ICangles Investment Post…
History didn’t repeat in the 1987 stock market crash and the bear market that began in 2007, but it rhymed. Both market tops were propelled by the use of derivate security products that falsely promised to remove risk from investing, were characterized by unrealistically high valuations around an asset class and witnessed an important financial market freeze due to an ‘insurance run’. Although the general symptoms were the same however, the specifics were very different. And it is important to understand both the similarities and differences in order to spot future stock bear markets and assess the current market.
In 1987 the stock market was at an extremely high valuation on the basis of the earnings yield of the S&P 500 versus the yield of the ten-year Treasury note. This is referred to as the Fed stock valuation model, and in 1987 it was showing that the stock market was overvalued by over 30 percent on a historical basis. The risk of a market decline however, didn’t worry many investment firms, including large pension funds, aggressively buying stocks. They believed they were protected from significant losses by way of portfolio insurance products and by 1987 about $60 billion was “protected” against risk via these instruments that used S&P 500 futures contracts.
In 2007 the plot was the same, but the story different. The stock market was not at an extremely high valuation. Instead the residential real estate market was historically overvalued in yield or income terms when measured by how much income a house could expect to realize in rent versus the cost of buying that house. This is called the price-rent ratio and by 2007 residential real estate was overvalued, not unlike stocks in 1987 by over 30 percent. Once again however, financial institutions exposed to an overvalued market weren’t worried thanks to financial derivates by way of collateralized debt obligations and credit default swaps. The CDO’s meant banks and investment houses were diversified across different regional real estate markets and types of buyers, while the CDS’s were actual insurance against defaults.
In financial markets there may be nothing more ominous than high historical valuations of an asset being combined with a widespread belief among market participants that new developments, such as derivative products, have removed market risk. The story always ends badly. In both of these cases the insurance schemes revealed the same basic flaw. In 1987 when those using portfolio insurance products all attempted to sell futures contracts at the same time, market liquidity evaporated and the stock market crashed. In the case of the 2007 and into 2008 credit crisis, the synchronized downturn in residential real estate caused credit market liquidity to evaporate as the value of mortgage CDO’s fell and the liabilities associated with CDS’s soared. As the credit markets ceased to function the stock market fell.
But if the plot was the same, another important difference in the story was that the stock market decline that began in 2007 led to a major recession, while the stock market crash in 1987 did not. To understand the reasons for this I would draw a comparison between the complexities of the global economy to that of a modern automobile. All the associated electrical systems are controlled by software code, but when the variables of a given real world situation unmask a flaw in the code the fallout depends not so much on the nature of the errors as the systems involved. The impact of the brake pedals not working is very different than that of the preset channels on the radio being forgotten.
Similarly with the financial markets the impact in 1987 of stock prices resetting to lower levels was very different than that of credit markets freezing up and home prices resetting to lower levels, which caused a substantial impact on all the economic actors associated with home building and furnishing, as well as consumer purchases based on home refinancing loans.
In these cases differing economic stories following the same plot line of over-valuation combined with an illusion of risk management produced different outcomes. In 1987 and 2007 history rhymed, but it did not repeat. For market students such as myself many of us did not see the forest through the trees in 2007, as we got caught up looking for signs of overvaluation and misperceptions of risk in the stock market that were not there. Instead those signs were in the real estate and associated credit markets. Because of the importance of those markets they had a very real impact on the stock market. Of course that isn’t always the case. Crashes in the comic book or baseball card market for obvious reasons didn’t have an impact on U.S. stocks, while for much more nuanced reasons the 1998 crisis in emerging market economies did not result in a bear market for U.S. stocks. In fact usually when problematic signs are not found in the U.S. stock market, it does just fine.
In a complex system it’s not always easy to determine how a failure in one part of the system, for instance credit markets, will impact another, such as the stock market. If the market in question isn’t a significant driver of U.S. economic growth it probably doesn’t matter much. That determination isn’t always simple. The easy part is oftentimes spotting those extreme valuations and risk miscalculations. And today it is government debt that is worrisome. Credit default swaps weren’t limited to protecting the value of real estate investments and they recently again raised their risk-insurance head in the Greek government’s debt crisis. In America both government bond investors and the government itself are underestimating the risk rising interest rates would have on the underlying value and future obligations around said debt securities. Along with underestimating the risk around bond debt, investors are also under-estimating the risk around emerging markets, principally China where government spending and loans are fueling speculative investments, including once again in real estate.
Despite some similarities, the recent credit crisis and any future government debt crisis are too different in the details of their stories to be examples of history repeating, but the plots do rhyme.