Great Depression or Great Opportunity?

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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.