Are we in a depression?
No, and it’s ridiculous to even make the comparison. We’re not even officially in a recession yet, let alone a depression. The word depression is used perpetually in the media to describe our economy. These comparisons are irresponsible and only do more to unnecessarily destroy trust, making the economy tick.
For comparison between now and the Great Depression:
o Unemployment was 25% during the depression, today it is around 6%.
o Our economic production (GDP) contracted by 25% during the depression, during the last year it grew by 3%.
o Consumer prices fell 30% during the depression, today they continue to rise.
or 40% of all mortgages were late in 1934; today only 4% are late.
o In the 1930s more than 9,000 banks failed, in the last two years there have been around 30 bankruptcies.
Extraordinary circumstances are driving this bear market. A year ago, according to actual statistical measures, our economy was extremely strong and was running on all cylinders. Eighteen months ago, the presidential candidates started telling us how bad things were. At that time, his mantra of economic weakness was completely false. Since political gain is far more important to most politicians than telling the truth, they continued their pace of doom.
They told us we were in a recession when we weren’t. They told us unemployment was bad when it wasn’t. They remind me of the annoying salesperson whose strategy is to scare you to death to make the sale. Their goal is to convince us that to be saved (from whatever) we must choose them.
Plain and simple, our economy is built on trust. When your participants are confident, they spend, expand, and maximize growth. When they lose confidence and fear, they stop spending, stop borrowing, stop growing, and huddle in the corner. That lack of confidence causes the economy to slow down or stop growing.
About six months after the campaign, political scare tactics began to work. They were destroying consumer confidence. A year ago in October, the stock market started at its decent pace and then six months later, we started to see the first signs of economic weakness.
The problem and its cause.
At the epicenter of the current economic crisis is the subprime loan mess. In recent years, banks began making loans to borrowers who would not normally qualify for loans. Wall Street subsequently repackaged those loans into blocks and sold them to banks to hold as investments. Banks must have capital reserves equal to approximately 10% of the amount on which they make loans. If their capital reserves fall below 10%, then they have to raise capital or liquidate their shares to bring their ratio back to 10%.
Initially, subprime loans were assigned a value based on estimates of what the banks believed they were worth. As our economy weakened and home prices began to decline, the real value of these subprime loans came into question. In an effort to strengthen their balance sheets, many financial institutions tried to sell their sub-prime loan portfolios. Because many were for sale at the same time and no one knew for sure how much they were worth, the value of subprime loan portfolios began to plummet. Banks were stagnant because they were forced to sell these securities, and since no one really knew what they were worth, they were supposed to be almost worthless. For example, when Merrill Lynch was forced to merge, its subprime debt was assumed to be worth an absurd twenty-two cents on the dollar.
This turned into a credit crisis. Due to the subprime debt on their balance sheets, the banks weren’t sure if their capital ratios were in line or not. If those ratios are not online, they are not legally allowed to loan. If they can’t lend, consumers can’t buy cars and houses, businesses can’t borrow to buy inventory or pay payroll, and local governments can’t borrow for short-term needs. In essence, everything stops. As a result of this credit crisis, the markets continued their liquidation. By way of analogy, credit is to our economy what oil is to a car.
The essence of the federal rescue plan was that the government would buy subprime mortgages from financial institutions at a deep discount, but for more than ridiculous prices. This, in turn, would ease the banks’ short-term capital needs. Because the government doesn’t have the same accounting requirements as banks, they could keep subprime mortgages “long-term” by giving them time to determine their true value and allowing the depressed housing market to recover. In reality, it is very likely that the bailout will not cost 700 billion and that the government will actually make money. (That would be the first)
With all the accusations, who is to blame in this mess? The Clinton administration started it by making a politically popular decision and ordering that all consumers be treated equally regardless of whether or not they actually qualify for their loan. Banks were pressured to make loans that they had historically avoided. Republicans tried to curb liberal lending practices with regulations in 2005, but Democrats blocked them.
Once the mandate was in place, banks and mortgage brokers found that they could charge much higher fees if the quality of the loans were high risk. At this point, they were incentivized to make lower-quality loans. Wall Street’s role was to buy loans from banks, repackage them into blocks, and then resell them to other financial institutions. They were the delivery system. Because so many of them had them on their books, the balance sheets of Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, Merrill Lynch and other major players vaporized as subprime mortgages became impossible to value. .
The other culprit was the consumer. Hundreds of thousands of loans were taken out irresponsibly by consumers who made purchases and then failed to make their payments. Contrary to popular opinion, there is a lot of blame for all parties involved.
Where do we go from here?
Based on the history of the market, we know that this bear market has reached the average figures in terms of time and decline. The previous 34 bear markets have lasted a median of 363 days and are down 26.9%. As of September 30, this current bear has lasted for 354 days and the S&P 500 is down about 24%.
Unfortunately, while many of our “lower watch” indicators have been activated, we don’t know for sure if we are at the bottom or not. What we do know is that previous bear markets have often reversed when the news was most dire. We also know that some of the steepest drops have been followed by the strongest bounces.
Historically it has been a huge mistake to sell during the depths of a bear market.