The Depression of 2008? Don't Count on It

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http://online.wsj.com/article/SB122272238714287459.html

The Depression of 2008? Don't Count on It

by Jason Zweig-Wall Street Journal


Wall Street is dead.

Whether it was murder or suicide is beside the point: Wall Street as it has operated for the past 75 years has been obliterated in a matter of weeks. And witnessing this violent death in broad daylight has traumatized investors everywhere.

The Wall Street domino has toppled just about everything in sight: U.S. stocks large and small, within the financial industry and outside of it; foreign stocks; oil and other commodities; real-estate investment trusts; formerly booming emerging markets like India and China. Even gold, although it has inched up lately, has lost 10% from its highs earlier this year. Not even cash seems entirely safe, as money-market funds barely averted a "run on the bank."

Of all the dominos that have tipped over, the most psychologically damaging collapse was the last: the very notion of diversification itself.

September 29, 2008 in New York City. U.S. stocks took a nosedive in reaction to the global credit crisis and as the U.S. House of Representatives rejected the $700 billion rescue package, 228-205. Dow Jones Industrials fell as much as 700 points in midday trading.

Every day, my mailbox fills up with messages from agonized investors who can find nowhere to hide. The most common refrain: "I've lost money on everything." If you feel this way too, you are certainly not imagining. According to the researchers at Morningstar Inc., 91% of all mutual funds in existence have lost money so far this year. To put that in perspective, in 2001 -- the year Enron imploded, Internet stocks kept crashing and al Qaeda attacked the U.S. -- more than one out of every three funds still managed to generate positive returns.

How much worse might things get? Is there any way to prevent Wall Street's death from taking you out too?

Let's consider some of the arguments that have been surfacing lately.

"We're going into another Great Depression." The failure on Monday of the U.S. House of Representatives to pass the bailout plan makes those G-D words seem possible for the first time. But I don't think another depression is likely, for two reasons.

First, when you spend time studying the Crash of 1929 and the depression that followed, what stands out the most is the dearth of doomsayers. Even Roger Babson, the economist known to posterity as "the man who called the crash," did no such thing; he forecast only a 15% to 20% drop, not the apocalypse that actually occurred. Depressions start not when lots of people are worried about them, as we have today, but when no one is worried about them, as in 1929.

Second, the Great Depression and the Panic of 1873 (which triggered what arguably was the worst depression in U.S. history) both occurred before the Federal Reserve Bank had aggressively grown into its role as "lender of last resort." In the wake of 1873, after a railroad-building boom had swept the nation and then gone bust, companies and consumers alike were left gasping for capital. Nothing but the passage of time could supply it; the Fed would not be established until 1913. After the crash of 1929, when the Fed was still weak, years passed before the federal government could flood the economy with cash.

Today, however, the resolve of the Fed is not in question; nor is there any doubt that the Treasury Department is willing to provide the financing it takes to get the economy moving again. Furthermore, U.S. nonfinancial companies have just under $1 trillion in cash on their books. Even though Wall Street is dead, innovation is not: In the months to come, clever new financial go-betweens will spring up and find a way to get that cash flowing again. It's hard to see how a depression could get under way when so much capital is waiting in the wings.

"Diversification is dead." There's an old saying that the only things that go up in a down market are correlations -- the tightness of the linkages among various assets like U.S. and foreign markets, stocks and bonds, commodities or real estate. Normally, one asset will tend to zig while another zags. But in bear markets, they converge -- and in really terrible bear markets, they move in complete lockstep.

That's what is happening now, but it will not last indefinitely. It never does. While diversification does not work all the time, it does work over the course of time. There's nothing wrong with raising a little cash if that would prevent you from panicking completely.

This is particularly true for retirees. Whittle down your stock position gradually, in baby steps -- say, 1% at a time -- not in one fell swoop. And set a limit beyond which you will not go; otherwise, when stocks stage their inevitable recovery, you will miss out.

"Investors hate uncertainty." Well, that's just tough. Uncertainty is all investors ever have gotten, or ever will get, from the moment barley and sesame first began trading in ancient Mesopotamia to the last trade that will ever take place on Planet Earth.

If tomorrow were ever knowable with absolute certainty, who would take the other side of a trade today?

The financial future is no more uncertain now than it used to be; in fact, it's far less uncertain than it was in the summer of 2007, when the Dow shot above 14000, the future seemed bright, and utterly no one foresaw the disaster that would befall the financial system. The absolute certainty of blue skies ahead was an illusion then, and the notion that we all know that worse misery lies in store is an illusion now.

The only true certainty is surprise.

You've probably spent a lot more time worrying about negative than positive surprises lately. But we could get surprised on the upside by a further fall in oil prices, a kick from low interest rates -- and, of course, untold other possibilities that no one can foresee.

Whatever happens with the bailout, don't bail out.