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Fed and Treasury Efforts Might Not Be Enough to Avoid Another Great Depression

publication date: Mar 23, 2020
author/source: Brian Nelson, CFA

Image: The Energy Select Sector SPDR and Financial Select Sector SPDR, two securities removed from both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio in August 2019 have been ravaged during this market selloff. We maintain our view that the energy and banking sectors are worth avoiding during this market meltdown.

By Brian Nelson, CFA

Let’s not mince words: We’re facing a global financial crisis and the real and growing probability of another Great Depression (not recession, but depression). The Fed has unleashed just about every backstop facility that it did during the Great Financial Crisis of 2007-2009, with the announcement the morning of March 23, and it is now even buying corporate bond ETFs (LQD). It’s possible that an outright purchasing of equities by the Fed may eventually have to happen to keep this market orderly.   

The reality is that the stock market is going haywire. Price-agnostic quant trading and broad-based indiscriminate buying and selling by indexers has driven the CBOE VIX to unprecedented levels recently, as volatility measures surpass those of the Great Depression, what was once (prior to the past few weeks) the most volatile time in market history. We’ve already witnessed frequent 10% daily moves on the S&P 500 (SPY) and Dow Jones Industrial Average (DIA), but the market might really go bonkers. It’s looking more and more that the Nash equilibrium (or price setting on intrinsic value) may be completely disrupted as many fundamental discretionary traders step away and wait for calmer waters.

It’s crazy to think how wrong economists have been during the past few months, as we were calling for a global recession as recently as January 31, “Coronavirus May Trigger Long-Anticipated Global Recession,” but more importantly, we moved to more defensive positions in the newsletter portfolios in August of last year, removing both the Energy Select Sector SPDR (XLE) and Financial Select Sector SPDR (XLF) prior to their massive declines. We maintain our view that avoiding the energy and financial sectors will be a source of alpha in coming periods.

Complacency had gripped Wall Street during the past decade, reaching unprecedented levels by January of this year, and the chickens have come home to roost, as almost everybody was slow to react. Passive investing is largely to blame, as this GDP-delta caught almost everyone by surprise. We had been alerting members to the coming crash February 22, with the first of two crash protection alerts coming February 24. Goldman is now calling for a 30% GDP drop during the second quarter, while St. Louis Fed President James Bullard is saying the US unemployment rate could reach 30%. These are Great Depression-type numbers.

Here’s the situation the U.S. is facing and why it may be heading for the next Great Depression: Whether we have a medicinal breakthrough to treat COVID-19 in the near term may not matter. Consumers are pulling back spending aggressively, and they may continue to do so until there is an actual vaccine available, which won’t happen for another 12-18 months. The Treasury is seeking to bail out everybody, but this may come up vastly short in duration, much like the Fed’s efforts to stabilize the markets have failed, even though one can argue they’ve staved off a monumental crash of massive proportions, which may still yet happen.

We believe the U.S. can get through this in really good shape if it shut downs completely, under strict quarantine for 30 days, but a bailout supporting “everything” for the next 12-18 months, which may be required until a vaccine is potentially available, could be a tragic policy decision with severe negative long-term implications on equity values (i.e. higher corporate tax rates, etc.). Some people keep going out as normal (with New York Governor Cuomo saying people are hanging out at parks as if nothing is wrong; also, there are those Spring breakers, etc), and this behavior might keep most other consumers at home, with widespread ramifications on any economic resilience until a vaccine is available to all.

Quite frankly, unlike totalitarian regimes, the U.S. doesn’t have the tools to contain COVID-19. Just my recent trip to the grocery store (Northwestern suburbs of Chicago) showed me personally that this pandemic could go on for a while as people as recently as last week weren’t practicing social distancing at all, and many were socializing as if COVID-19 doesn’t exist. I could not believe my eyes. Valuentum has been writing about COVID-19 for months, and we’ve been surprised to only recently hear government emphasis on the asymptomatic transmission of this disease. We’ve been saying this for a long time.

While I think we need some type of bailout program, and I’ve written an Op-ed that says Boeing (BA) should be the only publicly-traded corporation that should be sent a life raft, I’m not completely convinced that we can avoid the next Great Depression even with Fed and Treasury intervention. If we don’t keep people in their homes until COVID-19 is completely gone, we’re going to need much more than $2-$4 trillion in government stimulus--but perhaps as much $10-$20 trillion to bail out the U.S. economy, which will practically double the sovereign debt load. 

Some consumers are staying home not only because the government is ordering them, but they’re also staying home because they are afraid and don’t want to catch COVID-19. This fear and its impact on the U.S. economy won’t subside until a vaccine potentially becomes available in 12-18 months!

I still don’t think the stock markets will start to improve until we have better visibility on a COVID-19 vaccine, and the markets probably won’t bottom until about 6-9 months before the vaccine release, which means we could still see another 3-6 months of real aggressive selling in credit and equity markets. We think the White House knows this, and I’m thinking that Trump is seriously considering asking for the removal of social distancing and some quarantines at the end of the 15-day Plan, a move that may only intensify the number infections and deaths in the U.S. and elsewhere.

Concluding Thoughts

The U.S. is stuck between a rock and a hard place, and we might get the next Great Depression regardless of what the Fed or Treasury does. The timeline for when these markets attempt to bounce back meaningfully from this disruption may not be based on whether COVID-19 cases roll over, but rather when consumers start coming out to spend in droves again, and that may not happen until we have a vaccine broadly available. We're maintaining our fair value range on the S&P 500 of 2,350-2,750, with expectations of panic/forced selling down to 2,000 on the broad market index (it closed at 2,304.92 on Friday, March 20).

We believe that savvy investors have been nibbling at this market during the past couple weeks and may have achieved up to 50%-75% of their equity allocation in a well-diversified portfolio via dollar-cost averaging strategies, with expectations of further market declines. Our best ideas remain in the Best Ideas Newsletter portfolio, Dividend Growth Newsletter portfolio, High Yield Dividend Newsletter portfolio and Exclusive publication. Expect more gut-wrenching volatility.



Tickerized for holdings in the DIA.


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Brian Nelson owns shares in SPY and SCHG. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

9 Comments Posted Leave a comment

Stephen Hanley (Perrysburg)
Thomas Judge (Annapolis)
Paul Robillard (St-Pierre-les-Becquets)
Brian Nelson (Woodstock, IL)

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