The talking heads say this is the worst financial crisis since the Great Depression (1929-1932), and I wouldn’t disagree. Will it lead into another Great Depression, or is the market so oversold and fearful now that it’s at–or near–the bottom? Is this a phenomenal opportunity to pick up cheap assets? Or is it more prudent to sell out now to preserve what cash you have left?
If your strategy over the last three months was just to sit and wait it out hoping for a rebound, you probably now wish you’d been more proactive. With that said, what should you be doing now? That’s a difficult question but one I will attempt to answer in today’s letter. It’s a bit longer than usual, but the stakes are higher than ever.
Over this past weekend, I studied the history of the Great Depression and discovered some striking similarities as well as certain profound differences with the current financial crisis.
From 1921 to 1929 there was a stock market boom brought about by technological advances, a surging economy accompanied with general optimism. The Dow registered a low of 63 during the panic of 1921 and ran to a high of 386 in September 1929; that’s a remarkable 600 percent gain in just eight years.
The Federal Reserve was created in 1913 and began a policy of easy money in the late 1920s. Sound familiar? The newly created invention of consumer credit surged. For the first time in history, this easy money allowed the masses to purchase big-ticket items like automobiles and electronic appliances. Construction boomed, entertainment boomed with credit and leverage also being used to buy stocks (traded on margin, just 10 percent down).
What caused the Great Depression? Today many economists say it was this easy money. Numerous stocks with low intrinsic values traded up to ridiculous price levels–just like housing before the recent crash. And the Fed, worried the stock market was an unsustainable bubble, made borrowing money for stock speculation more difficult. Interest rates were raised, the stock market crashed, and although only an estimated 8 percent of Americans owned stocks at the time, this set off a chain reaction. The artificial demand created by easy money that pushed the prices of stocks and goods to artificially high levels came crashing down in a deflationary spiral. Credit dried up and–just like today–it reverberated throughout the markets and the economy.
What did governments do wrong at this time?
In an effort to restore fiscal sanity, most of the major governments attempted to balance their budgets. As mentioned, the newly created Federal Reserve raised interest rates after the 1929 stock market crash to curb stock market speculation. And the overheated, overvalued markets were ripe for a crash. However, this action and the subsequent crash had the effect of further depressing demand for industrial goods, farm products and services, and this further reduced wages and prices of just about everything cratered in a downward deflationary spiral.
The value of money went up as prices continued to plummet by as much as 10 percent annually. The natural thing to do when something like his happens is for people to stop what they’re doing and hunker down until the situation improves. So consumers stopped buying cars and other durable goods. And because demand collapsed, businesses stopped investing in new equipment and had to lay off workers. The stock market continued its downward spiral, and it all fed on itself from Wall Street down to Main Street.
Bottom line, stocks were overvalued, and in their attempt to raise interest rates to cool things off, they overdid it. And what could have been a normal recession turned into the Great Depression with unemployment peaking as high as 25 percent in 1932.
Today many economists agree the Fed first caused the economic and stock market boom and the subsequent crash via an easy money policy. And they made it worse with a tight money policy. No doubt this go around economists will say this crash was also caused by Greenspan’s easy money policy that created the housing boom (and the toxic mortgage derivatives this spawned) and channeled good money into overvalued real estate and other non-productive projects.
Bernanke is an expert on the Great Depression and no doubt he wants to avoid a repeat at all costs. In 1930, the Fed did nothing to stimulate the economy. All they did was raise interest rates. They felt it was a normal recession that would work its way out without government help. The problem was compounded by the Hoover Administration because, in an attempt to balance the budget, they increased taxes. This had the opposite effect of what was intended. It put more workers out on the street, with many corporations and municipalities subsequently defaulting on their debt obligations.
What concerns me today is that the government is creating an artificial stimulus to buy up bad mortgage derivatives to try and undo the excesses of the past. And although this may result in a short-term recovery, it doesn’t help to revive lasting prosperity. By creating a false recovery, another world financial crisis is in the works. Investor confidence has to ultimately be restored. Continually raising the debt ceiling does nothing to restore this confidence over the long term. Spending a trillion dollars to prop up bad mortgage debts won’t create new jobs or a new prosperity, but I don’t want to get ahead of myself here because what the Fed is doing now is totally different from the 1930 Fed actions.
Other striking similarities with the Great Depression:
In my research, I found it interesting that Hoover also came into office with a substantial surplus. He left office with a substantial deficit due in great measure to out of control Congressional spending. Congress overrode his vetos on relief spending and Veteran’s bonuses that brought the budget from surplus into deficit. Then–as one of our Presidential candidates is advocating now–he raised taxes. However, despite this (or perhaps because of it), tax revenues actually collapsed.
The pre-Depression peacetime Federal Government taxed 5 percent of gross national product (GNP) and spent 5 percent; that’s a balanced budget. The Depression-era Federal Government taxed 5 to 7 percent of GNP and spent 8 to 10 percent with higher tax rates. The result: In the 1932 fiscal year, tax revenues decreased by a whopping 50 percent. Despite higher tax rates and deficit spending, unemployment remained high for a decade. The unemployment rate as late as 1940 was more than 11 percent, and it took a major world war (that brought defense spending up to a whopping 35 percent of GNP) to bring that number down.
Frankly, I don’t see either Presidential candidate advocating sound monetary policy. (The other candidate in the recent debate actually advocated more government handouts to support bad mortgage loans, a policy that will add to the deficit while doing little to stimulate economic activity).
In the 1930s, deflation rose as high as 50 percent. Banks saw the value of their collateral on loans decrease by this much or more in many cases. The banks began to worry that if their borrowers defaulted their collateral wouldn’t cover their loans, and this is what causes banks to fail. Depositors saw these potential loan defaults as a sign the banks were shaky and (pre-FDIC) withdrew their deposits. In other words, it was a run on the banks.
The solvent banks also were becoming nervous that their loans were being jeopardized by deflation and believed it was time to become liquid and move their assets into the safest place: government Treasuries. The problem with this is they became less willing to loan money for private projects, and this further hurts the economy. During the Great Depression, safe interest rates (government paper) moved lower while borrowing companies in the free market. Even those with stellar credit history had to pay much higher rates. This is exactly what’s happening today as the credit markets and banking system freezes up. This process feeds on itself, and it creates less demand for goods and more unemployment. The way to reverse this is to restore solvency to the banking system, and this is what Henry Paulson and Ben Bernanke are attempting to do.
If the world continues to value liquidity and safety over investing then Treasuries (and gold) will continue to be in demand. I have always felt that gold would be most sensitive to inflation (and it still likely will be if and when inflation heats up again) but currently we are in a deflationary spiral like the Great Depression. Note that gold rallied during the inflationary 70s, but it has also held its value very well and acted as a safe haven during the Depression.
Profound Differences from the Great Depression
When the Great Depression was developing, the government’s first response was to do nothing. Today they seem to be doing everything. Perhaps they’ve panicked in an attempt to avoid another Depression and eroded confidence in what is actually a normal recession. After all, 6 percent unemployment (even though it will likely go up from this level) isn’t anywhere close to Depression-era levels.
During the Great Depression, there was no international cooperation and most countries were on the gold standard–making it impossible to expand liquidity (print money) or borrow above gold reserve levels. There was no coordinated policy of money expansion, and this turned what could have been a recession into a depression. Now there is a global coordinated effort. Most of the world’s Central Banks (Europe, England, Canada, Swiss, Australia, South Korea, China and the US) lowered rates last week.
Before the Great Depression, governments relied on fiscal conservatism and used the gold standard to maintain discipline. Afterwards, the Keynesian philosophy of running deficits to stimulate economic activity gained credibility. In recent weeks, the Fed has come up with a bailout plan to pour billions into the credit markets with billions more to AIG and others to unclog the credit markets.
However, it should be noted that Keynes recommended governments maintain a surplus during times of high employment to be able to utilize deficits to fight a recession and rising unemployment. Unfortunately, the Bush Administration and Congress over the past eight years have overspent in Iraq and Afghanistan as well as at home, creating massive deficits during a time of high employment. This makes the job that much more difficult now with rising unemployment. If government spending wasn’t so out of control before the current crisis, a larger government would have had a much greater positive effect than we’ve seen in recent weeks. If we’ve learned anything from the Great Depression, raising taxes isn’t the answer. And, thus far, pumping in additional liquidity hasn’t restored confidence. But hopefully it will going forward.
Confidence has to be restored to the lending system. When the bulk of the bad banks are gone with just the solvent banks remaining, and with the government propping up the whole house of cards, all this grease should get this hulk rolling again–at least temporarily. Today fear and panic are at levels only seen at–or close to–market bottoms.
With this said, I’m not suggesting you try to catch a falling knife. I never advocate bottom picking. (Bottom pickers get their hands slapped). Rather, let the market tell us when it’s begun trending up again. In other words, listen to the markets; they know best. Look for prices to begin rising again for at least more than a day or two. This will indicate the worst of the economic downslide is over. I believe we’re close.
I look at the next few weeks’ price action as being critical. Technically, stocks and commodities are at–or close to–the perfect level for a rebound. Why? In real panics over a wide variety of markets and market conditions, it’s a known fact that bear markets generally will either bottom or–at the very least–temporarily bounce at or near the 50 percent correction level; this phenomenon is termed the 50 percent retracement.
The CRB index–a basket of commodities–is now down just about 50 percent of its six-year bull run. Of course, most of the decline took place in just the past few months. But right now it’s at–or close to–the level we’d expect from a forming bottom, or at least a bounce.
The 1987 bottom for the Dow was 1,706. The October 2007 high was 14,198. The 50 percent retracement level works out to be 6,246 Dow points lower from the high, and this number subtracted from the high equals 7,952. Friday’s low was 7,882, which is within just a few points of our expected bounce level. So let’s see if this low can hold.
The 50 percent mark often indicates the end of a crash; but even if it’s not the end, it usually holds the first go around. Even at the time of the 1929 crash, the market first broke about 50 percent. And then there was a major stock market rally from November 1929 until April 1930 that brought the market back up from Dow 195 to 297.
In other words, a trader could have made 50 percent in just those few months if he timed it right. Here’s another interesting market point; that 297 top in April represented very close to a 50 percent retracement from the September 1929 Dow high of 386 to the crash low. After the bounce, from the April peak the Dow proceeded to collapse and lose an incredible 90 percent of its value, bottoming out at 40 in July of 1932.
Bottom line, the early 1930 rally was a profitable trading opportunity and gave those who were stuck with devalued assets after the crash a chance to cash out if they were nimble. But, ultimately, it was meant to be sold. If history repeats and the 50 percent retracement low does end up holding, a 50 percent retracement back up would rally the Dow to approximately 11,000. This would be a very tradable rally, but perhaps it’s one meant to be sold.
And if stocks start to rebound, commodities will follow. In fact, commodities might even lead. At current levels, I prefer investing in commodities over stocks. Commodities such as soybeans are now trading below their cost of production at very attractive price levels for end users such as China. Again, a commodity rebound is dependent upon a rebound in the global financial markets, but the timing for this is right.
During the next few weeks, extreme volatility will no doubt continue. But I will go out on a limb here and predict an interim bottom is close at hand. The next big move for stocks, particularly certain commodities, is likely to be up. After an initial rally from the bottom, one or two scenarios are common: either one more break that doesn’t lead to a lower low–in other words, a test of the lows that successfully results in a higher low–or for a sharp rally with minor corrections as significant moving averages are crossed to the upside.
This is the writing we need to see on the wall, and I believe we’re there or very close–just waiting for the market to confirm. And if I’m correct on this, over the next six months we also need to be alert for the end of the corrective rally. Particularly, watch for a sign at the 50 percent correction levels from this low to the October 2007 high.
Note: I learned much of the background material regarding the Great Depression from the works of J. Bradford DeLong, a Berkeley economist who I gratefully thank.
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