"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

Are we headed for a Depression?  The media has certainly tossed around comparisons of the current financial crisis to the Great Depression but this type of sensationalism, which is used to steal our attention, is expected from a source of information whose primary objective is to sell advertising.

I would not give this subject any attention if I had not observed several traders and bloggers who are experienced and knowledgeable of market and economic history are also joining the media noise to draw serious parallels from this financial crisis to "the D-word."

Are we headed for a Depression or are we not headed for Depression?  Should a rational person be asking this question now?

Let's take a look at some opposing views from notable sources and draw our own conclusions... 

An economist and notable blogger, David Merkel, recently posted an article titled, "It's Called a Depression," where he draws several parallels from this current financial crisis to a depressionary environment, which is generally defined as a 10% decline in economic growth or Gross Domestic Product (GDP):

Many go hat in hand to the government The spreads of the bond market are at record levels since the last depression, and maybe comparable. There is policy paralysis and confusion.  No one knows what to do (or leave alone), they act blindly or cower in fear. Ultra-safe investments have record low yields. Banks don't trust each other. GDP is shrinking, and unemployment is increasing at a rapid rate. Financial businesses are failing and shrinking at high rates. The government comes in to "help" the markets, and ends up replacing the markets. The security of banks and other financial entities is open to question.

Mr. Merkel's grim observations are based upon his view that the "gears of finance are jammed," which results from "financial systems that are in danger."

"To every action there is an equal and opposite reaction." ~ Newton's third law of motion

The counter-argument we will look at comes from fund manager, John P. Hussman, and his recent article titled, "The Stock Market is Not in Uncharted Territory:"

Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) – points where stock prices were not far from their lows even though negative economic news persisted for a longer period.

If we seriously need to talk about the Great Depression (I personally believe that it is an outrageously dire comparison), we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support.

If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives.

Veterans like Warren Buffett and Jeremy Grantham... know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

Mr. Hussman is essentially saying that today's stock prices have already (or nearly) factored in a worst case scenario, which is quite severe but significantly less severe than the Great Depression.  Furthermore, he implies that a prudent investor will not pay much attention to labels put forth by the news media but look for value opportunities that such an extreme environment has historically created.  

"All human situations have their inconveniences. We feel those of the present but neither see nor feel those of the future; and hence we make troublesome changes without amendment, and frequently for the worse." ~ Benjamin Franklin (1706-1790)

While Mr. Hussman's points come from a stock price and valuation perspective and Mr. Merkel's come from an economic and bond market perspective, both contrasting views show respect for history and illustrate the broad spectrum of opposing views prevalent today.

In my personal view, I believe conditions are certainly bad but likely not as bad as most people perceive them to be, especially the sectors outside of housing and financials.

Market cycle extremes, both on the upside and the downside, are accompanied by extreme emotions where our brain's limbic system will naturally seek patterns that make us believe that the current momentum will continue in the same direction... but the pendulum swings both ways...

Are fears of Depression justified or is it just more noise?  Or is there a human tendency to find the worst outcome that will make our current environment seem more tolerable?

What do you think?

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Related Post: "Know Thy Risk"