Great Depression, Great Recession: What 1929 can teach us about 2009

How do you commemorate the worst stock market crash in history? With the news that another devastating economic implosion may be nearing its end. That's where America finds itself on the 80th anniversary of the Great Depression -- reacting to the first positive GDP numbers in a year, slowly pulling itself out of the Great Recession, and looking for ways to make sure the country doesn't wind up mired in a decade of dismal economic conditions similar to the one that began 80 years ago on Oct. 29, 1929.

Analysts and market watchers have been comparing the two meltdowns all year, and investors can take note of the similarities in their causes as they consider how to navigate their portfolios through the aftermath (we hope) of the most recent one.
The 1929 crash is infamous for the 12 percent drop the markets took on Oct. 29 and the 89 percent slide the Dow Jones Industrial Average took over the three years that followed (falling from 381 to 41). The 2008-2009 crash was swift, but not as steep a drop – the Dow declined about 45 percent over seven months, before beginning an ascent in March that took it back above 10,000 in recent weeks.

David Adler, an expert on behavioral finance and author of Snap Judgment, points out that the key similarity between the two crashes is that in both cases investors were overleveraged. In 1929, investors were overleveraged primarily through the use of margin accounts, which weren't regulated then. In the 2008-2009 crash, investors were overleveraged through the use of loans and risky mortgages.

"Whereas the 1929 crash involved overleveraged stock speculators, the more recent crash involved overleveraged homeowners and investment banks," said Adler, adding "And right now the U.S. government is overleveraged and heavily in debt."

To safeguard investors and the markets after the 1929 crash, tighter banking regulations were enacted. Margin accounts were regulated to prevent investors from borrowing their way to ruin. The FDIC was established to insure bank deposits and restore confidence in the markets. The SEC was created to fight corruption in the stock markets. And the precursor to Fannie Mae was created to stop the need for short-term lending that had also played a role in causing people to be overleveraged during the 1929 crash.

Diane Swonk, chief economist of Mesirow Financial, doesn't expect investors will see the federal government acting to protect their interests with the same level of regulatory reform this time around.

"The policy response [to stop the market slide] was pretty swift and dramatic, but the change in regulation in terms of the structure of our financial services industry has yet to really take its full form," she said. "Although we're seeing things come out piecemeal right now, the type of seismic shift you saw coming out of the Great Depression, we have yet to see."

So the markets lose 45 percent in seven months and regulators don't see a need to change anything? In Swonk's opinion, because fiscal policy was handled better during the current crash and markets rebounded quickly, regulators are probably more inclined to add a few new rules or reinforce rules already in place, rather than do a major restructuring. The Great Depression was different in that it lasted about ten years: "Partly because it went on for so long, it forced us to make much more dramatic changes in the way financial markets were structured," Swonk said.

So with few major regulatory changes coming and a rocky recovery on the horizon, where is the investor left? Speculation is still a problem, pushing up the price of everything from stocks to gold to oil. And both Inflation and deflation lurk as dangers.

"With inflation from the government debt and the decline of the dollar a major threat, investments that protect against inflation such as TIPS [Treasury Inflation-Protected Securities] are a good bet for part of your portfolio," advised Adler. "This will allow you to take more risks with the remainder of your portfolio, with diversification among asset classes -- foreign equities; U.S. equities; commodities; global bond funds -- still critical to investment success."

Swonk encourages investors to stay invested and stay the course. "I am long in equities, but I'm not buying as much right now because the market is correcting at the moment," she cautioned. "But in a year from now, do I think the market is going to be higher than it is right now? Absolutely."

And she had a prediction: Even with all the failures and all the scrutiny they've endured this year, bank on the banks. "Banking is the place to make a lot of money over the next couple of years -- the spreads are there, they've got the capital -- the ones that want to make it are going to make it really big."

How ironic that the industry many blame for pushing the country into the Great Recession could be the one that may benefit most as we're coming out of it. Happy Anniversary, everyone.
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