastly greater problems down the road. Already we have seen speculative bubbles develop across all major asset markets including stocks, bonds and selected commodities. One has to look no further than our gas pumps in the U.S. or recent geopolitical events around the world such as the Arab Spring to see the effects from sharply rising prices.
4. Fixed Currencies - The potential demise of the euro was a concern then, and it may soon become a reality today. Greece may be delivering some unsettling news to the markets later this week on this front if the PSI deal falls through. Stay tuned.
5. Taxes - It was President Hoover and the U.S. Congress in 1932 three years after the 1929 market crash in 1932 that raised taxes in an attempt to balance the budget. This included raising taxes on those making over $1 million in annual income. Today it is President Obama and the U.S. Congress that are joined in an ongoing debate about the Buffett Rule, which would raise taxes on those making over $1 million in annual income. Of course, $1 million in annual income today captures a far greater number of individuals and small businesses than it did 80 years ago. Whether it is 1932 or 2012, raising taxes does not stimulate economic activity. Instead, it stunts growth. And given that the public sector is not typically the most efficient resource allocator, perhaps a fiscal policy focused instead on spending restraint and targeting expenditures toward those programs with higher economic growth multipliers might prove more beneficial in supporting a recovery.
6. Protectionism - This has still has not emerged as a major problem today, but the risk still lurks in the shadows.
7. Global Credit - One of the biggest concerns we face today across the globe is the ability to borrow going forward. And over the last year, we have seen sovereign debt levels in many nations rise to unsustainable levels and the ability to borrow in the future coming increasingly into question. This remains a story that is not only far from resolved, but appears to be getting increasingly worse, particularly in the U.S., Japan and Europe.
The aggressive fiscal and monetary policies enacted worldwide were supposed to buy us time. Unfortunately, this time has been squandered. Not only are we not much further along than we were three years ago, in certain respects conditions have deteriorated. And short of fiscal and monetary policy that has provided short-term adrenaline to the economy and has inflated asset bubbles along the way, these policies have done little more than create the illusion that things are getting better. Regrettably, they are not in a sustainable way.
This leads us back to an important point. When I wrote my original article on March 5, 2009, the S&P 500 stood at 682.55. Exactly three years later it peaked at 1378.04 just last Thursday on February 29, 2012 (of course, it had previously peaked at 1370.58 on May 2, 2011, but this may be a potential "double-top" article for another day). Thus, the stock market more than doubled along the way in the three years 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 a global economy that continues to struggle under the weight of massive global debt and has now already deployed many of its resources in attempting to fix the problem, is the market rally that we have achieved all along the way sustainable? Or are we at risk for considerable downside going forward, particularly once the crutches of fiscal and monetary policy are removed?
A final excerpt from my article on March 5, 2009, hints at my view on the market outlook:
"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."
Overall, the stock market gained +107% to its recent peak last Thursday in the three years since the March 2009 lows. While then is then and now is now, today's rally bears a striking resemblance in magnitude to the +137% rally from June 1932 to January 1934 and the +101% gain from February 1935 to January 1937 mentioned above. And we've already seen swift sharp declines of -17% from April 2010 to July 2010 and -21% from July 2011 to October 2011 that have only been prevented from falling much further by global monetary policy makers frantically rushing back in to inject more stimulus.
What the Great Depression showed us was that major bull market rallies occur within ongoing secular bear markets. And the last three years for stocks have clearly been a great ride (of course, it is now flat over the last year, but once again a topic for another article). 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 global growth slowing generally and Europe in particular now falling into recession and a still teetering on the brink of crisis. And given the similar underlying problems still at work today, it will be much harder for stocks to hold their ground above 1350 on the S&P 500 today than it was at 682 a few years ago.
So what is the best course for investors as they celebrate the three-year anniversary of the stock market bottom? The key as it has always been over the last three years is to remain hedged and to stand ready to capitalize on opportunities when they present themselves. This, of course, has included stocks. On three separate occasions already, they have corrected sharply only to rebound. Thus, it is worthwhile to stand ready to capitalize on this potential opportunity if it develops a fourth time around. In the meantime, holding some exposure in stocks is prudent only for the fact that the stock market may continue to melt higher on the adrenaline of ever more monetary stimulus. But it is prudent to limit these allocations to the most defensive names including those that have demonstrated the ability to hold their ground in the face of severe market stress. These include McDonald's (MCD), Family Dollar (FDO) and Bristol-Myers Squibb (BMY).
The good news is that attractive investment opportunities reside outside of the stock market. For those who are looking for a way to effectively short the stock market at current levels, a position in Long Duration Treasuries provides an ideal way to establish this exposure, as both the iShares +20 Year U.S. Treasury Bond (TLT) and the Vanguard Extended Duration Treasury (EDV) have demonstrated the ability to hold firm during rising stock markets but rally sharply during corrections. These should be viewed only as tactical positions, however, given the threat of rising interest rates down the road and the unsettled the long-term fiscal situation in the U.S.
Given that the global economy is awash in liquidity, exposure to positions that provide protection against both deflation in the event that monetary policy makers fail in preventing another financial crisis as well as inflation in the event that monetary policy makers continue to create an environment where inflation accelerates regardless of whether they achieve growth or not. Such positions include U.S. Treasury Inflation Protected Securities (TIP), gold (GLD) and silver (SLV).
Lastly, highly defensive positions that can hold steady while benefiting from the ongoing zero interest rate policies are also worthwhile in the current environment. These include Agency MBS (MBB) and selected Utilities Preferred Stocks.
One final point bears mentioning. An additional consequence of the massive injection of liquidity in the economy by global central banks has been the distortive effect on asset correlations. Many asset class categories that have historically either moved independently or in opposite directions to one another have experienced increasingly positive correlations in recent months. While these are likely short- term phenomenon (my complements to Brad Zigler for his excellent recent article on SA focused on this topic), it is something that warrants close attention and potential fine-tuning along the way. I will be revisiting this topic in the coming weeks.
So on this third anniversary of the stock market bottom, it is worthwhile to stop and enjoy the view from our now much higher perch. For it may not be long before we find ourselves descending back toward lower levels just as we did a year ago.
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.