Stocks rallied yesterday as trade tensions eased and consumer prices rose less than expected. Industrials and tech shares led to the upside while financials and energy were relatively weak.
Ten years ago tomorrow, Lehman Brothers filed for bankruptcy settle off a chain of crisis events. On the same Sunday, Merrill Lynch was bought by Bank of America. The next day, Monday, JP Morgan had to lend a bankrupt Lehman $138 billion to settle outstanding trades. On Tuesday, AIG collapse necessitating an $85 billion government bailout (for an 80% ownership stake) as it could not unwind its derivative facilities. Also, on Tuesday, the Reserve Fund was unable to maintain its $1 per share price given its exposure to Lehman Brothers commercial paper and related debt securities. With two days, sell orders for money market funds exceeded $500 billion or about 13% of all money market fund assets. That forced the Fed, on the 19th, to temporarily insure all money market funds until markets stabilized. On the 20th, the SEC and British regulators banned short selling on major financial stocks. On Sunday, September 21, Goldman Sachs and Morgan Stanley both became bank holding companies. By the end of the ensuing week, Washington Mutual collapsed and had to be absorbed by the government and Wachovia agreed to be bought by Citigroup. Finally, the Fed infused $600 billion into financial markets and Congress passed TARP (on the second try) bringing some sense of stability back to the markets. Stocks bottomed in October, retested those lows in November and reached a final bottom in March, 2009. Treasuries reached a bottom in November. In December, government guarantees saved Chrysler. Early in 2009, right after Barack Obama assumed office, General Motors filed a prepackaged bankruptcy. Junk bonds hit bottom right about the end of the calendar year after high yield debt rose to a return on average in excess of 20%.
Over the next few years, Congress moved to strengthen the banking system. The Fed injected billions into the largest banks even over the protests of a few who claimed they didn’t need it. The terms of the preferred stocks were onerous and all banks felt the pressure to get additional outside capital to shore up balance sheets and quickly repay the Fed. By March, most banks were no longer in dire critical condition. As most passed their first stress tests, markets recovered and the bull market that continues to this day began.
We study history to learn from the past. While no one, including me, expects a repeat of 2008 any time soon, looking back is constructive. Market participants have learned some lessons well but, as time passes, they are also prone to repeat, in some variation, the same mistakes that have caused many recessions in the past. Again, 2008 wasn’t your typical recession. If there was one lesson every U.S. bank has learned over the past decade, it is that sufficient capital reserves can absorb a normal or even an above normal amount of pain. The percentage of tangible equity value to total assets on almost all bank balance sheets today is far higher than it has been in a generation.
Capitalism is best to release the animal spirits of entrepreneurship. But in a pure capitalist system the strong will consume the weak. Competition won’t necessarily be fair. Therefore, it is up to the government to establish the rules of engagement and to enforce the rules. Obviously, in 2008 either the rules were inadequate to achieve safety or the rules were adequate but enforcement was missing. Human nature strongly suggests that reaction to a crisis morphs into overreaction. We are now in the process of unwinding some of those excesses. It is not my place to judge the exact correct level of regulation. Over time open markets and public opinion will help to find the happy medium. What we can say, however, is that the U.S. banking system is substantially better capitalized today than it was a decade ago and it can withstand almost certainly all but the very worst financial crisis. The gap between the Great Depression and the Great Recession was about 70 years. Two generations. I suspect the next financial crisis of that nature and magnitude is at least another 40 years. away. With that said, there are other events (war, cyber attacks, etc.) which could be market disruptive. But other than raising those red herring risks, which are always present, I will move on.
From a government/regulator point of view, one of the major reactions to 2008 was to modify our financial system in a way that the taxpayer would no longer have to foot the bill for collapse. While that was clearly, in part, a reaction to public anger, it should be noted that every major bank repaid the government with interest, and Fannie Mae and Freddie Mac turned out to be hugely profitable to the government. Regardless, banks were required to formulate living wills explaining how, if financial conditions got even worse than in 2008, they could unwind without any cost to taxpayers. In 2008, the largest banks were considered too big to fail. Today, at least in 2
terms of assets and deposits, the four largest banks are bigger than they were in 2008. Regardless of any living will presented to the Fed, should a true financial crisis happen again, I believe the same four banks would require some form of public assistance or government engagement to be saved. Once confidence erodes and there is a run on the banking system, only the government can return stability. To do so they must enter the market with overwhelming force and assets to rebuild confidence. How this is done may vary from crisis to crisis but to presume that banks will have the ability to unwind in a non-disruptive manner is a dream, not reality.
In order to protect the banks, government regulators limited their abilities to take risk. The costs to continue certain risky activities was made so onerous that banks simply walked away from certain activities like proprietary trading. That doesn’t mean, however, that the government eliminated risk from the financial system; they simply moved it away from banks. Today, the bulk of mortgage creation is done by non-banking entities. When confidence rises, so does the willingness to take risk. The quality of auto loans today is worse than it was a few years ago. Loans today now require less documentation. Collateral is getting to be less. Loan-to-value ratios are coming down. When all this unwinds, as it does every economic cycle, this time it won’t be the banks that take a licking; it will be the shadow banking community. If you remember early 2006 and 2007, a year before the Great Recession began, it was the sub-prime mortgage lenders that started to fail and go into bankruptcy. Every cycle is different. It may not be mortgage lenders who ignite the next downturn, but all downturns ultimately resemble each other.
We should also reiterate a point. 2008 was a crisis. Psychologically, it is natural to fear that the next downturn is going to look like 2008 again. Almost certainly it won’t if, for no other reason, that our collective nerves are still raw from the Great Recession. That is why the interval between serious crisis is long. But that doesn’t mean the next stock market downturn won’t be painful. A bear market can be a 20% correction or it can be a 50% correction. Even if GDP doesn’t collapse to the extent that it did in 2008 and early 2009, if inflation spikes or P/Es collapse, a correction could be nasty. Again, that is a statement of logic and not a prediction.
Recessions are a reaction to imbalances. Imbalances can occur because of too much credit, an imbalance of supply and demand, a crisis on one of the world’s largest economies, war, or, in the future, major cyber events. Right now, it is hard to see any major imbalances. There are always events to watch. The collapse of currencies in Turkey and Argentina bear watching for signs of contagion. As growth improves and world economies approach full employment, inflation threatens. But so far, there are no obvious signs that inflation is anywhere near a worrisome level. Sovereign debt levels are a growing concern. But until interest rates rise meaningfully, debt service is manageable. If I looked into a 3-5 year crystal ball, I probably would be most concerned about sovereign debt service.
Very often, I try to identify the clouds on the horizon and decipher which might become storm clouds. In this hurricane season, many are watching the Atlantic for pending storms. Hopefully, Florence won’t meet the worst predictions but the ability to warn millions to get out of harms way reduces the damage. That is what we try to do by identifying the financial storm clouds before they become storms. At the same time, we shouldn’t ignore the strong economic state of today. Earnings are surging. Obviously, they won’t grow at the same rate a year from now once the tax cuts are anniversaried but even if growth is only 5-8% next year, if you add 1.5-2.0% for dividends, potential 2019 returns are still in the 6.5-10.0% range. That is probably better than almost any other asset can produce and it almost certainly more attractive than bonds. One has to be mindful that markets become risky when they move from the confident to the euphoric stage. There are almost no signs that we are at that point yet.
Therefore, heed the lessons of 2008, stay disciplined, try not to get overconfident and remain true to your long term asset allocation. I see no reason now to get either more aggressive or more cautious.
Today, Deshaun Watson is 23.
James M. Meyer, CFA 610-260-2220
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