Meeting the Cowardly Lion: Crises, Crashes, Recessions…OH MY!

Dorothy: "I don't like this forest. It's...it's dark and creepy!"

Scarecrow: "Of course I don't know, but I think it'll get darker before it gets lighter."

Are we really in uncharted territory? Upheaval in financial systems has been occurring for thousands of years. According to Yale professors, William Goetzmann and K. Geert Rouwenhorst, one of the earliest examples was in Greece around 1600 BC when farmers were unable to pay their mortgages; the landowner repossessed the properties and enslaved the farmers. A debt crisis, sound familiar? By the latter part of the 1700's financiers were already creating packages of mortgages for resale to investors. Common elements of financial crises are debt and financial innovation. Goetzmann and Geert also note that in the 20th century, there has been a financial crisis almost every 10 years. The financial disarray we are living through today has deep roots in history.

While there have been other financial crises, stock market crashes, and recessions the current one feels scary because we are experiencing it now. So much is going wrong and many of us have never seen anything like this in our lifetimes. We will briefly review where we are relative to history, and in that context, how it might help us plan and invest for the future.

As far as recessions go, the Great Depression was the worst of the recent past but not the worst ever. There were at least three depressions in the 1800's that lasted in excess of five years, compared to the Great Depression, which began in 1929 and lasted 43 months. In those months unemployment reached 25 percent and GDP (a broad measure of the growth of the economy) actually declined by that amount.

There is now a lot of talk suggesting we may be in another Great Depression. In a recent New York Times article entitled, "Expect the Worst and You May Get It" Yale economics professor Robert Shiller says, "…the Great Depression itself was partly driven by the retelling of earlier depression stories." The depressions of the 1870's and the 1890's were particularly long and grueling. His main point was that "The Depression narrative could easily end up as a self-fulfilling prophecy." As they made their way through the Haunted Forest, the fears that Dorothy, Tin Man and Scarecrow felt were much greater than the reality of actually meeting the Lion.

Just what is the difference between a recession and a depression? According to The Economist there is no widely accepted definition of a depression. However, The Economist suggests two principal criteria for distinguishing a depression from a recession: a decline in real GDP that exceeds 10 percent, or a recession that lasts more than three years.

According to a recent study, the causes of the downturn also matter. A depression is the result of bursting asset and credit bubbles, a contraction in credit and a decline in the general price level. By these measures, only the general decline in price level, or deflation, has not occurred. Deflation, in my opinion, is the more unruly problem and the actions of the Federal Reserve in conjunction with the stimulus package are designed to address the issue. If it is any consolation, I have not seen any predictions of outright depression and it is my best guess that our current recession could extend to early 2010, which would put its duration in excess of 26 months.

What about the history of stock market declines? From the peak in the Dow Jones Industrial Average in 1929 to its bottom in 1932, the average declined almost 90 percent. Since its peak in October of 2007 the S&P 500 (a broader reflection of US stocks) is down about 55 percent as of the first week of March. In Japan the real estate bubble burst in 1989. Their stock market declined about 60 percent in the two years following. It has not yet returned to its highs, but instead is still below where it was 24 years ago. Ouch!

I truly believe that the events of the last year will profoundly alter the way we save, invest, and plan for the future. We have witnessed cataclysmic moves in the markets (a euphemism for loss of wealth) and the overnight disappearance of businesses. We all know someone recently unemployed. People can't help but be impacted psychologically by such events. The fallout from these times will be felt for years to come, just as the Depression deeply affected the previous generation.

So what are we to make of all this? There are three major takeaways. First, there are many instances of crisis, crashes and recessions. They all have their own unique characteristics and occurred at unique points in history. The financial innovations, human behavior and causal events are different each time. This limits comparability. Thus the outcomes of the present situation and the time required to repair the damage will not likely be predictable.

Second, while things seem bad now, from a historical perspective, times have been much more difficult.

Third, the biggest concern is how should we invest for the future, given what we know today? Most of us have been told to live by the mantra of the long-term investor. Don't try to time the market; buying and holding quality investments is one of our best bets to grow assets over time. The historical data suggests that stocks should return about 10 percent per year on average.

The reality of investing is that we seldom see that average, or trend line. Stock returns vary wildly from year to year. A highly respected finance author, Peter Bernstein, wrote recently in the Financial Times, "Relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny? Trends bend. Trends break. Today in fact, we have no idea where any trend lines might begin, or end, or whether any trend lines still exist." It is quite possible that in the working and saving portion of our lifetimes we may not see the returns on stocks that we anticipated when we began investing.

It may sound trite, but fear and greed are still the most powerful negative emotions and we are feeling the fear right now. This is what it is like at the depths of bear markets. We lose faith; we think that we can't take it. We cannot tolerate losing one more dollar in the stock market. There may be circumstances unique to you where this might not be true, but this is where the individual investor usually throws in the towel. Bottoms in the market occur when we give up hope. One statistic I neglected to mention is that the market advanced almost 180 percent in the year after it bottomed in 1932. If you've stayed for this much pain, you might try to be there for the gain.

We need to remember the lessons of this downturn in terms of our individual tolerance for risk. Risk is an abstract concept. Advisors can only help you to assess your financial ability to take risk, not your willingness to take it, or in other words, your stomach for it. That comes from your gut, and from knowing yourself. This is a very interesting topic and will likely be the subject of an upcoming article. Self-examination on the subject of risk is highly recommended.

Finally, most of us need to do a serious review of how we are invested (another lion in the haunted forest?) It may no longer be appropriate to be invested so aggressively, particularly in light of what you may have discovered about your personal ability to take risk in the stock market. There are other ways to invest and this all continues to point to the need for diversification. Even in the stock category, there are ways to help reduce the risk of owning stocks.

To conclude, you have three choices. First, you can choose to ignore what is happening and hope for the best. This option may involve considerable worry, depending on the individual. It also suggests the lack of a plan or any strategy to get you where you want to go. Second, you could make the decision that your plan is fine and that you will take no action at this time. This is different from option number one in that you have addressed what is happening, reviewed your situation, and made a conscious decision. There is likely greater comfort in this option because you have at least examined your position. Third, you could evaluate how your current strategy has fared and discover that it has not worked well, and may not. This involves reassessing where you are relative to your goals. Therefore you need a new plan and investment strategy. I urge you all to select one of these options. I suggest that at least two of them offer greater peace of mind.