The past year has been financially chaotic on a level almost no one alive has ever seen. The devastation has hit almost everywhere, world wide, including finance, manufacturing, oil, consumer companies, technology, real estate and commodities.
2008 was the worst year for the S&P 500 since 1937, and the third worst year ever for the Dow (behind only 1907 and 1932). The NASDAQ had a worse year than in 2000, when the great tech bubble broke. 95% of S&P 500 stocks were down for the year. Only six funds out of 1,591 US mutual funds larger than $250mm were up, leaving 99.6% of the funds down for the year.
Since the Great Depression, only two recessions have run longer than this one, the first ending in 1975 and the other in 1982. Each lasted 16 months, according to the National Bureau of Economic Research.
The current recession, beginning in December 2007, has run 13 months and could easily surpass those two. If it goes past March, as many economists expect, it will become the longest-running since the 43-month Great One that ended in 1933.
So what brought all this about? I will try to describe in a nutshell what transpired this past year:
Suppose a bank has $1 billion of capital. They buy $30 billion worth of triple-A mortgage-related debt using $29 billion in loans from their gracious neighborhood banker. This sounds like very high leverage (and it is), but many financial institutions did just that, because their models told them they can't lose more than 1%. However, suddenly home prices decline nationwide, and 20% of the mortgages default. The recovery on them turns out to be only two-thirds, thus the bank loses $2 billion, or twice its capital, which makes it insolvent. The marketplace quickly grasps that there'll be nothing left for the people who are last in line to withdraw their money, and there's a run on the bank.
Sounds bad, but that's just the beginning. Many related scenarios also took place simultaneously. Suppose now that another bank sold some hedge fund $5 billion of credit default swaps on the bonds of a certain company, and to insure itself bought $5 billion of credit protection on it. The company went bankrupt, and the bank paid the hedge fund $5 billion. But the firm that sold our bank the insurance also went bankrupt, and the bank can't collect the $5 billion of insurance due to it. The bank's capital is gone and now it is also bankrupt.
Now assume another bank lent $5 billion to an investment firm with equity of $1 billion. That investment firm in turn bought $6 billion of securities, a conventional leverage ratio on Wall Street until this year. The value of the firm's portfolio fell 17% (not uncommon in 2008 markets), wiping out their entire equity. The bank demands more collateral but there is none. So the bank forecloses the portfolio and tries to sell it in an illiquid down market. It can only get $4 billion for it and so they lose $1 billion, their capital is gone and the investment firm is out of business.
Consider all the funds that borrowed to buy securities and had many of the same positions. When the firm in the example above got its margin call, its liquidation forced securities prices lower. This exacerbated the downward spiral and created mark-to-market losses for many more institutions.
All of the above scenarios and many more are exactly what happened to banks and financial institutions across the globe, and that's why so many of them either disappeared or needed a bail out from their respective governments. The common denominator was the combination of leverage and a false sense of security borne by flawed assumptions. Because extreme volatility is rare, they assumed unusually large losses did not exist, so banks all over the world were engaged in a high-risk game, misunderstanding it as low-risk.
How can scores of sophisticated, experienced people make such flawed assumptions, and be inveigled into making such horrible investments? They did so because they placed ambiguous values on homes, the underlying collateral of all those mortgages. Some people may think a house is worth its cost to build, others prefer replacement cost, yet others place a certain multiple of rental income as the value, or what it last sold for, or what the one next door sold for. Some people even gullibly believed a house is worth what the bank is willing to lend against it. But the truth is houses are worth what someone will pay for them at any given point in time.
So now we are witnessing the greatest deleveraging in history, leading to forced selling in security markets around the world. The panic is extreme and the indiscriminate selling urgent.
This is the third bear market I personally endure since starting in this business, and the second since launching my investment firm, Wellcap Partners. Bear markets are difficult experiences, but they provide unique prospects. I believe we will look at the present U.S. stock market valuations as perhaps the best investment opportunity of a generation.
For the market to go up from here, the news doesn't have to be good. It just has to be not quite as bad as what has already been discounted. The world is not ending; indeed there are many mitigating factors. Interest rates are low, inflation is low and unemployment is still within reasonable levels. The US and EU took initiatives to bolster banks and guarantee their debt. Consumers now benefit from drastically lower energy prices.
There are also many indicators showing the US stock market in general is cheap. For example, equities as a percentage of GDP are now at 59% vs. long term average of 79%.
Or ponder this: at the November market low, the S&P 500 annualized ten year real return (inflation adjusted) was a negative 3.8%, an all time low. At the 1974 low, the trailing ten year annual real return was negative 2.7%. Moreover, the annual 10 year return for large company stocks has turned negative only two other times since tracking began in 1926, and that was in 1938 and 1939.
The S&P 500 index was at 1,200 on January 1999, ten years ago, and it is at 900 now. Do you really think the largest US companies are worth 25% less than they were ten years ago, with all the economic growth, technological breakthroughs and productivity advances, not to mention plain old inflation, of the last decade? I don't think so. Eventually value will trump fear, as it always does.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.