As the third quarter comes to a close, we are reminded that financial markets don’t always rise, and volatility can attack without warning and as we have just seen, quite swiftly.
When the dust settled, the S&P 500 finished the quarter down 6.4%, corporate bonds lost close to 5%, and emerging market equities would go down an unbelievable 18.5%!
Times like these understandably bring back memories of the financial crisis of 2008. Many looked on helplessly as their 401(k)s were reduced to 201K’s, and investors’ (especially retirees) lives were changed. It’s taken eight years and a good deal of anxiety to crawl our way back. So, clients are asking me to important questions: first, is this the start of another crisis, and second when will the pain stop.
But, to address the first question, let’s recall the key factors that caused the financial crisis back in 2008; and then compare them to what’s happening today.
- Debt levels: Companies and even consumers were so badly in debt they could barely keep up with interest payments. And when borrowers defaulted, lenders incurred massive losses and this completely shut down the credit markets. “To big to fail!” became a much abused expression.
- Economic Health: The Fed was pushing us into a recession for many years in order to control inflation. There were many interest rate hikes and that started to impact the economy in nearly every sector.
- Banks: because the banks had so much risky debt on their books, they were severely under-capitalized. Nevertheless, they promoted complex financial products that nobody could even understand including themselves. They even convinced ratings services like Moody’s, S&P, and AM Best to forsake their unbiased analysis; and to instead, became complicit in the bad credit carnage that was to follow.
- Corporations: In the years leading up to 2008, companies spent a great deal of money, which in turn, resulted in depressed profit margins. This resulted in another recession, and they were in no shape to weather the storm.
- Subprime Lending: Imprudent lending standards combined with falling housing prices across the globe created a panic that spread to the world’s entire financial system.
In other words, we were in really bad shape back in 2008, and it was inevitable that there was going to be a crash. What made matters worse, is that all these negative effects created the perfect financial storm. It happened with such speed and such depth that it was impossible to time the crash or to trade through all the volatility. It would be easy to compare this to not just a 100 year storm, but maybe even 1000 year storm. Wall Street and the global economy was hit with a category 5 hurricane all at once.
So as you can see, the financial crisis of 2008 was in fact very rare event. Let’s look at these same factors today to see if there’s any reason to think that history could repeat itself:
- Debt Levels: Companies and even consumers have gone out of their way to reduce their debt burdens. Credit is accessible and inexpensive. The savings rate has doubled, credit card balances have shrunk and with the low interest rates, corporations are beginning to grow their businesses.
- Economic Health: We all have seen that our economy has experienced some steady but slow growth; and the Fed is going out of their way to avoid another recession. If anything, they will make sure that we remain in this growth mode for the foreseeable future.
- Banks: Regulations and financial reform has caused banks to straighten up. Financial institutions are no longer exposed to the kinds of risks that were prevalent back in 2008.
- Corporations: Across the economy, companies have cut costs, installed leaner technology, and have become better prepared to manage critical situations. Operating margins and cash balances have never been higher for S&P 500 and international companies.
- The Subprime Crisis: In retrospect, the subprime situation has been beneficial in the same way a brush fire promotes new growth. Even though the media hyped up the damage when consumers and corporations defaulted, they were nowhere near what was originally feared. Most consumers have since recovered and most lenders have survived.
As for our second question about when the volatility will end, I don’t pretend to have an absolute answer. When I try to analyze the reasons for the selloff that we just experienced in the third quarter of 2015, the only conclusions I can make on that they were largely emotional and really had no basis in fundamental financial logic. For example, why the markets worried so much about China and Greece, given the fact that we do not have that much exposure to them, is a mystery to me. I’m also scratching my head over the major selloff in the biotech industry due to Hillary Clinton’s criticism of drug pricing; particularly since we are 16 months away from an election where she hasn’t even been nominated as the candidate.
As you heard me say before, you shouldn’t be listening to all the financial noise out there. Don’t use the headlines to sell stocks one day and then buy them the next. In other words this emotionally – inspired volatility will only become real if you let it. Those who sell into the panic or try to time a bottom are asking for trouble.
Rest assured I have no intention of making this downturn relevant. Instead we continue to remain focused on positioning your overall allocations to benefit from a slow growth economy in a rising interest rate environment. The changes made this quarter in our strategist portfolios reflect this fact. We are certainly watching the volatility very closely and understand that we could be in for a more robust correction of another 10%. However, I don’t recommend making any moves until the risks-to-reward opportunity becomes more attractive… We are not going to buy stocks simply because they’re going down on any given day.