First, a Great Depression of the 1930s is not in the cards.  The world will not suddenly lose its color and turn black and white (the colors that come to mind when we think about 1929 Great Depression, as there were not color cinemas then).  No, we won’t have food lines, our kids will not start playing with bricks and sticks instead of toys and they will not be wearing handed down clothes several sizes their senior.   Their collection of toys rotting in the attic may shrink and -  I have to warn you – you may still see kids wearing torn jeans with holes that are too big for them.  But don’t blame the economy, blame the latest fad.  Our economy is stronger, more diversified, and far more developed than in the 1930s.  It is unlikely our government will repeat the mistakes it made then.  We also have a system of social nets, such as unemployment insurance (which will probably be extended, like it was in 2001 and 2002) and welfare.

I see three possible scenarios for the economy: (1) a Great Recession (2); a (semi-normal) recession; and (3) a quick recession leading to growth. 

Our problems today stem from two sources (here I am oversimplifying a bit): an abundance of bad debt and a loss of trust in the financial system.  Banks don’t trust their current or potential customers; investors and depositors don’t trust banks; and banks don’t trust each other.  The government is trying to restore this circle of trust.  Two months ago, socializing the financial system would have seemed preposterous.  Now there is no way around this, at least temporarily.   The Fed and Treasury are trying to restore trust by shoring up banks’ balance sheets and by stamping government guarantees on otherwise risky loans, and they will likely succeed.  

The next step is dealing with the bad debt.  Some of it will be socialized (paid for by the taxpayers).  Some of the bailout programs will cost money, and some won’t.  Warren Buffett says the government will make money on the CDO auction program, but I think this will depend on the price the government will pay for this debt. 

The possibility of a Great Recession (which would be a steep decline in GDP growth and a sharp rise in unemployment, lasting a long time) is higher than in the past.  The only reason a Great Depression would happen is if the “circle of trust: not restored. 

The bottom line is, if the Fed is successful at restoring the circle of trust, a Great Recession is avoided. 

We are very likely to be in a semi-normal recession.  How long and deep will the recession be?  We really don’t have a good benchmark to forecast the level of unemployment, nor the level of growth or decline in GDP, nor the duration of the recession.  This is a consumer-driven recession and the consumer is two thirds of the economy.  The last recession of 2001 was led by corporate slowdown; the 1991 recession was a consumer recession, but it was very different from current one.  Housing prices did not decline nationwide; the consumer was not as leveraged and the global economy was in different shape.   And yes, we are in a recession, no matter if it fits into traditional definitions.  Growth is down and unemployment is up.  The definition of a recession doesn’t matter.

A possibility of the third scenario – a quick and shallow recession leading to growth – is not high but it is there.  For this scenario to play out the bulk of losses in financial sector need to be behind us.

Historically, secular bear markets developed when you had a combination of high valuations and a prolonged recession.  The first condition is met – today’s valuations are not cheap.  If the second condition is met (a very deep and long term recession), then all bets are off, and we will end up like Japan in its Lost Decade. 

If the economy is just experiencing a cyclical downturn, one that is possibly more severe than similar downturns in the past, then we are likely to be in a relatively short-lived cyclically driven bear market.  The last 1966-1982 secular range bound market had 11 shorter term market cycles inside of it (5 cyclical (short-term) bull markets, 5 cyclical bear markets and 1 range-bound market).  See the chart below.

Despite all that, I would not try to time the market, as it is a very difficult market and will likely turn before the economy, as the market is a discounting mechanism.  If you own stocks that will survive the worst case scenario, you will come out stronger in the end.