Over time investors become conditioned to assume that market returns are relatively tranquil, that they closely follow something akin to a normal distribution curve. Most market outcomes are well defined and fall within the centre of the distribution, or so that’s what investors think. This view is reinforced when they see equity markets gradually appreciate year after year. Investors may even leverage up their portfolios, betting that market returns will broadly follow this benign profile.
The tails at both ends of the curve reflect extreme market outcomes (either extremely positive or negative), but which are assumed to be very unlikely to occur. And since tail risks do not happen very often (and are difficult to quantifying), investors fail to take account of them in their portfolio - either by seeking to gain or protect themselves from those events.
As price volatility becomes compressed, investors are emboldened, and they begin to price in an ever more favourable view of future returns. Meanwhile, other investors join the bandwagon. In turn, asset prices become further and further disjointed from reality.
When conditions are like this a spark can result in a dramatic shift in sentiment and asset prices: a major hedge fund announces losses on mortgage backed securities, or something else. For smart investors, a crisis creates danger but also opportunity.
In this article I look back to the Global Financial Crisis (GFC), spotting the parallels and the differences between that period and the current Corona crisis. I then look further back in the financial history books for why “this time is different” really are the four most dangerous words in investing. Finally, I look at some of those investors that won and lost during these periods of financial crisis, how they did it and what it means for smart investors on the lookout for asymmetric returns.
The Global Financial Crisis (GFC)
The housing market was the epicenter of the 2008-09 Global Financial Crisis (GFC). In the lead up to the crisis banks and other financial institutions dramatically increased the amount of credit they made available to homeowners. The overriding view was that because there had never been a nationwide decline in US house prices lending was safe. Everyone always pays their mortgage after all. Don’t they?
The bursting of housing bubbles in the US and in other countries brought major global banks – many of which did not have enough capital to withstand the shock – almost to their knees. The banks paid a price for bundling subprime mortgages into complex, opaque derivatives to maximise profits. This made it incredibly difficult to know who was holding toxic debt, and who was not. The banking system froze. There was a very real risk of the entire financial system toppling over.
The GFC was primarily a liquidity crisis, which meant that there was a shortage of cash to meet commitments. The GFC was often named “the credit crunch” after all. The US Federal Reserve and other major central banks stepped in and injected billions of dollars of liquidity into the financial system. This prevented the contagion that would have infected the global economy had banks, mortgage providers and insurance companies collapsed.
Asset markets fell heavily during this period, but they fell off a cliff when investment bank Lehman Brothers collapsed, prices finally reaching their nadir in early 2009. The actions by central banks saved the financial system, but they also prevented economies from working off the debt that had gradually built up. Instead, corporate debt continued to march ever higher along with asset prices for over a decade more. They also skewed the incentives of investors who went away thinking that the Fed would always have their back.
The Corona Crash
The crisis that is affecting the global economy in 2020 is very different from the GFC and previous crises. The best analogy for the 2020 recession is the large bush fires that hit Australia at the start of January 2020. They were particularly destructive due to the prevalence of dry tinder, which meant that fire quickly spread under the right conditions.
In the same way as the Australian bush, the global economy and its financial system was stretched tight in early 2020: trade flows were optimised for just in time delivery leaving little in the way of a buffer to ward off nasty shocks; record high equity market valuations meant that a bout of uncertainty would be quickly reflected in sharply lower asset price valuations, and finally, high debt levels meant that many companies could only be kept on life support for so long. This made it vulnerable to a spark.
That spark was a virulent disease, covid-19. As the virus spread across the globe authorities attempted to keep one step ahead of it by imposing strict lockdowns designed to restrict people coming into contact with each other. In turn economic activity came to a grinding halt causing an unprecedented shock to global supply chains.
Central banks sought to use the same playbook from the GFC. But this time their response was quick, and the sums being used to backstop the global financial system were on an entirely different scale. By summer 2020, global central bank balance sheets had swelled by several trillion dollars as authorities sought to ensure the liquidity of the economy and the financial system.
So far at least, the 2020 corona crisis has yet to turn into a financial crisis. But it could…
If financial markets see further sharp falls this may mean that banks and other financial institutions face margin calls requiring them to unwind their own investments, which in turn triggers further downward pressure on asset prices.
If commodity prices fall further and / or the US dollar strengthens then borrowers in countries that have borrowed heavily in dollars will see their loan exposure explode. This in turn increases the chance of business closures and knock-on impacts to other sectors and financial institutions.
If indebted households or companies are unable to service their debt repayment obligations, they are effectively insolvent in the eyes of their lenders. As government support is gradually reduced as lockdown restrictions are eased the extent of the damage will become apparent. In contrast to the GFC which was a liquidity crisis, the Corona crash has the potential to be a slow-motion insolvency crisis.
In late January 2020 billionaire hedge fund manager Ray Dalio advised investors shouldn’t stay on the sidelines in 2020 because “cash is trash”. One month later, markets collapsed as fear over the impact of covid-19 related lockdowns reverberated around the globe.
In October 1929, shortly before the crash that brought on the Great Depression, economist Irving Fisher declared that the stock market had reached a ‘permanently high plateau’. In the weeks after the crash he told an audience that he believed nothing fundamental had changed and that they should ride out the storm in the markets.
The four most dangerous words in investing are, “It’s different this time.”
Blindly following the advice of ‘experts’ views on the future wouldn’t be so bad if we knew that they had special insights that had reliably outperformed the rest of us. We could at least then justify that the cost to our time was being spent rationally. There is a small problem though. There’s no evidence that ‘experts’ are any better at seeing the future than the rest of us.
In 1984 Philip Tetlock, author of Super-Forecasting: The Art and Science of Prediction, invited 284 experts to assign probabilities against events occurring in the future. All were acknowledged experts in their fields, with more than half holding PhDs. A few years later, when scoring the accuracy of the predictions Tetlock found an unsettling conclusion, at least unsettling for some of the pundits, “the more famous the expert, the less accurate his or her predictions tend to be.”
Characteristics of financial crisis
The origins of major forest fires - whether they take place in the Australian bush or in the USA – take root over several years. Fire fighters may seek to dampen small fires to protect local communities, but in doing so they prevent the natural cycle of forest decay and clearing to occur. Dry tinder begins to form, and build-up across the forest floor. And then, seemingly out of nowhere, a spark ignites.
The underlying characteristics behind financial crisis are very similar. The economy and financial system are operating smoothly, and the future begins to look rosy - new technologies and innovations begin to appear including alternative assets. Investors gradually raise their stakes, often using novel sources of leverage, resulting in higher asset prices. Less sophisticated investors are attracted to the prospect of gains feeding the asset price increase.
At some point the value of the market becomes decoupled from the real economy it was supposed to represent. Here monetary authorities react to market weakness by providing more liquidity. This supports asset prices, but it stops the dry tinder from being cleared. The market continues to rise, until at some point investors perception of wealth are revealed to be an illusion.
The crash begins.
Things start to get ugly when people begin to worry about cash flow. With financial institutions unwilling to continue lending and borrowers scrambling to find cash to cover their debt payments, the ability to sell investments for cash becomes a major concern. Cash is no longer trash.
Asset price correlation moves to 1 (i.e. perfectly correlated) as all assets are sold off together. Risk-on quickly becomes risk-off. Assets that investors held to protect themselves in a crisis (gold for example) sell-off as well as investors, worried about meeting margin calls on investments elsewhere become desperate to offload their investments.
Monetary authorities and the government begin to step in to quell the fire. But as hedge fund manager Ray Dalio describes in his book, Principles for Navigating Big Debt Crisis, authorities rarely learn the lessons of past crisis. Investors place too much faith in them to make things right again - actions to stimulate the economy have far less impact than investors believe (or hope) they will at the time, “people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to past earnings and expected earnings, failing to account for the decline in earnings that is likely to result from what’s to come.”
Learning from history
One of the most valuable lesson an investor can take is history. History provides many important clues as to what to watch out for as crises develop and then erupt. It also offers guidance as to where, when, and how to take advantage. Because although the circumstances driving markets and economies may change over time, human nature does not.
The South Sea crisis
2020 marks the 300-year anniversary of England’s most notorious speculative mania, and the first of many economic and financial crisis.
The South Sea Company owned the monopoly rights to trade with South America. The real prize that investors had their eyes on was the anticipated trade that would open up with the rich Spanish colonies in South America.
Between January and August 1720, the price of South Sea stock rose sevenfold. Restrictions on the supply of shares, coupled with surging credit availability fueled the share buying bonanza. The fear of missing out on riches drove the share price even higher.
At its peak, the Company’s market worth was around twice the total value of land in all of England. Those charged with running the Company and connected to it in government knew they had a problem: they had to keep fueling the boom or fear that it would fall around their ears and crash the economy.
But that confidence act could only last so long. Eventually it began to crumble, and with it the share price. As the bubble collapsed in September 1720 financial distress rippled out through the financial centres of Europe – from England through Holland and onto northern Italy.
The Asian financial crisis
In July 1997 foreign investors, bankers and currency speculators lost trust in Thailand’s ability to cope with a deteriorating economic situation. The country was suffering under a rising trade deficit and a growing international debt burden at the same time as other countries in the region suffered mounting business and banking closures.
After depleting its hard currency reserves in a desperate attempt to protect the Thai currency (the baht) from depreciating, it eventually plunged anyway. The devaluation precipitated a wave of similar sharp currency moves across Indonesia, Malaysia, and the Philippines.
In the runup to the crash companies, banks and governments loaded up on short-term debt on the assumption of never-ending growth. The easy availability of low-cost credit from foreign investors fed the feeding frenzy of debt. Local governments removed obstacles in the way of borrowers by relaxing controls in place on international borrowing by companies and financial institutions.
The collapse in the region’s currencies and stock-markets wasn’t the end of the story. Contagion began to ensue.
Through the 1990’s the leading emerging market was Russia. The destruction of the Berlin Wall in 1990 and the collapse of the Soviet Union one year later offered the potential for investors to participate in the development of the free market in a country previously cut off from global capital flows. It set up a compelling narrative in the minds of investors eager for high returns.
As with previous crisis (and those that were to follow) rising prices provided the illusion that all was well. Large global investors felt confident that the country had turned a corner. Corruption, organised crime and other signs of impending collapse were hidden, or worse ignored by investors chasing the market higher.
And then it all started to unravel. Beginning in early 1998 political uncertainty increased fueling fears that the country’s leaders would not be able to manage should speculators attack the currency as they had done in Asia the year before. Later that year the Russian currency and stock-market collapsed as the illusion became clear – the country was drowning in debt and a breakdown in the banking system.
Which investors played financial crises correctly and won? And who lost and blew-up?
Just as each crisis has its similarities, so the investors involved (those who won, and lost) share similar traits. In the 300 years since the South Sea crisis, markets, economies, and technologies have evolved and become more sophisticated. But people have not. Today’s investors have the same software installed as their ancestors three centuries ago. That offers reason for caution, but also opportunity for those smart investors able to take advantage.
The oil trader spotting opportunity
One trader that has consistently spotted the opportunity that a crisis can present is French hedge fund manager Pierre Andurand. The oil trader correctly called the crude price’s ascent towards $147 per barrel in 2008, its subsequent crash in the GFC, and its eventual rebound to $100 per barrel. A decade passed and in that intervening period Andurand’s funds were punctuated by meagre successes but also a fair share of disappointments.
Fast forward to early 2020 and Andurand placed a series of large bets on oil prices falling, betting that the corona virus would make a severe dent in global oil demand. At the time he even speculated that oil prices would go negative, something his colleagues and other participants in the industry thought was impossible.
His foresight shows why it is so important for a successful investor to be able to imagine alternative futures - other investors fail to foresee the possible outcomes, and so fail to price the market correctly. His recent success also shows why it is so important to be resilient during the barren periods and maintain the lookout for opportunities.
The bookseller beats the scientist
Sir Isaac Newton is the name most famously associated with the South Sea crisis. When asked about South Sea stock in the spring of 1720, Newton famously declared that he “could calculate the motions of the heavenly stars, but not the madness of people”. Newton lost a great deal of money in the bubble – possibly as much as $20 million in current terms - having sold his South Sea stock at an early stage, later re-entering the market and investing his entire fortune in the Company.
Not everyone lost their head. Much less well known, bookseller Thomas Guy sold his entire South Sea holding at an average price of 416, subsequently betting that the price would fall. He later used his enormous profits to establish the London hospital that still bears his name.
Both Newton and Guy sold out their initial long position at around about the same price. Newton eventually came back into the market after seeing his friends get rich. He invested significantly more this time, but only after the share price had nearly doubled, chasing the winnings he felt he had missed out on. The share price peaked weeks later before collapsing. Newton sells out. Guy on the other hand (perhaps understanding that the deck was stacked against him and spotting the opportunity for asymmetric returns) later bet on the share price falling.
A Nobel Prize (or two) is no guarantee of investment success
Long Term Capital Management (LTCM) was an American hedge fund staffed by industry veterans and respected academics including Robert C. Merton and Myron Scholes. LTCMs edge came from its mathematical modelling. Its huge financing allowed it to undertake massive trades.
LTCM made use of these mathematical models to discover discrepancies between asset prices, betting that they would converge, as they always had in the past. So long as asset prices behaved according to LTCM models then the hedge fund faced very little chance of losing.
Eager to juice returns LTCM added increasing amounts of leverage to their portfolio. But in order to keep up with the competition and expectations of their clients they strayed into ever more exotic locations.
In late 1998 the Russian currency collapsed, and the government defaulted on its debt. The resulting panic in global markets resulted in the prices of all kinds of assets moving in unexpected ways. LTCM had always reassured investors – often with extreme precision – that it could only lose a certain amount ($35m) on any single day. On one Friday in August 1998 LTCM lost $553m.
The 7 lessons smart investors must learn from financial crises
Crises occur when systems lack any redundancy - too much debt in our financial system or no spare capacity in our supply chains. When systems are unstable, they are vulnerable to sudden events that surprise market participants. These then set off non-linear impacts that spread like a virus through asset markets and across borders. The key is not to predict the spark that sets off the chain, the key is to be positioned to take advantage, so called “tail hedges”.
The lesson from the investors in this article is that you should always be careful with leverage. According to Warren Buffett, "When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices.”
Beware FOMO. Emotion can override your ability to make rational decisions. Fear and jealousy are especially powerful. Isaac Newton got suckered back into the South Sea Company after seeing his friends get rich, after he sold out. That decision was ultimately ruinous.
Closely related to this is the concept of TINA, or “there is no alternative”. Throughout history financial crisis have been preceded by an asset class that investors felt they had to be invested in. Whether that’s the South Sea Company, emerging markets, housing or technology stocks. This can result in prices of these assets reaching levels far higher than the reality should suggest.
Smart investors can take advantage of this distortion by betting against the market narrative, either by shorting the asset or by investing in an alternative that has seen its valuation disappear from market view in the shadow of the TINA asset. But recall that assets divorced from reality can always move to even more extreme valuations before gravity sets in.
Markets may change, but people do not. While technology, economies and companies morph and change over time the same cannot be said for investor behaviour. Historical financial crises show familiar patterns. Ultimately that’s because we still make the same mistakes - this time is never different.
The financial crises illustrated in this article are just a small snapshot of the opportunities that have availed themselves to investors over the past 300 years. The Corona crash will not be the last. That knowledge shows why survival is so important. It is only through time in the market, being resilient yet open to positive shocks that you can take advantage of opportunities.