"The Financial Wreck We Missed"

Sydney M. Williams

Thought of the Day

“The Financial Wreck We Missed”

July 20, 2010

A good friend recently mentioned that the most important event of his investment career (which at 43 years is the same as mine) is what did not happen following the collapse of Lehman Brothers in 2008 – Armageddon never arrived. I concurred. It is almost impossible to recreate the feelings experienced during those few days when the world’s financial system teetered. Had the financial system collapsed, trade and commerce would have ceased. I have mentioned this before, but it is worth repeating. No matter our opinions today, we owe a debt of gratitude to Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke and Timothy Geithner, then President of the New York Federal Reserve, for holding the system together. It is easy from our perch today to “Monday morning quarterback” and to criticize them for doing too much or too little at the time. What they did worked. It may not have been pretty, mistakes were surely made, but we did not topple over the edge.

Our very lives depend upon trade and commerce: without them we would starve. None of us are self sufficient. Trade and commerce, in turn, depend upon banks and the flow of credit; and credit is based upon confidence, a fragile and vulnerable condition. The failure of Armageddon to arrive gave birth to the restoration of confidence; the wheels of banking and commerce continued to turn, gradually and reluctantly perhaps, but turn they did. GDP, which had declined by 5.4% in 2008’s fourth quarter and 6.4% in 2009’s first quarter, was down only 0.7% in last year’s second quarter, and was actually positive in the third and fourth quarters.

That confidence is best manifested in the TED spread. It is the difference between Three-month LIBOR and Three-month Treasuries and reflects the “risk premium” of lending to a bank as opposed to the Federal government. For the six years ending December 2006 that spread averaged 39 basis points. By the end of 2007, the spread had widened to 156 basis points, a clear warning of storms ahead. It reached its zenith during the week of October 10, 2008 at 460 basis points. Yet, a little more than two months later, by the end of December, the spread had narrowed to 131 basis points – lower than it had been a year earlier! While a recent rise in the TED spread from 14 basis points at the end of 2009 to a little over 40 in early June worried some observers, the spread remained well within the range for the years 2000-2006 when year-end spreads varied from 67 basis points in December 2000 to 20 basis points in December 2002.

Despite the avoidance of Armageddon, the fear of that near collapse remains with us and is manifested in confusion and cynicism among investors. But the future is never clear and human psychology can be deceiving. A market trending in one direction or the other can provide a false sense of confidence. In December 2006, on the eve of the financial collapse (it arrived in the summer of 2007), the mood was very different. In a Market Note dated December 21, 2006, I wrote: “Complacency has settled over the financial markets…This happy-go-lucky attitude is reflected in the opinions of Wall Street strategists…the consumer [is] borrowing to ensure he lives as well as the next man, while ignoring rumblings from the housing sector…risk is an adaptable beast and can attack when least expected.”

The focus of investors and most people is directed toward the problems we have…and they are real. Debt at the federal and state level is far too high. The consumer, sensibly, is retrenching, but thereby slowing economic growth. The unprecedented expansion of government appears to be at the expense of the private sector, at least in terms of employment. But none of this has gone unnoticed in the market place. Stocks are lower than they were a dozen years ago, and the S&P 500, at 1071, is slightly below the midpoint between the lows of 666 and the highs of 1576. During the past decade, while stocks languished, earnings for the S&P 500 have risen 37% (and 180% from the trough in second quarter 2002). GDP has risen during the past decade by 45%, while energy consumption – according to a table in today’s Wall Street Journal – has declined. Despite no “cap-and-trade” bill, energy consumption per person in the U.S. declined 11% during the decade.

Stocks partied hard during the 1980s and 1990s, and real estate in the 00s; what we are experiencing is the hangover, a perfectly natural consequence. This self-adjusting mechanism has to work itself through the system and, as it does, stocks become more reasonably priced. It is my opinion, for what it is worth – not much I am sure – that we will remain in a trading range for a period of time, as we make amends for the excesses of past years. But, as time goes on, and as despair may deepen, the fundamental attractiveness of stocks will increase. The future is never clear, but investors should take care not to be governed by the emotions of the moment; the fatal crash that did not happen in the fall of 2008 has made regulators and investors more vigilant and, consequently, decreased the likelihood of a repeat.