Is This the Modern 1931?

This column was originally published on Street Insight on March 13 at 10:53 a.m. ET. It's being republished as a bonus for RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

In a recent column, Doug Kass posited that it feels like 1937 out there, based on similarities between technical patterns of then and now. That's a scary proposition, at least if one remembers what lurked around the corner.

I wouldn't use 1937 as the analogy. One superficial reason would be that 2007 is a year before the presidential election, whereas 1937 was a post-election year.

However, I do think Doug is asking questions about the right decade. Instead, I'd focus on whether this feels like 1931. That was also a pre-election year, like this one, but a better reason for comparison is that both 1931 and 2007 could represent potential fundamental economic turning points.

The 1929-1932 crash actually took place in two stages. In the first stage, from late 1929 through the end of 1930, the market corrected the overvaluation excesses, relative to then-prevailing fundamentals. Specifically, the Dow Jones Industrial Average pulled back from 381 to below 200, which represented fair value for the time.

In the second stage, from 1931 to mid-1932, the Dow fell to 41, nearly 90% off its 1929 peak, because the fundamentals themselves collapsed. My estimate of the Dow's "investment value," based on book value and dividends, slid from 202 at the end of 1930 to 82 at the end of 1932.

Deja Vu

A similar set of events may be unfolding this decade. The bulls rightly point out that we've had a correction of earlier valuation excesses. This happened primarily as a result of the bear market of 2000-2002, together with recent earnings growth in excess of stock price gains. But the bulls may be underestimating the potential for a collapse in fundamentals, such as earnings and dividends.

Recent stateside growth has taken place because consumers have been willing to spend in excess of wage growth, and they've been able to do so because of easy money and a buoyant housing market that led to "capital" income. With housing now in a tailspin, this source of "income" is gone, at the same time that overleveraged consumers are now demanding higher wages in their role as employees to compensate. Both effects threaten to crimp corporate profit margins, as happened in the 1930s.

---

At the time of publication, Au had no positions in the stocks mentioned, although holdings can change at any time.

Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Au is the author of A Modern Approach to Graham and Dodd Investing. Au appreciates your feedback; click here to send him an email.