Have investors learned from the past decade?
As the 10th anniversary of the start of the 2007-08 meltdown approaches, today's markets show some similarities – and differences
Looking back on his own notes from a decade ago with a kind of morbid fascination, Jim Hall had one big question for his former self: "Why weren't you selling?"
Going on a selling spree certainly would have spared him and his investors from much of the carnage that was to come – the credit crunch, the stock market crash, the global recession.
As chief investment officer of Mawer Investment Management Ltd., a position he still holds, Mr. Hall took extensive written notes that now serve as a time capsule of sorts, revealing his mindset as the crisis unfolded in real time.
His thoughts from that era show an investor disinclined to make dramatic defensive moves, though he was keenly aware of a buildup of systemic risk long before the global financial crisis truly swung out of control.
And though he did take a more cautious stance back in 2006 and 2007 by reducing exposure to financials and loading up on the kind of companies that might be better positioned for a downturn, like those with low debt and high recurring revenues, by no means did he fully retreat from the stock market.
But that probably would have been the wrong move, anyway, Mr. Hall conceded.
Even if forearmed with the knowledge that the worst collapse in stock prices since the Great Depression was on its way, that would hardly have made timing the market any easier, he said. These kinds of episodes take a long time to play out.
"The temptation is to think you could have done things differently and gotten yourself out of the way. But I just think that's a false lesson to take away," he said. "And it would be the wrong thing to do today."
That resolve could very well be tested before too long, he said, just like it was tested a decade ago.
On Oct. 9, 2007, the S&P 500 index hit a new all-time closing high, marking the start of a devastating bear market that took almost a year-and-a-half to bottom out, by which time 57 per cent of the index's value was wiped out. Canadian stocks followed a slightly different trajectory, peaking in June, 2008, thanks to a brief mania for oil stocks.
The 10th anniversary of that tipping point in U.S. stocks finds the market in a strikingly similar state to that which preceded the great collapse. From valuations, to volatility, to sentiment, the parallels are hard to ignore.
From the perspective of some investing pros and strategists who lived through the turmoil just getting started in 2007, we look at what's changed, what hasn't, and what lessons the crisis might teach us about the market today.
Signs of strain
Back in October of 2007, a long bull market in U.S. stocks was looking increasingly fragile, if not doomed.
Five years of steady equity gains had followed the low point of the dot-com bubble bursting. Since the fall of 2002, the S&P 500 had doubled, with late-cycle strength being provided by sectors tied to the broader economy. That long up-trend inflated stock valuations to the high side.
While volatility had begun to awaken earlier in 2007, the CBOE market volatility index, or VIX, registered unusual calm in dipping to a 14-year-low below the 10-mark.
Investor sentiment was generally running pretty high in 2007, though the tremors rippling out of the U.S. housing market were gaining strength.
The business cycle in 2007, meanwhile, seemed to be coming to its later stages after a long credit binge. And the U.S. Federal Reserve had been raising short-term interest rates after a prolonged period of easy money conditions in response to the tech bust.
All of which is to say that 2017 is starting to feel a whole lot like late 2007, said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. "I'm just as concerned now as I was back then." He gives the bull market another year, tops.
Considering the source, that statement alone should give market bulls some pause.
Then Merrill Lynch's top North American economist, Mr. Rosenberg was a voice of doom over the U.S. housing and mortgage market as early as 2005, and he foresaw the end of the credit cycle and the economic recession.
The crumbling of the subprime mortgage market was "a classic late-cycle development," he wrote in 2007. He's starting to get similar readings about today's markets.
Which leads to the first big lesson of the financial crisis: That events of that magnitude are possible, however unlikely.
"The idea of a financial system meltdown was very fringe back then," Mr. Hall said.
By October, 2007, the scope of the problem was coming into focus. New Century Financial Corp., a leading U.S. subprime mortgage lender, had filed for bankruptcy protection, BNP Paribas and Bear Stearns had stopped allowing investors to pull money from some funds exposed to subprime losses, and Northern Rock was subject to the first run on a British bank in 140 years after the mortgage lender received emergency liquidity support from the central bank.
What was previously unfathomable was quickly moving into the realm of the possible. But even still, Mr. Hall said he pegged the risk of a collapse in the global banking system at no higher than 30 per cent.
By the following March, Bear Stearns – one of the world's largest investment banks – was rescued in a shotgun wedding with JPMorgan Chase.
"That's when everybody got the plot," said Hanif Mamdani, then the chief investment officer of Vancouver-based money manager Phillips Hager & North.
"We had to go down the list of every financial institution and figure out who's going to make it and who's not."
Now serving as head of alternative investments for RBC Global Asset Management, Mr. Mamdani said he now carries with him a healthy fear of extreme outcomes, as improbable as they may be.
"The credit crisis left an indelible mark on our investing psyches," he said.
That's not to say that a replay of 2007 to 2009 is in the works. The risks are different this time around. Financial institutions now have thicker equity cushions and nowhere near the same level of risky loans on their books.
The level of complacency is surreal.David Rosenberg
But the markets still have to sort through the effects of a decade of ultra-low interest rates, and the unprecedented stimulus programs known as quantitative easing. Since 2008, the world's central banks have pumped more than $12-trillion into the global economy through asset purchases.
Stimulus programs have kept long-term interest rates low and served to direct investors into riskier assets, like equities. Valuations on equities and other assets have pushed higher as a result, leading some to fret over whether central bankers have inflated multiple asset bubbles by keeping loose policy in place too long. If so, those bubbles could deflate or pop as all that stimulus starts to go into reverse.
At the same time, investors seem to be exhibiting no sensitivity to the risks, as nearly every trading day rings in a new all-time high in stocks with very little variation. On Thursday, the VIX index hit a new record low of 9.19.
"The level of complacency is surreal," Mr. Rosenberg said. The apparent absence of fear is a sign that the market's collective attitude has swung too far back toward greed and away from a healthy fear of the risks, he said. And that kind of sentiment is but one hint that the bull market is in its later stages.
"I think it's time to move to a late-cycle portfolio," Mr. Rosenberg said. That kind of approach generally tilts toward balance sheet strength, earnings predictability, and a low correlation to the economy.
However, "there is always the danger of being way too early," Mr. Rosenberg said. "That was the lesson I certainly learned when I was at Merrill."
It's another important lesson for all investors to bear: Timing the market is never easy.
In late 2006 and early 2007, it was not terribly difficult to sense the approach of danger. But liquidating one's investments in anticipation would have resulted in missing out on some blockbuster returns.
From June, 2006, to October, 2007, the S&P 500 rose by 28 per cent. Canadian stocks took far longer to succumb to the credit crunch. In the two years up to June, 2008, the S&P/TSX composite index rose by 38 per cent.
That's not to say that investors shouldn't take precautions in the face of rising market risks; there's a big difference between that and selling everything, Mr. Rosenberg said.
"I'm not saying to have to head for the hills, that you have to move into cash, that you have to start stocking your shelves with canned tuna," Mr. Rosenberg said.
But an irrational market calls for a more conservative strategy, another key lesson the financial crisis made clear.
Fear of missing out
One of the iconic quotes from the pre-crisis days came courtesy of then Citigroup CEO Chuck Prince.
"When the music stops, in terms of liquidity, things will be complicated," Mr. Prince said in July, 2007, regarding the prevalence of loose lending standards and problems in the subprime mortgage market. "But as long as the music is playing, you've got to get up and dance. We're still dancing."
Citigroup was saved from bankruptcy by a government bailout in November, 2008.
One of the features of the aging bull market in 2007 was that few were willing to sit out on the market's still-impressive gains, Mr. Mamdani said.
"Everyone kind of knew we were getting close to the scary part of the movie, and yet nobody wanted to miss out. Nobody wanted to be too early. If you missed the last run-up, your clients would fire you," he said.
His own clients, however, were willing to give Mr. Mamdani and his team the latitude to move away from the market's riskiest pockets, potentially sacrificing some returns in the process.
His big moves at the time, however, left him with another important lesson: While your market call may be correct, you may not choose all the right safe havens.
He correctly avoided a lot of the "really bad stuff," like structured products and the mortgage market, he said. "But we upgraded our portfolios by buying debt in some very high-rated U.S. financial institutions. We felt that the debt of Morgan Stanley and other investment banks were sound. That was a mistake obviously. We didn't appreciate just how much risk was embedded in those balance sheets."
He got the chance to unwind some of those positions in the autumn of 2007, which was one of the last really good opportunities to shed risk, he said.
After that, the indiscriminate selling in the market made it difficult to unload much of anything.
For Mr. Hall, that was another crucial lesson: "You can't fix your ship in a hurricane. Once the storm hits, it's too late. There's nothing you can do," he said.
Selling a security at 50 cents on the dollar to buy something else as deeply discounted would have left one no further ahead.
Fortunately for Mr. Hall, he was able to insulate his portfolios from the market's worst losses, by having already shifted into the equity of high-quality, low-debt companies.
Once the worst of the storm had passed, however, the playbook changed entirely, emphasizing a lesson of any major market event: They can present once-in-a-lifetime buying opportunities.
In early 2009, it became clear that governments and central banks were going to do what they needed to backstop markets and "stop the fear cycle," Mr. Mamdani said.
The bargains were everywhere, on even the best companies.
"You didn't need to be a genius stock picker at that point," he said. He focused on the equity of some of the most enduring consumer brands, like Colgate-Palmolive, Coca-Cola, Procter & Gamble. Their price-to-earnings ratios had plunged to around 12 times, and on depressed earnings.
In 2009, the hedge fund he oversaw put up a return of nearly 50 per cent.
"Probably never again to be repeated," he said. But anything's possible, no matter how unlikely.