Monday, December 1, 2008

What year is this?

Despite the sense of panic out there, I don't believe that the world is about to see a repeat of 1929. We are just experiencing a deep and nasty recession. The world will emerge out of this downturn sometime next year and investors should be positioned in anticipation of a recovery.

The importance of a historical perspective
When people react to difficult events, their immediate reaction is to reach for parallels from their own experience. This is problematical in this current bear market. For a portfolio manager with ten years of working life, his bear market experience consists of the post-NASDAQ bubble crash. Twenty years gets you the post-NASDAQ bubble and the bear market of 1990. Both of those occasions involved fairly mild recessions.

I was personally involved in the market during the peak in 1980 and the subsequent bear of 1982. I apprenticed mostly under people who lived through the recession and bear of 1974. Those were inventory recessions, caused by the central bank putting on the brakes on an overheated economy. Those recessions, while deeper than the downturns of 1990 and 2000-2, were not good parallels to today.

Grizzled veterans like Warren Buffett lived through the Go-Go years of the 1960s and their collapse in 1968, as well as some of the markets in the 1950s. Even those markets were not good parallels to this current period of macroeconomic stress. To analyze today’s conditions we need to delve deeper into market history.

Looking for parallels in Non-US economies
Many American investors make the mistake of thinking that market history start and stop at the US border. I can remember a lot of silly analysis that went on after 9/11. Analysts cited the market’s reaction after Pearl Harbor as to the probable market reaction after the start of a war. Did World War II start in December 1941? It did for America, but was that true for the rest of the world, or more importantly, Mr. Market? Ask the Europeans. Did the German blitzkrieg invasion of Poland in 1939 mean nothing? What about the fall of France in 1940? Did Mr. Market think that Operation Barbarossa, the massive German invasion of the Soviet Union in the summer of 1941, mean that the war was “well-contained” like the sub-prime crisis? Meanwhile over in Asia, the Japanese occupation of Manchuria began in 1931 and well pre-dated the German invasion of Poland. Was that just a historical blip?

If we look at non-US markets for parallels, many analysts cite Japan’s Lost Decade as a parallel. I have also suggested that the case of German re-unification could give us some historical perspective. While both those periods do give some insights, they are less than fully satisfying models for today as those downturns were localized. This time, it’s global.

The Great Depression as a model
Many others have sounded alarms about another Great Depression (see examples here and here). To be sure, parallels exist. Too much leverage and speculative excess were seen in the boom that pre-dated 1929. After the Crash, we saw de-leveraging in the subsequent bust. The Great Depression was a classic downturn reminiscent of the depressions seen in the 19th Century, which caused a great deal of concern for economists like John Maynard Keynes.

Nevertheless, there are important differences. We don’t have the massive and soul-destroying 20%+ unemployment seen during that era. There were no automatic stabilizers built into the economy. The effects of the Great Depression were exacerbated by problematic policy response. Today we have many policy tools available to avoid a repeat of the Great Depression.

Fiscal and monetary policy saves the day?
In short, there is no exact historical parallel to today. The current downturn has two unique characteristics: a high degree of financial stress and global reach. The closest might be 1929. Unlike 1929, policymakers have many more tools to combat the current crisis. No doubt today's authorities will make their own mistakes and the efficiency of some programs will be less than perfect. (FDR's New Deal didn't always work either). Nevertheless, the level of global awareness and sense of urgency and purpose by fiscal and monetary authorities around the world should prevent this downturn from becoming a repeat of the Great Depression.

I believe that the current situation is best characterized as a cross between Japan's Lost Decade and German re-unification. Richard Koo of Nomura Research says that the world can learn the lessons of the 1990s from Japan. He believes that the correct response is an aggressive expansionary fiscal policy which can be summed as "spend, spend and spend until it hurts" (see his webcast here, it's long but well worthwhile). Koo’s prescription is an echo from a previous era, when Keynes advised FDR to do the same thing.

President-elect Obama seems to be listening to the likes of Koo. In his weekly address, he appears to be calling for a New Deal style stimulus package:
I have already directed my economic team to come up with an Economic Recovery Plan that will mean 2.5 million more jobs by January of 2011 — a plan big enough to meet the challenges we face that I intend to sign soon after taking office. We’ll be working out the details in the weeks ahead, but it will be a two-year, nationwide effort to jumpstart job creation in America and lay the foundation for a strong and growing economy. We’ll put people back to work rebuilding our crumbling roads and bridges, modernizing schools that are failing our children, and building wind farms and solar panels; fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead.
In addition, we have a Fed Chairman whose life work was the study of the Great Depression and he has made it clear that he intends to avoid the policy mistakes of that era. Consider these excerpts from the FOMC Oct 28-29 minutes [emphasis mine]:

In the forecast prepared for the meeting, the staff lowered its projection for economic activity in the second half of 2008 as well as in 2009 and 2010. Real GDP appeared to have declined in the third quarter, and the few available indicators that reflected conditions following the intensification of the financial market turmoil in mid-September pointed to another decline in the fourth quarter...The staff expected that real GDP would continue to contract somewhat in the first half of 2009 and then rise in the second half, with the result that real GDP would be about unchanged for the year.

...the Committee agreed that it would take whatever steps were necessary to support the recovery of the economy.
The Fed well recognizes that the economy is in a slowdown and will do whatever that’s necessary to mitigate the downturn. Thus we see the alphabet soup of rescue programs. When it has an important message to convey, Fed governors typically fan out across the country to spread the word, as Don Kohn did recently in a speech before the Cato Institute as he spoke about the perils of deflation.

Global stimulus
What's more, fiscal and stimulus is not isolated to the United States alone but global in nature. In early November, China announced a large stimulus package. Over in Europe, there seems to be room for Eurozone rates to fall as inflation rates decline. What's more, the ECB has signalled that it is ready to deviate from its inflation fighting mandate by becoming the lender of last resort in Eastern European countries such as Hungary.

It’s only a recession
The IMF released a study indicating that financial stress presages a severe downturn, but the length of the downturn doesn’t seem to be any different than other recessions. The FOMC minutes cited above indicates that the Fed expects the economy to bottom out at the end of 2Q 2009. To me, that seems to be a reasonable estimate.

As for the stock market, bear markets tend to end a few months before the economic trough. With equity valuations reasonable, insiders in a buying frenzy and long-term sentiment washed out, investors should be positioning in anticipation of the revival of the next bull and rise of the Phoenix.

1 comment:

Tom Grey said...

Hi, I'm here from Fabius Maximus.

I think pointing out the numbers of people losing their jobs in housing (500 000) is important, and some note should be made about how few bankers are needed, but how many there are. Too many.

We should be acting like it's a depression coming to keep it down to a recession.