Harvard economist Robert Barro recently estimated that there is a 20% chance that the U.S. will fall into a depression. He defines that as a 10% decline in GDP per capita or consumption.
It's a credible estimate -- the 6.2% annualized real GDP decline in the fourth quarter is already approaching the 6.4% annualized decline we saw in 1982 during the worst post-World War II recession, and we look nowhere near recovery. Our unemployment rate of 8.1% is close to the 8.6% our country experienced in 1930.
If you were a reckless bank executive who would get paid huge bonuses regardless of how many billions of dollars you destroyed, you'd be saying right now, "80% chance of no depression? Why not lend billions to people who have no hope of ever paying it back!"
But some of us don't have our gross incompetence bailed out by taxpayers. And to us, that one in five chance is disturbingly large.
It's time to prepare for the Second Great Depression. Here's what to do.
Line up ducks
Start with the basics. Make sure that you're covered if you lose your job.
In the depths of the Great Depression, 25% of all workers and 37% of non-farm workers were unemployed. That's a devastating statistic. It means that in cities, almost four in 10 people didn't have jobs, and that doesn't even take into account the underemployed -- people who wanted full-time jobs, but were only able to find part-time work.
So, prepare for the worst. Make sure that you have an emergency fund -- in cash -- of at least three to six months worth of expenses. Then, pay down your debt, starting with the debt with the highest interest rate. Debt is terrible during deflationary times because deflation doesn't just affect prices, but incomes as well. As incomes fall, that debt becomes more and more onerous. During the early 1930s, there was 30% deflation. So, pay back debt now, while you can.
Finally, recognize that, in a Second Great Depression, losing your job is a real risk. Whenever you buy something, think hard about whether you truly want to spend that cash. Imagine that you'll lose your job in six months. Looking back from that time, will you still be happy that you made that purchase?
Shelter from the storm
Your investment portfolio should also be able to handle the Second Great Depression. Long-term Treasuries should perform well during a financial collapse, but are a poor investment right now. At today's low interest rates, Treasuries will have negative real returns if we don't have a depression -- the 80% likely scenario.
Instead, keep cash in the bank, below the federal deposit insurance limit of $250,000. Or, if you want higher interest, look at corporate bonds of the strongest companies outside the financial sector. Only buy bonds of companies with the most sustainable earnings and strongest balance sheets.
Stocks are cheap
Though it might seem counterintuitive, stocks are still a reasonable option right now. It's not that stocks did well during the Great Depression; during the first three years of the 1930s, pretty well everything fell.
But the market's already dropped nearly 50%. And while that's not the 89% loss that signalled the bottom during the Great Depression, it's also not like we just started the crash. If we do hit the Second Great Depression, the market will probably fall more. But to hit that 89% loss took a 37% unemployment rate in cities. We're nowhere near that level of pain now, and nobody is predicting it. That means a repeat 89% drop still seems a remote possibility.
And, if the second Great Depression doesn't hit, stocks are cheap enough that the returns could be excellent. Off the brief 1932 stock market bottom, equities gained 372% in less than five years. What's more, many blue-chip stocks are now yielding more than Treasuries. So, you get paid now, and can reap capital gains later.
Lessons from the first Great Depression
Obviously, you need to be careful. Only buy businesses with strong balance sheets -- companies that can survive a depression and come out the other side even stronger.
From 1930-1933, the logging industry was the top-performing sector, posting a 120% gain. But, considering that one of the causes of the current recession was overbuilding, a prolonged slump in construction would make logging a questionable choice today. Beyond that, food, cigarettes, and candy stocks outperformed. People were buying the necessities they needed to survive and the cheap luxuries they wanted for comfort.
The stocks to buy
If you're looking to buy, tobacco stocks are a good option. Cigarettes are either a luxury or a necessity, depending on your level of addiction. Altria (NYSE: MO ) and Reynolds (NYSE: RAI ) both look interesting, offering over 7% dividend yields. And these guys aren't worried about deflation; they're raising prices.
Hershey (NYSE: HSY ) and Coke (NYSE: KO ) both survived the Great Depression by providing cheap luxuries, and they would survive a Second Great Depression as well. Though they don't yield as much as the tobacco companies, they have less regulatory risk, and are therefore safer.
If you'd rather own necessities, consider Wal-Mart (NYSE: WMT ) . People have to shop somewhere, and in a depression, that place is likely to be the cheapest retailer on earth. ExxonMobil (NYSE: XOM ) and ConocoPhillips (NYSE: COP ) are also good options. Even with possible deflation and the rise of alternate energy sources, oil will continue to be needed for a long time.
The Foolish bottom line
The Second Great Depression is unlikely, but it's smart to prepare for all eventualities. These stocks are good investments for tough times because they're both solid and really cheap. They won't simply survive the Second Great Depression, but will yield superior returns going forward because they're so undervalued.
That said, they're not our favorite picks right now. Our Motley Fool Inside Value analysts have identified many stocks that we think will deliver excellent long-term returns, even if we hit the Second Great Depression. You can read about them with a free trial.