What If We Were in a Great Depression?

Let's play this week's favorite parlor game: Are we in another Great Depression?

History may never repeat itself exactly, but you wouldn't know that from the spate of recent articles comparing our current economic plight to what has been described as the worst economic contraction since The Plague. I confess to a certain grim fascination with the subject, which has had me brushing up on my American history. It's fascinating reading, even if you don't have to get very far to recognize that the comparisons are pretty off-base. There's no doubt the global economy is undergoing tremendous stress with likely far-reaching and still indiscernible consequences, but the Great Depression this is not.

This seems so obvious that I'm not going to dwell on the well-intended but seriously misguided economic policies that made the Great Depression so bad, and recent steps that should help ease the stresses that have developed this time. But for the sake of our parlor game, let's cast all that aside. Let's say we are in another Great Depression and that markets will be every bit as bad as they were then. What should investors do?

For stock investors, the headline for the Great Depression is usually that the S&P 500 index lost 86% of its value, falling from 31.86 on Sept. 16, 1929, to 4.40 on June 1, 1932. Obviously, it was a terrible time to be holding stocks.

The early years of the Great Depression were marked by deflation, or falling prices, a relatively rare occurrence during which bonds traditionally outperform other investment classes, since their interest payments buy an ever-increasing number of goods and services. It's the opposite of inflation, when the value of fixed interest payments is eroded. U.S. Treasury bonds also offer the comfort of almost risk-free returns. For the same reason, even cash does well in a deflation.

So it seems obvious that if we are again in a Great Depression, the place to be is Treasury bonds and cash. Given the global flight to safety, the stampede into Treasurys, and even reports that people are stuffing their mattresses with cash, that's certainly how investors are behaving.

So let's test that hypothesis. It's important to recognize that we're now nearly a full year into the current bear market. It's 2008, not 2007. The S&P 500 has already fallen about 45% from its peak, which is more than half the decline of the Great Depression. Back then, the S&P 500 had declined by nearly the same amount by Sept. 26, 1930, almost exactly a year after the index's then all-time high. That's eerily similar to now, since the S&P 500 peaked about a year ago.

If you bought stocks at that point in 1930, you faced a further severe decline. Stocks had another 40% or so more to drop, but that's a much higher percentage of the price you just paid. Measured from 1930 to the low in 1932, the S&P 500 lost nearly three-quarters of its value. No one would've patted you on the back for having astute timing, even though you missed the entire first half of the collapse in stock prices.

But look what happens as the years passed: Based on data compiled from the Federal Reserve, $100 invested in stocks on Jan. 1, 1928, was worth $98.75 by the end of 1930. Five years later, at the end of 1935, they were worth $110.18, a 12% gain. Ten years later, at the end of 1940, during the darkest days of World War II, they were worth $107.37, which was still a 9% gain. And if you held the stocks for 20 years, they were worth $355.60, a nearly 260% rise.

Cash, of course, appreciated little. Short-term Treasury bills rose 5% from the end of 1930 to the end of 1935, and were just a hair higher by the end of 1940. Twenty years later, at the end of 1950, T-bills had gained just 11%. Ten-year Treasury bonds fared better over five (22%) and 10 years (49%), but over the 20-year period they returned 81%, far shy of stocks' 260% climb.

Now let's continue with our assumption that things are as bad now as the Great Depression, meaning the S&P 500 has another three-quarters decline ahead of it. Let's say you bought stocks at the end of 1932, when things looked their bleakest. Five years later, at the end of 1937, stocks had gained 86%; in 10 years 120%; and in 20 years 926%. Comparable numbers for 10-year Treasurys are gains of 22%, 41% and 75%, respectively. In other words, stocks substantially outperformed bonds in each period.

What are the implications for investors today? I'll leave you to play your own version of the parlor game and draw your own conclusions.