Could History Repeat Itself?

by Inya Ivkovic, MA

In two short months, stock markets have on average gained 35%. Sure it’s great, but is it sustainable? If history is truly the best teacher, let’s hope not. And not only that, but investors who hope for the gains to continue would be wise to be careful what they wish for.

Here is one scary scenario that happened just after the market crash of 1929. Then, too, after two short months following the October 1929 crash, stocks surged 48%, gaining every basis point lost on those three fateful days on October 24, 28 and 29 of 1929. But, in the next two years, the Dow Jones Industrial Average plunged about 86% from the peak of the rally immediately after the Great Crash. Could history repeat itself?

While most analysts believe the pullback from the current rally is more than likely, and even healthy to an extent, the prospect of the Great Depression era plunge of the stock market probably is not. The argument supporting this forecast is that all the ugly cats have been let out of the bag by now and are not likely to blow up in our faces anymore. This means there is not enough steam to propel the prolonged plunge of stocks, the kind experienced in the early 1930s.

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Another argument against a prolonged downturn in the stock market is the unprecedented, highly aggressive government economic stimulus, which did not exist in the early years of the Great Depression and which apparently is working today, staving off the worst the recession of 2008/2009 has to offer. This explains the recent optimism that there are signs — albeit weak ones — that the economy is improving and that earnings, while far from great, were not as bad as everyone expected.

Even the recent stress test has shown that most major banks have enough capital to stay afloat if the economy gets fairly worse from the current bad state, while the banks that have failed the stress test need to raise altogether just $75.0 billion in new capital. And even though it sounds as if I’m saying “$75.0 billion” far too lightly, I say so having in mind that over a trillion dollars has been thrown into the economy to prevent it from completely free-falling into the abyss.

But let’s play the devil’s advocate and look for arguments potentially supporting the repeat of the Great Depressions nasty precedent. Setting aside the economic stimulus, which, granted, is a rather important factor that wasn’t present during the Depression, most of the current market gains have been almost wished into existence. But that doesn’t necessarily mean that the fundamentals are supporting market rallies. The only clearly defined underlying fundamental behind recent rallies is the sentiment that, while things are bad, they could be far worse, but they’re not. So, of course, we cannot be talking about a bull market in that context.

We should also be wary of bear capitulation, which often happens when bulls are winning short-term, persuading bears that the risk is tipping to the upside and that it is time to jump ship. In that case, sharp selloffs are more than likely to occur, because the market would find itself in excessively overbought territory.

What are ordinary investors to do? First, remain cautious and doubt everything, from rallies to selloffs. Also, don’t be greedy. If you have been riding the current rally these past two months, it might be wise to consider raking in your profits and taking your money off the table and putting it into something boring and safe. Remember, we should have learned by now to love boring and safe, shouldn’t we?