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 March 2009 Lessons from the Rout The Market's Teaching Some Tough Lessons, We May As Well Pay Attention
To be sure, a number of market watchers saw storm clouds brewing, particularly after the first shiver from the subprime market went through the economy in early 2007. Nevertheless, who would have thought that subprime loans -- that little corner of the fixed income market -- would have such a deep and lingering impact on the global economy? Who could have foreseen even just a year ago that Merrill Lynch would be purchased in a fire sale and Lehman Brothers would be bankrupt? Who knew Congress would be throwing billions and soon trillions of dollars at the problem? Or that interest rates would be 0%? Or that venerable money center banks would be on the brink of nationalization? Probably no one. But the fact that everyone was caught off guard doesn't mean we can't learn from what's transpired. Indeed, we'd be fools not to. What follows is a list of observations every investor should have learned and seriously taken to heart. It's by no means exhaustive, but it does hit upon some of the most important lessons. Perhaps you have others you've learned from your investing experience over the past 12-18 months, so feel free to pass them along. If there's enough interest, we'll revisit this subject in the coming months. For now, here's a few observations to get you going:
Diversification is Little Help in a Crisis
The lesson here isn't that diversification doesn't work, just that it doesn't work when global markets are experiencing a once in a century shock. Diversification (as well as many other investment strategies) are designed to work over the long-term and in average market conditions. Recent market activity has been far from average. Statistically speaking, losses sustained in the U.S. equity market fell into the third standard deviation from the average. Translated into normal English, these results fell into the lowest 1% of the market's return distribution and can be expected once every 100 years at most, so it's no wonder that strategies designed for the average market failed to work. The same is true for so-called "defensive" stocks. In a typical market slowdown, shares of consumer staples and utilities tend to be safe havens. No matter how bad things get, people still need toothpaste, toilet paper, and energy to heat their homes. But when consumers are hoarding every last dollar and capital is not available to any business because banks aren't lending, no sector can be a market leader. There are simply no safe sectors. The lesson here: In such extreme situations, there is no safe place to hide while still invested. Risk is not rewarded and investors' best move is to the sideline.
Government Policy Tends to Converge But the current recession began when interest rates were already relatively low. As recently as mid-2007 the benchmark Federal Funds Rate was steady at 5.25%. When the subprime crisis first hit, the Fed was quick to push them downward and then accelerated the pace as the Bear Stearns bailout and the Lehman Brothers collapse quickly unraveled the credit market. As 2008 came to a close, the target rate was essentially 0% -- the monetary equivalent of being on the floor. At this point, the main tool of monetary policy can no longer be used. The Fed would like to be innovative, perhaps buying long-term Treasuries on the open market in an effort to increase demand and price, thereby driving down interest rates that move inversely with price. It's an interesting idea, but may not be as effective as hoped although it would certainly be costly. Even if successful, it wouldn't be as effective or timely as the ability to lower benchmark interest rates. With the Fed essentially on the sideline, the government is left with fiscal policy. Back in the summer of 2008, initial plans called for the government to purchase bad loans from banks, thereby freeing lending institutions to lend without fear of holding all available capital in reserve to back non-performing debt. That went by the wayside and quickly all government assistance turned into government spending. Both republicans as well as democrats are on board with this, their main differences focusing on where and how they want to spend. The republicans talk of tax cuts, but unless they are clearly and directly targeted to create new jobs (e.g. tax credits for each new job created), their impact will be delayed for months, possibly until after the recession has ended by natural causes. Although the President's stimulus package signed into law in February ignores it, spending, too, should be clearly targeted. Funding projects to build or repair much needed infrastructure not only creates jobs, it provides tangible benefits for the future as well. Green initiatives? Not so much. Even if they prove successful, few jobs will be created and the results will be 10-15 years down the road, if then. The President's stimulus package was larded with other pork, little if any of which will create any jobs.
In a similar vein, sending tax rebates to consumers won't have the desired effect, either. President Bush tried it in the first half of 2008 only to have net incomes rise but expenditures remain unchanged. Why? Because consumers used the one-time payments to pay the mortgage or mounting credit card debt, or simply saved it to buttress their finances in the face of the darkening economy. None of these actions increased spending or demand and consequently, none of them helped spend our way out of recession. In testament to how little effect this had on consumer spending, in February 2009, less than one year from the Bush tax rebates, velocity (the number of times a dollar changes hands in a 12-month period) fell to its lowest level in eight years. Consumers simply weren't spending. Yet lawmakers can't be faulted for trying to spend the U.S. out of recession. With no monetary tools to fall back on, government spending is the only real path available. The shortcomings of the President's stimulus bill offers an expensive lesson: In order for government spending to have the desired effect on the economy, it must be targeted to create as many jobs as soon as possible. Strapped consumers can't be expected to spend direct payments when it's much more prudent to pay down existing debt or save the windfall. Instead, the government should focus on those who can create jobs immediately, and that means businesses. That might not win populist votes on the campaign trail, but it will go a long way to reversing the rising trend in unemployment while blunting the deepening recession.
No Business is Too Large to Fail You might have thought so prior to the distressed sale of Bear Stearns and Merrill Lynch or the utter demise of Lehman Brothers. These were well-established and respected institutions, too, yet in just a few short weeks, all were gone. By capitalization, Lehman was the smallest of the three, but its bankruptcy arguably had the biggest impact on the financial markets. At this point it's not possible to know for sure, but with Lehman being the smallest, perhaps the Treasury and Fed didn't think it was too big to fail. Instead of going to bat and facilitating a shotgun wedding at the eleventh hour as they did for Bear Stearns and Merrill Lynch, they may have just decided to let Lehman go under, thus avoiding the charges of creating a moral hazard. If this is what happened, the government certainly underestimated the impact even a smaller player could have on an already tenuous economy. Indeed, part of the problem was no one knew how intertwined unregulated securities were throughout the financial markets. When Lehman went under, everyone got a crash course (no pun intended). Unlike IndyMac Bank and Washington Mutual -- two other casualties of the subprime washout -- Lehman didn't harbor a lot of subprime debt on its books. It did, however, serve as counterparty of a number of credit default swaps tied to them. As you probably already know, a credit default swap is essentially just what it's name implies. It's a tool that allows the holder of a questionable credit to transfer the risk of default to a third party (called the "counterparty") in exchange for a premium. If the debt defaults, the counterparty pays the debt holder the full face amount of the debt as if it had matured. If the debt doesn't default, the debt holder is only out the premium and the counterparty makes a profit. Lehman was a counterparty and broker for a lot of subprime debt. When Lehman went under, the holders of that debt were suddenly totally exposed just as defaults were beginning to escalate. Lehman's demise greatly escalated the subprime crisis by increasing the demand to sell questionable debt. Everyone wanted to sell it, no one wanted to buy it. The price of credit default swaps skyrocketed, and debt holders found it virtually impossible to hedge their exposures. Did the government miscalculate by letting Lehman fail?
And that brings us back to GM -- and Bank of America, and Citibank, and so on and so on. On the one hand, one could argue if Lehman could fail and the economy could stand it, why should any institution be too big to fail? Certainly the demise of GM or Citigroup would have far reaching repercussions, but ultimately things will better without dysfunctional companies and bad debt. We bit the bullet with Lehman and we can do it again if necessary. Japan tried to sustain zombie banks for the better part of a decade sending the country into debilitating deflation. Perhaps the U.S. Treasury and Fed leaders learned from misstep. Of course what should happen and what will happen are often two, very different, things. U.S. leaders are doing everything they can to preserve jobs, not cost them. Any major firm going under will have immediate and dire effects throughout the economy. Not only that, and quite possibly even more importantly, the loss of confidence from such an event would weigh negatively for months to come. Like it or not, much of what drives the economy is perception and confidence. When those are compromised, the damage takes time to repair, perhaps more time than the government is willing to permit. The lesson here: No company is too big to fail, no matter what its capitalization or its reach. Lehman's bankruptcy proved that. Perceptions, however, are bigger than any immediate consequence and they alone may be enough to spur the government to prevent any additional loss of major industries. Hedges Don't Work Under Stress In the good times, Wall Street is known for handing out lavish bonuses. When the media hears of it, there is often a barrage of reports "exposing" this largess with the underlying assumption that no one can be that smart or that valuable to be worth that much. But those claims are actually arguable. When you stop to look at some of the remarkable (and complex) structured investment vehicles, swaps, and derivatives that have been created in recent years, you realize just how sharp their creators are. At least some of these Wall Streeters earn their extravagant bonuses. But despite all this, there's still a problem: Even the most sophisticated hedges don't do what they were designed to do when the market goes to extremes as it did in 2008. Hedges (again as the name aptly implies) are designed as a means for an investor to pass off some or all of the risk from a specific position. If investors feel they can rely on hedging instruments, they're willing to invest more aggressively. In other words, hedges offer the ability to leverage up risk. That's precisely what was going on before the subprime crisis broke. Unfortunately, most hedges weren't designed to work in severe credit crises like today's. Even if they were, it's difficult, if not impossible, to test them under such simulated conditions. This again comes back to relying on something that was designed for average market conditions when in fact this is a once in a lifetime situation. That's when investors need them to work the most, but precisely the time when they don't. Just as no one could have anticipated the depth and duration of the current crisis, no one could have tested available hedges under these conditions either. The lesson here: Don't rely on hedges to get you through abnormally rough markets. Hedges are best viewed as vehicles that can help you control risk you have to take but not as means to safely leverage up the risk on your entire portfolio. As investors learned in 2008, hedges are bound to fail you when you need them the most. Search this site! Just enter you key word or words:
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HEN THE ECONOMY FINALLY RIGHTS itself and growth resumes, pundits will emerge from the woodwork claiming to have predicted the sharp selloff that will have just ended. One thing's certain: More will claim this accolade than will be truly entitled to it. When even former Fed chief Alan Greenspan admits to being surprised by the quickness and depth of the crisis, you know virtually no one truly anticipated the extent of what was to come.
