September 15 marked ten years since the largest bankruptcy in United States history. Lehman Brothers, along with several other financial institutions, were casualties of the bursting US housing bubble - dismissed as a near impossibility just a few years earlier as evidenced in this 2005 interview of Fed Chairman Ben Bernanke:
INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, "Oh, this is a bubble, and it's going to burst, and this is going to be a real issue for the economy." Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
CHAIRMAN BERNANKE: Well, I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis…
Today, we get the feeling that many stock market participants view any sizable downturn as a near impossibility – just because it hasn’t happened in a long time. Howard Marks of Oaktree Capital accurately describes the danger of viewing the last decade as normative: “nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus new minted investment managers haven’t had a chance to learn firsthand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.”
The events of 2008 are a reminder of how quickly things can turn. Matthew McLennan, manager of the First Eagle Overseas fund, recently recalled his experience from that tumultuous time: “…a week like that reinforces our belief that markets don’t act in linear, predictable ways. Markets are like complex ecosystems, where vulnerabilities can sometimes accumulate until negative change is telescoped into a moment…It’s a very healthy thing for all long-term investors, ourselves included, to be reminded of the fact that the tide does go out – sometimes in a very violent fashion.”
As we review our mutual fund lineup, we are encouraged to see portfolios that are defensively postured. Elevated cash positions are useful, not only to cushion the downside, but also to scoop up potential bargains when everyone else is selling. That kind of environment may be hard to imagine with the financial crisis now ten years removed, but the tide will go out again.
Aaron Pettersen, CFA, CFP®