March 3, 2008 in Investing

Learning from past recessions

If the women in your life are stocking up on lipstick, it might be time to tighten the purse strings. What you’re seeing may not be a sign of vanity; it might be an economic indicator.

Leonard Lauder says that during tough times lipstick sales zoom at his cosmetics company, Estée Lauder. When recessions set in, consumers tend to forgo luxuries and big purchases. Instead they concentrate their buying power on smaller items — like lipstick — to get their retail kicks. The tendency to hunker down and spend less when times are tough also characterizes investing when the financial news is bleak.

As the ghost of real estate past haunts Wall Street and economists try to discern where the buck will finally stop, Bankrate takes a look back at trends during previous financial meltdowns and what — if anything — we learned from them.

What goes up

Randall Parker, an economics professor at East Carolina University, says economists are about 50-50 on whether a recession is on the horizon, but if one materializes or not, slowdowns in general are normal.

One of America’s first financial crises took place in 1764, when England prevented the colonies from producing paper money — a move that advanced the cause of revolution. In 1819, the country suffered a recession following the War of 1812. Although other factors were evident (most notably banks overextending themselves), Parker says it’s not uncommon for recessions to follow wars.

“Prices were already way out of line, so it was a great time to buy stocks”

In 1837, the country entered a depression that lasted until 1843, a period historians have compared to the Great Depression of the 1930s. Collapse of a large life insurance company and falling grain prices combined to spook investors at that time. Land speculation, particularly that in the projected path of the railroads, also contributed to the bursting of this bubble.

The collapse of a major banking company that was also the source of railroad funding was a contributing source to the Panic of 1873. The failure of a major railroad 20 years later would also sweep the country into panic.

Short recessions dot America’s financial landscape, but recessions are brief by nature, usually lasting from six to 18 months, and affecting all aspects of a country’s well-being, from industry to employment.

More recently, in 1973 and 1979, oil crises sparked poor economic health. The country underwent a memorable recession in 1981, leading to the bail-out of the savings and loan industry. In the early 2000s, the dot-com bubble burst, throwing tech stocks into disarray.

“Prices were already way out of line, so it was a great time to buy stocks,” Parker says of the period following the bursting of the dot-com bubble.

As for the immediate future, Parker says it’s not looking so hot.

“We’re in some awful squishy territory right now,” he admits.

We’re forever blowing bubbles

History is full of stories about investments that dropped spectacularly, taking fortunes and futures with it. One famous example is the tulip bulb craze in the mid-seventeenth century United Provinces, known today as the Netherlands.

According to the most popular version of the story (historians and economists are divided on the exact details and historical impact), tulip bulbs were imported from Turkey. Due to the tulip’s increasing popularity, prices for bulbs began to rise, eventually to ridiculous levels, which prompted a wild rush of investment.

Tulips were traded on local stock exchanges, with some fetching fabulous prices. Their increased value led to speculation. Large returns were made, but eventually the bubble burst and prices took a nose dive, no doubt leaving the Dutch sadder but wiser.

Although we like to think we’re savvier than past investors, looking at the cyclical nature of investing, it’s easy to see that the dreaded bubble is inevitable. From tulips to railroads to real estate, we’re always finding something to binge on and that leaves U.S. investors facing the aftermath of their own “burst” bubbles.

They’re not making it any more

Buying real estate is a sure thing. Not only does a real property purchase come with its own collateral, it will never lose its value.

“Real estate is a great game for pros and a not-so-great game for amateurs”

Uh, not exactly. While it’s true that real estate is generally a good investment, there’s no such animal as a sure thing. That’s where a lot of would-be investors got into trouble when the recent housing bubble burst.

“Residential real estate composite values are down about 8 percent and they’re not through yet,” says Ben Jacoby, Certified Financial Planner and senior adviser with Brinton Eaton Wealth Advisors.

Jacoby says there is a four-year cycle of excesses. “Every four years or so the people who loan money do something stupid,” he says.

In this case, investors made real estate loans to people who couldn’t afford them, including speculators. Investors purchased run-down property, renovating and reselling or flipping it, acquired property for rental units and made pre-construction purchases — all in hopes they’d have a big return for their investments.

Problem was, most of the property purchased was overpriced in the first place, and when values tumbled, speculators in general couldn’t get their money back, much less the mammoth profits they’d anticipated. But even though real property investments can’t really be taken to the bank, Jacoby says property has always been an investment target in good times or bad. Individuals like the idea of owning something they can actually put their hands on, but it’s a much bigger gamble, even when prices are rising, for the uninitiated.

“Real estate is a great game for pros and a not-so-great game for amateurs,” Jacoby says.

Historically, investing in real estate during bear markets can yield some real bargains for those who can afford it. Since lenders are understandably skittish when the economy is less stable, financing property becomes much more difficult. Would-be investors who hope to take advantage of falling home prices need to have enough cash to reassure the bank that its loan will be money well-spent.

All that glitters

Gold is kind of like comfort food — something we latch onto whenever we feel threatened. It’s the meatloaf and mashed potatoes of finance.

During political upheaval, wars, civil unrest and even when interest rates aren’t returning much on investments, investors have seen gold as a safe haven. Comparing gold and stocks in the American markets, stocks have done very well against gold, but gold remains an investor favorite. Parker characterizes gold as a generally good investment. Gold (and silver, for that matter) back up Parker’s assertion with a solid performance when weighed against stocks in the first few weeks of 2008.

CFP Jacoby says the weak dollar has boosted gold, which sold at historic highs at the beginning of 2008, then began a correction in early February as the Fed cut the benchmark lending rate. However, whether gold rises or falls, investors are historically drawn to it.

“People stand by gold,” Jacoby says.  

Foreign investments may not be for everyone

Thinking of jumping into international waters when home waters are troubled? Lots of people have. William Gamble, principal of Emerging Market Strategies, says unless you know what you’re doing, you should hold that thought or you might end up taking a bath.

“India, China, Russia — they are all going to have enormous (economic) problems”

Gamble, who writes frequently about foreign market strategies and helps clients manage risk in international markets, says that often one of the first reactions investors have when their own economy starts wobbling is to sink their money into another one. He reminds investors that there’s more at play than simply finding what appears to be an attractive investment. Investors have to understand the political and economic situations behind the market to make it work for them.

Gamble points to countries where free speech may be limited and many businesses are controlled by the state. He says it’s within the best interests of the government to prevent economic problems from being publicized. So trolling for a good return on investments in China, for example, may not be such a smart move.

“India, China, Russia — they are all going to have enormous (economic) problems,” he says.

Gamble predicts recession will strike all three countries, with double-digit inflation in many parts of Latin America and Asia. That doesn’t mean there are no good buys in emerging markets, just that the average investor isn’t going to find them without professional assistance.

Investors in Argentina at the turn of the century suffered the slings and outrageous fortunes of political instability — one of the characteristics often associated with an emerging market. Many of those who turned to emerging market mutual funds in the mid-to-late 1990s saw enormous gains, which then plummeted, resulting in equally devastating losses. For example, in 1996, the Lexington Russia Troika Fund went up 67.5 percent, only to drop a whopping 83 percent the following year.

“Now is probably a good time to invest in stamps,” says Gamble, not entirely tongue-in-cheek.

Don’t get emotionally involved

When the going gets tough, many investors jump ship. Doug Charney, senior vice president of Charney Investment Group of Wachovia Securities LLC, says the problem with many investors is that “they get emotionally involved in their investments.”

Definitions
  • Bond — A debt instrument issued to borrow money for a fixed amount of time and set interest rate.
  • Commodity — A physical substance, such a food, grains, and metals, which investors purchase, usually through what are called futures contracts.
  • Emerging market fund — A mutual fund or exchange-traded fund that invests in less developed countries with high growth potential.

See the Guide’s Glossary for a further explanation of these terms.

Before the dot-com bust, Charney says everyone wanted into tech stocks. When a lot of tech stocks tanked, the rush to the exit was like someone yelling “fire” in a crowded theater.

“When things get extreme, people get irrational,” he says.

There’s also what’s known as a “herd” effect. When the market starts to show losses, many times smaller investors will become spooked and get out. That, say many financial gurus, is exactly the opposite of what a good investor — particularly one who is investing for the long term, as in retirement — should do.

Parker says that although the tendency may be to cut one’s losses and run, it’s infinitely better to wait it out. “I’m a buy it and hold it kind of guy,” he says.

When the country’s in a recession, most people don’t invest in stocks. They opt instead for safer investments like Treasury bills, CDs and bonds, or look at precious metal commodities.

“In the case of recessions, stocks go down at the beginning and back up when the recession is over, and sometimes stocks even go up when the recession is still going on,” Charney says.

Charney also says that stocks going down before a recession is a leading indicator that a recession is about to start, so once the recession is on the horizon, it’s generally too late to sell without substantial losses.

“When things get extreme, people get irrational”

Most people who lose big in the market during a recession jumped on the “hot thing of the moment,” like the dot-coms or reaching even further back, railroad expansion. Charney says whenever there’s a common buzz on a “sure thing” it’s a good bet it’s not sure at all.

He recounts a famous story about millionaire John  Rockefeller who reportedly exited the stock market when his shoe shine boy started giving him tips — about a year before the start of the Great Depression.

Everyone knows how that story ended.