The economy and market might not replicate the Great Depression, but things are certainly bad. It's worth studying history.
History shows there is no rule the market can't fall by another 10, 20, 30%+.
Bear markets frequently experience big rallies. Don't let these rallies distract from fundamental economic and market analysis.
Bullish investors might be more prudent to dollar-cost-average.
(Source: Goldman Sachs, Zero Hedge)
Going even further than Goldman Sachs, Federal Reserve Bank of St. Louis President James Bullard on March 22 said the economy could shrink by 50% in Q2 with unemployment reaching 30%. These are Great Depression numbers!
While the economists predict doom, there are many market practitioners eyeing stocks that have fallen 20, 30, 40%+ off their highs. There are many companies with strong balance sheets and relatively inelastic demand that could survive a major downturn. Furthermore, there are other 'social distancing' facilitators - like Amazon (AMZN) and Netflix (NFLX) - that might actually thrive in a post-coronavirus world.
Despite a growing bullish buzz out there, I am being cautious.
While the coronavirus could be a one-and-done exogenous shock and the economy rebounds sharply, it is also possible the battle against the virus is protracted. How will the market react if the virus appears beaten (as it does currently in China) only to return in the fall? What if a vaccine cannot be created? What if society just has to live with an endemic virus that simply continues to kill off a portion of society? Right now, the answers to all those questions are speculative. There is a lot of uncertainty so I think caution is warranted.
What if This is Great Depression 2.0?
During the early years of the Great Depression the S&P 500 (SPY) lost almost all of its value (S&P 500 data sourced from Robert Shiller). Despite the massive decline, the index had a 'face-ripping' 24% rally from November 1929 to April 1930. This was the ultimate bear market rally. It sucked in many investors who thought the worst was over. These investors subsequently lost a lot of money over the next couple years.
The S&P 500 is currently down around 30-35% from its peak (with current volatility this can change by 5% daily). Comparing the current timeline to the Great Depression would align the current drawdown to around November or December of 1929 (-34% and -31% respectively).
If someone invested in December of 1929 they would have subsequently lost over 50% of their money within a couple years as the bear market raged on.
Before I continue: Today is a lot different than 1929. The financial system is much stronger than it was back then, monetary policy is loose, deposits are FDIC insured and we have numerous social safeguards (e.g. unemployment insurance) to help soften the blow for individuals. The Federal Reserve made the Great Depression worse and I think it's pretty clear it has learned from that experience. However, new policy errors might occur since we are in uncharted territory. Still, things might get bad but probably not Great Depression bad. With that said, I wrote this article to explore investing strategies for the worst case scenario.
As previously mentioned, on December 1929 the stock market was down about as much as it is today. If someone invested at that point, over the short term an investor would have lost over 50%. What about the long term? If an investor who was sitting on cash invested $20,000 into the market and held for 10 years they would have still lost about 32% (cumulative). Diving into the market did not work.
If that same investor instead took a more cautious approach by investing $1000 every 2 months (until the $20,000 was fully invested) he would have actually made +32% over the decade (cumulative).
Over a decade a +32% return is nothing to write home about. However, it's certainly a vast improvement over a -32% return.
If you're cautious like me, examining the extreme historical scenario - even if unlikely to repeat - is helpful in creating a strategy that hopefully reduces risk.
The points I'm trying to illustrate in this article are actually quite simple:
- There is no rule that the current market decline stops at 30% or even 50%. Pay attention to fiscal and monetary policy responses and the Covid-19 progression to get a sense of where this ends up. The Great Depression was largely due to multiple policy errors. While these errors might not be repeated, new ones might be made since the modern world has never fought a global pandemic before.
- There tends to be huge rallies within bear markets. This happened during the 2008/2009 financial crisis and during the Great Depression. A bear market rally is often followed by a re-test of the lows. Don't be caught off guard if this happens again.
- Investors leaning towards the bullish-side may be tempted to jump into the markets head-first. Investing a big wad of cash all at once is a risky bet in a down market. A more prudent approach is to dollar-cost-average periodically.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.