Lessons for the next financial downturn, courtesy of 2008

During the grim days of September 2008, many saw the bankruptcy of Lehman Brothers Holdings Inc. as the end of Wall Street.

In the weeks after its collapse, German finance minister Peer Steinbrueck declared that the long era of U.S. economic hegemony was over. For his part, French president Nicolas Sarkozy was sure Lehman’s failure marked the end of unrestrained American-style capitalism.

Just about nobody at the time recognized Sept. 15, 2008, for what it turned out to be: A fine moment to buy U.S. stocks.

In the 10 years since then, the benchmark S&P 500 index of large U.S. stocks has roared to new heights and delivered a total return of 267 per cent, in Canadian dollar terms. Rather than signalling the end of U.S. financial dominance, Lehman Brothers’ failure marked the beginning of a decade in which U.S. stocks would far outstrip the returns from every other major asset class around the world.

You can take this as you will. For some people, it’s proof of the superiority of American capitalism. For others, it’s not so much an endorsement of business U.S.-style as it is a story about how investors overreact to crisis. For still others, it’s a matter of luck.

But whichever perspective you prefer, a look back at how various asset classes have performed over the last decade can suggest a few tentative lessons about what to do when the next market downturn hits.

The first lesson is that doing nothing is often an outstanding idea. The problem with rushing to safety during an emergency is that it’s not always clear where safety lies.

The accompanying table demonstrates the point. Since Lehman Brothers failed, the S&P 500 has produced a total return – that is, both stock price gains and dividends – of 13.9 per cent a year. By comparison, people who responded to the crisis by stampeding to the apparent haven of gold have had to be content with a total return of only about 6.4 per cent a year. And those who took refuge in bonds have enjoyed even more lacklustre results. (All returns calculated in Canadian dollars.)

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Investors who figured there might be safety in avoiding the troubled U.S. market have also been left in the dust. Canadian stocks have produced less than half the gains of U.S. stocks over the past decade. European, Asian and emerging market stocks have also lagged behind, although by smaller amounts.

If nothing else, the surprisingly strong performance by U.S. stocks demonstrates the unpredictable nature of financial crises. As Lehman collapsed, it would have seemed lunatic to pour money into the epicentre of the expanding financial catastrophe. But, in retrospect, it would have been a genius move.

Mind you, sticking with that decision would have required an outrageous amount of intestinal fortitude.

The S&P 500 closed at 1,192.70 on the day Lehman died. It was not until nearly six months later that the market finally hit bottom, at 666.79, on March 6, 2009. So someone who rushed to take advantage of the crisis atmosphere in September 2008 would have lost nearly half their money before finally seeing signs of a rebound.

This points to a second observation about crises: Backward-looking valuations are an uncertain guide when everybody is panicking. Markets began to fall in late 2007. When Lehman failed, U.S. stocks already looked cheap in comparison with their highs of a year earlier. But that didn’t prevent those apparently cheap stocks from becoming far cheaper.

The key factor in turning around market sentiment was evidence that U.S. policy makers were willing to take decisive action. The Federal Reserve dropped its key lending rate to zero and stepped up to play its role of lender to last resort, not just to U.S. financial institutions but as a provider of liquidity to central banks around the world. In addition, the newly elected Obama administration unveiled a large stimulus package in early 2009.

This suggests an uncomfortable truth: An investor who hopes to do well during a crisis has to pick not just the right assets, but also the right policy makers. The supremacy of U.S. stocks over the past decade owes a lot to the willingness of the Fed and Congress to experiment with at least a moderate amount of stimulus.

In contrast, the euro zone has stumbled from one self-made crisis to another. Its tangled politics and steadfast reluctance to take more dramatic action in terms of fiscal stimulus are arguably the big reasons its economy, and its stocks, have struggled through such a lacklustre decade.

To be sure, policy is not the only reason for Wall Street’s big comeback. U.S. stocks have benefited hugely in recent years from the amazing performance of a handful of tech stocks, such as Amazon.com Inc. and Apple Inc. In contrast, Canadian stocks have suffered from the collapse of the commodity boom after 2011 and a later swoon in oil prices.

This underlines a final point about financial crises, and financial trends in general: They tend to have a relatively short life. Few bull markets last for more than a decade. Today’s winners are often tomorrow’s losers and vice versa.

After nearly a decade of going straight up, U.S. stocks now look expensive on many measures. Rising interest rates are likely to pose a challenge to continued gains. Whenever the next crisis comes, investors shouldn’t count on a replay of the last emergency. Just as U.S. stocks have dominated the last decade, chances are that another asset class will be the big winner over the next 10 years.