A Long Way From the Dust Bowl

Every day it seems someone is seeking to compare the current financial crisis with the Great depression of the 1930s. There's no doubt these comparisons are an attention grabber. But how do today's events really match up?

A search of a newspaper database reveals 30,000 mentions so far this year of the term 'Great Depression'. References to dust bowls, long and winding dole queues and overflowing soup kitchens are getting a real workout.

These are striking metaphors, particularly for the generations (and that encompasses most of us by now) whose only knowledge of the misery of the 1930s comes from grainy newsreels, Hollywood movies and John Steinbeck.

Certainly there are parallels now in the breathtaking day-to-day market volatility, rising default rates, financial instability, banking strains, worsening economic indicators and the global nature of the crisis.

But there are also as many, if not more, ways in which this crisis is different from what occurred eight decades ago. These other signs suggest that while we face the prospect of an economic downturn, this is unlikely to turn into a 30s-style Depression.

By the way, there is no universally accepted definition of a recession or a depression. The standard international definition of a recession is a period in which an economy contracts for two consecutive quarters.

However, In the US, the National Bureau of Economic Research, uses a broader definition as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."1 The bureau says it typically takes 6-18 months after a recession is started to make its declaration. Often by that time, the recession is over.

As to the term depression, there is no commonly agreed definition of that either, other than as a particularly deep and prolonged recession. So what are the signs that argue against a 1930s-style downturn?

Firstly, there is a keen awareness among policymakers about not repeating the mistakes of that time, when the Federal Reserve actually tightened monetary policy at a time when the system needed additional liquidity.2

Current US Federal Reserve governor Ben Bernanke, himself a scholar of the Great Depression,3 has shown he is highly aware of the risks of such an approach and has led efforts in the current crisis to recapitalise the banking system, cut interest rates and provide liquidity in certain areas of the market, such as commercial paper.

Also worth noting is that policymakers in other countries are taking a similar, flexible approach. Extraordinary policy actions in recent weeks by central banks and governments in Canada, the UK, Europe, Asia and Australasia have made progress so far in unfreezing credit markets. In addition there has been an increase in global cooperation among central banks, primarily through coordinated interest rate cuts.

Global policy coordination was rare in the 1930s. At that time, most nations adhered to the gold standard, a system in which currency values were expressed in terms of the price of ounces of gold. In 1931, Britain left the standard after a speculative attack on the pound. When speculators turned their attention to the $US, panic ensued. Depositors withdrew their money from banks to convert them into gold. To stop the loss of gold reserves and defend the dollar, the Federal Reserve raised interest rates sharply.

As scholars of the Depression, such as Bernanke, have since identified, the Fed made a significant error in tightening monetary policy at a time when an easing of conditions was required.
In contrast with the 1930s, we now have a level of global oversight that was unheard of between the wars. Bodies such as the G7, the G20 and the International Monetary Fund provide forums for international cooperation and coordination during economic and market crises.
But aren't the banking failures of 2008 a mirror image of what happened in the Great Depression? Again, some perspective is needed.

Between 1930 and 1933, thousands of US banks failed. In 1933 alone, 4,000 institutions went to the wall.4 By contrast, by late October only 19 US banks had failed in 2007 and 2008.
On the other side of the Atlantic, a dozen or so banks have been bailed out or nationalised by the UK and European governments. While suffering strains, Australian banks remain highly profitable, with a relatively low level of problem loans.5

Bear in mind, also, that prudential regulation, while still clearly imperfect, has improved immeasurably since the Great Depression. Up until 1933 in the US, there was no Federal Deposit Insurance Corporation. When a bank failed, depositors lost everything.

People subsequently hoarded cash, stashing it in old coffee containers, burying it in the backyard and, yes, hiding it under the mattress. This withdrew hard currency from circulation, adding to liquidity pressures.

Another contrast between then and now is the broad commitment of governments internationally to free trade and capital flows. The problems of the Depression era were compounded by protectionism. In the US, the Smoot-Hawley Tariff Act raised tariffs on more than 20,000 imported goods, triggering tit-for-tat trade restrictions and making the downturn even worse.

Further fuelling the downturn in the United States were the effects of the 'Dust Bowl'—a prolonged drought which combined with poor farming practices to devastate the Plains states. More than 500,000 Americans were left homeless by the drought and more than 2.5 million migrated from those affected areas. In many countries, particularly in the US, there was virtually no social safety net, so the hit to household spending from rising unemployment (the unemployment rate in the US rose to nearly 25 per cent versus around 6 per cent today6 ) was exacerbated by a lack of jobless benefits. These days, most western democracies operate a mixed economy where governments provide protections for workers.

This brings us to the understanding that governments now have about the role they can play in economic downturns by providing liquidity and attempting to increase confidence in the markets. Back in the Depression era, there was not the same sense that governments could play these roles.

In summary, governments have learned from past downturns that quick, decisive action can limit the economic effects of a financial crisis. They also understand that global problems require global solutions, and there are signs of coordinated efforts on that front.

While the level of banking failures has been alarming, it is nowhere near the proportions of the 1930s. In any case, prudent regulation, insurance and government guarantees are acting to protect investors.

Protectionist responses similar to the Smooth-Hawley Act are now seen as unlikely given the broad commitment of governments to free trade and capital flows. And within their borders, governments generally are committed to providing social safety nets for those dislocated by tough economic times.

While markets have fallen a long way, it is worth remembering that they are forward looking. So by the time a peak or trough in the business cycle has been identified, the market has already incorporated that information into prices.

None of the above is intended to downplay the seriousness of the situation the world economy finds itself in. But it does seek to put current events into historical context. We are still a long way from the Dust Bowl.

The author would like to thank Gerard O'Reilly of our research group for his assistance in researching this article.
1National Bureau of Economic Research, 'Business Cycle Expansions and Contractions'
2Christiano, Motto and Rostagno, 'The Great Depression and the Friedman-Schwartz Hypothesis', Federal Reserve Bank of Cleveland, Jan 2004
3Bernanke, 'Money, Gold and the Great Depression', the Federal Reserve Board, March 2004
4Source: FDIC
5'Financial Stability Review', Reserve Bank of Australia, September 2008
6Bernanke

Buffett Speaks Out

Arguably the most cluey of investors Warren Buffett has published the following in the New York Times on October 17, 2008.

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down rice.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66
to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice:

“I skate to where the puck is going to be, not to where it has been.” I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a
diversified holding company.

Reasons to be Cheerful

Ten Reasons to Be Cheerful
Jim Parker, Regional Director, DFA Australia Limited

Ladies and gentlemen, please raise your half-empty glasses and view them as half-full, because here are ten reasons to be cheerful about the global economy and the state of investment markets:

An awful lot of bad news is in the price. It is the nature of markets to assimilate new information quickly, which means that as we all sit around feeling gloomy, markets have usually moved on.
In bad times, demand for risky assets falls. So the compensation for taking this risk needs to adjust higher to attract investors. Lower share prices relative to fundamentals just means expected returns are higher.

Governments in the US, Europe, the UK and Australasia are pulling out all the stops to recapitalise their banking systems and get credit flowing again. The extraordinary response of risk assets to recent moves on this front shows how important confidence is in supporting markets.

Central banks have mounted a globally coordinated reduction in benchmark interest rates. Markets are priced for further moves. Insofar as banks pass on these lower borrowing costs, this will support business and consumer activity, buttressing the real economy.

Some governments are providing fiscal stimulus to bolster economic activity. Australia, for instance, recently unveiled a $A10.4 billion package. In the US, there is talk of a post-election stimulus plan.1

Oil prices, which until recently were seen as a major threat to global growth, have retraced significantly. From late July until early October, crude oil futures fell by 45 per cent from a record $US147.27 a barrel.2

According to Dimensional research, the average duration of bear markets in the US from the end of 1965 until the middle of this year was about 14 months.3 This one has now lasted just on a year. This is not to claim it is near an end, but the longer it goes on, the closer is the next bull market.

Someone is buying. It's important to remember that on the other side of the trade from all those people liquidating their portfolios and mutual funds are other investors who are happy to buy. While some are market timers, others see this as a long-term buying opportunity.

Unless you have sold your holdings, your losses so far are only on paper. Market recoveries after prolonged downturns tend to come in quick sudden bursts. All you need to do to capture those recoveries is to stay in your seat.

The sun will come up tomorrow. Anxiety over the market downturn is understandable. But there have been crises before. The world moves on and risk appetites have a tendency to reassert themselves.

1'House Democrats Weigh New Economic Stimulus', Reuters, Oct 13, 2008
2Bloomberg data
3'Bull and Bear Markets, S&P-500 Index', Dimensional
Copyright Dimensional Fund Advisers, Australia 2008

Welcome Aboard

Welcome to the inaugural Parkside Weblog . .

Designed to complement our website, you now have a direct opportunity to catch up on breaking news, reproduced articles which reflect events happening right here and now, historical perspectives and some investment insight. We invite you to comment, both to us and to each other and we value your feed back!

What a mad month!
The crash of the past 2 weeks and the panic compounded by de-leveraging has been one of the most disturbing things ever witnessed by most investors. Friday down 8%, the week down 18%. Similar figures worldwide (not helped by the mid-week lifting of short-selling restrictions in the US). Fridays +10% intraday volatility in the US and the VIX (volatility Index) at a record 70 points may be a turning point?

Australia cut rates by 1% (0.8% passed on, which with the recent 0.2% cut earlier in October, a positive for borrowers and mortgages) led the northern hemisphere cutting by 0.5%. The A$ collapse to mid-60’s (down approx 30% from recent highs) is some offset to global share investments.

We now need some serious people making serious decisions re this serious situation.
World leaders met over the weekend – but with little firm action delivered. We need to see a boost to liquidity in the credit markets as well as the rebuilding of confidence (investor, counterparty and customer).

Sunday’s Government announcement that ALL bank deposits will be guaranteed for 3 year (Including Macquarie Cash Management accounts as Macquarie will now only invest in cash secure assets) is the first sign of reassurance to investors and households. This will apply to all depositors (individuals and corporate’s), as well as to all credit unions and buildings societies. They will also guarantee bank borrowings from global credit markets as well as extend funds to the secondary market for home loans.

We expect European and US governments to announce similar commitments following agreement to take ‘decisive’ and ‘urgent’ action before the markets opened last Monday, or at the latest this coming week. We await firm action, as we have only heard vague principles so far.

What we need to see?

The markets convinced of a package of guarantees, and
A narrowing of credit market spreads, and
A rebuilding of confidence among investors

The Australian share market was up around 5% on Monday in response to the
Government’s commitment. Early indications from futures markets are for positive
moves in overseas markets.

Our advice:
Avoid knee-jerk reactions to the current crisis. In terms of financial crises, this is significant and unsettling. But as we have been saying – ultimately – it will pass.
Markets will recover. In the meantime ensure that your finances and investments are positioned to gain from the recovery when it occurs. It’s important to remember the 7 Deadly Sins of investing and to stick to your plan. They are:

Instant gratification – or choosing the immediate pay-off over a larger
reward down the track.
Naïve diversification – you know it’s unwise to put
all your eggs in one basket. But it is also foolhardy to sink money into
holdings that do not suit your individual risk profile or tolerance just so that
you can hold a ‘safe’ investment. This can be just as
dangerous.
Overconfidence – after five years of bull markets it can become
tempting to attribute your market success to your skills as an investor – our
skills as advisers - rather than a naturally occurring buoyant market. The share
market is never without its risks.
Belief persistence – a refusal to
acknowledge that a situation is not as you thought, despite compelling evidence.
Let’s face it, even we expected the markets to resume rising
earlier.
Overweight recent events – we all place much greater weight and
importance on what has just happened and our actions are guided by expectations
that those conditions will continue. Remember the returns of the past four years
exceeded all expectations.
Loss aversion – the impetus to avoid losing money
is greater than that to maximise wealth. This causes us to ignore opportunities
in challenging environments and times like the current.
Fear of regret – when you become paralysed with indecision for fear of making the wrong choice.

To avoid the above and preserve your wealth, you need to re-evaluate your plan to
ensure it is still appropriate to your goals and risk tolerance for the mid-
longer- term, and not the temporary market conditions.

Remain diversified and insure that your investment portfolio is suitable. Stay committed to your investment strategy, rather than chopping and changing based on the noise of the day. If possible, start trickling money into the markets (you will be buying more units at lower prices and when markets recover it will grow more quickly).

If you are drawing a pension or regular withdrawals – perhaps you could reduce
your payments in the short term to allow maximum exposure to recovering markets.
Some of you may be Centrelink pensioners or benefit recipients – or you may now qualify for benefits. Our staff are re-assessing all our clients positions to ensure that you will receive that maximum benefits possible. If you believe that you may benefit – please contact our office to ensure that your position is evaluated and re-assessed.
Most important of all – delay ‘gratification’. Probably the mother of all ‘sins’ in this erratic market climate is to give into fear and panic and sell out – that applies more-so now that the values have fallen so far.

If you have any questions – please do not hesitate to contact your adviser or our office for assistance and assurance.

Take our poll in the sidebar and let us know what you think about whether the markets have bottomed out or not!