COAN: Stocks will get worse before they get better

Looking at the final years of the Great Depression tells me that next year might not be so kind to investors.

Comparing similarities between the Great Depression and the current Great Recession, we see not only what we’ve experienced over the past 20 years, but what could likely happen over the next two.

Although we are much closer to the end of the tunnel now than before this crisis, we still have another train wreck coming. A negative correction of around 13 percent in 2011 would not surprise me at all, followed by a whopping 30 percent drawdown in 2012.

Look back and judge for yourself the similarities of what we’ve just come through and where we may be going.

It wasn’t called the Roaring ’20s because money didn’t flow freely while consumers practiced frugality. The newly created Federal Reserve expanded credit by setting low interest rates and reserve requirements for big Wall Street banks. The Fed increased the money supply 60 percent during the period and by the end of the decade “buying on margin” entered the vocabulary as Americans overextended to speculate on the soaring stock market.

Banks offered the first mortgages. Credit soared. Thrift and saving were replaced by spending and borrowing.

Encouraging the spending, the 1920s had laissez-faire economics. Top tax rates were cut from 77 percent to 25 percent by 1925. Non-intervention into banking became policy. These policies led to investor overconfidence and a classic credit-induced speculative bubble occurred.

This all came to an abrupt halt in October 1929 and continued with major stock market swings through 1942.

Government expenditures surged between 1929 and 1936. With the government creating agencies and hiring people into make-work projects, private industry was crowded out. The expansion of credit, propping up of weak firms, and increased government spending on public works prolonged the Great Depression.

It could be said both the Great Depression and Great Recessions were caused by a Federal Reserve expansion of the money supply that led to an unsustainable credit-driven boom. In both cases, when the Federal Reserve tightened, it was too late to avoid financial collapse.

One important difference between the two eras was the passage of financial reform in 1933. The Glass-Steagall Act, designed to separate Wall Street investment banks and depository banks to prevent these types of situations, unfortunately was unwound in 1999 by the Gramm-Leach-Bliley Act.

The repeal of Glass–Steagall removed the separation that previously existed between Wall Street investment banks and commercial banks and could be blamed for exacerbating the damage caused by the collapse of the subprime mortgage market that in turn led to the ongoing financial crisis that began in 2007. The Dodd-Frank financial reform legislation passed this year did not renew the separation.

The parallels between the two eras are uncanny. Federal Reserve Chairman Alan Greenspan expanded the money supply after the dot-com bust, dropped interest rates to 1 percent, encouraged a credit-driven boom, and created a gigantic housing bubble.

By the time the Fed realized it had created a bubble, it was too late. The government response to the 2008 financial collapse has been to expand the money supply, reduce interest rates to 0 percent, borrow and spend $850 billion-plus on make-work projects, encourage spending by consumers, and artificially prop up housing through tax credits.

The government has sustained insolvent institutions with $700 billion and continues to waste taxpayer money on these companies. As with the Great Depression, the agony today is being prolonged by not allowing the real economy to bottom and begin a sound recovery based on savings, investment and sustainable fiscal policies.

However, did you know the stock market returned about 160 percent between 1920 and 1940, and about 161 percent (as of this writing) between 1990 and 2010? Yes folks, it has been that similar.

If we continue to look back to find out what 2011-2012 may have in store for investors, we should note that the markets were cut in half the last two years of the Great Depression before bottoming in 1942.

The upshot is that between now and 2012, we could lose half the market’s value.•

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Coan is managing partner of Wealth Planning & Management LLC in Indianapolis. Views expressed here are the writer’s.