Fear Less

A bubble forms when the price of something becomes completely unhinged from its intrinsic value.

October is a month that spooks people perhaps more than any other month. I’m sure October 28, 1929, the Crash that ushered in the Great Depression has something to do with it. In any case, October tends to be the month that clients hear the tense strains of the theme from Halloween as they open their laptops to look at on-line statements. Let’s kill that music and replace it with the dulcet tones of Franklin Delano Roosevelt giving his most famous fireside chat to the nation: “We have nothing to fear, but fear itself.”

He was right. Markets can be driven by emotion, but we are not cattle stampeding to our own deaths because one of us got bitten by a horsefly. We are human. We do err, but we can right ourselves. Sometimes, it is hard to see the big picture when you are in the middle of it, so let’s step back–way back–and provide you all with some perspective.

First, we need to understand the nature of “the market.” It is not actually one market, but many marketplaces, both in the U.S. and in nearly every country on the globe. When news organizations speak about “the market,” they are usually referring to a series of stock, bond, or commodity indexes—hopefully, by name.

In the U.S., popularly tracked indexes include the Dow Jones Industrial Average (DJIA), a basket of 30 stocks traded on the New York Stock Exchange (NYSE). Dow Jones and Co considers these to be trendsetters.3 The S&P 500 includes 500 of the nation’s largest companies as determined by McGraw Hill, publishers of the Standard and Poor’s series.4 There is also the NASDAQ (National Association of Securities Dealers Automated Quotations), which provides a market for stocks not listed on an exchange. Such stocks may be referred to as “over-the-counter stocks” because they used to be traded over a counter at a bank.5 Nowadays trading is computerized.

Each index around the world ticks up and down inexorably. Normally, watching an index can be about as interesting as watching paint dry—until it crashes. That is when human beings cannot tear themselves away from the spectacle of perceived disaster, especially if it is a slow news day otherwise.

Generally, after 1929, sharp downturns to the indexes were referred to as “Crashes,” but until then, a word that is perhaps more accurate was applied to this phenomenon–Panic. A Panic signified the totally unreasonable and even foolish sell-off that occurs for no good reason.

Just as it is hard to pinpoint the exact event that starts a cattle stampede, it can be difficult to pinpoint exactly what starts a sell-off particularly when the buying and selling is being done by computer programs, as was the case on October 19, 1987. The computers did not have the sense of people. Once the sell-off began, it became a cascade. This event came to be known as “Black Monday.”

In October 1987, I had just started my investing career. I was the liaison to the Administrative Committee of the California Society of CPAs Group Insurance Trust. These fiduciaries controlled a Multiple Employer Welfare Arrangement that provided 29,000 CPAs, their staff, and families with health insurance.

In September, the Committee had invested our $6.4 million rate stabilization reserve into a stock and bond portfolio. On October 19th, I received a call from our Stock portfolio manager. “Martha, we are holding steady. If it was a good buy in September, it is even a better buy in October, and a horrible time to sell in any case.”

I learned the lesson of patience and fortitude that day. Our investment managers held on when others panicked. The rate stabilization reserve lived to grow and prosper. It fulfilled its stated purpose. And when California changed its health insurance laws in 1993, the rate stabilization reserve provided seed money to start a member-owned health insurance company. Thanks to the healthy rate stabilization reserve, the Committee had more choices, and was able to choose the best solution to this new problem.

What if the market downturn results from a genuinely sick economy such as the “Credit Default Swap” debacle that caused the Great Recession of 2008-2009?

The stock market slide that preceded the failure of Bear Stearns, and then Wachovia on September 15, 2008 actually started in October 2007.6 This gradual slide was imperceptible while it was happening and could only be discerned in hindsight.

By October 2008, volatility, daily up and down movement, bounced like a super ball slammed into concrete. By March 2009, the S&P 500 Index had lost about 50% of its value.7 We have been in recovery since then. Understanding how our economy was sick may mitigate fears of another unhappy October surprise. Let’s take a few moments to review the real estate bubble that burst in 2008.

The Federal Reserve Bank issues an interest rate, called the “fed” rate. The federal funds rate is the interest rate at which banks lend each other money overnight. Alan Greenspan, Federal Reserve Chairman, orchestrated a series of interest rate cuts that eventually produced a fed rate of 1% by 2004.8 With money so easy to borrow, more of it was injected into the economy. What was great for borrowers was not so great for those seeking a decent interest rate for their bank depositors.

Investors in search of a safe haven for money happened upon mortgage-backed bonds. These instruments were created when banks sold their loan portfolios to Wall Street. The mortgages were grouped into categories called tranches that represented the borrowers’ ability to repay the loan. Those with sterling credit got the best interest rates on their mortgages. These bonds became AA and A rated bonds. Those borrowers with less illustrious credit paid higher interest rates and their mortgages became BBB, BB and B bonds. Since homeowners tended to protect their home above other purchases even those with less perfect credit seemed a pretty good risk.9

Indeed, most of the loans written at this point carried little risk. Even those people with spotty credit records had to demonstrate sufficient income to service the loan. Sound loan underwriting practices were still the norm. It was only later when Wall Street’s insatiable appetite for mortgage bonds–particular those doomed to fail–caused normally responsible bankers to act dastardly.10

The worst offenders used an esoteric instrument called a credit default swap to enrich themselves. The credit default swap was a quasi-insurance policy. For a fee, a company such as AIG would agree to make a bond investor whole if his bond defaulted. So if you owned $10 million dollars of XYZ mortgage bonds issued in 2007 maturing in 2027, and enough borrowers in the pool defaulted on their loans so you had no chance of 

getting back your initial $10 million investment, AIG would take the bonds and you would get your $10 million from AIG.11

Somewhere along the way, the so-called independent credit-rating agencies were convinced, coerced, or co-opted into giving high ratings to shoddily underwritten mortgages that were assured spectacular failure.   AIG took the rating agencies’ high-quality ratings at face value and did not do their own underwriting. Had credit default swaps been an actual insurance product, it would have been highly regulated, and this scheme could not have been possible.12

Remember how high real estate prices got by 2008? Easy money, lax mortgage underwriting, and ever-rising prices of real estate swelled into a bubble. A bubble forms when the price of something becomes completely unhinged from its intrinsic value. Today we can buy a bag of tulip bulbs at Home Depot for $5.00 (a trifling sum). In 17th Century Holland, a single bulb might have fetched 10 times a skilled craftsman’s annual income.13 This was Tulip-mania in 1637.

So how can we detect a bubble?

Short Answer: Only time will tell. Experience is the best teacher. Unlike Influenza, there isn’t a diagnostic test for a market bubble, and there is no vaccination either. A healthy, diverse asset allocation is the best defense. Allowing a stricken portfolio the time to recover is the best treatment.

But what if I am retired already and don’t have the time?

As long as you have breath in your body, you have time. A retiree nibbles away at her life savings bit-by-bit each month. That means the bulk of the savings remain in that well-diversified portfolio she and her financial advisor so carefully selected to match her risk tolerance. The only time a loss is made permanent is when the portfolio is cashed out during a deep, deep downtick. This can be easily avoided by not doing that!

When a deep downtick is not called a “crash,” you may hear the term “correction.” The definition of correction varies over time. It is currently defined as an index ticking down 10 –20% in a relatively short time. Since 1932, corrections have happened on average every two years.14 Because “the market” is global and we cannot see it, it is hard to visualize this phenomenon.

Imagine the world’s indexes as plants in a garden. Now imagine how that garden might look in October when those of us in the Northern Hemisphere renovate our yards. Like anything undergoing renovation, it looks terrible. Craters mark where bulbs will be planted. Day lilies and irises appear ravaged while you divide them. Meanwhile, your neighbor drops off heaps of withered hostas and peonies he’s swapping out for your surplus day lilies and irises.

For a while both yards look like the surface of the moon, but by Halloween all the plants are tucked into the earth and mulched. They wait for winter rains and Spring warmth to unfurl their leaves once again.

The patient gardener waits for Spring just like the patient investor waits for the tide to float all boats again. If one begins to look at markets in terms of seasons and natural cycles, then one can begin to make sense of the eco-system.

It is true that Nature is not always gentle. Stock and bond markets can be turbulent. But if you want to sail, you need wind. Wind makes the water choppy. But without the wind, you cannot move forward, so we will let the wind fill our sails, and we’ll keep a firm hand on our tiller. 

We will ride the waves. And if we hit a gale, we will demonstrate our fortitude by keeping our hand on that tiller and trimming our sails when necessary. The important thing is to stay in the boat. Better in the boat than in the shark-infested water beneath, I say. Should you ever get the urge to jump, call me.

Endnotes

3-5 Passtrak, Series 7, 12th Edition, copyright 2001, Dearborn Financial Publishing, pages 22-24.

The Dow Jones Industrial Average, published on market close October 7, 2007. Dow Jones & Co.

7 The S&P Index closed at 1562 on October 7, 2007. By March 2, 2009, the S&P closed at 683, which is a difference of 56%, McGraw-Hill Financial publishes the Standard and Poor’s Index.

8 The Big Short: Inside the Doomsday Machine, Michael Lewis, 2010, WW Norton & Company.

9 “Explaining the Housing Bubble,” Adam J. Levitin, Susan M. Wachter (Professors at Georgetown School of Law) and Richard B. Worley (Professor, Financial Management at the Wharton School, University of Pennsylvania), Georgetown Law Review, 2012.

10 The Big Short: Inside the Doomsday Machine, Michael Lewis, 2010, WW Norton & Company.

11 “Outsmarted” by John Lanchester, The New Yorker, June 1, 2009.

12 The Big Short: Inside the Doomsday Machine, Michael Lewis, 2010, WW Norton & Company.

13 “Tulip mania,” Wikipedia, the free encyclopedia, Wikipedia.com, August 29, 2015.

14 “How to Survive a 10% Correction” by Anna Kates Smith, Kiplinger Personal Finance newsletter, August, 2014.

Required Disclosure

Diversification and asset allocation strategies do not assure profit or protect against loss. The S&P 500 is an unmanaged index and cannot be invested into directly. Past Performance does not guarantee future results.

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