Brent Sheather: Dealing with economic depression

In this second instalment of a two-part series on how the 1929 sharemarket crash affected investors, we look at how Aunt Daisy fared. The first article dwelt on Uncle Sam, who had the resolve to stand up to the bear and make it out the other side alive, savings intact.

It is August 1929, the top of the bull market and lucky Aunt Daisy has just retired. Taking the advice of her certified financial planner, she has invested all her hard-earned US$50,000 in the stockmarket. Fasten your safety belt, Daisy.

Whereas Uncle Sam was interested in total return (capital gain plus dividend income), Daisy is primarily interested in cash dividends because she intends to live off her capital and reluctantly leave the residual to her three useless children who spend all day sleeping and all night dancing.

Now the scary thing about the 1929 sharemarket crash (compared with the 1987 crash) was that it was followed by a depression where growth and inflation went into reverse and millions of people became unemployed.

J. K. Galbraith writes in the Crash of 29: "A common feature of earlier stockmarket crashes was that having happened they were over. The worst was reasonably recognisable as such.

"The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning."

When the economy turned down, company profits plummeted so Aunt Daisy's dividend income fell precipitously. But if you owned the market portfolio, every listed company weighted according to its size as index funds do and Aunt Daisy did, dividends didn't disappear completely.

Analysis of the actual historic dividends paid for the period shows that Aunt Daisy's income from stocks did not dry up. Sure it halved in 1932 and it was volatile but, over the 15.5 years, it was about equal to the income from a government bond portfolio and more than three times that from short-term treasury bills (a proxy for bank interest rates).

The dividend yield on US stocks stayed reasonably constant over the period at 4 per cent to 7 per cent - however, this yield was on a rapidly diminishing capital base.

In fact, Aunt Daisy's children received less than half, in nominal terms, of the amount that she originally invested some 15 years previously.

Most people would consider 15 years as long term, but even that time period wasn't enough for Aunt Daisy to get her initial capital back.

One of the most amazing things about the Depression era was that short-term government stock rates - a close proxy for bank rates at the time - plummeted after 1929 and averaged less than 0.5 per cent a year in the period from 1932 to 1947.

If the history of the 1930-1940 period has one fundamental lesson, it is the attraction of long-dated government stock in a depression. Many banks went bust in the 30s so there are no prizes for guessing what happened to finance companies lending to the entrepreneurs.

Sensibly constructed investment portfolios must be robust enough to cope with all economic conditions ranging from inflation to deflation.

The risk of this latter phenomenon, a fall in the general level of consumer prices, presents investment advisers with an overwhelming case for including some long-term, low-risk bonds in every client's portfolio.

Deflation, if sustained, would put highly geared companies under huge pressure as the real value of contracts fixed in money terms would be increased, just as inflation reduces them.

During the past 20 years or so, the biggest threat to most New Zealanders' wealth has come from inflation so investors have been conditioned to concentrate on the risk of increasing, rather than falling, prices.

In an environment of high inflation, high tax rates and low real interest rates, the most appropriate investment response has been to borrow heavily and invest in assets with a proven inflation-proofing ability such as residential property. Deflation requires an entirely different investment strategy where security of cashflow is paramount and debt is minimised.

Lessons from the 1929 crash:

* Hold a diversified portfolio including some long-term government bonds.

* Diversify your equity portfolio. Holding only 10 stocks is asking for trouble.

* Gearing either via options or margin trading is a risky strategy.

* Don't panic. Things eventually will get better. Probably.

* Brent Sheather is a Whakatane-based financial adviser.