It is common for investors to “follow the herd.”
If the stock market has been performing well, and there is euphoria that the U.S. economy is recovering from the pandemic, there is a tendency to assume the stock market will continue to climb indefinitely. Remembering that the U.S. stock market has had severe corrections may help you remain cautious. Let’s take a trip down memory lane.
The Great Depression:
The Great Depression occurred over 90 years ago (from 1929-33). The economy did not actually “turn the corner” until 1939. Most of us don’t remember it and, unfortunately, I was not wise enough to ask my grandparents to talk about it while they were alive. However, books about the Great Depression paint a vivid picture of the severe hardship during that time.
Black Monday: The first downturn I remember was “Black Monday” on Oct. 19, 1987, when the stock market plummeted 20% in one day. As a young investor, this caught my attention and was the first major correction that suggested computerized trading could cause problems.
Dotcom Bubble (Technology): The next major downturn was the “dotcom bubble” in 2000, when the technology sector declined 78%. Some technology companies went out of business, but most recovered. This downturn was only 22 years ago, yet it is rarely mentioned.
Let’s look at Microsoft as an example. The stock price was $58.69 when the stock market opened on Jan. 3, 2000 (before the dotcom bubble burst). The stock price lost over 65% during 2000 and had declined to $20.15 on Dec. 21, 2000. It took until August 2016 for the stock price to return to above $58. Clearly, Microsoft is a successful U.S. corporation. The stock price has performed extremely well since 2016 and a share is now priced (on July 26, 2021) at roughly $288. It pays a dividend that is less than 1%. The current price reflects a price-to-earnings ratio of 38%. In my view, this is incredibly high. Many US stocks are currently priced at unreasonably high levels. The S&P 500 (500 large U.S. corporations) has an average price-to-earnings ratio of about 22 (according to FactSet), which is the highest level since 2000.
2008 Financial Crisis: To review the 2008 financial crisis, we cannot overlook the housing crisis. According to a white paper issued by the Federal Reserve (containing data from CoreLogic), housing prices in the U.S. declined by about 33% from 2007 to 2009 compared to their peak in early 2006.
Unfortunately, the mortgage industry was encouraging folks to borrow large sums of money – beyond what they could afford. The assumption was that housing prices would continue to increase. Investors and homebuyers forgot that real estate values are cyclical.
If only housing prices had declined, the outcome may have been less dire. Unfortunately, the banking and investment industry exacerbated the problem. The high-risk mortgages (termed “sub-prime”) were bundled into “collateralized debt obligations” (CDOs), and rated (absurdly) as double A and triple A by major rating agencies in the U.S. They were sold to unsuspecting investors in the U.S. and abroad as safe, low-risk investments. Greed was in full swing.
As housing prices declined, many people discovered their mortgages were greater than the (decreasing) value of their home. If the homeowner lost their job or had unexpected medical expenses, there was not enough to cover all the bills. Many homeowners quit making monthly payments or walked away from their mortgages, causing a collapse in the housing market.
While the housing market was in a correction, the stock market also suffered. The S&P 500 declined 54% from October 2007 until March 2009. Do you remember how much money your investment accounts lost? If you had a portfolio with 100% equities (stocks), then you probably lost over 50%. If you had a portfolio with 50% equities and 50% fixed income (bonds), you likely experienced a decline of roughly 25% because bonds remained steady during the 2008 financial crisis.
How did you feel after losing that much of your hard-earned nest egg? I encourage you to research how your portfolio performed and keep those numbers close at hand.
To refresh your memory about the consolidation during the 2008 financial crisis, U.S. investment bank Bear Stearns failed in March 2008. It was purchased at a bargain price by J.P. Morgan Chase. On Sept. 7, 2008, mortgage giants Fannie Mae and Freddie Mac were placed directly under government control. On Monday morning, Sept. 15, 2008, we learned that investment bank Lehman Brothers had filed for bankruptcy and Merrill Lynch was purchased by Bank of America. These deals were arranged very quickly during the prior weekend. In late September 2008, AIG failed. The U.S. government bailed it out with a $180 billion loan. Next, Washington Mutual bank failed and was seized by the U.S. Treasury. Shortly after, it was purchased by J.P. Morgan Chase. When Wachovia Bank failed, it was purchased by Wells Fargo.
On Oct. 3, 2008, the U.S. Congress agreed to provide U.S. Treasury Secretary Henry Paulson with $700 billion in a bailout program titled TARP for Troubled Asset Relief Program. It was doled out to many investment firms and banks. More government money was provided in early 2009 and the stock market began recovering in March 2009.
Where are we now?
In 2021, housing prices have increased significantly. I recently heard of a 2,100-square-foot house in Jackson, Wyoming, that sold for $2.4 million. The house is an average one-story home with no luxuries and is located on a small lot. The sale signifies that people are willing to pay unreasonable prices in areas where the supply of homes on the market is much less than the demand. Many have suggested that we are currently in a housing bubble.
With over 12 years of healthy stock market returns (since the 2008 financial crisis ended in early 2009), many investors have forgotten that the market can decline rapidly and severely. The COVID-19 pandemic led the U.S. government to provide financial assistance beginning in March 2020, and it is continuing today. The Federal Reserve is keeping interest rates near zero to encourage investing. Inflation is increasing as COVID restrictions are being lifted, and Americans are now spending money on traveling, houses, cars and furniture.
Stock valuations are at the highest levels since the dotcom bubble of 2000, and home prices have risen to levels similar (or above) where they were before the housing crisis of 2007-09. The U.S. debt is far too high and countries such as Russia and China are (allegedly) mounting cyberattacks on U.S. corporations, utilities and cities.
On the positive side, the U.S. is very resilient and we have come through dark periods before. I do not have concerns for the long term. For the short term, I recommend caution. Use your memory of past financial crises and monitor your investment accounts, making certain the asset allocation is appropriate for your risk tolerance. The goal is to provide some shelter when the next financial crisis occurs.
The next downturn may not come next week or next month. We do not know the timing. However, rest assured, there will be bumps in the road and they may seem more like deep craters than bumps.