A Client Asks, "What's the Worst Case Scenario?"


A miserable start to the New Year, with US stocks down 7.9% in January, European markets down 7.4-11.4%, and Japan down 10.9%.  The biggest declines are in Shanghai down 17.7% YTD and down 43.7% from an all-time high.  Clients are obviously concerned and want to know if we should expect a repeat of the 2008-9 bear market.

Let's start that conversation by looking at the last ten years of S&P 500 activity:

Significant dates include:

  • October 2007 - S&P 500 makes all time high on back of "robust" housing market
  • March 2008 - Bear Stearns fails - stocks sell off but recover mid-summer
  • September 2008 - Lehman Brothers fails - stocks sell off violently, declining peak to trough by 57.7%
  • April 2010 - Greece hits the wall, threatens to exit the Euro
  • July 2011 - Greece hits the wall a second time
  • September 2012 - Spain, Italy and Portugal have trouble servicing debt
  • April 2013 - S&P 500 sets new all time record, goes on to rise 32% for the year
  • October 2014 - stocks fall 9.9% on fears of European slow down, Ebola, but set new records by November 2014
  • August 2015 - stocks correct 12.5% from May record level on fears of China slowdown
  • November 2015 - stocks rally to within 0.9% of a new high.
  • January 2016, -stocks correct 11% from the November high water mark as China, falling oil prices dominate the news.

As we have seen in the last 10 years (and last 50 years and last 100 years), there is ALWAYS something to rattle investors.  And yet on each occasion, stocks recover to new highs.  How is this possible?  The people who run companies like General Electric, McDonalds, Pfizer,  thousands more, don't sit around obsessing about the stock market,  They obsess about how to make better wind turbines, better hamburgers, better Viagra.  With each passing year, company executives figure out how to sell more products to more markets.  From their hard work come revenues, which generate earnings, which generates the increase in value in individual stocks and the overall stock market.

The Worst Case Scenario (also the most unlikely scenario)

Between October 2007 and March 2009, US stocks fell 57.7%.  Leading in to the crisis, the major banks and brokers bought billions of dollars of junk securities with borrowed cash, then were shocked when their equity disappeared literally over the weekend, leading to the demise of Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, AIG and dozens more in US and Europe.  The rest, including Goldman Sachs, Morgan Stanley, Citibank, Bank of America, Barclays, Deutsche Bank, barely survived and only with massive governmental intervention.

The resulting destruction of capital, trillions of dollars, pushed the US into a two year recession and Europe into a recession that still prevails.

Some analysts have declared, irresponsibly we think, that China's troubles are the same as Lehman's troubles.  No!  The two aren't remotely comparable.  Lehman was a badly managed bank levered 32:1 (3 cents of capital for every 97 cents of debt.)  China is a sovereign nation growing (reasonably speaking) 5%/year and maintaining foreign currency reserves of $3.65 trillion.  Lehman was a debtor; China is a creditor.  China has a host of political and structural problems to resolve, but going bankrupt is not one of them.

At present, the big banks are levered around 9-10:1 and are throttled back in the riskiness of their operations.  There simply is not the level of risk in the system that we saw in 2008-9 and also in 1998-9.

Recession Driven Bear Market

The worst bear markets occur in the context of major recessions, as we saw in 1973-4, the early 1980's and of course, during the time of the Great Depression.

The bear market starting October 1987 was triggered by the technical failure of US stock markets on "Black Monday," October 19th.  The economy was doing fine, so that bear market lasted only three months.  Similarly, the US economy was doing fine in 1961-62, but investors were primarily concerned about the threat of nuclear Armageddon.

Stocks generally fall during recessions, but not necessarily the full 20% that defines bear markets. Over the last 90 years, US stocks spent 88% of the time in bull markets, only 12% of the time in bear markets.  However, it's human nature to remember the scary times and forget the good times.

Bungee Cord Corrections

In most aspects of our lives, making decisions involves friction; it's not easy to trade to a new car, a new house, or a new spouse.  Not so in the capital markets, where it's all too easy to trade euphoria today for panic tomorrow.  Instead of creating a sensible all weather portfolio (our approach) designed to deal with both calm and stormy seas, investors ricochet from the "risk on" trade (buy stocks, emerging markets, corporate bonds) to the "risk off" trade (buy government bonds, gold, cash) destroying capital with each iteration.

This schizophrenia creates what we call "bungee cord corrections" as we saw in October 2014 and August 2015 where stocks plummet 10-15% in a matter of days, only to recover and move to news highs a few months later.  We even have "flash crashes," where technical problems at the exchanges have allowed stocks to fall and then regain 10% in a matter of minutes.  There are far more corrections than bear markets

So what is our answer to our client's question?

Reduced demand from China will obviously negatively impact emerging nations that export commodities.  Oil below $30/barrel (and probably heading to $20 as Iranian crude shipments resume) is a big problem for oil exporters such Saudi Arabia, Russia, and Venezuela.  Oil at $20 is a big problem for US oil and gas companies (36 went bankrupt in 2015) and the banks (Citibank, JP Morgan) that extended energy loans. 

However, none of these events is likely to drive the US economy into recession.  Instead, the US economy should grow at the middling rate of 2.5% in 2016, with unemployment hovering around 5% as more Americans rejoin the work force, and with inflation in the 0.5-1% range.  In this context, the US Federal Reserve can move slowly to raise rates, or not at all.  Corporate earnings should grow at a modest rate, reversing the negative trend of the last two years caused by declines in the energy sector.  Bottom line, our forecast of gains in US stocks for 2016 remains intact at 5%, 13% higher than Friday's close.  Stocks may sell off a little more in the next few weeks, possible testing the lows of last August, then resume the long term upward trend.