Market Epicurean


Tying It All Together: What The Financial Crisis Meant and Means For You - PART TEN

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It would be impossible to do justice to the financial crisis of 2008 in just ten parts, let alone a tenth part that ends on October 2.  As a couple previous issues referenced, by October 2 the House had not even passed TARP yet (that was the 3rd).  The week of October 6 became one of the worst weeks in market history as a 10,300 open on the Dow that week resulted in an 8,450 close.  The stock market drop was becoming unthinkable, and we were now four weeks past the demise of Lehman Brothers!

I have written in each of the last nine articles of vivid memories related to specific instances and milestones in the crisis.  The truth is that by mid-October, much of the crisis became a daily routine.  The high drama of a new bank or iconic firm failing had subsided, and instead, we were just stuck in, well, a crisis.  Markets teetered at 8,500 from all of mid-October to mid-November, going to 8,000, and then above 9,000, but unable to really figure out where a bottom could make sense.  One famous Tuesday (the 28th) saw the market rally almost 1,000 points from open to close in one day.  No matter how bad things were then, and they were bad, a 1,000 point rally day understandably reinforced the futility of trying to trade around the horror of the market.  Those with equity exposure at that time were already in the drama – to try and exit after this multi-thousand point drop seemed silly.  Yet that did not mean the markets were done going down.  It just meant no one knew.  I didn’t know.  And no one else did either.

I remember the Friday afternoon that President-elect Obama announced Tim Geithner to be his Treasury Secretary.  The markets went up 500 points.  Instead of wallowing in the 7,000’s we would spend the remaining months in 2008 (November and December) wallowing in the 8,000’s.  November also saw another bout of what I called “before Asia opens” – the Sunday night drama where the financial media is forced to break into special coverage – and some urgent drama is covered as needing reconciliation before markets in Asia opened (i.e. their Monday morning).  We had plenty of such moments in the peak portions of the crisis, and then we got a resurgence in November when all of a sudden Citi was on the brink, after receiving $25 billion of TARP money.  Only when the U.S. government promised to backstop an unfathomable $306 billion of risky assets in late November did their bonds come back from the dead.  Stability was still a ways away.

The first quarter of 2009 may have been more gut-wrenching than the fourth quarter of 2008.  Fatigue is a huge factor in a bear market.  The shock and awe of quick and violent drops in the market can be brutal for investors, but when it continues with [what feels at the time] like no end in sight, it is mentally and emotionally exhausting.  The problem in January and February was that markets still were not clear what the Obama administration planned to do around the financial crisis itself (resolution of the banking industry at large), and full-blown nationalization was not off the table enough to satisfy investors.  There were days that President Obama would go on TV, and the market would drop 300 points.  Then Secretary Geithner would go on TV, and it would drop 300 points.  I recall one client asking me “if they go on TV together (split screen?), does that mean we will drop 600 points?”

Of course, the “real world” ramifications of the recession were dominating the tape (collapse of corporate earnings, massive unemployment, total cessation of productive economic activity).  It would have been impossible for circumstances to be much worse.  And yet, stock prices in late February (the low 7,000’s) were no longer pricing in a recession, or even a horrid recession – they were pricing in the failure of the American economy.  That has never been a very good thing to bet on.

On Friday, March 6, 2009, I sat in an economics conference at The Breakers Hotel in Palm, Beach, FL, trying to listen to the speakers (which included a plethora of elected officials, Federal Reserve governors, Treasury Department personnel, and various economists), but simultaneously working on my laptop.  I served as the trader at that time, in addition to being the portfolio manager, and as markets hit what would become a generational bottom (666 on the S&P 500 and 6,469 on the Dow), I just sat there buying – wherever I had available cash to do so.  The time had come.  I had no idea that was the bottom – none.  But I wrote to clients then, “we do not need to know that this is the bottom; we only need to know that we are surely far closer to a bottom than the top; that the risk-reward trade-off has moved in our favor; that our financial goals are better served at this point by buying than selling.”

I was back in my CA office on Monday, March 9, and within days I would never see a 6 in front of the Dow Jones Industrial Average again.  And by the end of April, it would never see a 7 in front again.  The stock market would end 2009 up 25% in the S&P 500, and up well over 60% from its intra-year bottom in March 2009.

The market had opened 2008 at 13,338.  It’s opening day price on January 2, 2008, would be its high for the year.

In 2017, the opening day price would be the low for the year.  What a difference a decade makes.

But let’s talk about the decade that was between 2008 and now.  Has this been a bull market for the ages?  Sure, in the sense that the market has a technically positive return nine years in a row (it appears the tenth year is on track), and that the % return in the market is over 300%.  But has it been a straight line higher?  Of course not.  We had a thousand point drop in a day in the so-called “flash crash” of May 2010.  We dropped 20% in the S&P 500 in the summer of 2011 as Europe appeared to be on the brink.  The market went two years without advancing at all (in terms of start to finish) from mid-2014 to early 2016.  The market dropped violently in August 2015 and January 2016 around China fears.  It dropped another 1,000 points around Brexit in mid-2016.  It has confounded critics, devastated bears, shocked bulls, and done so with little regard for anything other than the machinations of markets themselves.

Markets are measurements of sentiment in the short term.  And they are measurements of value in the long term.  Same as it ever was.

The lesson of 2008 in terms of an investor’s life is not how to time the exit from markets or time the re-entry – for no one can do that.  It is not how to place huge “big shorts” on bubbles – though books and movies on those who did so are admittedly fascinating.  One hedge funder who made about $8 billion shorting subprime mortgages has since lost over half of that – first on gold, then on an over-levered pharmaceutical company.  A few billion here and there and soon you’re talking about real money.  Easy come, easy go.  And never confuse luck for talent.

Look, the financial crisis was the most brutal economic period of American history outside of the Great Depression, and certainly the most challenging period of my career.  But the financial crisis was only fatal for one type of investor – the person who capitulated to the fear.

This is not to insult the person who capitulated (though it may be to insult their financial advisor).  Human emotion, nature, and psychology were not calling for “measured maintenance of a disciplined asset allocation” when new companies were failing every Sunday night.  Markets dropping 20% can hit us, but 50%?  And just a few years after the tech crash?  With tens of millions of boomers ready to retire?  Hell hath no fury like two bear markets in one decade …

But the fact of the matter is that 2008 should be the greatest lesson we will ever get in the downside volatility capacity of risk assets.  “Why don’t I have the exact same return of equity markets?” is a question only those who can say, “I am willing to take the exact same downside volatility capacity of risk assets” should ever utter.  Asset allocation is a tool to blend the risk and reward potential of various asset classes into a coherent portfolio targeting a desired return, within an acceptable level of risk.  It is not perfect.  But it sure beats the arrogance that 2008 punched in the mouth – the arrogance of, “I know when the market will be up, and when it will be down, and when it will be back.”  No, you don’t.  No, I don’t.  No, that person doesn’t either.

Those who mocked the possibility of a housing bubble were humbled in 2008.  Those perma-bear newsletter writers who mocked the idea of a market recovery were humbled ever since.  Humility is the way of a mature portfolio manager.  And truthfulness better be – or you won’t be in business for long.

The truth is that I do not know when the next recession will come, but I do know one will come.  I do not know what will cause it, but I do know what will solve it.  And it is out of that latter statement that we should draw this to an end.

The purpose of risk asset investing is to generate a return that will enable you to meet your financial objectives through time.  Because of inflation and time-realities, that generally cannot be done without a risk premium – a return above the “safe rate” of treasury bills (which you will note went to 0% during the years after the financial crisis) – or a denominator of money so high that the investor is willing to just spend down their own capital.  The accumulation of capital requires a premium return to beat inflation, taxes, and time – and in the great companies of the country and often the world one can find a growth of earnings and dividends that can play a vital role in one’s achievement of return premium, and through such, the achievement of their financial goals.  But that requires human behavior (and more often than that, non-behavior) that can withstand macro events like war, natural disaster, and economic crises.  It is a trade-off – we pursue a better return to meet our goals, and invite occasional migraines along the way.

The 2008 financial crisis was not a mere migraine.  But it was a reminder about all the other infirmities that markets will give us in our investing lives.  We cannot predict the future.  Yet we must behave with discipline and faith.  Trusting in capital markets to resume their pursuit of efficient, rational use is hard to do when it feels like there is an economic tornado coming.  But trusting in your own ability to time your way in and out is an exponentially riskier endeavor.

I hope to never go through an event like the credit crisis of 2008 again, yet I know we will go through bad times again.  I am significantly more confident, read, researched, and competent than I was ten years ago, and yet I also am significantly more humble.  I can read 10,000 more pages of investment research, but when the madness of crowds kicks in, I will be unable to “think” my way out of it on behalf of our clients.  What I can do, and will do, is call on every lesson of 2008, every lesson before that, and every lesson that ever will be …

And they all come down to this:

Free markets work.  The profit motive works.  Optimism is the only realism.  The world doesn’t end.  Even bad crises end.  The arc of history is on the side of the disciplined investor.

And family, friends, and faith, trump all.  Even 2008.

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