My How Time Flies in the Bull Market

Happy 10th Anniversary!
My How Time Flies in a Bull Market!

We humans celebrate and mourn many things, typically on their anniversary dates. Happy ones such as marriages, births, graduations or victories, as well as infamous ones such as the attack on Pearl Harbour or “9/11” are all well recorded in our memories and history books.

This September, we investors are dealing with two anniversaries. The first was a financial disaster that occurred ten years ago when Lehman Brothers collapsed, triggering the worst stock market crash since 1929 and ushering in The Great Recession. Then, a mere six months later, we celebrated the birth of what is now the longest (but so far, only the third strongest) bull market in history!

On such an occasion, it makes good sense to look both backward and forward, to see where we’ve been, where we’re at, where we may be headed and why. As Winston Churchill so famously put it: “Those who fail to learn from history are doomed to repeat it.”

Let’s start with the history:

In mid-to-late 2007, all looked to be going swimmingly. The markets were on a roll, rallying strongly over the five years from the bottom of the “Dot Com” crash that finally reached its final low in late 2002.

Then suddenly, and seemingly out of nowhere, two hedge funds at Bear Sterns & Co. (then, the fifth largest investment banking firm) collapsed. What was going on here??? Turns out, these two hedge funds were invested in heretofore little understood instruments known as CLOs, CDOs and other “obligations” that ultimately proved to be worth very little (if anything at all). In March of 2007, Bear Stearns itself collapsed and was bundled off to J. P. Morgan Chase for only $2.00/share.

Well, mistakes happen and that (surely) would be that. Except that it wasn’t. In September of 2008, Lehman Brothers, the fourth largest investment banking firm, saw its shares crater – from over $85 in January of 2007 to ZERO by September of 2008 – after the Federal Reserve and other Wall Street and global investment banking firms all refused to step in to save the crippled firm with a bail out or acquisition. What was going on???
Lehman’s, like Bear Stearns, had made huge bets on these leveraged instruments based on the strength of the U.S. housing market. Then, with a collapsing real estate market, these complex instruments became toxic, bringing down the eighty-five-year-old Lehman Brothers and nearly the entire global financial system. For those who saw this as a uniquely “American” crisis, it should be noted that the European Banks and other financial institutions owned half of all the “O”s outstanding.

The party was over, and only quick action by the Federal Reserve, the U.S. Treasury and Congress averted financial catastrophe by creating the Troubled Asset Relief Program (“TARP” for short). The rating agencies had egg all over their faces – for they had seen none of this coming and had assured investors of the creditworthiness of much of what turned out to be junk.

How quickly it fell:

The equity markets swooned in the face of banks being unwilling to lend to one another (let alone anyone else) and Hollywood got some great material for at least three subsequent blockbuster films. By March of 2009, the S&P 500 hit 666, down almost 55% from its high of 1503 less than two years prior.

Here’s the point: virtually no one saw any of this coming. Not the Federal Reserve, not the Treasury, not the Rating Agencies, not the Wall Street pundits…no one. But that didn’t stop it from happening.

Once the system was stabilized Congress got to work, predictably fighting the last war, by enacting the Dodd-Frank Act. This legislation was meant to ensure that the reasons behind the 2008-09 meltdown would not serve as the reasons for the next market downturn. So far, it can reasonably be claimed to have worked.

As an aside, Congress made sure that Wall Street took its fair share of the blame while side-stepping its own culpability in the creation of the financial crisis through forcing Fannie-Mae and Freddie-Mac (the two Federally Insured mortgage corporations) to relax their mortgage lending standards to the point at which one didn’t even need an income to acquire property. Be that as it may, banks did raise substantial additional capital and are, to be sure, on a much sounder financial footing than they were ten years ago.

Where we are now:

Today, both equity and fixed income markets are near or at all-time highs. We have a reasonably robust economic landscape in both North America and Europe (with certain exceptions, like Italy), with low absolute rates of unemployment and some wage growth, fueled by yet more borrowing (by the U.S. Federal government and the over-extended Canadian consumer), and a much-improved banking system. The Euro has held up and the U.S. dollar is strong, as are corporate profits. Valuations in the equity market are not unreasonable given where interest rates are presently. As the optimist proclaims – we live in the best of all possible worlds (and the pessimist fears…this is true). So, what could go wrong … what could go wrong???

There is no “law” that states when the economy or markets must (let alone will) top out, but they always have and it would be naïve to say it won’t happen again. The trick is identifying the ‘when’ in advance of the fact.

Let’s be very clear – at Logan Wealth Management we do not think the world is a bad place nor is it to be shunned from an investment perspective. As ever, some investments will prove better than others depending on the environment we find ourselves in over these upcoming two years. Just because markets are at all-time highs does not mean that we are facing a crash – in fact, a run-of-the-mill ‘pull-back’ (of say some 10%) could be both useful and welcomed.

We can identify three factors which could bring on a market pull-back and/or economic slow-down. They would be:

1) An earnings recession. After a strong run-up in corporate profitability (some induced by the recent Trump tax cuts) earnings could take a breather and grow at a slower to a much slower pace in 2019 -2020.
2) Lower economic growth. This would not surprise as, according to economists, the U.S. has been growing at “above trend” growth, again, in part, due to the tax cuts. Meanwhile, growth in other regions has slowed from what may in hindsight prove to be a peak.
3) Rising interest rates, particularly at the short end (three months to two years). This is very much at the behest of the Federal Reserve which is anxious to curb any upward trend in inflation, and to have some room to reduce rates if (when?) the economy teeters.
We can also identify three factors which, if allowed to occur (or, worse, get out of control) could – we repeat, could – trigger a crash in either the markets or general economy.

1) The eruption of a trade war, especially between the U.S. and China.
2) An Emerging Market crisis. Think here of Turkey or Brazil, or a surprise default from another country, which at the time of writing could prove to be India, as a prominent infrastructure bank in that country teeters. In and of themselves, such crises can and typically have been contained. However, like the “Asian Flu” crisis of 1997 (which started in Thailand and quickly spread to other countries), or the Russian debt default in 1998, these one-offs can metastasize very quickly and, like a cancer, spread to other countries or markets in short order.
3) A Flash Crash. This could be triggered by what has become known as the “Fat Finger Syndrome”. Imagine that a trader enters a trade on his computer and hits the wrong combination of numbers, which causes massive sell order to go through (say of a million shares instead 100,000). When this happened in 2016, it knocked 1000 points off the Dow Jones Index in less than five minutes and spooked the market for weeks. It could also come from a variant on this theme which has one of the massive derivative contracts outstanding (there are over $600 trillion worth outstanding) failing to settle. It is no mistake that Warren Buffet, of Berkshire Hathaway fame, has referred to derivatives as “financial weapons of mass destruction”. The risk of these innocuous events degenerating has increased with the evolution of algorithmic trading (computer programs set to make trades based on specified trigger points). Once a catalyst is triggered, the computers send out sell orders at a rapid pace, causing a market to plummet until a buy trigger is hit. So far, these events have always been short-lived and quickly resolved themselves, but it may be naïve to believe that will always be the case.
We are all aware that just because something can happen does not mean that it will. Happily, most disaster scenarios don’t play out. Over time, net-net, the world grows and crises, when they do occur, are managed. The challenge isn’t the risks one can see but those one cannot. Despite all the “risk analysis” and “risk and stress-testing” known to man, crises often come from an angle that no-one is looking at. As portfolio managers we endeavor to balance the upside opportunities against the downside risks to even out the gyrations in the capital markets.

The previous charts showed rallies to the top of the cycle and a collapse to the bottom of a market cycle. One thing we can be reasonably certain of this: the “market cycle” has not been abolished. Given where we’ve been, and with history as our guide, our view is that the most likely outcome is a steady-as-she-goes environment for now in which the economy slows (but doesn’t roll over and die), corporate earnings rise (but at a much more measured pace) and interest rates continue to grind higher keeping inflation in check.

Each client has a target or “normal” asset mix established within their investment policy statement. With this cycle now being the longest bull run in history and interest rates on the rise, it is likely too late in the cycle to have an aggressive position. But with economic growth remaining solid, it is likely also too early to assume the worst. By default, that leads the tactical asset mix towards being “normal”, if such a condition ever truly exists.

So, Happy 10th Anniversary everyone!


Logan Wealth Management Inc.