Debunking the Depression Myth: Why We Are Not Going There This Time

US economySome old-time market watchers are still calling for Great Depression II. One research report I read earlier this week by a well-known economist says we are in a depression.

I’m in the enviable position of being one of the few analysts who called the severity of this recession back in the beginning of 2007, before the word “recession” was even on the lips of the majority of economists.

Back on November 15, 2006, on these pages I wrote, “The risks to the U.S. economy in 2007 are greater than I’ve seen in years.” On January 31, 2010, I wrote, “The hard facts about the real estate market in the U.S. are truly scary. How can the U.S. economy escape the hard landing in U.S. home prices? As we’ll soon find out, it simply can’t!”

A week later I said, “1932, 1933…who remembers those years? The depression of the 1930s was the biggest bust of modern history. 2005, 2006, 2007…welcome to the biggest boom of the same period. When will it all end? Soon, my dear reader. Soon.”

But I’ve always predicted a severe recession, never a depression. And here’s why I continue to believe that:

Ten thousand American banks failed during the Great Depression. Many depositors lost their money. By the time this recession is over, 1,000 banks in the U.S. will have failed. The FDIC covers the money depositors have in banks to the tune of $250,000 per depositor per institution. There was no FDIC insurance in 1932.

The stock market had been rising for the majority of the 1920s until the crash of 1929. If we look at the chart of the S&P 500 stock index (which is not as easy to manipulate as the Dow Jones Industrials, with stocks being cherry-picked in and out of the Dow Jones), the S&P 500 stock index has been down for over a decade.

In the 1920s, you could have bought stocks with 90% margin (only 10% of your money). For years now, you’ve needed at least 50% up front to buy a stock and stocks have to be preapproved for margin.

During the Great Depression, the official rate of unemployment in the U.S. surpassed 20%. This morning, the U.S. Labor Department reported that the August unemployment rate was 9.6%.

The inflation rate during 1932 was negative 10%. We do not have a negative inflation rate today.

The one aspect of the economy that has hurt us more in this recession compared to the Great Depression is the housing market. During the Great Depression, the average price of a home in the U.S. fell 15% from peak to trough. This time, from their ridiculous peak in 2005, U.S. home prices have fallen 30%. Compounding this problem is the fact that a much greater portion of the population owned a home in 2005 than in 1932. The government is combating this problem with interest rates that are low, a program to help people restructure their mortgages, and a home-buying incentive program, which recently expired (and which I wouldn’t be surprised to see come to market again).

As I wrote a couple of days ago, the black clouds in the economy are dissipating ever so lightly. But make no mistake; they are dissipating. In my life as an investor, I’ve always made money buying investments when others have feared to do so (the old “buy low, sell high” adage). For those who are more concerned about us entering a depression as opposed to us exiting a severe recession, they are missing a huge buying opportunity.

Where the Market Stands:

Trading range? Yes, that’s what analysts have been calling it; we are stuck in a trading range. The Dow Jones Industrial Average has been trading in the range of 11,000 on the upside and 9,750 on the downside since May of this year.

Two things about trading ranges: 1) eventually they are broken (either through the upside or downside); and 2) you can still make good money on stocks during a trading range.

With 30-day U.S. Treasuries yielding a pathetic 0.12% and the five-year Treasury at 1.43%, the dividend yield on the Dow Jones Industrial stocks of 2.7% is an attractive alternative for investors. Hence, I do not see stocks as overvalued.

Until proven wrong by the stock market, I continue to see stocks in a bear market rally that started in March 2009.

The Dow Jones Industrial Average opens this morning down one percent for 2010, but up 60.2% since March 9, 2009.

What He Said:

“For the economy, the message from retail stocks is quite clear: consumer spending, which accounts for roughly 70% of U.S. GDP, is in jeopardy. After having spent like “drunkards” during the real estate boom years, consumer spending is taking the same trend as housing prices, slowing down faster than most analysts and economists had predicted. As news of the recession continues to make headlines in the popular media, the psychological spending mood of consumers will continue to deteriorate, lowering earnings at most high-end retailers and bringing their stock prices down even further.” Michael Lombardi in PROFIT CONFIDENTIAL, January 28, 2008. According to the Dow Jones Retail Index, retail stocks fell 39% from January 2008 through November 2008.