Is It Just Recession or The Greater Depression?

Are we having a normal economic recession or is this the next Great Depression? The answer to this question will literally determine your investment strategy for the foreseeable future.

Why? Because investment strategy today is necessarily a top-down process. What that means is you begin your analysis with the macro-economic picture and drill down to industry, company, and investent specifics. In other words, you start with the economic climate – recession, depression, or recovery – and work your way down from there. The reason it is necessary to invest from a top-down perspective is because all investments are essentially a bet on the macro-economy these days.

The current investment climate  is not business as usual. In normal times you can find pockets of opportunity in any economic environment by focusing on non-correlated assets, but in todays investment climate all assets are correlating. Everything is being driven by the global liquidity crisis/credit crunch and all ships rise or fall on the success or failure of government policy to halt the mass liquidation.

As a result, a lot has been written in recent months about economic recovery since economists and investors widely recognize the economy as the critical investment question of the day. Is the government liquidity machine adding enough to offset the destruction of credit? Is the worst over? It seems everyone wants to be the genius that calls the bottom. As my long-time readers have probably guessed, I disagree with that whole line of thinking.

Nobody can predict the future reliably. I have written extensively on this issue here. All you can do is understand the current data and its potential implications. Fortunately, that is good enough for investing.

To understand the current economic data forget all the forecasters and just look at the facts. A great resource that compares the actual economic data for this current decline to the Great Depression can be found here. The link takes you to Voxeu.org, which contains original academic and economic research. It is primarily for financial nerds like me, but occasionally it offers a user-friendly article with original research worthy of you, my cherished readers.

This particular article qualifies because it simply compares the current economic decline to the Great Depression using a variety of economic measures. The data speaks for itself. The message is quite clear. The authors provide some commentary to explain what the charts clearly communicate, but there is not a lot of text because not much is needed. It is a quick read and user friendly with a minimum of economic jargon.

The reason this article is important is because the data clearly shows the current credit collapse is driving a recession that is comparable to its most recent analogue – the Great Depression. Most economic data series are performing as bad or worse for the same point in time as the Great Depression: the only exception being those data series controlled explicitly by government (money supply, short-term interest rates, etc.).

So that is the macro-economic investment backdrop you are investing under – it is the beginning of your top-down investment strategy analysis. While most people want to guess at a bottom I will stick with what the facts tell me is actually happening: we are in the midst of a deflationary decline driven by a banking and credit collapse which is similarly driven by the collapse of the housing bubble. Notice that the whole thing is driven by the housing bubble collapse – that is a key point which we will discuss later in this email series. The cause, the cure, and the investment opportunity will all be related to the housing bubble.

Again, check out the article here and look at the data yourself. Come to your own conclusion.

So the top-down analysis tells you that we are somewhere in the midst of deflationary economic collapse right now. The government is trying everything it can to re-inflate the bubble, but the data clearly shows no measurable success yet. 

This is an extremely important point. It should become the sunglasses through which you view every investment decision. Investing during a deflationary decline is a rare event. Inflation is the norm. Stability is the norm. Instability and deflation are rare and they have serious implications for investment strategy. Indications from past data can mislead when the macro investment environment is fundamentally different from the past (see this post for an example). During deflationary collapses cash and cash equivalents rise in value relative to other assets which decline both in nominal and inflation adjusted terms. Those are the primary investment implications of deflation.

However, at some point deflation will have run its course and the worst will be behind us. At that point you will want to switch from cash and cash equivalents to assets that benefit from inflation. That is where the above reference to the housing bubble collapse takes on importance.

In future posts over the next few months I will introduce you to some resources specifically oriented toward real estate investing as one potential investment choice to consider when this deflation has matured. For a variety of reasons, I believe real estate will represent an unusual value for a long-term hold beginning sometime in the next 1-3 years. For that reason we will begin exploring resources to help educate us on picking a reasonable risk/reward entry point for building a real estate investment portfolio while also developing strategies to build that portfolio. Best of all, you will get to learn right along with me through these posts.

So stay tuned over the next few months as I develop this theme. I hope this series of posts helps you with your investment decisions and provides useful tips that advance your investment skills to the next level. Please tell your friends so that we can expand our community. The more input the better.

These are rare times we live in. Let's make the best of them.