I want to make a clarification.

The tone of my posts over the past six weeks has become decidedly more bullish.  After being worried about the economy and the stock market for most of my authorship of this blog, I have become more bullish on risky assets, i.e. stocks, corporate bonds, etc., than I have been in a very long time.

Some may misconstrue my bullishness for risky assets as bullishness for the economy in general.  This is incorrect.  I am bullish on risky assets because they range from inexpensive (stocks) to ragingly dirt cheap (corporate bonds, at least a few weeks ago).

I am of the opinion that the excesses of the past decade need time to work out. I expect economic recovery will be sluggish.  However, I am not a believer in Depression 2.0 (more below) and we may have seen the worst of the recession in the fourth quarter, at least from a contraction standpoint as Q4 GDP is liable to be somewhere around -5%.  I doubt we will see a similar quarterly contraction any time soon, although Q1 and Q2 are likely to be negative and unemployment will probably reach double digits.

From an investment standpoint, I think that if the S&P 500 were to rise into the 1000-1050 range, I am not sure how much longer one would want to stick around as such levels appear to be fair value. 

However, the biggest surprise counter-trend move would be to the upside, not the downside.  The air is thick with negativity, with cash levels at extraordinary levels.  Opinions about stocks range from apathy to loathing, with very few making the case for a new structural bull market, me included.

Thus, the move that would surprise the most people would be an upward one.  New bull markets do not start when everyone is happy.  New bull markets start when everyone is wretchedly miserable, and advances are met with skepticism and cynicism.

The fuel for a prospective new bull market would be an economy that is more resilient and buoyant than people expect.  If the economy resumes growth in the second half of the year, then stocks will explode upwards.

To reiterate, I am not in this camp.  However, we must be aware of all scenarios, not just the ones that agree with our pre-conceived ideas.

So I present to you the happy case as it relates to the interaction between asset markets and the economy, via Greg Mankiw.

Many pundits (e.g. Krugman) are warning that a dire recession is in the offing. We would have agreed with them three months ago; indeed, we wrote a VoxEU column predicting a severe recession in 2009; based on the analysis of 16 previous economic shocks, we forecasted a 3% drop in GDP and a 3 million increase in unemployment in each of Europe and the US with these predictions made from VAR forecasts (see Bloom 2008 for details).

We also worried about a far worse outcome – Europe and the US slipping into another Great Depression due to damaging policy responses. Luckily, using the latest data on uncertainty measures, our model predicts that the worst has been avoided. ...

The heightened uncertainty after the credit crunch led firms to

postpone investment and hiring decisions. Mistakes can be costly, so if conditions are unpredictable the best course of action is often to wait. Of course, if every firm in the economy waits, economic activity slows down.

Much like today, the Great Depression began with a stock-market crash and a melt-down of the financial system. Banks withdrew credit lines and the inter bank lending market froze-up. What turned this from a financial crisis into an economic disaster, however, was the compounding effect of terrible policy. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by desperate US policymakers as a way of blocking imports to protect domestic jobs. Instead of helping workers, this worsened the situation by freezing world trade. At the same time policymakers were encouraging firms to collude to keep prices up and encouraging workers to unionize to protect wages, exacerbating the situation by strangling free markets.

In fact economic uncertainty is now dropping so rapidly that we believe growth will resume by mid-2009.

This seems a little optimistic to me.  However, the case that this will not be a repeat of the 1930s can be made.

The Great Depression did not become the Great Depression after the stock market crash in 1929.  The Great Depression became the Great Depression after the bank failures of the 1930s.  The Federal Reserve's intransigence in implementing the appropriate policy responses lead to the failure of thousands of financial institutions, which not destroyed capital, it also led to a withdrawal of funds from the banking system as depositors panicked. 

The cash to deposit ratio was low in the summer of 1930, meaning that individuals had confidence in the banking system.  However, within a year, that ratio had risen to highs as bank after bank failed, particularly the Bank of the United States. People withdrew their cash from the banking system, inducing bank runs and reducing the amount that could be lent out into the economy.  If deposits fall and people stuff their mattresses with cash, credit contracts, leading to a contraction in economic activity.  This occurred on a massive scale in the 1930s.

To some extent, this dynamic is occurring today as the shadow banking system disintegrates.  However, the responses of the government are far different.  Today, the Fed is inflating its balance sheet like a drunken sailor, effectively attempting to finance whole swaths of the economy it had never lent to before.  Whatever one might think of the government's ham-handed attempt to prop up the banking system - and it is at least that - the Fed is madly attempting to relate the economy.

Another important difference is that there was no deposit insurance in 1930.  Ben Bernanke has written that the establishment of the FDIC was one of the most important reasons why the Great Depression ended as confidence seeped back into the financial system due to the implementation of deposit insurance.  No worry about that today as the government is guaranteeing just about everything.

Finally, during the Depression, America was on the gold standard.  Britain left the gold standard in 1931, leading to a devaluation of the pound.  This devaluation caused an outflow of gold from the United States.  To counter-act the outflow of gold, the Fed raised interest rates during the Depression, reversing the easing policy it began the year prior.  Under the gold standard, standard policy was to raise interest rates to attract gold into the country as gold is high-powered money in the gold standard.  Thus, the Fed raised interest rates during a severe contraction, not exactly the wisest counter-cyclical policy.  Today, there is no gold standard to effect an interest rate increase caused by an outflow of gold.  The Fed has cut the funds rate to zero and is not going to raise rates anytime soon.

I think the authors are being too Pollyannish, though for the sake of the country, I hope they are correct.  However, I highly doubt there will be a repeat of the Great Depression.