"It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so." --Mark Twain
One of the benefits of having started this blog is that I can go back and see what I thought was interesting and/or worthy of attention over time. I have no idea how close we may be to the end of the historically long expansion we are in, or whether the still lofty market valuations will correct ahead of a downturn, but the temperature of things does seem to have changed somewhat over the last few months.
So while I personally have no strong opinions, and am a firm believer in the near impossibility of trying to predicting anything macro, especially in regards to timing, I am confident that there will be plenty of reasonably-sounding opinions from people on all things related to the economy, stock market, and policy responses to any downward volatility that may surface.
I thought it might be worthwhile to go back and review some things that I had on my radar leading up to the crisis of 2008-2009, mostly as a reminder to myself of the uncertainty and unpredictability of the future. There were a number people who were both roughly correct and others who were incredibly wrong, especially in regards to loading up on financials at the end of 2007 and the first part of 2008. While I didn't want to post everything I reviewed, especially since some of those that made the worst calls have recovered nicely since 2008, I did want to highlight three particular excerpts below that I thought were worth re-reading.
How does the current turmoil stack up against past crises?
Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.
If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?
Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.
The scenario you're describing suggests we're a long way from turning a corner.
I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.
David Einhorn, in an early April 2008 speech at the Grant's Conference:
The next question is whether the bail-out was a good idea. It really comes down to Coke vs. water. If you are thirsty you have choices. Coke tastes better and provides an immediate sugar rush and caffeinated stimulus, while quenching thirst. Water also quenches thirst, but it isn’t as stimulating. It purifies your body. It doesn’t make you fat and is much better for your long-term health.
One of the things I have observed is that American financial markets have a very low pain threshold. Last fall, with the S&P 500 only a few percent off its all time high prices after a multi-year bull market, certain TV commentators and market players were having daily tantrums demanding that the FED give them the financial equivalent of Coke. Other parts of the world endure much greater swings in equity values without demanding relief from central planners.
The FED responded by providing liquidity and lower rates. Even so, the crisis deepened. So, now they have introduced the Big Gulp, also known as the Bear Stearns bailout, and an alphabet soup of extraordinary measures to support the current system. If that doesn’t turn the markets, they are threatening the financial equivalent of having the water utilities substitute Coke for water throughout the system.
Last week Mr. Bernanke told Congress that he hopes that Bear Stearns is a one-time thing. In the short-term, it might be. If market participants accept as an article of faith that the FED will bail them out, it reinforces risk-taking without the need for credit analysis. As night follows day, it is certain that in the absence of tremendous government regulation, this bailout will lead to a new and potentially bigger round of excessive risk-taking. If Mr. Bernanke is unlucky, the pay-back may come later in this cycle. If he is lucky, it will come in the next cycle.
Howard Marks, in September 2007:
What Next?
Lots of people are asking whether this is going to get ugly. Is this the beginning of a credit crunch? Will it lead to a recession? How bad will it get? When will the bottom be reached? How long will the recovery take? The answer’s simple: no one knows.
Some of the psychological and technical preconditions for a challenging market environment have been met. The bubble of positive investor psychology has been pricked and could become seriously deflated. When others are aggressive, we should be worried, but when others are worried, we can be confident. That’s the essence of contrarianism, and by that standard these are better times.
The easy-money machine has had some sand thrown in its gears and seems to be grinding to a halt. Previously, anyone could get any amount of money for any purpose. Right now, deserving borrowers are unable to obtain financing, and this could continue or get worse.
The outlook for the economy is murky, as usual. It continues to limp along, not growing strongly but not sagging. The big question surrounds the effect of the subprime crisis on consumers. Home prices are through rising. Home equity borrowing is probably finished for a while as a supporter of consumer spending. Ditto for the “wealth effect.” The reset of adjustable rate mortgages from artificially low teaser rates to full market rates over the next 18-24 months is likely to have a depressing effect on a large number of households, and thus on the economy. I would think furniture and auto manufacturers, building materials suppliers, retailers and financial institutions have seen their best days for a while. I consider the economy unpredictable, of course, and thus a lot of people’s answers will be more definite than mine. But not necessarily more correct.
Everyone’s looking to the Fed to take action. Its last act – cutting the discount rate on August 17 – was largely symbolic but had a positive effect. A reduction of the federal funds rate would mean more, telling investors the Fed’s there to help, cutting the cost of borrowing and stimulating the economy. But it wouldn’t do much for banks’ balance sheets or willingness to lend.
It’s my view that Bernanke would rather not cut rates. Stimulative action that looked like an investor bailout would contribute further to moral hazard and the expectation that the Fed will always protect investors on the downside. This is an unhealthy expectation, as each bailout encourages risk taking and thus increases the likelihood that another will be needed. But the Fed is being importuned for a rate cut, and there are few people to argue on the other side, for a good dose of unpleasant medicine.
I’m usually cautious, so I might as well keep my record intact. The economy should weaken. Deals built on optimistic assumptions and paid for with a lot of borrowed money shouldn’t all thrive. Generous capital markets should not be expected to bail out ailing companies. Bargain hunters and distressed debt investors will have more to do. Eventually. But no one at Oaktree would advise you to act as if these views are sure to be correct. We certainly won’t.