Weekly Economic Update 08-04-2017

The Crash of 1929 and the Next Recession

This summer I have been studying the monetary policy of our country. Most texts focus on the 1920’s and, as I mentioned in the video portion of my last weekly update, it concerns me that we are following the same path that led to the Great Depression. This is why legendary investor Jim Rogers has said the next downturn will be the worst in our lifetimes, why Warren Buffett is holding huge amounts of cash in his investment portfolio, and the reason Mark Yusko of Morgan Creek Capital is warning everyone that things are looking like the 1920’s all over again. It’s important, then, for us to understand the history of the monetary policies throughout the 1920’s and how they compare to the policies of today. Then an informative decision can be made about whether you think the economy is going to boom or if it’s on the cusp of a big bust.

The story begins in 1923 after World War I. The United States held about 4.5 billion dollars in gold reserves, which was a large amount, considering the four top economic powers combined held about 6 billion in gold reserves. This means the United States commanded 75% of all the gold. Since we were on the gold standard, the more gold you had, the more currency you could print. Being on the gold standard means that a country can print a certain amount of currency for every ounce of gold in reserve. This was a problem for the U.S. because we had so much and a problem for the other countries who had so little. Those with less couldn’t print as much money, which made their recovery slow and painful.

In the early 1920’s the Federal Reserve was formed. To say that the Fed from the 1920’s didn’t know what they are doing is an understatement. They were basically making things up as they went. There was no real basis for monetary policy, so they created policies that they hoped would work.

To help Europe emerge from the war the Fed lowered interest rates so those other countries could borrow money to rebuild. Those low rates led to a U.S. economic boom. A bull market in stocks began in 1921 that ran all the way to 1929. But, before that happened, in 1924 the economy experienced a mild recession. To alleviate that problem, the Fed lowered rates and it worked. Between 1921 and 1925 the Dow Jones Industrial Average (Dow), which was the main index at the time, doubled in value. By 1925 earnings were exploding as well and were double the amount they were in 1913. Things were looking good.

However, there was cause for concern. The amount of margin debt, or amount of money investors have borrowed against their brokerage accounts to buy stock, went from 1.1 billion to 2.2 billion dollars by the end of 1924 and was on track to reach 3.5 billion dollars by the end of 1925. Investors were leveraged, but nobody sounded the alarm.

The Fed and the other central bankers around the world believed that it was necessary for the United States to keep interest rates low. By keeping rates low, the European countries could borrow from the US to rebuild their economies. And because the Fed believed it was important to rebuild Europe, they kept interest rates at a low level for a long time. The Federal Funds rate, or bank-overnight-loan rate, would hold at 4% despite repeated calls to raise rates.

To the central bankers at the time this policy made perfect sense. By keeping rates low in the United States, European countries could borrow money at a low rate to rebuild their countries. As economies recovered, it would attract capital and with that capital would come gold. As their gold reserves grew, they could print more money to further expand their economies. Once the gold reserves were redistributed, the Fed could then raise rates. It seemed like a good idea, but it didn’t work.

By 1927 the Fed lowered rates to 3.5%. The Dow continued its run and was up another 20% that year, even though profits fell. Nobody seemed too concerned about profits because stock prices continued to rise. By 1928 the amount of margin debt had exploded to 4.4 billion dollars. There was growing concern that all this leverage wasn’t a good idea, so the Fed hiked rates from 3.5% to 5%.

The stock market responded by nearly doubling over the next 15 months. Only a few companies were driving the market, but nobody cared. Wall Street interpreted the rise in interest rates as a sign of confidence and money poured into the stock market from all over the world causing our gold reserves to increase. It was in the later stages of this doubling that a record number of brokerage accounts would be opened. While this is often interpreted as a sign of higher stock prices to come, the public always buys the most at the top. Always.

In 1929 the Fed had raised rates to 6%. The stock market kept rising on the backs of an increasingly smaller number of companies. One-third of all stocks had fallen 20% by this point, but it went largely unnoticed because the Dow continued to rise.

In September 1929, the system would start to break. The business empire of Clarence Hating broke apart. Investors would lose 70 million dollars.

On October 23, 1929, large sell orders hit the market from all over the country. The Dow fell 20% in one hour. Radio Corporation of America (RCA), which was one of the biggest winners of the stock market boom, fell 35% in that hour. The Fed responded by pouring tens of millions of dollars into the banks, but it wasn’t enough. On October 28, 1929, also known as Black Monday, more selling hit the market and the Dow dropped 14% that day.

The Fed continued to ease in hopes of calming the markets, but they were ineffective. In a six-week period from the peak, the Dow fell 50%. The money supply contracted by one-third. At the time, the news said the fall in the market wouldn’t have widespread repercussions on the economy and that life would continue as normal. But it didn’t. Economic activity tumbled and workers were laid off. The U.S. soon thereafter entered a recession.

As margin debt continued to unwind it put further selling pressure on stocks. The Fed continued to respond by pumping more money into the banks and by lowering interest rates from 6% to 2.5%, but it had no effect. In a two-and-a-half-year period, the Dow fell nearly 90% from its peak; almost 50% lower than where it was at the beginning of 1921.

Later, fingers were pointed at the United Kingdom, who ended up raising rates to counteract all the money flowing out of their country into the U.S. stock market. Others blamed the Fed for keeping rates too low for too long which created a huge asset bubble. In the end, the efforts of the central bankers to stabilize the world’s economy by printing money and artificially keeping interest rates low left the world in a worse place.

On to the comparison…

In September 2008, Leaman Brothers failed and filed for bankruptcy, which I believe is similar to the Hatings failure in 1929. Both sent the financial markets into turmoil which will eventually lead to a recession, or did lead to a depression in the case of the later. The collapse of Leaman in 2008 nearly caused the entire banking system of the United States to fail. Had it not been for the Fed intervening, things would have been much worse.

The mistake that the 1929 Fed made was not injecting enough money into the system fast enough. The 2008 Fed didn’t want to make that same mistake, so they injected 4.5 trillion dollars over an 8-year period. Rather than deal with the problem of the debt, the 2008 Fed decided to monetize it by swapping the bad loans on the bank balance sheets for U.S. Treasuries. This was done with hopes to inflate the bad debt away. In a sense, they swept the bad debt under the rug, but it still exists on the Fed’s balance sheet! Now we have even more debt than we did in 2008 and the economy is struggling. The 2008 recession was caused by too much debt and now we have even more debt!

Recall, the 1929 Fed tried to prevent the market crash by pumping money into the economy and lowering interest rates, but it didn’t work. Every leveraged economy or market reaches a breaking point where the problem can’t be solved by printing more money. It’s at that point it collapses in on itself.

In 1929 there was a record amount of margin debt and now, in 2017, there is a new record amount of margin debt. Today you can borrow up to 50% of your account value, but in 1929 you could borrow 80-90%. Leveraged markets always peak when the amount of margin debt peaks.

Despite being referred to as the Roaring 20’s, one aspect that didn’t roar for most people were wages. While wages increased in the 1920’s, the wages for the wealthiest far outpaced everyone else. Today we have the same problem. Wage growth for the bottom 90% has been stagnant for decades, meanwhile, the top 10%, and even more so the top 1%, have seen their wages significantly increase.

The recent stock rally has been led by a very small number of stocks. Three companies in the Dow, which represents 10% of the 30 stocks in the index, have accounted for 50% of its recent increase. This is no different than in 1929 when the Dow reached its all-time high on the back of a small number of stocks. When markets rise on the backs of a small number of stocks, the next correction is usually quite severe.

The investment vehicle of choice in the 1920’s was something called an “Investment Trust.” An investor would buy shares of an Investment Trust that would, in turn, use that money to buy stocks. Some Investment Trusts even bought shares of another investment trust. The best part is that investors could leverage their money on margin to buy even more. Today we have Exchange Traded Funds (ETFs) that investors purchase shares of and that money is used to buy stocks. And as you probably guessed, investors can buy ETFs on margin. Even better, some ETFs invest in other ETFs and some allow you to buy a two-to-four-times leveraged position on the major indexes, also on margin.

Right before the bubble burst in 1929, a record number of brokerage accounts were opened. In the first half of 2017, a record number of brokerage accounts were opened. As I said earlier, the public always buys at the top and sells that the bottom.

As far as earnings and profits go, stock prices usually follow profit. By the late 1920’s profits were growing at about 11% per year, but stocks had been growing at 20% per year. They were completely detached from one another. Today we face the same issue. Stock prices continue to rise where earnings are growing slightly and profits are declining. This is not a trend that can continue indefinitely.

By the end of the 1920’s bull market, the trading volume for the Dow, or number of shares trading hands each day, had been steadily rising until it reached 5 million shares a day. This is how Bull markets should work. Trading volumes should increase up to the peak of the market based on demand. Over this past eight years this market has seen the opposite happen. Trading volumes have been falling and are now trading about the same number of shares per day as the market did back in 2005. What makes this market different is that demand has been falling as stock prices have been rising. Usually prices rise as demand rises, but in this market, new buyers are paying a premium.

The biggest mistake the 1920’s Fed made was holding interest rates low for too long. Low rates led to a leverage-fueled stock market bubble that eventually burst. From 2009 to 2015 the Fed maintained a Zero Interest Rate Policy and, more specifically, due to Quantitative Easing 3 (QE3), the Fed created a huge asset bubble in stocks and certain sectors of the real estate market.

Leveraged markets need an ever-increasing amount of money (or buyers) to keep rising. As long as the money supply is rising and credit is flowing, things are good, because leverage comes at a cost. There’s a cost to borrow to flip a home just like there’s a cost to borrow on margin to buy more stocks. As long as asset prices are appreciating, everything is good. When asset prices flatten or decline, it turns into a major problem.

Every recession since the Fed started manipulating the monetary policy has been precipitated by a fall in the money supply and a contraction in bank credit—both of which are happening now. While I can’t say for sure when this bubble is going to burst, I can say that when you consider this bubble is built on leverage and debt, when it does burst, it will be spectacular.


Introducing Portfolio Shield™

Portfolio Shield™ is an algorithmic-momentum portfolio strategy. It’s strategy I developed that can match or outperform the S&P 500, all with less risk, over a three, five, ten and fourteen-year period.

Does it Work?

Yes! Using my algorithm, I back-tested the strategy using real market data from the S&P 500, using Morningstar® to validate my results, from the years 2003 to the present month. The results exceeded my expectations!  The Portfolio Shield™ Strategy beat the S&P 500 by a wide margin on a three-, five-, and ten-year annualized basis, with less risk.

What is the Algorithm?

An algorithm is a procedure for solving a mathematical problem. In this case, on the first trading day of each month the Portfolio Shield™ algorithm takes the cumulative 6-month return of the S&P 500, Nasdaq-100, Russell 2000, and a long-term US Treasury bond fund, and sorts them based on the highest to the lowest return. The formula then takes the top three based on their cumulative return and applies a proprietary formula to determine the weighting in the portfolio. The algorithm is run on the first trading day of each month and the portfolio is adjusted accordingly based on the algorithm.

How Can This Possibly Work?

The strategy is designed to allocate itself to the S&P 500, Nasdaq-100, and Russell 2000 when the equity markets are rising. When the equity markets slow down or start to correct, the algorithm adjusts and replaces one of the equity positions with the long-term US Treasury fund. The Treasury fund acts as a brake to reduce the downside risk of the portfolio when stocks go down. This works because frequently, when stocks fall, bonds rise. The bond allocation has the potential to offset a large portion of the fall in equity prices. Once the risk levels subside, the algorithm adjusts the portfolio back to the three equity funds.

Is the Data Accurate?

The data and analytics are provided by Morningstar® who is the premier provider of data for the finance industry.

Portfolio Snapshot

Linked in this e-mail (and on my website) is the most recent portfolio snapshot in PDF form for August with all the historical returns. Be sure to watch this week’s video for an explanation of the information included in the snapshot.

When Will Portfolio Shield™ Be Implemented?

The strategy will be implemented when the algorithm can be successful. It doesn’t work well at market peaks. It wouldn’t make sense to buy into this market right now given how high the valuations are relative to the norms. I believe the appropriate time to implement the strategy will be at the bottom of the next correction or closer to the bottom of the next recession.

How Did YOU End Up Creating This?

Portfolio Shield™ is a combination of ideas; mostly mine but some from other strategies.

Does a Similar Strategy Exist?

No. Portfolio Shield™ is unique to Atlas Financial Advisors, Inc. and my clients.

Will This Prohibit Us from Investing in Gold or Gold Miners

Not at all! The next financial crisis will create incredible opportunities in certain asset classes, gold being one of them, and I intend to take advantage of them.

Portfolio Shield™ investment detail explanation is in the middle of the video update.