Posted by Davy Bui on March 6th, 2009 in Book Reviews
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In dedication to today’s awesome bear, I continue my Blogging the Bears series. Other parts in the series:

• Part 1 contains my bullet point summary of the book and the 1921 bear market.
• Part 2 details the 1929 – 1932 bear market.
• Part 3 describes the 1949 post-WWII bear bottom.
• Part 4 summarizes the 1982 market decline.

1949 Bear Market: -24% DJIA (from highs in 1946)

The 1949 bear market was unusual in the mild nature of the decline.  The author uses an unusual method in delineating his fearsome four bears, ranking them in order of the market bottoms which produced the highest 40-year returns afterward. While 1949 market lows were higher than the lows reached in 1942, the 40-year returns for 1949 includes the bull market of the 1980s and thus bests both 1942 and 1973-74. While each of the four major market bottoms share certain characteristics, it is more a case of rhyming than repeating. Distinguishing characteristics of this bear include the following:

• The relatively small magnitude of decline in stock prices. What made this market cheap was not a drastic decline in share prices but rather, strong earnings and economic growth outstripped the stock market.
• The enlarged role of the government. The Federal Reserve was 35 years old and yet, as unpredictable as ever. The Roosevelt Administration had introduced a slew of regulations and government agencies, which changed the tenor of the economy and markets.

Russell Napier’s narrative of this time period reads like a continuation of the the previous bear market (1929 – 1932), which shouldn’t come as any surprise as they both share the context of the Great Depression and later, World War II. I repeat my suggestion to readers interested in financial history to pick up this book and read the details for themselves as it is impossible for me to suitably condense all of the details.  A few details did catch my eye:

Much like today’s media commentary, the Roosevelt administration was accused of implementing “socialism” in America and depressing share prices. Consider the following timeline:

• 1933 Inaugural Address (FDR): “the money changeres have fled their high seats in the temple of our civilization. We may now restore that temple to the ancient truths”
• Federal Home Loan banks created in 1932
• Home Owner’s Loan Corporation created in 1933
• Securities Act of 1933
• Glass-Steagall Act (1933)
• Tennessee Valley Authority created in 1933
• Federal Farm Mortgage Corporation created in 1934
• Securities Exchange Act of 1934
• Banking Act of 1935
• Public Utility Holding Company Act of 1935
• private ownership of gold is criminalized
• Reconstruction Finance Corporation (created by Hoover) becomes the largest company in the world
• Prior to FDR, the greatest non-war fiscal deficit was 0.7% of GDP. In 1932, the deficit reached 4.7% of GDP and peaked at 5.5% in 1934.

With the equivalent of today’s Larry Kudlows, Fox News personalities and the Wall Street Journal (well, WSJ hasn’t changed much since then) decrying socialism, 1932 – 1937 witnessed what Napier calls “one of the greatest bull markets in history” with markets gaining 370% against a tepid economic recovery.

The end to this upturn in the economy and markets coincided with the Fed increasing reserve requirements in August 1936. While Napier defers judgment on whether fiscal or monetary policy ended the recovery, it suggests the economy needed government support to stem its decline. The specter of WWII would intrude upon markets in May 1940 with Hitler’s blitzkrieg of Western Europe. From then on, the combination of the war effort and the Fed’s involvement in markets would heavily influence the course of markets through the bear bottom.

The Fed heavily intervened in the bond markets to support the war financing effort. This had the effect of distorting the debt markets, with the Fed fixing Treasury rates on the longest-term bond to 2.5%. The Fed continued its intervention even after the war and during this period, high-grade corporate bonds reached their all-time low of 2.46%.

Napier highlights market and Fed watchers fighting “the last war”, as they waited for price deflation and credit contractions to reach levels comparable to the post WWI period. These contractions never came, perhaps due to the inflationary bias some commentators held was now built into the system due to the lack of the gold standard among other factors. In any case, as market actors waited for contraction, earnings took off while stocks slowly drifted downward. For the period from 1932 to 1949, the last 4 years accounted for 66% of the growth that occurred over the 17 year span.

A couple key points to consider:

• Any pundit decrying Obama’s “bear market” should probably be ignored, if the FDR experience is any indication.
• The Fed’s actions and its implications are unpredictable. In fact, even if they could be predicted, Napier has repeatedly shown that Fed actions are not a reliable indicator of market bottoms in these major bears.
• Through three bears (and the fourth), Napier asserts these massive bear markets bottom in a whimper, with lows on small volume and rallies on rising volume. These major bear markets aren’t just a reduction in share prices but constitute a major shift in attitudes as investors, worn out by constantly dropping prices, leave the market. Compare this to the behavior of the 1987 crash. Keep this in mind the next time some pundit talks about a washout and capitulation.

I will finish the series with the final bear bottom – 1982.