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Investment Outlook — First Quarter 2009
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There was no escaping one of the worst years in stock market history
There was no escaping one of the worst years in stock market history
Since the S&P 500 was first compiled over 80 years ago there has been only one year worse than 2008. That was 1931, when the market declined 44% as the Great Depression took hold in the United States. Fewer than 30 stocks in the S&P 500 advanced last year, and major international markets actually fared worse. When looking back at 2008, there were numerous remarkable political and financial stories, but the complete turmoil that overwhelmed our financial institutions and paralyzed our financial system stands out.
The size of the stock market declines worldwide surprised even the most pessimistic forecasters. Previous major market debacles were usually preceded by huge gains in the stock market and rampant speculation by small investors. The 1930 washouts were preceded by the “Roaring Twenties” and years of 30% plus gains. Likewise, the bear markets of 2000-2001 followed five years of 20-35% annual gains and massive participation and speculation by individuals. Last year was preceded by three years of moderate gains in the U.S. stock market. As we entered 2008, other than speculation in selected international stock markets, there were few signs that suggested a historic decline was brewing.
So what accounts for the sharp drop in equities worldwide last year especially the waterfall decline in the fourth quarter? We offer three major rationales:
The economic outlook deteriorated as consumers reduced spending and increased savings. The declines in the stock market that started in the fourth quarter of 2007 and worsened in 2008, combined with the nationwide decline in house values, caused consumers to curtail spending. Huge increases in energy prices in the first half of the year further crimped consumer finances.
Prominent financial firms failed, including major lending institutions, and the threat of more failures led to a tightening of credit that further weakened the economy. The health and survivability of major financial firms came into question and the financial system, which facilitates borrowing and lending, became paralyzed.
Institutions were forced to sell assets which added to the severity of the decline. Commercial and investment banks, insurance companies, and hedge funds were forced to sell assets when their lenders demanded lower leverage and more collateral.
The underlying theme of the above problems was the excessive use of debt. Consumers borrowed to keep up with their neighbors, and banks borrowed to keep up with their competitors. From 1950-1985, consumers saved 8-12% of their income, but by 2008 were saving literally nothing. Mortgage debt grew from 30% of GDP to over 75% in 2008, and borrowers switched from fixed rate mortgages to short term variable rate mortgages. Financial institutions also increased their use of short term leverage and off balance sheet debt in order to buy higher yielding, risky assets, such as mortgage backed securities. As we detail below, these funding sources dried up, causing many financial firms to turn to the government for a bailout and homeowners to default on their mortgages. Plunging home values and rising foreclosures along with the misuse of complex financial products by levered financial institutions turned stock markets into a historic rout by the fourth quarter.
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