he
third quarter was a time for reflection on Wall Street as the
three-month period witnessed a number of milestones. At the top of the
list for the chattering classes was the tenth anniversary of the
collapse of Lehman Brothers into administration on September 15, 2008,
the largest bankruptcy in U.S. history. So dramatically was the event
impressed on the collective memory that it seems like only yesterday
when the investment bank, founded in 1850, succumbed to the era’s
rampant speculation in real estate and the products of financial
engineering, not to mention over-indebtedness, to be subsequently sold
off in pieces to Barclay’s Bank of the UK, and Nomura of Japan. However,
while its demise was the most breathtaking, Lehman was not the only
major financial institution to fail that eventful quarter: shortly
thereafter, Washington Mutual, the largest Savings and Loan institution,
was seized on September 25 and fell into the arms of J.P. Morgan. We
should also recall that the events of that September did not come out of
the blue. The crisis of confidence that almost engulfed the entire
financial sector had begun earlier. Troubles with mortgage securities
popped up the prior year. Then, in March of 2008, Bear Stearns, another
old Wall Street firm that had survived the Crash of 1929 and had only
recently been considered one of the “most admired” firms in the
industry, merged into J.P. Morgan at a vastly reduced share price (not
low enough for some observers) of $10, down from $93 just the previous
month (and $172 in January 2007). We lived through interesting times,
indeed.
Another milestone happened this past quarter that saw the string of
advances in U.S. stocks since 2009 gain the status of the longest bull
market in history. Who would have thought that on March 9 of that year,
in the midst of a market collapse spawned by the Lehman debacle and the
financial crisis that ensued, market averages would reach a bottom,
after which they began to rise and never looked back. Market routs of
this magnitude are usually, though not necessarily quickly, followed by
recovery. Those possessing knowledge of this history, and the skills and
stamina necessary to take advantage of it, stood to enjoy large gains in
the decade to come.
One more milestone was reached when, for the
first time since 2008, one-month treasury bills sold at a price to yield
over 2% annualized to buyers. Rates on long-term bonds reached
several-year highs as well. During the financial crisis, monetary
authorities around the world took unusual steps to stem the panic and
protect the real economy (the economy that produces things and services
and provides employment). Among these policies was the suppression of
interest rates to very low, even negative levels. (Many do not realize
how extraordinary these efforts were — they produced the lowest rates in
history according to one study). The aim was to incentivize
investment and risk-taking
— activities that promote enterprise and
“animal spirits.” 2%, while still low, represents a significant
reduction in stimulus, and a significant step on the way to a return to “normalcy”
as the economy has recovered.
Also
noteworthy during the past quarter: Apple Computer became the first
public company to reach a market value of $1 trillion. In a sense this
was inevitable —
as economic growth and inflation over time expand
corporate values —
but it is also a tribute to a company that has created
products that engage consumers, and attracted large, influential
investors. Of course, it helps to be in a popular market sector as well,
one that has led the entire market to new highs.
It is
clear that all of these milestones are connected. The Lehman collapse
triggered the monetary and fiscal responses aimed at averting economic
catastrophe a decade ago. The stimulative actions taken subsequent to
the event contributed to the large rise in stock values and to the
eventual return to economic growth that we still enjoy in the U.S. A
stronger economy has, in turn, brought about a rise in interest rates,
normal under such circumstances. Finally, while the appearance of the
world’s first trillion dollar company is an outstanding success for all
parties involved, such an achievement owes much to the favorable
business and financial environment prevailing over the past decade.
While
the anniversaries of market events and notable corporate achievements
make for entertaining commentary in the financial press, we find the
real value of such discussions lies in stimulating thinking about larger
issues which can have important implications for corporate and market
behavior going forward. What, for example, has been the aftermath of the
Lehman collapse for the financial industry and markets? Well,
fundamentally, not much has changed. Following a lot of talk about “too
big to fail,” banks are bigger than ever. Compensation schemes remain as
before, and big payouts are back on Wall Street. As some observers
foresaw even during the worst days of the financial crisis, crisis-era
regulations, introduced to reign-in bank risk-taking with publicly
insured funds, and reduce the likelihood of future crises, have been
partially scaled-back under persistent industry lobbying pressure. As
for the markets, while the rise in stock values has been long and steep,
it has also been “unloved.” Even as stocks soared, the allocation of
pension fund assets to public equities has fallen, continuing a trend
that began in 1999. And the increase in public enthusiasm for stocks
that usually accompanies a bull market seems absent this time, although
it is possible that public interest in the markets is now reflected in
the vast flow of money into “passive” vehicles, such as exchange traded
index funds.
“Will
another crash happen?” has also been the subject of much debate. In
light of the experience of 2008-2009, and the subsequent rise in
securities prices to new highs, commentators have been positing what the
next “black swan” (something totally unexpected) event will be that will
bring on another crash. That another market dislocation will occur at
some point is not subject to doubt —to do so would ignore the lessons of
history. When it will happen is unknowable, as is the cause. Despite the
talk of “black swans,” it is the nature of such unknowable and
unpredictable factors to be, well, unknowable and unpredictable. The
next crash could be caused by something beyond our current perception,
or it might be right under our noses
— the immense amount of debt in the
world, for example
— or it could be a combination of many small causative
factors, as some economists have suggested. At any rate, it is not what
you do in reaction to market ructions that will prevent damage to your
wealth
— by then it is usually too late
— it is instead the consistent,
rational behaviors that you engage in at all times that will save you
from disaster.
Another notable phenomenon has been a dramatic decline the in the number
of listed companies on the U.S. stock exchanges. Mergers, bankruptcies,
and “taking private” transactions take companies off the stock
exchanges, while a dearth of initial public offerings has failed to
replace them. The result was a 50% decline in listed U.S. companies
between 1996 and 2017, despite the rise in stock prices to new highs.
This phenomenon is also, indirectly, at least partly a result of low
interest rate policies over the last decade. Borrowing became so cheap
that taking companies private became more attractive. Low rates and a
lack of alternatives also prompted those controlling large pools of
capital to seek out “alternatives” to the public stock and bond markets.
Hence, large amounts of capital became available to “private
equity” and
hedge funds to be used for funding private companies, or in mergers
involving public companies. Some observers have expressed concern over
the impact that the enormous shift of funds into passively managed
investment vehicles may have on the proper functioning of capital
markets. The significant decline in publicly traded investment
securities could magnify this effect.
Oil
prices have climbed to their highest levels in four years (about $77 per
barrel in the U.S., $85 internationally at publication time), nearly
tripling the lows reached early in 2016. The oil markets have been a
classic example of supply and demand during this decade. After trading
above $100 in 2014, prices collapsed after OPEC unleashed production and
flooded the global market, attempting to cripple the U.S. unconventional
oil (shale) business that had come to threaten OPEC’s hold on the
market. However, low prices put such a strain on producer economies that
they reversed course and reduced production to soak up the glut. Prices
rose accordingly.
Subsequently, demand has come into play. Growing world economies (helped
in part by the lower energy prices) have boosted demand for oil, which
is now growing by more or less 1 million barrels per day of consumption,
to about 100 million bpd currently. Curtailed exports from producers
such as Iran, Venezuela, and Libya have further tightened the market,
while the shale boom in the U.S. has run into labor and infrastructure
bottlenecks that have slowed the growth of its contribution to world
supply. Demand and supply seem roughly balanced at present, but with
demand growing and spare production capacity reaching limits (excepting
Iran and Venezuela), prices could continue to be firm.
Since
the collapse in oil prices in 2015-2016 we have been convinced that the
sharp drop in investment activity in the industry resulting from low
prices would eventually lead to an unbalanced market, with new resources
failing to keep up with the depletion of existing reservoirs. We still
expect this process to eventually play out, perhaps over the next five
years. There has been some revival of interest in exploration and
drilling as prices have firmed, but investment still remains far behind
what is needed in order to meet future demand. Despite the attention
given to renewable sources of energy in recent years, a transition to a
greener future will take years. Oil as an energy source will be with us
for a while to come.
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