Great Depression Is Good For Stock Investors

The $700 billion bailout cleared the Senate hurdle Thursday, together with a bill for tax cuts of more than $100 billion which included a variety of alternative energy credits and dozens of breaks for businesses and individuals.

Senate approved the legislation on a 74-25 vote which empowered the Treasury Department to buy troubled assets, mainly mortgage- backed securities that are burdening financial institutions. The sweetener from tax provisions is designed to swing Republican votes, whose lack of support was crucial in the defeat of the previous bailout plan by 12 votes on Monday.

However, stark naked fear is still in the air. Dow Jones fell 348.22 points (3.22%) to close at 10,482.85 while S&P 500 and Nasdaq Composite tumbled more than 4%. In his latest interview with PBS, Warren Buffett revealed that he has not seen this level of fear reigning over the market in his lifetime and he has seen plenty before.

“In my adult lifetime I don’t think I’ve ever seen people as fearful, economically, as they are now… The economy is going to be getting worse for a while.”

Buffett called the problems facing world markets “unprecedented” and warned of a “disaster” if Congress does not move faster to shore up the economy. And to depict the problem graphically, he drew analogies to Pearl Harbor and a super athlete who suffered a heart attack throughout the interview.

“We had an economic Pearl Harbor hit. For a couple of weeks we’ve been arguing about who’s at fault [and] fooling around while things have gotten a lot worse.”

“We have a terrific economy — it’s like a great athlete that’s had a cardiac arrest.  It’s flat on the floor, and the paramedics have arrived.  And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch this way, or they shouldn’t start criticizing the patient, because he didn’t have a blood pressure test or something like that.  They should do what’s needed right now.

“It will cost more to solve this problem today than it did two weeks ago. If we don’t get it solved next week, I may go back to delivering papers.”

My opinion of this crisis is closely similar to Warren Buffett. Tackle the immediate problem first, rather than finger-pointing and apportioning the blame. We can go after the culprits later. There are imperfections in this bailout and seriously, even if we discuss it for another month and send it to all the revered economists for vetting, it will be nowhere near perfect either.

I believe the bailout is a crucial step in the right direction but on hindsight, expectations shouldn’t be artificially inflated when this bailout plan was proposed. This bill is not a miraculous elixir which can raise the dead. The economy will not turn around overnight and neither will stock markets embark on a bull run immediately

It will take a while for the bailout to work itself through the system and the economy is going to struggle even with its passage. Credit markets won’t be unlocked unless confidence returns sufficiently but with toxic assets taken off the balance sheets of many financial institutions, the immediate crisis of bear raids are staved off and business can resume normally instead of financial firms hoarding cash and writing down assets every quarter.

Fear can manifest itself in many ways and I don’t see fear dissipating any time soon. What should long term investors do? I think an analysis of previous bear markets will be helpful. You may be surprised to know that bear markets in the mold of the 1929 Great Depression are actually a blessing in disguise for investors.

Great Depression Good For Investors

A dreadful scenario that has been bothering investors is that this recession drags on for years and stocks simply do not go anywhere. For the purpose of discussion, let’s assume that instead of a 1-2 year bounce back, the economy is indeed stagnant or experiences low growth for the next decade, resulting in mediocre returns from the equity markets.

In the history of US equities, there are two periods, the first from 1929 to 1953 and the second from 1965 to 1982, when the stock market “did not go anywhere.” In those periods, a high point was attained, followed by a sustained period of decline and accumulation.

In August 1929, the Dow Jones Industrial Average reached about 380 but could not surpass that peak until November of 1954. Likewise, in December 1965, the Dow Jones Industrial Average reached about 1000 and could not break out until December 1982.

While it sounds as though stocks offered little to no return over these periods, one must remember to include dividends. In addition, it is very important to consider the performance of stocks against inflation and other investment opportunities.

Imagine that the 1929 Great Depression never happened and the economy coasted along nicely. As such, stock prices were stable and stock dividends, instead of dropping sharply, made a smooth ascent till 1954. For the real economy, such a trend is certainly more desirable, rather than the sky-high unemployment, bankruptcies and economic hardships.

Yet, this scenario is not good for long term investors. Although the market reached the same level by November 1954, the returns to shareholders vary markedly. Investors who accumulated stocks as a result of this economic catastrophe achieved at least 60% more returns than if the Depression never happened.

The reason is that although dividends decline a whooping 35% from its peak in 1929 to their trough in 1933, stock prices fell even more. Thus, the dividend yield on stocks which is critical to an investor’s total return, actually rose.

Short term investors were the hardest hit between 1929 and 1949 because of the Depression as they were forced to sell their stock, either because they purchased using borrowed money or more commonly, because they dumped their shares in a panic, figuring that getting some money from their investments was better than nothing.

To be fair, when experiencing the lows of a market cycle, investors’ psyches are tested to the extremes and twenty years is not an insignificant period of time. But for those who persevered, the extra shares purchased during the bear market caused their returns to rocket ahead when stock prices finally recovered.

Long term investors can generate their wealth not from timing the market but through the reinvestment of dividends. Bear markets are heart-wrenching periods for investors but they are also the very reason why investors who reinvest dividends experience sharply higher returns.

The takeaway lesson is when fear and pessimism grip shareholders, those who stay with dividend paying blue-chips are the big winners. And if you need to see a better example of someone who walks the talk, just look at Warren Buffett. He uses actions to back his words and he is aggressively buying into companies  which have strong global presence and are at attractive valuations.

His latest target is General Electric, on almost identical terms to his snag of Goldman Sachs. In April, the industrial titan (widely viewed as a proxy for the U.S. economy) missed forecasts for first-quarter earnings and a breakup of the company was proposed. GE’s stock price have lost nearly a third of their value this year.

On Wednesday, GE announced that it intended to raise $12 billion through a common stock offering, in addition to plans to allow Berkshire Hathaway to buy up to $6 billion in stock – $3 billion in preferred stock and a 10% dividend. Buffett called GE “the symbol” of American business with strong global brands and business divisions and is “confident GE will continue to be successful in the years to come.”

Buffett rationalized his actions, saying: “Yeah, we want to use cash.  The reason we haven’t used our cash two years ago, we just didn’t find things that were that attractive.  But when people talk about cash being king, it’s not king if it just sits there and never does anything.  There are times when cash buys more than other times, and this is one of the other times when it buys a fair amount more, so we use it.”

I am sure there may be critics who think Warren Buffett has a screw loose to invest in this uncertain market or that his words are now biased having emptied his coffers into the stock market cauldron, but I have little doubt that Buffett’s wisdom will shine through and he will be laughing all the way to the bank when the market recovers.

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1 Comment

Filed under Banking, Stocks

One Response to Great Depression Is Good For Stock Investors

  1. alex

    So, how about investing in precious metals like gold during these stagflation like periods…pays off better doesnt it-?

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