Some Lessons from 2008

Some Lessons from 2008

As we prepare to close the chapter on 2008, few tears will be shed as we leave a truly dreadful year behind us. Before we consign the year to the dustbin, here are 10 lessons we can take from 2008 to help guide us going forward. In a few cases, these were new lessons – in most, however, they were reminders of things we had learned in the past but perhaps forgotten.



1. Mispricing of risk

Arguably, the root of the market downturn was the dramatic mispricing of risk by companies in the financial sector. Going forward, there will be much greater focus on the level of risk all companies assume and risk management will be crucial for every financial institution in particular. There will also be much greater emphasis by companies on transparency, managing complexity and ensuring that incentives for management are aligned with mid term shareholder interests.

This will be evident in two dominant areas, the cost of borrowing, and in the value given to equity investments, and their earnings. About eighteen months ago, I discussed the state of commercial borrowing with the president of a Canadian bank. He expressed that there was little return in commercial lending, and that it made no sense. He told me that there was little difference between the cost of government bonds, and commercial loans, so risk was not being rewarded, nor was it being priced properly. To his credit, he was proven right, but his company's stock has followed the financial sector lower.

The pendulum has swung to the other extreme, with high yield debt currently yielding around twenty one percent over government treasuries...approximately triple what would be considered normal. Incredibly strong companies are forced to pay well over ten percent to raise equity in the US today, and even the Canadian banks are paying eight percent or more to raise capital.

Common equity is even more expensive, with one Canadian bank dropping in price to the point where its dividend yielded in excess of ten percent. That would have been unthinkable as 2008 began.



2. A subprime mortgage bubble

The high cost of capital for banks may not be a surprise in a global market where money was loaned to people with little or no capacity to repay their loans.

It’s now evident that the trillion dollar subprime mortgage industry built around the run up in U.S. real estate prices and financial engineering on Wall Street was just as much a bubble as the high tech sector in 1999 – a reminder of the truth of the old adage that “if something seems too good to be true, it probably is.”

The irony is, the subprime market was primarily a US phenomenon, but its tentacles have polluted the balance sheets of financial institutions worldwide. As the bubble burst, Wall Street's engineering popped up everywhere. Worse, the well intentioned regulatory changes rearding bank balance sheet accounting were badly timed. As mortage defaults rose, mark to market accounting made many of the "toxic" assets nearly worthless, and this dramatically reduced bank lending capacity.



3. Lessons about owning stocks

The lesson was reinforced that stocks are not the place to be unless you have a time horizon of at least five years. After the income trust implosion of 2006 and the hit that banks around the world took this year (Canadian banks actually performed well compared to most countries), we were once again reminded that there is no such thing as a truly “safe” stock in the short term. The dramatic hit taken by U.S. banks and resource stocks was also a reminder of the risks of undue concentration in one sector, no matter how safe it might appear – and particularly of the inherent volatility of commodity-based companies.

That lesson stands in stark contrast to one basic fact; over the long term, stock ownership outperforms other asset classes in long term return. The key is, you must have that long term on your side, and reduce risk as short term cash needs increase.

4. The impact of leverage

We were reminded that the lessons about leverage are just as relevant for investors as for financial institutions - borrowing to invest cuts both ways, boosting return during rising markets but dramatically increasing losses in downturns. Nowhere is this more evident in the massive losses being experienced in highly leveraged US hedge funds, or even money centred US banks.



5. A new level of volatility

With the continuing presence of hyper short term oriented hedge funds, it appears that we’re going to have to get used to historically high levels of volatility. (It seems that the definition of short term has changed; short term investing used to mean investing for years, then months, days and hours – today short term can mean minutes and sometimes seconds.)

One of the more remarkable measurements of volatility is that the VIX, an index that essentially measures the degree of volatility is currently experiencind a 100 day moving average higher than the peak it reached after 9/11. That is insane.

Hedge funds have taken a lot of the blame, but there is plenty to go around, with leveraged ETFs, record mutual fund redemptions (October doubled the old record) and the unwinding of credit default products that were badly regulated, if regulated at all.

6. An interconnected world

In the period leading up to 2008, there was much conversation about global economies and stock markets becoming “decoupled” – and in particular less dependent on the U.S. The reality of 2008 reminded us our world continues to be very much an interconnected one – and that there is no escaping major financial downturns in leading economic sectors such as the U.S. or Europe.

The best evidence of decoupling's lie is the universality of global equity losses, with every major global equity market down 30 percent or more. Canada's own decoupling myth played out in the second half of 2008, with the unwinding of the hedge fund mania for commodities and energy, which crested in June, and saw nearly half of our market value dissolve from July to today. The oil bubble of 2008 will not soon be forgotten.

7. What it means to be truly diversified

We got a lesson about the virtues of true diversification – that if protecting ourselves from market declines is a priority, while it is important to own stocks across different sectors and markets, true diversification only comes by also owning high quality bonds and cash.

Every advisor has met with the client, who has experienced a number of years of solid equity returns, and who has been lulled into believing that holding a global equity mutual fund represents diversification. Worse yet is the investor with a few Canadian equity funds providing their safety net. This investor likely felt insulated from the global crisis in June, but has certainly suffered in the latter half of the year.

This lesson does not mean diversification has eliminated loss. Many properly diversified portfolios have been hit, as corporate bonds, high yield bonds, Asset Backed Commercial Paper, and even money market funds, have had their inglorious days during 2008

8. Maintaining discipline

When it comes to asset allocation, it’s critical that we stick to our guns and maintain our discipline – even when tempted to chase hot sectors or boost equity weightings after periods of strong returns.



9. “It’s different this time”

Some of the hedge fund and private equity investors who were lionized over the past five years and whose performance appeared to defy gravity emerged greatly humbled – again a reiteration of the danger of the words “it’s different this time.”



10. The key role of confidence

Even when it seems we’ve entered a new world, the old truths still apply. The most important element for economies and for markets to work is trust and fundamental confidence. We are unlikely to see a strong economic recovery until we see a return of confidence – confidence by banks in lending to consumers, businesses and each other; confidence by businesses in hiring and investing; confidence by consumers in spending and investing.