Fear of Depression vs. Fear of Missing the Rally

by: The Society October 16, 2008 | about stocks: DIA / QQQQ / SPY / XLF    

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By Karl Weber

The Great Depression vocabulary is growing by the day. Indeed, some of the similarities are uncanny. Excessive credit arrangements in mortgage markets were arguably the prime cause for the Great Depression of the early 1930s. At the time, general debt levels had risen sharply.

And then the economy abruptly caved in. Construction ground to a standstill. Banks tightened up on credit. By autumn of 1932, some 6,000 banks (about a quarter of all banks) had already collapsed.

The next two years won't be as bad as the early 1930s. The world's central bankers have all studied the miserable monetary policy of that time, and today's massive liquidity injections coupled with government support will help in the short term.

But banks will not become ‘more generous' in their lending practices. They are likely to invest cautiously in low margin ‘safe' projects or in government paper until ‘things improve' before they relax their loan policy. Banks in Japan did just that when they were in trouble a few years ago.

"Contained Depression"

We are now confronted with the real possibility of a so-called ‘contained depression,' i.e. not the typical V-shaped cycle but rather a couple of years of muted economic activity.

This will be a hard time for those with lots of debt and low liquidity or insufficient working capital. Consumers will increase their savings rate (which in the U.S. hangs at a paltry 1%), and governments will be asked to stimulate demand.

The world has already entered a recession. Demand is grinding to a halt. Consumer confidence has plunged amid dim job prospects and massive asset-value destruction.

While not impervious to recessionary forces, East Asia will do better than the Western world. It is the growth center of the 21st century. The business super-cycle is still intact. East Asia will go through boom-bust cycles like the ones Europe and the U.S. experienced in the last century.

But the underlying trend for growth is up. Debt levels are lower and debt markets are developing. Consumption of goods and services is expanding while the savings rate is dropping.

East Asia's central banks and Sovereign Wealth Funds' coffers are full to the brim. This massive liquidity allows them to sponsor substantial infrastructure projects should the economy need a Keynesian kick-start.

Equities: Oversold...Just Like in 1929

It's no secret that stock markets have crashed.

But my technical models for the equity markets (and surely most other quantitative models too) clearly signal an oversold situation. The short-term losses can only be compared with the 1974/75 bear market and the 1929-1933 period of the Great Depression.

The rate of change is one of my favorite tools to gauge behavioral abnormalities in the markets. For instance in the U.S., the percentage change over two months displays a 30% drop.

We have to go back as far as 1929 to see this kind of a plunge. The market shed 47% between September and November of 1929.

Afterwards, then-president Hoover reminded the nation that "Any lack of confidence in the economic future...in the U.S. is foolish." And the market actually began to recover at his words. The rally was impressive: The Dow Jones rose more than 45% in the five months leading into the spring of 1930, before the bear market resumed.

In times of heightened market stress, my preferred instrument for guidance is the dividend yield (12-month trailing dividends divided by stock price). Recessions are generally reflected in abnormally high dividend yields. On the U.S. equity market, the dividend yield historically peaked between 4% and 9%.

Currently, the yield stands at a mere 2.9%. From this point of view, shares could fall further in 2009 and take the dividend yield to the historical recession norm.

So start buying stocks with defensive properties (i.e. high dividend yields; P/Es of 6-9; net debt/equity ratio should be below 80%). It may not be a lasting bull market that lies ahead of us, but over the next three to six months, courage will be rewarded.

Long-Dated European Bonds Making a Comeback

Most research institutions had - until just recently - ruled out the possibility of a recession in Europe. Therefore, they saw long-dated bonds as an unwise investment. However, I expect this to change, since the outlook for inflation has dramatically improved.

The price collapse of oil, wheat, industrial metals and other commodities will shave 1-2% off of next year's inflation rate. Add to that a recession and inflation is no longer an issue. We could definitely see 0% inflation in 2009/10. As such, long-term bonds look like the best value in this context. Indeed, their total return indices have already embarked on a new bull market.

So just to recap:

  • Equities are currently oversold. Expect a temporary, sharp three to six month rebound, but be aware that further stock risks will continue into 2009.
  • Ignore P/E ratios on equities that are above 10, because they do not yet reflect recession.
  • Avoid companies with poor balance sheets
  • Go for the high dividend yields
  • Remain focused on sovereign or AAA agencies; even corporate debt if the cash flow is acceptable
  • Longer-dated bonds are becoming more attractive again, thanks to the virtually non-existent inflation we expect in coming years

Disclosure: none

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This article has 12 comments:

  •  
    Oct 16 06:15 AM
    the economy may cool off faster than you are anticipating. if it does the market is not oversold. the market is supposed to be ahead of the economic storm. my data indicates the market is not oversold.
    Reply | Link to Comment
  •  
    Oct 16 09:43 AM
    Good article except for this:

    "Longer-dated bonds are becoming more attractive again, thanks to the virtually non-existent inflation we expect in coming years"

    With government interference, expect diminished real economic growth. But they still got the printing presses so I expect stagflation at the best.
    Reply | Link to Comment
  •  
    Oct 16 10:29 AM
    Q3 results show nothing, everything is cooling down in one big freeze, Q4, Q1/09, Q2/09 are going to be deep frozen. We will plunge significantly below the dotcom burst bottoms. We're headed straight to hell.
    Reply | Link to Comment
  •  
    Oct 16 10:34 AM
    Other than the part about east Asia, this seems reasonable. Not sure that any economy based on exports is going to be doing well in a time of collapsing demand
    Reply | Link to Comment
  •  
    Oct 16 10:50 AM
    "massive liquidity injections coupled with government support will help in the short term" ... at the expense of the long term.

    "Banks in Japan did just that when they were in trouble a few years ago"
    Ummm ... make that a couple decades ago, and they're still floundering.

    "The Dow Jones rose more than 45% in the five months leading into the spring of 1930, before the bear market resumed." After which the market lows were eventually reached several years later at a total of 89% below the peaks.


    "be aware that further stock risks will continue into 2009." And far beyond.

    Have patience. There is plenty of time to find the bargains. Wait for revisions in earnings and lowering of dividends to play out, then find the needle in the haystack that has the indicated low P/E and high dividends. Those will be the keepers for the start of the next upturn.
    Reply | Link to Comment
  •  
    Oct 16 10:59 AM
    Smarty,
    Good advice and it neatly dovetails with my laziness, procrastination, and lack of a brokerage account.
    Reply | Link to Comment
  •  
    Oct 16 11:55 AM
    My father, who experienced the Great Depression, explained that while stocks were low and PE ratios were high nobody had money to buy. The market is not oversold; wait for the beginning of next year.
    Reply | Link to Comment
  •  
    Oct 16 12:03 PM
    Successful investors are picking and choosing stocks that have the potential to run 1000% after each major correction.These stocks will continue to run after initial bounce as market volatility subsides.

    They are the leaders of their group, they have big market to grow and they are mostly in an emerging industry with little or no competition.

    My pick: Thermogenesis(KOOL), an early CSCO in stem cell research/therapy and regenerative medicine. KOOL guided higher both revenue(30-35%) and gross profit margin(from 33% to 40+%), lots of cash and no debt.
    Reply | Link to Comment
  •  
    Oct 16 12:06 PM
    When you've sold out or missed the last rally, nothing makes you happier than one doomsday story after another. This article qualifies well...
    Reply | Link to Comment
  •  
    Oct 16 12:18 PM
    moonbat:

    Preparations do not require a brokerage account. Gold, guns, ammunition, and dry foodstuffs are also a good starting point. Booze, cigarettes, and soap are good for trading vehicles as well. Of course a Bible wouldn't hurt.

    As the Boy Scouts like to say: Beep Repaired.
    Reply | Link to Comment
  •  
    Oct 16 12:31 PM
    Smarty,
    I was hoping to provoke the banksters enough so I could go out in glory when the cops break down my door. I do have some copper-coated lead and a dispenser so they are sure to kill me several times if I can get to it before they get to me.

    Survivalism bores me but I wish you and the Mogambo well. Stock up on red-headed women. They must not perish from the earth!
    Reply | Link to Comment
  •  
    Oct 16 01:04 PM
    Good post.

    You put me on your list of things to buy... I just don't have enough patients to find them on my own.
    Reply | Link to Comment
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