The Wall Street Journal ran a story yesterday entitled, "Central Banks are Creatures of Financial Crises" in which Justin Lahart showed a graphic that has been popping up from time-to-time over the last four months. It is a picture of the DJIA today mapped on top of the DJIA from the Great Depression with the peak levels lined up and normalized to 1. The story goes that the current downturn in stock prices looks a lot like the Great Depression, therefore we are at risk of a depression in the current crisis. I thought this might be the fallacy of cum hoc ergo propter hoc in that the Dow probably drops like it has currently in all recessions (including the Great Depression). But the graph below has changed my mind.
Before you're overwhelmed by the 14 different series charted in the figure above (see Art Carden's piece on graphical presentation), a short explanation makes it much easier to read. The figure plots the Dow Jones Industrial average over the last 14 recessions. In particular, it plots the six years surrounding the peak DJIA level during the recession (2 years before and 4 years after) and normalizes the level to 1 at the peak and sets the time equal to zero. The two lines that are important are the bold black line (the 6 years around the first downturn in the Great Depression: 1927-1933) and the bold lime green line (the last four years). I call this figure a Normalized Peak Plot.
The key characteristic that jumps out of the figure at me is that the downturn in stock prices over the last year of our current recession (down 60 percent in about a year) is very bad compared to the last 14 recessions. In fact, the only steeper decline in prices was the Great Depression. If stock prices are a good indicator (and this is a big if), then we are certainly at risk of the most prolonged downturn since the Big One in the early 1930s.
Another interesting property from the figure is that the distribution of how stocks recover after a recession is roughly symmetric. During the average recession, stock prices return to their peak levels after about 3 years and are up by around 10 percent after 4 years. However, the bad news is that, excluding the Great Depression, the worst stock performance four years after the stock peak is prices 60 percent off the peak level. This was the case in the 1937 recession. If you consider the 1937 recession as part of the Great Depression, then the next worst stock performance was after the 1973 and 2001 recessions, each of which had stock prices that were between 80 and 85 percent off their prior peak four years after the peak.
In summary, the current stock situation looks like it might actually be worse than all other stock declines since the Great Depression. However, the response of the market to the waves of stimulus being administered by Congress and by the Fed wil be critical to how long it takes for equities to recover. Hopefully, the Dow can keep treading water above the 8000 level until something good takes hold on the economy...sooner than later.
The key characteristic that jumps out of the figure at me is that the downturn in stock prices over the last year of our current recession (down 60 percent in about a year) is very bad compared to the last 14 recessions. In fact, the only steeper decline in prices was the Great Depression. If stock prices are a good indicator (and this is a big if), then we are certainly at risk of the most prolonged downturn since the Big One in the early 1930s.
Another interesting property from the figure is that the distribution of how stocks recover after a recession is roughly symmetric. During the average recession, stock prices return to their peak levels after about 3 years and are up by around 10 percent after 4 years. However, the bad news is that, excluding the Great Depression, the worst stock performance four years after the stock peak is prices 60 percent off the peak level. This was the case in the 1937 recession. If you consider the 1937 recession as part of the Great Depression, then the next worst stock performance was after the 1973 and 2001 recessions, each of which had stock prices that were between 80 and 85 percent off their prior peak four years after the peak.
In summary, the current stock situation looks like it might actually be worse than all other stock declines since the Great Depression. However, the response of the market to the waves of stimulus being administered by Congress and by the Fed wil be critical to how long it takes for equities to recover. Hopefully, the Dow can keep treading water above the 8000 level until something good takes hold on the economy...sooner than later.
What happens to this graph if you control for inflation? Yes, stocks plummeted during the Great Depression, but if since prices fell some 25%, the real value of stocks wasn't nearly as low as one might think.
Good question. But it might be mitigated by the fact that inflation pressures are usually very low (near zero) over the time periods around a recession. So I would guess that this figure is not too far off even though it ignores inflation.
The Great Depression is clearly an exception to that rule. In fact, I would guess that controlling for inflation would make the current downturn in stock prices look potentially worse than the Great Depression. Thanks for that downer.
In what ways is the economy different for the green line than the salmon line just below it (maybe the 1955-1961 recession, but it is hard to tell)? 1955 showed a quicker drop in the DJ that quickly flattened whereas the green line is flatter at first and then drops steeply. Of course the current recession has the capacity to become much worse than the 1955 recession since it is not yet over.
By plotting six-year sections around the peak stock prices at the beginning of NBER-determined recessions, I am holding some things constant. One thing that is not controlled for is length and severity of each recession. I'm sure there would be less variance in recoveries if I only included recessions that were at least 9 months long (I just pulled an arbitrary number out of the air). But I still think this picture is instructive and interesting.