A reader left the following;
Please talk about the deep recession or depression scenario.
As you say, a 100 depression is also "normal" and we are do but you seem to be too "emotional" to take this scenario seriously. It is a very, very real scenario everyone that built financial careers of the last 30 years is ignoring, seems like almost denial and I'd love to hear your macro analysis of that very possible and normal scenario?
I pasted the whole thing because there are parts of it I don't follow but as to the parts I do follow...
First I would say I am not sure why a depression is very possible. From a stock market standpoint down a lot would start out as down a little. So same as anything else have a strategy devised to take defensive action. I have spelled out mine countless times, so far I have tweaked the portfolio and am ready to take more action if the market devolves from here.
According to the Stock Trader's Almanac the Dow Industrials peaked at 381.17 on September 9, 1929. It bottomed on July 8, 1932 at 41.22--about a 90% hit. So that is probably the biggest fear out there, another 90% drop in the market. A couple of things to keep in mind is that the Dow was up 80% in 1933, almost 40% in 1935 but it fell 27% in 1937.
Although the market did not take 381 back until 1954 from the period between 1929-1954 inclusive there were 15 up years and 11 down years. This tells me that a repeat of the 1930s will have some chance for gains but even if you cannot catch any of those up years, discipline to a get-defensive plan could add tremendous long term value. This will make some people groan but down 40% in a down 80% world would be a colossal success.
Unemployment during the depression was, I believe around 25%. That was at a time when more people had manufacturing jobs. Now we have a lot of service jobs. Demand for a lot of services will not wain as much as the need to manufacture big heavy things made of metal.
There would be plenty of jobs lost and I also think people would face taking pay cuts to keep their jobs. So who does this hurt the most? My first thought is people who are over leveraged but this is always true. Regardless of what is going on a couple living beyond their means will be in deep trouble right away if one of them loses their job. If you have a low monthly budget you face an easier time covering the bills with replacement work.
I am not sure a depression and a 90% stock market decline is normal, and I apologize if I ever said it was but it has happened before could happen again at some point. I do not think it is a realistic possibility this decade but if happens it will take a long time to unfold, giving plenty of time to reduce exposure.
Things to own might include equities from countries in their own world, foreign currency and bonds from certain countries and some commodities.
As far as being emotionally complacent; I'm not sure how to answer that. Down a lot, whatever it becomes, starts with down a little; I preach about taking defensive action all the time. Not over extending yourself in life seems to me to be common sense even though many folks are too extended. I can only account for myself; when I first started managing money I had two clients and some savings that I did not want to spend. I spent my afternoons doing things like logging, putting on a roof and building a rock wall for money so I wouldn't have to spend the savings. Point being I was willing to do whatever it took.
If this person is right we may all have to have some sense of whatever it takes. I was not put off by doing it then I won't be in the future, if that is what it takes. To me this is what being enterprising, entrepreneurial and living the American dream is all about. Taking the bull by the horns and doing what needs to be done.
This post really offers no macro analysis because analyzing is it does not benefit my clients. What benefits them is staying disciplined to the defensive strategy I tell them we use and believe in and figuring out what to do if, I think the rest will take care of itself.
Wikinvest Wire
19 comments:
Well said.
i think it is important for people to understand that depression is not a singular event. We are not going to have a depression on Tuesday and then wake up on Wednesday with a 90% drop in equities and 30% unemployment rate.
Depressions are labeled in hindsight and are a description of the combination of stock market collapse, higher unemployment, lower wages, etc...
In my view a depression's likelyhood is very close to 0 while a recession is almost guaranteed.
Where i have a huge problem wrapping my head around Roger's analysis is to know when/how to exit at 40% down on the way to 80% down. How can you tell whether it is 40% on way to 80% down or 40% and done? that's the thing i could not get a clear answer for, even after reading the blog for years.
Or maybe you do not exit and you simply get a 40% cut, instead of 80%, because of the way the portfolio was constructed.
Everyone wants to know what to do now, it is natural to ask others to help remove the burden of a decision. I think you have been consistant, but may I stress one of your points. If a person were to worry a little less about asset allocation and more on DEBT reduction, they may significantly lower their future risk. Just a thought and enjoy your comments. Now if the heat will go away -Tucson.
Roger, you do a good job for your clients and readers. You're no lightweight.
90% declines in the stock market are possible; they have happened before. They are not likely, though. The Great Depression was a case of extreme speculation giving way to extreme fear.
There are some aspects of what happened in the Great Depression that can't recur. We're not on a gold standard now. We are more likely to experience high inflation rather than depression. That said, someday we could have a market that depreciates 90% in inflation-adjusted terms, while not depreciating nearly so much in nominal terms.
I'm not saying this is likely, but merely possible. The types of speculation and governmental incompetence that led to the Great Depression could recur; it is something common to mankind that we don't learn from our previous mistakes. That most think that the Great Depression could not recur makes it more likely, in my opinion. (But it is not a high probability.)
To me, it is just another reason why investors should always have a allocation of safe assets to complement risky ones. The world is a risky place, and it pays to have something that doesn't depreciate in extreme scenarios.
Sami,
Good question and since I do not have a documented track record from 2000-2001 there is no way to know for sure but....the average 10% return of the market includes the great depression. so if one was lucky enough to only be down 40% when the market is down 80% their average would return would sky rocket over a very long term-point conceded that a 75 year old might not be around 23 years from but a 65 year old might be.
I currently have some double short and have done the calculation about how much to add for a next trade if need be. A hypothetical 5% in a double short neutralizes 10% of the portfolio. Assume no trades but a 20% decline in the market. The double short might then be up to 9% of the portfolio neutralizing now 18% of the portfolio. The more the market goes down the larger weight the double short takes up. This continues all the way down. Now if you can make one more purchase of the double short somewhere during what wold have to be a multi year decline you could get an even better result. This is the goal.
Hey Tucson, you are exactly right. Within your means and income coming from somewhere and you would be very well off if something horrible happens.
David,
thank you for the kind word. within the narrow possibility of something worse than a recession, i agree it would have have an origin different from 1929 and many aspects would have to be different surrounding the event.
The realistic worst case (so still not a high probability IMO) is demand for US paper at 5% dries up, dollar loses another 20%, a mortgage costs 10%, whatever that does to the economy and stock market so be it but I think less than an 80% decline in that scenario.
This may tie in to the "depression" post.
I just received the latest federal revision in our region for income requirements to qualify for free or almost free housing. This is in an area where you can buy a three bedroom home in move-in condition for $30,000.00
Family of 1
Partial- $34,350
Full - $21,450
Family of 2
Partial - $39,250
Full - $24,500
Family of 3
Partial - $44,150
Full - $27,600
Family of 4
Partial - $49,050
Full - $30, 650
The scale slides significantly upwards if the average regional home cost is greater, as on the coasts and in well-run flyover areas of the country.
A reasonable person may rationalize
that if the country goes into depression, don't take that second job, work harder or spend less than you earn - just hop on the Section 8 program and switch to cash positions in another family member's name.
Plus, welfare handouts are almost always tax free.
A depression would accelerate the re-distribution of income cherished by the far, and not so far, left. This goes far beyond the intent of a temporary social safety net, which was put in place to avoid the mass desparation of many citizens during the 1930s depression.
Who would pay? Those stupid not to figure out the system and the few of us who would not fall prey to laziness with a dash of victim mentality.
Magnificent post, T.
The issue of holding on to a job during a depression is only half the problem if you happen to also owe money. Economic contractions tend to be deflationary -- money/cash increases in value, it has greater purchasing power -- so if you owe a debt your burden increases dramatically because you're not only paying interest but the dollar you're paying back is worth more than the dollar you originally borrowed.
IOW during the Great Depression people often couldn't maintain mortgage payments and wound up losing their homes even when they kept their jobs. Contractions are great times to _own_ cash and/or debt and the worst time to _owe_ it and assets tied to it; that's very high quality debt of course, bankruptcies are more common than shark's teeth during major contractions.
A serious deflation is far less likely now that we're off the gold or some other fixed monetary standard -- stagflation or even hyper-inflation is more likely -- but a significant credit crisis such as we are experiencing now can make people doubt the value of any debt and the abilities of counterparties who owe it and that can lead, at least intermediate term, into a deflationary spiral I would think.
IOW credit is what makes our modern world go round and contraction is, or can be, as much a psychological event as an economic or financial one; you can't sell if someone won't buy and people become afraid to borrow for any reason, even short-term, to buy anything so money velocity drops like a stone. Don't think that will happen here though; Americans do like to spend.
Regardless the best asset to hedge a deflation are top-quality, non-callable, long duration bonds w/ 30-year Zero-coupon T-Bonds giving the best bang for the buck.
"Demand for a lot of services will not wain as much as the need to manufacture big heavy things made of metal."
I don't know about that one. "Services" cover a big area. At least people pounding things out of metal produced tangible wealth. But then I always thought that the "Service Economy" was just an excuse to outsource everything possible. The dire effects of that have been masked by credit - another "service."
"whatever that does to the economy and stock market so be it but I think less than an 80% decline in that scenario."
Wow. So a 75% decline in the market which will basically cause mayhem is ok with you. A person with $1 million and retired will only have 250,000 in this case if he is indexed to the market. This is a huge problem.
If you were retired and had $1m you'd have it all in equities?
One thing to keep in mind T is that there is a limit to the number of Section 8 vouchers a state has and there is often a waiting list to get on the program. In a downturn with State and Federal budgets under pressure and the number of folks seeking assistance growing the problem is likely to worsen. Government subsidized products and services usually wind up being rationed in some way whether it's gas in Tehran or Section 8 apartments in Dubuque.
anon 1:51 you are missing a mountain of context to that item both in this post and throughout the entire life of this blog. My reply at 8:28 to sami addresses your point.
RW, Leisa, et al
Have any of you guys checked out (or have an opinion on)- Managed Futures - Rydex has a new fund (RYMPX) based on the S&P DTI Index
According to yhe sales brochure the index has not been negative in 20 years
Appears to be a good anti-cyclical, returns are impressive.
I have to think there is a catch somewhere!
Roger I can't find anything in your search file on it. How come, -that's why were paying you the big bucks!
OG
i wrote about in March for RealMoney
OG, haven't been tracking the managed futures fund but I took a quick look at the H shares (RYMFX) and didn't see anything that particularly stood out: Volatility was low as advertised but, just eyeballing the chart, correlation with S&P500 sure didn't look non-negative (eyeball is not a number natch).
Roger, have you taken another look at Rydex Managed Futures since your article?
I have not looked at the fund since that article. perhaps I should though, thank you.
Just a quick note on the "what if" scenario of somehow coming close to matching the '29 market fiasco.
According to Charles R. Geisst's book, "Wall Street - A History", a vast number of middle income investors (actually, gamblers) who could not afford to buy securities were able to buy through a broker, stocks on margin with as little as 3% down.
This small sum made 'investing' appear affordable to ordinary wage earners and gave them an open invitation to speculate in the stock market. Brokerage firms reaped the benefits of the commissions on the stocks trades as well as the interest they charged on the money borrowed.
When the market sold off these folks went broke. Stocks we buy today have what economists call limited liability. You can only lose your original investment. These folks never had the money to cover margin call.
And to make matters worse, the brokerage houses sold their inventories first when the market tanked and then their clients positions. Many brokers had anticipated a market downturn and were ready to sell their securities quickly. Brokerage firms were also given extended grace periods by their banks, which allowed them to recoup their losses and to repay the banks without fear of financial collapse. Unfortunately, brokers did not extend the same courtesy to their customers who were forced to pay their loans off without delay or have their accounts liquidated.
The 1929 crash was a catalyst for legislators to rein in the freewheeling ways of Wall Street and to put a stop to some of the abuses.
My point is that the crash of '29 is an unlikely scenario for today given the new laws in place. Unless there's a nuclear war or something.
Not to say that Wall Street isn't a bunch of lying crooks. I mean, if they could get away with it now they would. ;)
What percent did the nasdaq fall?
Individuals are not that leveraged but hedge funds and Bank conduits are very highly leveraged.
In 1970's it took $1.20 increase in consumer debt to increase gdp by $1.00 and this has now increased to over $5.00 to increase gdp by $1.00
I am not predicting a redo of 1929 and I am not saying it has to happen now. But this trend is not going to go on forever.
Thanks RW, Roger - Good Analysis in Real Money - if you want to read something really strange about RYMPX look it up on M* they call it a large cap growth stock fund.
OG
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