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Lessons Learned from Previous Market Corrections

By June 12, 2017 No Comments

So about the actual strength and health of the current U.S. economy – where are we? Are we coming up on an economic boom? Are we still in recovery? Or are we in a new form of economy where this is really as good as it is going to get? It’s pretty difficult to determine which direction the needle is pointing, even after almost a decade of uncertainty.

With real estate and equity index values at or approaching all-time highs, a near-term market correction would not be a blatant surprise, would it?

The ironic part about a market correction is that, inherently, they are a surprise. Other than the alarmists that are constantly predicting economic apocalypse (have you bought your gold yet?) and are – based on statistical certainty – eventually right, most reasonable market participants are left to react to market corrections after the writing is already on the wall.

With this in mind, what can we learn from past market corrections and apply to Credit Unions today? American history is littered with examples of the boom/bust economic cycle. So let’s explore what previous economic upheaval looked like, and see what lessons we can take away from the past.

Black Tuesday – 1929

Stock prices have reached what looks like a permanently high plateau

Irving Fisher, 1929

For a little background on the events of 1929, you can read-up here. But at a high level, Fisher’s comment summarized the mentality present before the crash. Conventional wisdom was that the stock market would rise in perpetuity, and thus, markets were safe. Why would anyone have challenged conventional wisdom? As late as October 25, 1929, the New York Times headline read “…Leaders Confer, Find Conditions Sound”. Black Tuesday occurred four days later.

Lesson: There is a tendency to follow the “herd” when it comes to understanding where your institution stands. Don’t! Be proactive in objectifying your risk, regardless of what the conventional wisdom says. As opposed to keeping your head in the sand, regrade your portfolio, obtain current collateral values, and assign risk metrics to your loans.

The Oil Crisis – 1973

No car with my name on the hood is going to have a Japanese engine inside.

Henry Ford II, 1973

Among other things, the Oil Crisis and subsequent recession in 1973-75 precipitated a sharp rise in oil prices and stagflation. At the time, the American auto industry was still producing large, heavy cars that guzzled gas. The Oil Crisis led to smaller, more fuel efficient Japanese vehicles filling the void in the market. But what does Ford’s quote reveal about what the Detroit auto elites thought at the time? That the same way of doing things would always work. Well, as history shows, that didn’t pan out too well for American automakers in the 70’s and 80’s.

Lesson: Innovate even when you don’t have to. For a Credit Union that means proactively finding new ways to serve your members, develop new lending channels, or upgrading your risk analytics. Waiting until the market has been disrupted is probably too late.

The Tech Bubble – 1999

The four most dangerous words in investing are: ‘this time it’s different.’

Sir John Templeton

While I couldn’t find a shining example of a quote directly before the dot com crash, I think this famous Templeton quote sums it up nicely. Remember Or These were tech companies whose market cap went gangbusters because the internet was ushering in a “new economy”. Never mind that the companies didn’t actually have cash flow or couldn’t generate profits to support their valuation. In the late 1990’s, some tech companies were trading at over 100 times their earnings just because they had “.com” in their name. It was new, it was exciting, and it was… different. Well, not really. Soon enough investors realized that an internet company still had to turn a profit to be a good investment.

Lesson: Know what products actually add value to your Credit Union. Just like in the dot-com bust, if there are not positive cash flows (i.e. yield) then evaluate if that segment should be growing. Consider the use of risk-based pricing to generate stronger yields.

The Great Recession – 2008

A national severe price distortion seems most unlikely

Alan Greenspan, 2004

The former Chairman of the Federal Reserve was talking about housing prices in the quote above. This general thought that “housing prices will always go up” was the impulse for the Great Recession. No one on the carousel ride ever thought it was going to stop, so why would they have consider the down-side risks? Obviously, as we remember, housing prices didn’t go up forever, which was a scenario that many “experts” didn’t even consider. When the market corrected, it left financial institutions and investors holding assets (and derivatives of assets) that were worth cents on the dollar.

Lesson: It is human nature to not consider the possibility that something bad will happen to them, particularly when the recent track record doesn’t suggest otherwise. As a Credit Union, quantifying the downside (no matter how unlikely it looks today) is important to managing risk. Stress testing your portfolio for a decline in credit and collateral quality along with a shock to interest rates reveals what is at risk if markets go south.

The Takeaway

So what’s the common thread in these previous market corrections? Well, concisely, few see corrections coming and even fewer are prepared to confront them.

As a Credit Union, there are tools available to measure your risk and be ready for inevitable market changes. Twenty Twenty Analytics doesn’t advocate an insular response where you immediately tighten underwriting, but rather a balanced approach to understanding where your portfolio is at risk.

Twenty Twenty Analytics is capable of helping with this balanced approach, which will help you have a leg-up on other financial institutions to confront the rainy day when it hits.

If you are interested in learning more about our portfolio analytics, don’t hesitate to reach out.

-Alan Veitengruber
Twenty Twenty Blogger

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