What the GFC is still teaching investors today
Investors ignore the lag between the economy and markets at their peril.
This is the last instalment of a three-part series on market crashes and what investors can learn from them. The first in this series explores the .com crash. The second explored the Nifty Fifty.
The premise of this market crash series
I came into investing later than my older colleagues. I haven’t experienced major market events to any real extent. I was in high school during the Global Financial Crisis and had no dog in the fight. I do have some advantages over investors my age. I get to spend my workday reading and gaining an understanding of these infamous events. I try and get a sense of how investors reacted and the chain of events that led us to where we are today.
An influx of new people have joined the ranks of investors in the last decade as barriers have been lowered. They’re in the same boat. They don’t know the ‘lore’ of large market events and the crucial lessons that they taught investors.
Markets go through periods of euphoria and despair, and investors who understand these cycles, not just academically, but emotionally, are the ones that are able to build lasting wealth.
It is hard to replicate the experience of living through a full cycle. But it is worth understanding a few of these major market events that have become part of investing lore, and what they can teach us about becoming resilient investors.
This is the last of a three-part series into market crashes and what investors can learn from them.
The Global Financial Crisis
Unlike the other crashes that this series explored, there’s a larger cohort of investors that remember the Global Financial Crisis. I was in high school and although I wasn’t investing or working yet, I remember that it consumed the news cycle which made it a particularly interesting time to be taking Economics for my Higher School Certificate (HSC).
I am likely not alone in not having experienced the GFC given the influx of new investors in the past few years. For investors that did experience the GFC it casts a long shadow over their psychology. The GFC also is a frequent reference point in the financial news media to instil fear with every slight market drop.
An underlying theme with commentary on the GFC is how many investors now say it was obvious. It was obvious that it was a bubble before the market drop. It was obvious that the market was cheap at the bottom. The underlying message - it was obvious what investors should have done.
The truth is much messier. Before panic ensued, nothing about the GFC felt obvious. It was only during and after the collapse that all of the factors that led to the crisis seemed apparent. The theme interwoven through distorted memories of the whole crisis is that everything is obvious...in hindsight.
The story of the GFC didn’t begin in 2008. It began years earlier, with the great global faith in housing and leverage. There was an illusion of endless growth.
By the early 2000s, interest rates in the United States were at historic lows following the dot-com bust and the September 11 attacks. The Federal Reserve cut rates to 1% aiming to support growth. The cheap borrowing led to a housing boom.
Banks and financial institutions around the world began repackaging home loans into mortgage-backed securities (MBS), turning pools of loans into tradable assets. Rating agencies awarded these products high credit ratings, assuming that property prices in different regions around the US would never all fall at once.
Investors around the world bought them, including Pension funds, insurers, and even Aussie super funds.
As long as house prices rose, the system was watertight.
Subprime mortgages were loans made to borrowers with weak credit histories. They made up a small share of the market, but when home prices began to slow in 2006 and 2007, the system faltered. These borrowers started defaulting causing the system to begin to collapse.
In the Shortest History of Economics, Andrew Leigh likened it to Agatha Christie’s Orient Express – everybody did it. The bankers, incompetent credit rating agencies, gullible homeowners and lax policymakers were all involved.
Halfway through 2007, the system was under severe strain.
Two Bear Stearns hedge funds collapsed in July. Then BNP Paribas froze three funds due to ‘a complete evaporation of liquidity.’
The initial perception that the problem was contained to Wall Street changed quickly in 2008. In March, Bear Stearns was sold to JPMorgan Chase for $10 a share, down from $170, 12 months prior. In September, Lehman Brothers filed for bankruptcy.
Global markets crashed. The S&P 500 lost nearly 50% from its 2007 peak. The ASX 200 didn’t fare much better. Credit markets froze and central banks intervened with unprecedented measures but it was too late as panic had spread. Australia’s stimulus package approach afforded it the title of the only developed economy to avoid a recession.
The market bottomed in March 2009 when the S&P 500 had fallen 57% from its peak. The ASX 200 was down 54%. Valuations were cheap for investors that were still paying attention. Many weren’t.
In the United States, the cyclically adjusted price-to-earnings (CAPE) ratio fell to around 13 verses a long-term average of 17. Dividend yields were approaching 6%, with cash rates near zero. By all measures, the market was cheap.
For investors however, it did not feel cheap. Even as share prices started recovering, the economic data kept getting worse.
The lag between the market and the economy
One of the most fascinating aspects of the GFC is the disconnect between market performance and economic headlines. It is a perfect example of how market headlines can fill investors with anxiety about market conditions, when all objective measures are screaming ‘buy’.
In the U.S. unemployment didn’t peak until October 2009. This is seven months after the market bottomed. Investors who were waiting for the signs that the economy had stabilised missed a substantial portion of the recovery.
In that intervening period between March and October 2009, the S&P 500 had already risen 50%. By the time the labour market ‘caught up’, a large portion of the recovery had happened.
This was mirrored at home in Australia. Business confidence and consumer sentiment remained deeply negative even though the ASX 200 was climbing. By the end of 2009, it had climbed 37% since March.
Investors miss the best days
Investors trying to time the market will likely miss the best days. After every crisis, investors believe they will know better during the next one and understand when markets are cheap.
The lesson from the GFC is that nothing is obvious when it is happening to you.
Investors were surrounded with images of unemployment lines, small business closures and foreclosures. Superannuation balances plummeted, and retirees had to rethink their lives.
It’s difficult to be bombarded with those images and think it is the right time to invest. Markets were moving ahead of the data as they anticipated a recovery long before the recovery happened.
Source: AMP, Shane Oliver
This disconnect can cause investors to move too slowly to tactically allocate their portfolios. It’s why I choose not to. If I miss the best days, the difference in my investment account is stark. Over the last 30 years, if you missed the S&P 500’s 10 best days, your return would be cut in half. If you missed the best 30 days over the last 30 years, your return would be 83% lower. Most of these days occurred when the market felt risky. It is particularly important for me, early on in my investing journey, to avoid losing capital unnecessarily. Reducing my capital base will mean a significant impact on my total returns, as there’s a smaller amount to compound.
Investors who stayed the course
During the GFC, investors were rewarded for riding out the market volatility or investing when valuations were cheap. In the 10 years since March 2009, the S&P 500 rose 400% while the ASX 200 nearly doubled.
Many people who waited for an economic recovery missed the rebound. This is why long-term investing, through the market cycle, continues to be a more sustainable approach than predicting market bubbles.
I shared the phenomenal recovery of the share market since 2009. Cash has returned close to nothing during that same period. Investors who were looking to time the market, waiting for an opportunity to jump in, often missed out on part of the run.
Final thoughts
More than 15 years after the GFC, it continues to be a yardstick for how investors think about risk in markets. Today, many speculate that the markets are overvalued. Some investors believe we are in a bubble and continue to invest anyway, in the fear of missing out.
Although it is easy to recognise a bubble in hindsight, it is much harder when you are going through it. It is particularly hard to pin the recovery as the economy and markets tend to move in two speeds.
In 2007, markets were expensive, but in 2009, they were cheap. Investors often wait for good news, or confirmation that conditions are improving. The problem is that these signs often come after the market recovery. It is difficult to jump into a market when you are surrounded by bad news stories – decision making is influenced based on the emotion that these images and conditions elicit instead of valuations.
All investors can benefit from automating investing and having a structured plan. If tactical allocations are part of your investment strategy, create a wishlist of quality assets and the valuation that you want to purchase them at. This can help guide your decision making.
Invest Your Way
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