Depressing Financial News Abounds – Are We Headed for a Depression?

I told you guys we were in a recession back in March, but now I fear we could move from a recession straight into a depression. Things could get really bad… Let’s examine shall we?

In economics, a depression is a sustained, long downturn in one or more economies. It is more severe than a recession, which is seen as a normal downturn in the business cycle. The mother of all modern depressions was of course the “Great Depression”:

The Great Depression was a worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s for different countries. It was the largest and most important economic depression in modern history, and is used in the 21st century as a benchmark in how far the world’s economy can fall. The Great Depression originated in the United States; historians most often use as a starting date the stock market crash on October 29, 1929, known as Black Tuesday. The end of the depression in the U.S. is associated with the onset of the war economy of World War II, beginning around 1939.

The depression had devastating effects in the developed and developing worlds. International trade was deeply affected, as were personal incomes, tax revenues, prices, and profits. Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by 40 to 60 percent. Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as farming, mining and logging suffered the most.

The majority of countries set up relief programs, and most underwent some sort of political upheaval, pushing them to the left or right. In some states, the desperate citizens turned toward nationalist demagogues – the most infamous being Adolf Hitler – setting the stage for World War II in 1939.

Here is a video outlining what happened that fateful day, which would take 15 years for the US to climb out of:

But to really examine this topic, we should go back a little further in time. How about 1837?

The Panic of 1837 was a panic in the United States built on a speculative fever. The bubble burst on May 10, 1837 in New York City, when every bank stopped payment in specie (gold and silver coinage). The Panic was followed by a five-year depression, with the failure of banks and record high unemployment levels.

A larger catalyst came in the form of the Bank of England. The Bank of England was not comfortable with the increased flow of funds into U.S. by British investors. To combat this negative flow of funds, the bank increased its deposit rate. The increase in the deposit rate made it more attractive for British investors to invest within the UK, thus pulling funds from the U.S. As with any “credit” bubble, once the available credit shrinks, the “crash” quickly ensues.

But wait, there’s more! As history so often repeats it’s self, the panic of 1837 was followed by the Panic of 1893.

The Panic of 1893 was a serious economic depression in the United States that was an extension of the Panic of 1873, and like that earlier crash, was caused by railroad overbuilding and shaky railroad financing which set off a series of bank failures. The Panic of 1893 was the worst economic crisis to hit the nation in its history to that point.

The 1880s had seen a period of remarkable economic expansion in the United States. In time, the expansion became driven by speculation, much like the “tech bubble” of the late 1990s, except that the preferred industry was railroads. Railroads were vastly over-built, and many companies tried to take over many others, seriously endangering their own stability.

As concern of the state of the economy worsened, people rushed to withdraw their money from banks and caused bank runs. The credit crunch rippled through the economy. European investors only took payment in gold, depleting US gold reserves, and threatening the US dollar’s value which was backed by gold. The investments during the time of the Panic were heavily financed through bond issues with high interest payments. As the demand for Silver and Silver notes fell, its price and value dropped. Holders worried about a loss of face value of bonds, and many became worthless.

A series of bank failures followed, and the price of silver fell. The Northern Pacific Railway, the Union Pacific Railroad and the Atchison, Topeka & Santa Fe Railroad all failed. This was followed by the bankruptcy of many other companies; in total over 15,000 companies and 500 banks failed (many in the west). About 17%-19% of the workforce was unemployed at the Panic’s peak. The huge spike in unemployment, combined with the loss of life savings by failed banks, meant that a once secure middle class could not meet their mortgage obligations. As a result, many walked away from recently built homes. From this, the sight of the vacant Victorian (haunted) house entered the American mindset.

There have been other crisis as well. 1873, 1907, but this one is shaping up to be one for the record books. (Thanks to StockCharts.com for this graph by the way.)

So, since everyone is comparing our current predicament to The Great Depression (pf 1929), one thing to keep in mind is that the market took 7 years to return to half it’s 1929 value, and 25 years to return to completely recover. So all I can tell you guys is that it’s time to be very conservative and careful right about now. We could be in for a long, long ride.

But wait – you say! Hold everything! Why the heck am I so pessimistic all of a sudden? Well, I’d argue that it’s not all that sudden, but anyway… let me tell you.

• Consumer prices in October took their biggest monthly plunge in the six decades that records have been kept. A prolonged, widespread decline would do serious economic damage, dragging down incomes, clobbering home prices even more and shrinking corporate profits.
  
  
• The Dow closed under 8,000 yesterday, at 7,997 – its lowest close since March 2003. The financial crisis has already wiped out $6.7 trillion of value from the S&P 500 since its October 2007 high. In the same period, the Dow has lost more than 6,000 points.
• Oct. 29, the Fed lowered the benchmark interest rate to 1 percent, a level seen once before in the past half-century. The Fed was worried about the effectiveness of previous rate cuts and had doubts about whether more cuts would help much.
• Americans have cut back sharply on spending amid mounting strains from job losses, shrinking nest eggs and falling home prices. More economic contraction in this quarter would meet the classic definition of a recession – two straight quarters of negative growth.
• Builders slashed home construction by 4.5 percent last month, driving it down to the lowest level on records dating to 1959.
• New claims for unemployment benefits jumped last week to a 16-year high. The four-week average of claims, which smooths out fluctuations, was even worse: it rose to 506,500, the highest in more than 25 years. It’s expected to get even worse next year.
• All three of the big US automakers are threatening bankruptcy and seeking $25B in bail out money from the government, which is looking shaky. They claim failure would cost 3 million jobs, though some people claim it wouldn’t be so bad.
  

Even with the S&P down more than 70% from its peak, the entire sector still has more pain ahead, says John Roque, of Natixis Bleichroeder, based on the historical peak-to-trough declines of past market manias, including:

• Dutch Tulip Mania (1637): 90% peak-to trough decline
• South Sea Co. (1720): 90% peak-to trough decline
• Tokyo Real Estate (1989): 84% peak-to trough decline
• U.S. dotcoms (2000): 92% peak-to trough decline

Part of the problem with the markets is that no one can predict what is going to ultimately help take us out of this recession. Is it going to be investment in alternative energies? Is someone going to invent a new world changing widget? What’s it going to take? I mean, until something comes along that makes everyone want to invest in it, we’re going to be stagnant at best.

Anyone care to take a guess at where all of this is going?