‘A chicken in every pot, a car in every garage.’
The above quote, attributed to President Herbert Hoover’s 1928 election campaign, epitomizes the mass psychology characteristic of the Roaring ’20s. In a country that had long enjoyed a remarkable period of prosperity, it was felt that the trajectory of the boom’s trend would eventually lead to an eradication of poverty.
The Industrial Revolution brought about a tremendous increase in productive capacity and living standards beginning with its origins in the mid-19th century. But the advent of consumer installment credit in the Roaring ’20s was the mechanism that shifted business into overdrive. Entrepreneurs all along the chain of production, from commodities to retail, geared up for demand that, in hindsight, was short-lived.
Lessons from the Great Depression: the consumer credit bubble
A credit-fueled bubble that affected nearly every corner of the economy – encompassing everything from consumer credit, to business loans, to margin debt at stock brokerages – crested the following summer. Alas, historians have thoroughly documented what happened when this euphoria morphed into panic.
With the onset of the Great Depression, priorities for many gradually shifted from return on capital, to return OF capital, to concern that modern industrialized society was unraveling at its seams.
As the panic that engulfed Wall Street spread to the banking community, pain that was previously only felt by those involved in the speculative stock market quickly consumed the business community. Consumers reined in spending, so business owners rationally cut expansion plans and investments in inventory.
Bankers comprised the heart of the capital allocation function of the time period; in the modern global economy, it’s quite another story, as the business of providing credit has shifted toward such institutions as hedge funds, private equity, and government-sponsored enterprises like Fannie Mae. Also taking share from bankers has been the secondary market for credit derivatives, including mortgage-backed securities, collateralized debt obligations, and collateralized loan obligations.
Once consumers had reached the saturation point of installment credit, companies like Ford had the capacity to produce far more cars than the market demanded.
Bankers, fearing defaults on their riskiest loans, called them in just as the ability to pay them off had vanished. The combination of falling asset prices (factories, inventories, real estate, etc.) and bank runs was lethal. The country witnessed an enormous number of bank failures in a short period of time.
Lessons from the Great Depression: the dollar devaluation
President Hoover’s interpretation of the authority granted to his office by the Constitution did not square with that of the business and investor communities clamoring for a bailout. The measures he took to clean up the mess left by a burst bubble, in which millions were complicit, were not perceived as radical enough under the circumstances.
In 1932, President Franklin D. Roosevelt was elected in a landslide on promises to take swift and decisive action. The foundation of this recovery involved devaluing the US dollar against its gold backing, and basically amounted to currency debasement and deficit- financed make-work programs. The cost of the New Deal – the brainchild of British economist John Maynard Keynes – was foisted upon future generations.
When confronted with these long-term costs and the necessity of running budget surpluses to pay off debt incurred by his ‘demand management program,’ Keynes casually dismissed this critique with the statement that ‘in the long run, we are all dead.’
Well, it’s safe to say that we have reached what would be considered ‘the long run’ and, no, we are not all dead yet. The only thing that has sheltered the current working generation from the financial consequences of government debt growth (taxes, runaway CPI inflation) is the fact that America successfully ‘dollarized’ the rest of the world in the post-World War II period.
This is not to say that the US will escape unscathed. International accounts will be settled through further destruction in the value of the dollar. It must, and the Fed will do everything in its power to ensure the dollar’s future devaluation. Whether it will be ‘successful’ remains to be seen, but you can be assured that painful consequences will accompany unconventional Fed policy.
Does anyone really stop to think about what would happen to the current economy if US Congress enacted a plan to pay off the gargantuan federal debt, not to mention fund the trillions in unfunded Social Security and Medicare promises made?
The consequences of such an action would lead to a second Great Depression. Federal spending that for generations has greased the wheels of commerce cannot be reduced in the face of the gargantuan debt obligations that must continually be paid or rolled over. Widespread default is not an option in the mind of the Fed.
In my mind, the important lessons of the Great Depression lie not in the New Deal’s remedies to its fallout, but in tracing its origins back to the seeds that were sown by post-World War I Fed policies: credit that is controlled by government institutions, rather than the free market, can lead to egregious misallocations of capital. In the 1920s, it clearly did.
Lessons from the Great Depression: the inefficient market
What do the Hoover campaign themes of seeking to universally end hunger and promote material prosperity have to do with current market psychology?
The efficient market hypothesis (EMH) basically states that current stock prices reflect all available information, so you are wasting your time attempting to take advantage of extremes in prices. ‘The market’ is lifted to the status of an omniscient capital allocation machine. In theory, it works, but when the human emotions of greed and fear are involved, it’s amazing to behold the irrational pricing that can develop at either extreme.
I can’t think of a better real-world refutation of the EMH than the tech bubble, yet in its aftermath, it is still included in the mainstream of financial theory.
For example, the bubble in the stock prices of fiber- optic equipment manufacturers might have been close to accurately pricing in the future growth of Internet traffic, but bubble stock prices were clearly not pricing in the reality that the race to build out fiber- optic capacity sowed the seeds of rapidly approaching profit-margin free fall.
When the powerful emotions of greed and the fear of being left behind combined to produce jaw-dropping rallies, sell-side analysts responded by publishing ridiculous discounted cash flow models in order to justify current prices. Remember the ‘click count’ and ‘eyeball’ methods of valuing triple-digit Internet stocks that ultimately crashed and burned?
A principle of financial theory that withstands the rigors of real-world experience is that the value of any stock is equal to the sum of future free cash flows generated by the underlying business. These free cash flows can be used to pay dividends or to repurchase shares and must be discounted back to the present time using a ‘reasonable’ rate in order to arrive at a current value for the stock. This is where it gets really tricky, with wild swings in stock value resulting in changes to the discount rate.
Lessons from the Great Depression: how to profit in a bear market
For individual investors, the important thing to take away from discounted cash flow (DCF) models is that future sales growth (or contraction) rates, costs of production, overhead, competition, and the availability of financing are all huge, unpredictable factors in the DCF calculation. Take an unreasonably optimistic view of these future assumptions, and voila: instant mathematical justification for bubble valuations.
Approaching the peaks of bull markets, investors tend to aggressively bid up the prices of those stocks with the most egregious assumptions about future sales and earnings growth and tend to ignore threats to those assumptions, including competition, inflating expenses, and, often, the ready availability of financing. Due diligence often consists of A) my neighbour just made a fortune in this stock, B) the chart shows that it’s a clear path to riches, and C) I’ll get out before the top by selling to a ‘greater fool.’
Consequently, in the early stages of bear markets, investors tend to flock toward safe havens with rock- solid balance sheets and business models with more predictable assumptions, like consumer staples.
While traditional safe havens may continue to fall in price, you can be reasonably confident that they will fall less dramatically than the most speculative stocks and aren’t going to flame out to $0. This, combined with solid grounding in macroeconomic trends, can in fact lead to profits in an otherwise choppy, downtrending bear market.
By Dan Amoss for The Daily Reckoning
P.S. Maybe ‘a chicken in every pot and a car in every garage’ was a good enough aspiration for the economy of the Roaring ’20s, but it looks like a campaign slogan for the new millennium should be modified to ‘convenient, tasty food delivered to every doorstep and unlimited cheap oil to fuel multiple cars in every garage.’
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