If this is like 1932, there will be hope as well as pain

By John Authers
Published: January 2 2009 18:24 Financial Times

Everyone became an expert on the deeper reaches of financial history last year. With almost any relationship on which market traders had come to rely in the past three decades breaking down, they had to delve deeper for precedents.

Early in the year, we were looking at the Long-Term Capital Management disaster of 1998 and the savings and loan scandal of the early 1990s. Once it became obvious that the new crisis was deeper than these and oil prices started to surge, comparisons with 1973 and 1974 grew fashionable. Now the oil price has dropped by more than $100 a barrel and we fear the first great deflation since the Depression, attention has turned to the 1930s. Some have disinterred long-forgotten incidents such as the panic of 1907 (which led to the creation of the Federal Reserve), or the panic of 1873, which followed a boom in investing in railroads.

No historical parallel can be perfect. But perhaps two years offer the best point of reference. What if last year was 1931? If so, this year could be 1932. In some ways this is good news. It was when the US stock market finally began its recovery. At one point the Dow Jones Industrial Average more than doubled in barely two months. But it still saw equity indices end the year worth less than when they had started. Intriguingly this is almost exactly in line with the apparently self-contradictory consensus of wisdom about the stock market this year: that it has not yet hit bottom but should do so this year and that at some point there will be an explosive rally.

There are differences. The bear market was already more than a year old when 1931 started, while 2008 started only shortly after equities had reached a final peak. And the point in the political cycle was different, as President Franklin Roosevelt was not elected until November 1932, some months after the stock market bottom. Policymakers took far longer to embrace monetary or fiscal easing.

But in the markets, 2008 looks a lot like 1931. It was the worst year of the 1930s for stock markets, with the S&P 500 falling 47 per cent, driven by fears for the banking system and by seismic shifts in foreign exchange rates.

As 1931 turned to 1932, the extra spread that investors required to buy the bonds of investment-grade companies, rather than US Treasury bonds, reached an all-time high – closely approached in the past few weeks. Then, as now, the Fed was about to buy back Treasury bonds, in a bid to push up their prices and push down their yields – a drastic way to lower interest rates payable in the broader economy, now known as “quantitative easing”.

So 1931 is a better comparison for the year just gone than most.

A look at how 1932 unfolded shows how the conventional wisdom about 2009 may yet come true. The year started with a rally as optimism took hold that the financial sector’s problems were over. That took the S&P 500 up almost 20 per cent by early March. Compare this with the current rally since the rescue of Citigroup in November.

But in spring 1932 gold started flowing out of the US, as foreign investors were convinced the dollar would be devalued, and this sparked a devastating sell-off in US stocks. By midsummer (at what turned out to be the bottom of the bear market), the S&P was down 50 per cent from its high for the year.

For 2009, a renewed run on the dollar is quite conceivable. Another fear is that investors grasp the scale of the damage to corporate profits only in the next few weeks, and this sparks another sell-off. Brokers’ forecasts suggest the scope for serious disappointment is real – and conceivably even enough to drive a sell-off like the one of early 1932.

In July 1932, optimism suddenly took hold that the economy was improving. This, according to Russell Napier’s definitive book Anatomy of the Bear, was based largely on evidence that deflation was coming to an end. The result: stocks gained 111 per cent in two months. Then in September they staged another sell-off as it became clear the economy was not out of the woods, and fell 25 per cent from there to the end of the year. Overall the index was down almost 15 per cent for the year but it never went back to its July 1932 lows.

How could this be repeated in 2009? An explosive rally at some point is possible, simply because record amounts of money are sitting in bonds and cash. And, as in 1932, what might move that money in a hurry would be a clear sign that inflation was returning. At present the risk is deflation and governments are actively trying to engineer a return to inflation: if that were to happen, bonds and cash would become horrible assets to be in, and so the chance of a race at the first sign of inflationary pressure is real.

As in 1932, when economic hope proved illusory, it is possible that could be a false alarm. But in these conditions, even a false alarm could spark a big rally. As for fundamental valuations, long-run indicators that have signalled market turning-points most successfully in the past, such as the multiple of stocks to long-term average earnings, suggest stocks are fairly valued, whereas they already looked cheap in early 1932. A drastic sell-off like the one in early 1932 would help address this.

The precondition for a sustainable rally is that share prices fall to a level where investors are widely convinced they are cheap. As 1932 demonstrated, getting there could yet involve a lot more pain. But it is fair to hope that we get there this year.

The writer is FT investment editor

More columns at www.ft.com/johnauthers