A calm moment to reflect of the lessons of the Great Recession of 2008

Stocks fell on Friday after the August employment report showed an acceleration in wage rates. Bond yields rose about 5 basis points and stocks fell by about 0.3%, not exactly a panic. Most of the decline happened at the start of trading. President Trump threatened to expand tariffs to everything China exports. But markets have heard this threat before and have largely discounted that occurrence.

This should be a relatively quiet week. The Jewish New Year began last night and will impact trading today and tomorrow. There is little in the way of earnings or government data of note due this week. Next week, the FOMC meets. A quarter point rate increase is a foregone conclusion and, after Friday’s wage report, another jump in December is increasingly likely. Both are expected and already factored into asset prices.

This week, we will hear a focus on the question, “Can a financial crisis like the one that occurred ten years ago be averted again?” We will also hear pundits try to answer an allied question, “What might cause the next crisis?”

As is often said, history doesn’t repeat itself often exactly but it sure can rhyme. There is little question that U.S. banks and brokerage firms have much stronger balance sheets today and Federal oversight is much stronger. Some argue that the government has gone too far regulating financial institutions. But in a world where capitalism rules, letting the foxes loose in the chicken coop without any oversight or control is an ultimate recipe for carnage. In some ways, ten years seems like a long time but in this instance, it really isn’t. We all still have vivid memories of 2008 and regulators are not going to want to see any semblance of a repeat on their watch. The gap between 1929 and 2008 was 79 years. That is a lot more than 10. With that said, European banks are not nearly as well capitalized as the U.S. banks. While everyone in this world is connected, the farther you are from a storms epicenter, the less likely you are to incur a fatal injury.

That leads to the second question, “What can cause the next disaster?” Again, given our vivid memories, after a 9-year bull market, there is a voice inside all of us telling us to watch out for pending disaster. That voice might fade with time but it is also worth spending a moment to suggest what might spoil the party.

  1. China – This is the world’s second largest economy. You can do the math yourself. It has about 15% of the world’s population and the U.S., the largest economic power in the world, is taking aim on China trying to slow a country growing 6-7% per year to a significantly lower rate. We can focus on intellectual property theft and unfair trade barriers but the root “problem” for the U.S. competitively is the fear that, left unchecked, China can ultimately eclipse American economic dominance. That isn’t going to happen this year or next and China is going to be loathed to agree to anything that will slow its 5 year game plan. That suggests that, however, the tariff wars end, the battle for supremacy is going to go on for some time.
  2. Emerging Markets – Countries like Turkey and Argentina cannot borrow on the world stage in their own currencies given rapid rates of inflation and a poor history of governance. They, therefore, must borrow in dollars or euros. When the dollar strengthens, they have to pay more and more to borrow. In countries where debt service is already high and inflation rampant, this becomes a recipe for disaster. Right now, market watchers can look at Turkey and Argentina as isolated cases. But the first sign of disaster, almost by definition, is an isolated case. Clearly, Turkey and Argentina are not the only two nations suffering from economic mismanagement, too much debt, and escalating inflation. They are simply the first two to reach the breaking point. Together, they are still less than 1% of world GDP. But emerging markets overall are a meaningful percentage and banks can be infected if they support lending in these countries.
  3. Valuation – A lot has been said that stocks are only 16-17 times next year’s expected earnings. That is only a bit over 10% above historic averages. True. But it is above average and any further rise in P/E’s threatens to lead to a market correction. Just remember what happened this past February when stocks fell 10% in just six sessions.
  4. Market illiquidity – This may be the biggest problem of all. With the rise of ETFs and a rising percentage of daily trading more and more concentrated in fewer and fewer hands, market illiquidity can rear its ugly head quickly. While ETFs still account for only a moderate share of trading, if one adds derivatives such as options and futures, in sharp market declines, they suddenly become dominant. You have heard of computer algorithms but for many of us that is a vague term we don’t fully understand. What you can understand is that computers are programmed to recognize certain trading patterns. When the right patterns appear, computers jump in and buy or sell in volume. The problem becomes more pronounced in down markets when multiple computers recognize the same pattern and decide to sell simultaneously. Big sellers and no buyers equal flash crash. While government agencies believe that they have put in some circuit breakers (i.e. trading in individual stocks get halted after a sudden 10% drop on no news), most of these rules have never been tested. The New York Stock Exchange used to employ specialists who were market makers and had to make contra bids when stocks were rising or falling. Today, exchange rules are designed to promote volume rather than protect against freefall. I have little doubt that we will see breath taking drops again. The only questions are when, and how long will they last. Anyone who thinks they have an answer to these questions is foolish.

With all this said, the best cure for my fears is an economy humming along with low inflation and no obvious imbalances. In the absence of much new data, the next few weeks could be bumpy. But third quarter earnings, about 5 weeks away, should be another positive catalyst and the fourth quarter is usually a good one for stocks. While some might argue that the mid-term elections pose a risk, I think little should be expected from Congress over the next two years regardless of the outcome of the elections. The conclusion, therefore, is to stay vigilant, pay attention to valuations, but stay calm. Even if we repeat the declines of February, stocks find their way back to fair value rather quickly.

Today, Alibaba” CEO Jack Ma is 54. Colin Firth is 58. Designer Karl Lagerfeld turns 85.

James M. Meyer, CFA 610-260-2220

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