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The Second Great Depression Cometh

Beyond Buy-and-Hold #48

We are headed into the second great depression.

I don’t say that to upset you. I of course wish it were not so. And of course I cannot say with certainty that it is so. Anything can happen in this crazy, mixed-up world of ours.

Still, I believe that we all should be using the academic research and the historical stock return data to guide our investing decisions. And the reality is that the research of the past 30 years and the data of the past 140 years both indicate strongly that we are headed into the Second Great Depression. Given that that’s so, we should be talking about it. Given that that’s so, we should be making preparations and thinking through what we will need to do once we are in the Second Great Depression to get out of it.

The Buy-and-Holders will say that it is not possible to predict future economic events. Everyone is entitled to an opinion Perhaps they are right. We certainly should all be saying a prayer that the Buy-and-Holders are proven right re this one. A Second Great Depression is going to cause huge amounts of human suffering. It is serious and scary and sobering stuff that we are pondering in this column.

Why the Second Great Depression is coming

Why do I think that a Second Great Depression can be predicted?

I read Yale Economics Professor Robert Shiller’s book Irrational Exuberance. It follows from that.

Shiller predicted the economic crisis. He was right about that one. Given his track record and the power of the research he has been doing for 30 years now, I think we should be taking his ideas seriously.

Moreover, it’s not only Shiller. There are scores of investing experts who share Shiller’s view that valuations affect long-term returns. They too predicted the economic crisis. They too follow a model for understanding how stock investing works that makes economic events at least somewhat predictable.

It’s actually the idea that economic events are not predictable that is the odd one. Think what it means to say that stocks are massively overvalued. It means that they are massively mispriced.

It is the job of a market to get prices right. So massive mispricing cannot remain in effect indefinitely. As prices work their way back to fair value from insanely high levels, huge amounts of spending power is removed from the economy. Is anyone able to come up with any reason for believing that the loss of massive amounts of spending power could somehow not cause an economic crisis?

The economic crisis became a virtual certainty once we reached the valuation levels that applied in the late 1990s. Predictions that we are on our way to a Second Great Depression are trickier. The Second Great Depression is looking more and more likely the longer we go without making serious efforts to head it off. But it is not a certainty. There are at least in a theoretical sense things we could do to head it off.

The Second Great Depression isn’t certain—but it sure looks as if it is

The economic crisis became a near certainty because stocks were overpriced to the tune of $12 trillion at the top of the bubble and it is hard to imagine a way in which an economy experiencing the loss of that amount of spending power could avoid collapse. The factors pushing us to a Second Great Depression are less unalterable. We could avoid this house of horrors. However, I cannot in honesty report today that it appears at all likely that we will elect to do so.

Stock prices reached fair value levels in early 2009. Had economic and political leaders taken efforts to stabilize stock prices at those levels, there would have been no Second Great Depression. We would be in the early stages of a recovery today.

Unfortunately, our leaders took it just the other way. They talked stocks up, playing once again to the Get RIch Quick impulse within all of us that caused the crisis in the first place. And we fell for the line once again. Stocks are today once again at dangerously high prices.

The Stock Market overshoots the mark—in both directions

And the reality is that we have never had an economic crisis in which prices fell only to fair value. Stock prices always fall to one-half fair value in the wake of an out-of-control bull market. That’s because investors become so frightened by the loss of the Pretend Wealth they came to count on during the bull years that they give up on stocks altogether, sending prices to levels as insane on the low side as the ones that applied on the high side not too long before.

A trip to one-half fair value means a 65 percent price from where we stand today. That sort of hit, felt on top of the Lost Decade and the 2008 crash, is going to leave middle-class investors afraid to resume normal spending patterns for a long time. We are headed into dark and rocky territory.

But we are not without hope!

We know more today about how stock investing really works than any group of investors coming before us was blessed enough to know. We know how to eliminate 80 percent of the risk of stock investing while still obtaining the high returns that make this asset class so appealing. Opposition to the idea of sharing what we know with our fellow investors is going to fade fast once we are in the Second Great Depression. So I am expecting (hoping?) that this will be the shortest Great Depression on record.

It’s always darkest just before the dawn!

Rob Bennett enjoys learning about the best ways to save money. Rob’s bio is here.

( Photo from Flickr by Helico )


4 Responses to The Second Great Depression Cometh

  1. Rob – Thanks for continuing to warn people in a simple and sane manner. Whether we actually experience another great depression or not, the fact is we are in a long deleveraging period that should make people more than cautious. As you know, from receiving my writings in the Arbor Investment Planner (http://ArborInvestmentPlanner.com) I believe we are 11 years into a 16-22 years bear market. Therefore an investors asset allcoation should be adjusted accordingly.

  2. Thanks for those kind words, Ken.

    It makes me happy that you used the words “simple and sane” to describe my efforts. I think it’s very important that we all work together to help the average person understand what is going on. And it is also very important that we do so in a healthy and balanced and positive (given the circumstances) manner. I know I don’t always pulls all that off. But I work it hard. And your kind assessment makes me feel that I am connecting with at least a few good and smart people.

    Onward! Courage!

    Rob

  3. Hi Ken–I agree with you that we’re in a long term bear market, but the problem is that John Q. Investor doesn’t generally believe it because the market has been generally going up for the past two years plus. Investor memories are notoriously short, perhaps because they get run over by the promise of Get-Rich-Quick. Complacency and downright apathy are a real problem right now. If people don’t see the bigger picture trends, they run a high risk of being clobbered by them. That will guarantee a Second Great Depression. Look at the debt ceiling negotiations going on right now–Wall Street is hardly paying attention to it.

    It’s almost a given that the crisis we’re prepared for won’t happen. But the flip side is that the one we aren’t prepared for…is usually just a question of time.

  4. If your house is “underwater”, then you’re already in a second great depression from which you’ll never be able to recover.

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