The Global Financial Crisis (GFC) remains one of the most important case studies for understanding investor behaviour and market cycles.

The crisis did not begin suddenly in 2008, but built slowly through years of cheap borrowing, a housing boom, and the widespread packaging of mortgages into complex financial products that were assumed to be safe.

When US housing prices began to fall and subprime borrowers defaulted, the financial system unravelled, leading to major institutional failures and a global market collapse.

Mark and Shani run through these events for investors who may not have experienced the crash in 2008, and the lessons that they can learn from the events that unfolded.

Read the full article here.

There are two other articles in Shani’s market crash series. The first in this series explores the .com crash. The second explored the Nifty Fifty.

Our guest episode with Morningstar Market Strategist Lochlan Halloway also covers lessons from market crashes, and how investors should prepare for one.

Mark’s webinar covers some lessons that we can learn from market crashes.

You can find the transcript for the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. Mark?

Mark LaMonica: Yes.

Jayamanne: You’re a squash champion.

LaMonica: I don’t know about that.

Jayamanne: You are. You are. So you got a medal. You won this championship at Hiscoes, your gym.

LaMonica: That is true.

Jayamanne: Tell us about it.

LaMonica: I won a couple matches in a row. They embarrassingly gave me a medal.

Jayamanne: Love it.

LaMonica: So they had some weird ceremony.

Jayamanne: I’m going to send the photo of the medal to Will, and then he’s going to put it on the YouTube.

LaMonica: Okay. That’s exciting. So yeah, no, they gave me this medal, and I just wanted to leave because I was getting into Saturday afternoon. But I felt like I couldn’t take the medal off while I was still in there. So I walked out and I walked out the door and there’s this cafe in Surry Hills and somebody sitting at the table and he was like, you won a medal. So it was all very embarrassing.

Jayamanne: Well, there you go. Well, congratulations. That’s awesome.

LaMonica: Thank you.

Jayamanne: So what are we talking about today?

LaMonica: Well, today, we’re going to talk about the GFC or the global financial crisis. And this is based on a series that you did, Shani. So you looked at three different market crashes. And what investors could learn from them? So which ones did you cover?

Jayamanne: Well, I covered the GFC, which is the one that I’m going to do today, the NIFTY50 and the dotcom bubble. And I was around for two of those, but I don’t remember one at all, the dotcom bubble. And I was in…

LaMonica: Because you were seven.

Jayamanne: Yes, I was. Yeah. And I was in high school during the GFC. So I really had no dog in the fight.

LaMonica: Okay. That’s good. So where’d you come up with this idea?

Jayamanne: Well, I think the series came from the fact that I started investing later on in life and much later than older colleagues. And I haven’t experienced major market events to any real extent, but I do have an advantage that I get to spend my workday reading and gaining an understanding of these events. And I try to get a sense of how investors reacted and the chain of events that led us to where we are today.

LaMonica: And just to be clear, you said later in life, you were 23.

Jayamanne: Yes.

LaMonica: Okay. It’s just not like you weren’t like 55. But I can imagine that you’re not alone. Many investors out there, relatively new investors have not experienced these events. We have had this huge, and this is a very positive thing, we’ve had this huge influx of new investors in the last decade, they’re all in the same boat as you, Shani. So they haven’t experienced these, you know, really monumental market events. And they do teach you a lot of good lessons. So it is something important to know. And you did have a line in your article, I’m going to quote you to you, but it’s a line in your article that I really liked. And you said 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.

Jayamanne: Deep stuff Mark but yeah, I mean, it’s 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.

LaMonica: Okay, so let’s get into the global financial crisis.

Jayamanne: Yeah, so I think unlike the other crises that we ran through, there is a larger cohort of investors that remember the GFC. And as I said, I was in high school. And although I wasn’t investing or working yet, it was a really interesting time to be taking high school economics.

LaMonica: I’m sure. But yeah, I mean, I think one of the interesting things is we are a product of all of our experiences. And so I think that for investors that did experience the GFC, it can of course, leave a mark and it can impact the psychology of how you actually invest. And I did live through the GFC. I was working, I was investing. And I think it’s left a mark on me. So as an example, I don’t invest in bank shares anymore. I’m the only Australian that doesn’t invest in bank shares.

Jayamanne: And I think it’s such a marker that it’s always the most common reference point in financial news media, when the market even drops slightly. And an underlying theme with commentary on the GFC is how many investors now say that it was obvious. It was obvious that it was a bubble before the market dropped. It was obvious that the market was cheap at the bottom. The underlying message is that it was obvious and it was obvious what investors should have done.

LaMonica: Yeah, and I think that is number one, just flat out not true. So the truth is much messier. So before all of the panic, nothing about the GFC felt obvious. It was only during and after the collapse. I’d really say after the collapse because during, it didn’t seem like things would ever come back. But it’s only after we’ve gone through that whole period that the factors that led to the original crisis seemed apparent. And everything obviously seems clearer in hindsight.

Jayamanne: And the story of the GFC didn’t really begin in 2008. It began years earlier with the great global faith in housing and obscene amounts of leverage. And there was this illusion of endless growth.

LaMonica: So by the early 2000, interest rates in the US were at that point historic lows, following the dotcom bust and then the September 11 attacks that occurred during the same time period. So the Federal Reserve cut interest rates to 1% and they were trying to support growth. And that cheap borrowing led to a housing boom. So of course, banks and financial institutions around the world started repackaging home loans into mortgage backed securities known as MBS. And they turned those pools of loans into tradable assets. And they did that so they could lend more money, right? If they could sell those bonds, they got money, they could go out and lend more. And rating agencies awarded those products high credit ratings. And their assumption, the underlying assumption behind that was that property prices in different regions around the US would never all fall at once. So investors around the world bought them because they had high credit ratings. So that include pension funds, insurers and even Aussie super funds.

Jayamanne: And 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 in 2007, the system faltered. And these borrowers started defaulting, causing the system to begin to collapse. And I recently read a book called The Shortest History of Economics by Andrew Leigh, and he likened it to Agatha Christie’s Orient Express. Everybody did it. The bankers, the incompetent credit rating agencies, gullible homeowners and lax policymakers were all involved.

LaMonica: What about you as a high school economics student? What role did you play?

Jayamanne: Just on the sidelines, watching along.

LaMonica: So halfway through 2007, the system was under severe strain. So there are two Bear Stearns, so Bear Stearns a former investment bank, they had two hedge funds and they collapsed in July 2007. Then BNP Paribas froze three funds. So basically froze investor withdrawals from those funds due to what they described as a complete evaporation of liquidity. 2008, the initial perception that this was a problem that was contained to Wall Street changed. So Bear Stearns was sold to JPMorgan Chase for $10 a share, and it was $170 a share 12 months prior. And then in September, the big collapse, that’s when Lehman Brothers filed for bankruptcy.

Jayamanne: And 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 because panic had already spread. An Australia stimulus package approach afforded it the title of the only developed economy to avoid a recession. And 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. But the thing was that many weren’t.

LaMonica: Yeah, and I think some context probably is helpful as well. So in the US, we always talk about the cyclically adjusted price to earnings ratio or the CAPE ratio. And it fell to around 13 versus a long term average of 17. So didn’t seem that cheap. Because even though the market fell so much, earnings were also falling significantly. Dividend yields did approach 6%, but a lot of those, of course, are backward-looking. And cash rates, as we said, were close to zero. So the market did appear cheap, maybe not screamingly cheap, but it turned out to be very cheap in retrospect. But a lot of investors just didn’t understand this. So even as share prices started recovering, the economic data kept getting worse and worse. So we do want to talk a little bit about the lag, and you discussed this in your article, the lag between the market and the economy.

Jayamanne: Yeah. So I think one of the most fascinating aspects of the GFC is the disconnect between market performance and economic headlines. It’s the perfect example of how market headlines can fill investors with anxiety about market conditions when all objective measures are screaming buy. And I mean, Mark, you were in the guts of this. So do you want to talk about your experience with this disconnect?

LaMonica: Yeah, absolutely. I mean, I think what people have to understand is that when you’re living through something like this, and I was obviously in the US, I think the US, as you talked about, was a lot harder hit than Australia from an economic standpoint, not a market standpoint. But one of the problems was that every headline was talking about huge layoffs. From a personal standpoint, I was a consultant at the time, and I was working with financial institutions who were all getting bailed out, who were going out of business, who were being sold at fire sale prices. And so unsurprisingly, a lot of our work dried up. They’re certainly not going to hire consultants when they’re laying off thousands of their own employees. And we were going through layoffs, the consultancy that I worked for.

And so, yes, maybe that we can say the market’s forward-looking, and it is, and it’s maybe looking 12 months out, but nothing feels safe. So it’s very hard to, one, put more money into the market if you’re worried about your own job. That’s a time that typically people will start building up cash reserves. And so, emotionally, it’s very difficult to deal with that time. You want safety. And so it’s hard to just go and try to interpret where the market is and put more money into it because it’s a buying opportunity. So, yeah, I think it’s just a lot more difficult to go through these situations because other things are going on than it’s often portrayed. And I think COVID is a good example of the same thing.

So something more people have lived through is that now we can sit there and say, okay, when the market fell a lot in February and March, it got really cheap, but we were all worried about the same things, right? We were worried that there would be wide-scale layoffs. You’ve had all these government programs coming out and they all worked. But ultimately, we were worried that the economy would crash. You lose your job. Worried about health outcomes. So there’s a lot of things going on in your head. It’s hard to objectively look at the share market.

Jayamanne: All right. So I’m going to add a little bit more context to this. So that’s that in the U.S., unemployment didn’t peak until October 2009. And this is seven months after the market bottomed. Investors who were waiting for the signs that the economy had stabilized missed a substantial portion of the recovery. And in that period between March and October 2009, the S&P 500 had already risen 50%. And by the time the labor market caught up, a large portion of the recovery had already happened. And this was mirrored at home in Australia. Business confidence and consumer sentiment remained deeply negative, even though the ASX 200 was climbing. So by the end of 2009, it had climbed 37% since March.

LaMonica: And, I think the lesson here is how difficult it is to time the market. And, it looks obvious when you go back, as we said before, it looks obvious when you go back and look historically at a price chart, right? You see these big dips. It seems obvious buy at the bottom. But it is really, really difficult to do that. And what ends up happening is investors tend to miss the best days. And, after every crisis, investors assume, okay, they’ll know better in the next one and understand when markets are cheap. But the lesson from the GFC is that nothing is obvious when it’s happening to you. Investors were, as I said before, surrounded by these images of unemployment. There were small businesses going under. People’s houses were being foreclosed on. So, superannuation in Australia, even though, as you said, the economy did not fall into a recession, the market goes down 57%. That’s decimating your retirement savings. So you’re seeing your super balance go down significantly. Retirees had to rethink their lives when they were going to retire.

And so it’s just really difficult to have all of these different images being bombarded by all of these different images. And have in your head, this is the right time to invest. So if it was easy, everyone, of course, would do it. So markets move ahead of data. But there’s also a lot of false rallies that then disappear. So we just need to remember that. So markets do anticipate recoveries, but it can be very difficult.

Jayamanne: And this disconnect can cause investors to move too slowly to tactically allocate their portfolios. And it’s why I choose not to. So if I miss the best days, the difference in my investment account is stark. Over the 30 years, if you miss the S&P 500’s 10 best days, your return would be cut in half. If you miss 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. And it’s 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. And there’s a much smaller amount to compound. So let’s talk a little about investors who stayed the course.

So during the GFC, investors who stuck it out and rid the market volatility and invested when valuations were cheap did really well. In the 10 years since March 2009, the S&P 500 rose 400% while the ASX 200 nearly doubled. And many of those 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. And we talked about 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 the best part of the run.

LaMonica: So it’s been 15 years since you were in high school and the GFC occurred. And I do think, as you said, it’s in the media a lot, still this yardstick for how investors think about risk in markets. And by a lot of measures, today’s market is considered overvalued. And some investors believe there’s all this bubble talks. Some people believe we’re in a bubble, but continue to invest anyway just because of this fear of missing out. So what should people think about?

Jayamanne: Yeah, although it is easy to recognize the bubble in hindsight, it is much harder when you’re going through it. So it’s particularly hard to pin the recovery as the economy and markets tend to go in two speeds.

LaMonica: And in 2007, markets were considered expensive. But in 2009, we knew on a forward-looking basis that they were cheap. So investors often wait for good news or perceived safety, just confirmation, some sort of confirmation that things are actually improving and that it isn’t a false rally. But the problem with this is the signs often come well after the market recovery, as we said. So it’s difficult to jump into a market when you’re surrounded by bad news stories and your decision-making is clouded based on all of the emotion that these images and conditions elicit instead of just focusing on valuations.

Jayamanne: So lesson here is that all investors can benefit from automating, investing and having a structured plan. If tactical allocations are part of your investment strategy, create a wish list of quality assets and the valuation that you want to purchase them at. And that can help to guide your decision-making.

LaMonica: And one place, Shani, that you can learn how to put together a structured plan is our book.

Jayamanne: Good segue, Mark.

LaMonica: Thank you. But anyway, thank you guys very much for listening. We do really appreciate it. Hopefully you learned a little bit from the GFC, whether you lived through it or whether you were in high school like Shani.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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