The daughter of all bear markets?

The bear market of 2007–2009 is now officially the second worst in US history, exceeded only by the mother of all bear markets, the one from 1929–1932 that coincided with the initial years of the Great Depression. Thus, we have no viable model to use in estimating the trajectory of the current bear market, except for the “big one.” It’s for that reason we see more and more pundits throwing out numbers where they guess this one will bottom: Dow 6000, Dow 5000, etc. But these are really no more than wild guesses, and have no basis in either history or current reality. There’s just no way to know when or where the bottom will finally occur.

As much as I loathe to do it, however, I will draw some comparisons between today and those fateful years in the early 1930’s. First, I’ll model what would happen should things actually get that bad again. Then I’ll give a bunch of reasons why they almost certainly won’t.

The S&P 500 is now -55.8% below its all-time high from October 2007, and the Dow is down -52.9%. These are both greater falls than in any prior bear market other than 1929–1932. Overseas markets are down even more: the Nikkei average of Japanese stocks, for example, is down -61% from its high. These are big numbers by any measure.

If this were 1930, though, we’d be only about halfway done. The US market would have another -63% to fall before hitting bottom in mid-1932. That’s a frightening prospect! Certainly, few people held on during this period, with many of them selling out near the bottom in 1932 (most of the rest were forced out earlier because of margin calls and the need for cash to live on).

But suppose you had held on, not expecting the market to continue to plummet, and knowing that it would eventually recover. How long would you have had to wait to make your losses back?

Not as long as you might think. You would have recovered your money from that second sickening drop and be back to your 1930 balance by March 1934, or about 20 months after that final bottom. By February 1937, about 3 more years, you would have recovered 81% of your money from the 1929 peak. This, of course, assumes you stayed 100% passively invested in stocks the entire time, not trying to own the better stocks, countries or industries. (These numbers include dividends, which remain an important part of stock returns.)

In real terms, the numbers look even better, because the 1930’s were a time of significant deflation, which itself contributed both to the drop in the stock market and the downturn in the economy. That’s why governments are so intent on avoiding deflation today. So, after inflation, you would only have had to wait until May 1933, or 11 months, to earn back that second drop. And by February 1937, you would have earned back 99.5% of what you had in August 1929, before the “Crash.” So in the greatest bear market in world history, it took less than 5 years from the bottom to earn back everything you’d lost. Bad, but not the end of the world. (Not only that, but US GDP had actually reached 1929 levels by 1936.)

So now you know what the worst case looks like. Now I’ll tell you why, as bad as things seem, they are not even close to the 1930’s, and extremely unlikely to approach that level of economic or financial decline.
1. The economic decline is not even in the ballpark of the 1930’s: Even the worst-case scenario sees a 5% drop in GDP during this recession (it was -3.4% in 1973–75 during the oil embargo). From 1929–1932, real GDP dropped nearly 30%. Unemployment may well reach double digits this time (as it did in 1982); in the 1930’s, it exceeded 25%.
2. As bad as things are with the banking system, it’s in better shape than in the 1930’s: Remember, mark to market accounting makes banks’ financial status appear much worse than they would under 1930’s accounting rules. And in the 1930’s, there was no deposit insurance, so runs on banks made some sense. When a bank went under, depositors lost most or all of their money. Thousands of banks failed in the 1930’s because of bank runs, which obviously severely reduced the amount of cash the banking system had to lend. This fed on itself, until the banking system was near collapse. It was only stopped by FDR’s bank holiday, shutting all banks for a week and then gradually reopening only the solvent ones. Also, today we have all sorts of government guarantees on bank liabilities, along with government programs to replace some of the lost lending.
3. US government responses were either inadequate or counterproductive until 1933: They actually raised some taxes and increased trade tariffs, as well as cutting government spending. Today, we’re seeing tax cuts and massive spending increases relatively early on.
4. The Federal Reserve didn’t have a clue in the early years of the Depression: They kept credit tight, allowing the money supply to plummet. This caused deflation to embed itself in the economy, leading to a downward spiral in economic growth that was difficult to reverse. Today, the Federal Reserve has not only reduced interest rates to near 0 and greatly expanded the money supply, it’s also working to lower long-term interest rates such as mortgages and implementing several new programs to provide liquidity and increase lending.
5. The US was on a gold standard until 1933: The gold standard was a big reason the Federal Reserve had such trouble increasing the money supply. When a country is on the gold standard, the amount of cash in circulation is limited by Federal gold reserves. And when people start trading in their dollars for gold (which was permitted then), this further reduces the cash in circulation. When other countries went off the gold standard before the US, this further drained our gold reserves. One of FDR’s very first actions, along with the bank holiday, was to take us off the gold standard. The economy then started growing almost immediately.
6. Protectionism and trade wars made the Great Depression even worse: This time, as I’ve said, protectionism is minimal. Governments around the world have dramatically loosened monetary policy and put large stimulus programs in place. In addition, there is a fair amount of coordination and cooperation between countries. In the 1930’s, we had a massive trade war with punitive tariffs, along with the rise of fascism in Europe that eventually led to WWII, something that we thankfully don’t have to contend with today.

Thus, while this recession is turning out to be the worst since 1982, and perhaps even become the worst since 1932, stock declines have already discounted something very severe, having been greater than any bear market since the Great Depression. I’ve listed above several reasons why it’s highly unlikely that the economy will sink anywhere near as much as it did in the 1930’s, and thus neither should the stock market. But given all that, it may be somewhat comforting to know that even during the economic Armageddon of the 1930’s, investors made virtually all their money back in less than 5 years by just sitting tight.

So given that neither I nor anyone else can predict the future, and given how far stocks have already fallen, and given the history of past bear markets, it seems to me that the bigger risk now is missing the rebound, rather than suffering a further big fall. I may be wrong this time (as I have been for many months now), but the longer this bear market goes, the closer we must be to the end. And the end will come when no one expects it, seemingly out of the blue, as has the end of every other bear market. I’m sure even I will be surprised when stocks finally decide that they can go up as well as down. And believe me, no one is more anxious to see this bear market end than I am!

In future emails, I’ll look more closely at the question of valuation (are stocks really cheap now, or do they just appear to be?), and finally explain mv=py and how it governs many of the Feds actions.