Will There Be a Great Depression II?


07/12/10
— Here’s the most common question that arises whenever I bump into a PROFIT CONFIDENTIAL reader: “Michael, how close are we to really having another Great Depression?”

This is a question best answered by the facts:

During the 1930s, approximately 9,000 banks in the U.S. failed and there was no FDIC insurance for depositors. Comparatively, after the FDIC shut down four banks last week, the total number of banks to fail in the U.S. this year has now hit 90.

The most pessimistic predictions are for 1,000 total bank failures in the U.S. because of the recession that started in 2007. The FDIC covers up to $250,000 per depositor per institution if a bank fails. Again this protection was not present during the Great Depression.

Unemployment in the U.S. hit 25% during the Great Depression. Today, unemployment sits around 10% and worst-case predictions are for that rate to go to 12%.

In the 1930s, in a huge government mistake, the “Smoot-Hawley Tariff Act” was passed to restrict trade with foreign countries. Today, the U.S. is a heavy promoter of international trade.

Leading up to the stock market crash of 1929, stock brokerage houses would lend you $9.00 for every $1.00 you had invested with the stock brokerage house in stocks, or a 90% margin. Of course, today margin accounts can only give you a 50% margin; for every $1.00 you have invested in a stock, you can get another $1.00 as a loan. And not all stocks are marginal.

Finally, there are mixed views on how the Federal Reserve acted during the Great Depression years. Economist Milton Friedman believed that the government was contracting the money supply at a time it should have been expanding the money supply. Of course, today, we have a very expansive monetary policy, with interest rates at record lows.

So back to the question:

Can a second Great Depression happen? Sure, anything can happen at any time. But if we look at the points above, we are very far away from Great Depression II. The recession we experienced in 2007 can be solely attributed to the decline in the value of U.S. real estate that
started in 2005.

Falling house prices led to failed mortgages, which led to failed mortgage-backed securities, which led to investment bank failures and mortgage company failures, which led to declining stock prices.

We need to give to give credit to Ben Bernanke and the U.S. Federal Reserve. They have done a masterful job at steering us away from the Great Depression II. We just need to see the long-term effects of how all that debt we accumulated trying to save the economy works out.

Michael’s Personal Notes:

“So where have you been, Michael?” From the e-mails and phone calls, it seems my loyal readers missed me last week. Thank you. It’s nice to be missed.

I’ve been travelling in the U.S., trying to get a handle on how our economy is faring. Reading the right newspapers and economic news stories on the Internet gets you a “feel” for how the economy is doing. But to get a real feel, you need to be in the trenches talking to big and small businesses about how things are going for them.

While I will talk about the findings of my travels in my next few commentaries, I did come back with a more upbeat feeling about the economy and our future. There is no doubt in my mind that the real estate market is dead and will be dead for the next couple of years at
a minimum.

But small and mid-sized businesses, in general, are witnessing an uptick in the demand for their products and services. While banks are still not lending like they used to, innovative American business people are climbing out of their rut. This is great news for our
economy.

At the end of the first quarter of this year, non-financial companies in the U.S. were sitting on $1.84 trillion in cash, according to the Federal Reserve. As a percentage of total assets, cash on corporate balance sheets is at its highest level in about 40 years. Such a high amount of cash on company balance sheets tells me three things: First, corporate America is playing it very cautious. They want to see how the economy fares in the months ahead before investing in plants, equipment, and inventory. Second, corporate America has the cash to spend as the economy improves. Third, if the economy does not improve, corporate America has the cash to work through a double-dip recession.

Cash is king in poor economic times. Corporate American has figured that out this time around.

Where the Market Stands:

The Dow Jones Industrial Average is set to open this morning down 2.2% for 2010. We’ve passed mid-year, and big-cap stocks have gone nowhere in 2010.

If we look at the fundamentals, as I have written above, there is no doubt that the economy has improved since late 2008. The risks are still there (sovereign debt in European countries and at home, the pathetic American real estate market, a slowing Chinese economy), but corporate earnings have been improving and there is nothing that the stock market loves more than rising corporate earnings.

On the technical side, a chart of the S&P 500 looks like a “dog’s breakfast.” A huge top is in for most stock market indices. When the right shoulder of a head and shoulders pattern has been formed, it is the kiss of death.

The most positive thing I think the market has going for it is the great number of pessimists out there. I have failed to see a stock market newsletter or advisory service that has not mentioned the big negative around the head and shoulders formation. You know how I feel about the market. It always does the reverse of what is expected of it. As long as so many advisors and analysts are bearish, the market has support.

What He Said:
“Partying Like a Drunken Sailor: The party continues. Stocks are making new highs and people are spending like there is no tomorrow. Why? I really don’t know. Big (cap) stocks, they just continue going up. Wall Street bonuses are at record levels. Popular consumer goods are flying off the shelves. Designer clothes, fast and expensive cars, restaurants with one-hour wait…people are spending in America today at an unbelievable clip. 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.” Michael Lombardi, in PROFIT CONFIDENTIAL, February 7, 2007. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.