By Simon Maierhofer
It's been said (and perhaps you are getting tired of hearing it) that those who don't learn from history are doomed to repeat it. If the parallels of the Great Depression continue to hold up as they have (and according to historical indicators they will), history doesn't have to repeat itself to severely hurt investors. A mere rhyme to the Great Depression would be enough to wipe out tons of portfolios.
But who cares about history when the market is up and the forecasts call for better days ahead. The Dow Jones (DJI: ^DJI) and S&P 500 (SNP: ^GSPC) have rallied over 55% while the Nasdaq (Nasdaq: ^IXIC) has soared nearly 70%. Wall Street is anxiously expecting another earnings season, which is expected to be predominantly good.
Reuters reports that 'earnings optimism lift Wall Street' while Credit Suisse encourages their clients to buy bullish Alcoa options in advance of Alcoa's profit reports.
If there is one thing we should have learned from history, it's that the bear strikes hardest when least expected. Pierre Corneille hit the nail on the head when he said that 'danger breeds best on too much confidence.'
Black Monday's or Thursday's wouldn't be called 'black' if they were expected. Market tops are always marked by extreme levels of optimism.
In January 2009, with the Dow Jones slightly above 9,000, the ETF Profit Strategy Newsletter noticed elevated levels of optimism and warned of a severe decline with a target of Dow 6,700. Today, sentiment readings are even more extreme than they were in January. The implications are obvious.
If there is just one time you want to take a lesson from history, it is RIGHT NOW. The parallels between today and the Great Depression are numerous and strikingly similar. This 5-minute history lesson might be the best investment you'll ever make.
Parallels between the 1929 and 2007 market tops
Even though a major storm was brewing, prior to the 2007 market top, Wall Street saw no 'cloud in the sky.' In its Global Economics Report, released in the summer of 2007, Merrill Lynch's analysts published the following outlook: 'The Merrill Lynch global economics team believes that the economy will continue to grow in 2007 - with no sign of a significant cyclical slowdown.'
From 2007 to 2009, the major indexes declined some 50%.
On December 4, 1928, President Coolidge sent the following message on the state of the Union to the reconvening Congress: No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. You may regard the present with satisfaction and anticipate the future with optimism.'
A few days before leaving office in 1929, the parting President cheerfully observed that the economy was absolutely sound and that stocks were cheap at current prices.
Following the 1929 highs, the Dow Jones (NYSEArca: DIA - News) declined 48%.
Parallels between the 1930 and 2009 major bear market rallies
Following the initial 48% decline in 1929, the Dow Jones rallied 48% within a period of six months. This rally was powerful and retraced 52% of the Dow points lost in the initial decline. Even though the market was far from its previous highs, investors had once again gotten excited about owning stocks and felt confident that the market would continue to move higher.
On March 25, 1930, just a few weeks before the waterfall decline resumed, the New York Times reported that 'Wall Street was in a cheerful frame of mind as a result of numerous vague reports of improvement in business and industry.'
Once the bear market resumed, it erased another 86% of the Dow's value.
Following the 54% 2007 - 2009 decline, the Dow Jones rallied 54%. So far, the Dow has retraced 45% of the points lost in the initial decline. The 50% mark, a Fibonacci retracement level, often exercises a magical pull and provides an upper target for bear market rallies. The chart below compares the first six months of the two rallies, up to 8-15-09.
Similar to the 'vague reports of improvements' reported in 1930, today's 'good news' reports are merely an adaption to lower expectations; many consider it the new normal. Just like in 1930, vague reports of improvements (in 2009 they've become known as 'green shoots') are enough to propel stocks. For savvy investors, the parallels between the two declines and subsequent rallies are certainly too close for comfort.
The instigator - real estate
Did you know that the Great Depression was preceded by a great real estate boom centered in Florida? The Florida real estate bubble burst in 1926, three years before equities. Just as we've seen recently, investors took their leftovers from the real estate bust and poured it into stocks. Talk about jumping out of the frying pan and into the fire.
The Great Depression's Warren Buffett
Yes, the Great Depression had its own Warren Buffett - John D. Rockefeller. In his first public statement in decades, Mr. Rockefeller expressed his conviction 'that fundamental conditions of the country are sound, my son and I have for some days been purchasing sound common stocks.' A few months later, on November 13, 1929, Mr. Rockefeller allegedly entered a million-share buying agreement to peg Standard Oil's stock price at $50.
Rockefeller's public appearance is strikingly similar to Warren Buffett's October 16, 2008 op-ed in the Wall Street Journal, 'Buy America. I am.' Buffett confirmed his view many more times since, most recently in a 7-24-2009 interview with CNBC's Squawk Box where he stated that Dow 9,000 is still a good time to buy stocks.
Initially, John D. Rockefeller looked like a genius because stocks started the mother of all sucker rallies the week he allegedly entered into the buying agreement. The 1930 green shoots, however, wilted quickly. A few years later, mighty Standard Oil - the parent company of Exxon and Mobil - traded at $20 share, more than 70% below its prior high. Few companies have been as influential as Standard Oil in the early 20th century and Berkshire Hathaway today. Even though they are decades apart, their paths might be similar.
Putting this bear market into perspective
The bear market from the 2007 highs has humbled all markets: large cap stocks (NYSEArca: VV - News), mid cap stocks (NYSEArca: MDY - News) and small cap stocks (NYSEArca: IWM - News). Defensive sectors such as consumer staples (NYSEArca: XLP - News) and aggressive sectors such a consumer discretionary (NYSEArca: XLY - News). Global developed markets (NYSEArca: EFA - News) and emerging markets (NYSEArca: EEM - News).
This unique 'red across the board' behavior has not been seen in the 70s, 80s or 2000 bear markets. The only other similar time period to be found is during the Great Depression.
Waiting for the last laugh
While bulls feast on the current gains, bears and average investors observe the market's rise with amazement. This doesn't mean that this humongous rally was entirely unexpected. Contrary to the prevalent dooms-day atmosphere surrounding the March lows, the ETF Profit Strategy Newsletter issued a Trend Change Alert on March 2nd, predicting the biggest rally since the October all-time highs with a target range of Dow 9,000 - 10,000.
John Kenneth Galbraith, author of 1929 - The Great Crash, described the pattern of the 1929-1932 bear market as follows:
'The worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few people as possible escape the common misfortune. The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. Even the man who waited for volume of trading to return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or a fourth of the purchase price in the next 24 months. The Coolidge bull market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable.'
This counter trend rally is likely to be the biggest one of the bear market which started two years ago. While we've seen the biggest rally of this bear, we have yet to experience the biggest decline. This decline may delay for another few days or weeks but it is certain to come.
Just when you thought it wasn't possible
If this sounds impossible, consider the following:
1) The Dow Jones measured in the only true currency - Gold (NYSEArca: GLD - News) has already declined over 80%. To reset valuations, the Dow measured in dollars will have to follow.
2) Japan's Nikkei has lost as much as 80% since its 1990 all-time high. This drop came amidst a global bull market. Imagine what a global bear market can do.
3) A look at current dividend yields and P/E ratios shows that U.S. stocks are grossly overvalued. The current P/E ratio of 141 (reported by Standard & Poor's) dwarfs even the P/E ratios seen during the dot.com bubble, where technology companies (NYSEarca: XLK - News) with no earnings traded at $100 a share and more.
The human tendency to shun overpriced stocks will take over once this emotional buying frenzy has run its course. That's how it's always been, that's how it will prove to be. Once that happens, the majority of investors will wish they'd listened to the subtle but clear advice presented by history.
The ETF Profit Strategy Newsletter contains a detailed analysis of P/E ratios, dividend yields, investor sentiment and the Dow measured in gold along with short, mid and long-term market guidance. Indicative of their implications we've named these indicators the 'Four Horsemen.' The four horsemen are in agreement with history; a market top is close and a multi-decade low is near.