Today's Crisis Should Set Stage for Future Gains

This just in: An email from a broker at a prominent Manhattan real estate firm eager to be quoted: “September 2008 and I get flashbacks of 9/11...After the initial shock waves this could lead to a real estate boom.” 

With estimates of 50,000 and counting layoffs on Wall Street, the bankruptcy of Lehman Brothers (LEH) and the fire sale of Merrill Lynch (MER), that strikes me as absurd. It’s true that 2001 marked the beginning of a real estate boom that has brought us to our current plight. But 2008 isn’t 2001.

This seems so obvious that I’m not going to belabor the differences. Suffice it to say that the causes of the current credit crisis are rooted in the ongoing collapse of the real estate bubble, which has proven to have far wider and deeper ramifications than the collapse of the tech bubble that began in 2000. A big difference is leverage. Most real estate purchases are leveraged, with the mortgage debt repackaged and distributed to myriad investors. Apart from the relatively small number of speculators, most tech stocks were not bought on margin. Even then, you can only margin up to 50% of a stock’s value, not the 100%-plus that became common in the real estate boom. Leverage magnifies losses. Now we’re seeing the consequences of a massive de-leveraging and the forced sale of assets at fire-sale prices. 

Wall Street investment banks were built on leverage. It is a stunning turn of events that it now appears likely that only two will survive: Goldman Sachs (GS) and Morgan Stanley (MS). Many hedge funds were built on leverage. A cascade of hedge fund failures appears to be underway. Many private equity partnerships were built on leverage. Expect some failures there, too.

So far, however, this is a financial crisis, as opposed to a broader economic crisis. Even a giant insurer like AIG (AIG) has gotten into trouble not because of its insurance business, but its (highly leveraged) investments in complex derivatives and mortgage backed securities. The latest economic data still show the broad U.S. economy expanding, and this is data from earlier this year when oil, gas and other commodity prices were soaring. Now commodity prices are plunging, which should provide the economy a much more powerful boost than the tax rebate checks.

No crisis is exactly like one from the past, but to me the current real estate and credit crises most closely resemble the S&L crisis of the late 1980s and early 1990s. You won’t hear any Manhattan real estate agents touting that claim, since New York real estate plunged in value, in many cases losing more than a third of its value, and it took many years to recover. But the overall economy proved remarkably resilient in the face of the failure of thousands of savings and loans as well as falling real estate prices. Recall that the crisis also required massive federal intervention in the form of the Resolution Trust Corporation, which acquired the real estate, mortgages and other assets of the failed thrifts and disposed of them in an orderly fashion that helped put a floor on prices. Something like this may be necessary this time, too, now that the Treasury and Fed have belatedly decided that the piecemeal propping up of wayward institutions is no way to restore confidence.

For investors, the good news is that a purely financial crisis can set the stage for strong future gains. Stocks rose moderately between 1990 and 1992 and rose very robustly from 1992-1995. For the decade 1990-99, the Dow Jones Industrial Average gained an average of 18% per year, one of the best decades ever. I’m not saying that’s likely to happen again — the '90s encompassed most of the tech bubble — but it does show that a financial crisis need not cast a pall over future returns. Indeed, to the extent it curbs dangerous excess, it enhances future returns.

These are long-term trends, none of which mean you should run out and buy (or sell) stocks today. Despite Monday’s 500-plus point rout, we have not yet reached another of the Common Sense buying thresholds, which is to buy on 10% dips (the next would be 2025 on the Nasdaq) and we’re not that far below the levels reached during the last wave of panic selling, which was in July.

As for me, I continue to eye some of the financial stocks. Bank of America (BAC), which I own, is well capitalized and is using its strength exactly as I would if I were the CEO, which is to aggressively capitalize on its strength. If there’s a fire sale, I want to be the buyer. Yet BofA was roundly punished for snatching Merrill Lynch, dropping more than 21% on Monday. That strikes me as an overreaction.

For investors interested (as I am) in some rock solid financial companies, see my current column in the October issue of SmartMoney magazine, which highlights Northern Trust (NTRS), SVB Financial (SIVB), Bank of New York Mellon (BK), and UMB Financial (UMBF).

Meanwhile, remember the Common Sense mantra: Don’t panic; don’t follow the herd. Be prepared to take advantage of any further declines. I’m confident your discipline and patience will be rewarded.