Other Shoe Yet to Drop on Financial Stocks

This is now the great debate on Wall Street, Main Street and in global capitals as investors try to assess the recent credit paralysis and market turmoil. The answer is of pressing interest, since the first scenario makes the recent stock market decline a compelling buying opportunity, while the other is cause for caution.

Last week, as markets stabilized and credit began to flow, however haltingly, proponents of the more benign, short-term financial crisis seemed to gain the upper hand. In this view, the problem is largely psychological — a panic-induced fear of risk — rather than anything more fundamental. Apt comparisons are the market crash of 1987, aggravated by the failure of program trading, and the collapse of Long-Term Capital Management in 1998, which prompted the Federal Reserve to cut interest rates. While those crises were painful for many investors, they had negligible impact on the broad economy and represented buying opportunities for stock investors. Market averages were significantly higher six months later in both instances.

History, however instructive, never repeats itself exactly. I don't think the current crisis can be dismissed quite so easily. Apart from the credit panic, several more fundamental forces are at work. First is the broad and sharp decline in real estate prices, leading some analysts to characterize the recent run-up as a real estate "bubble." The result has been a plunge in construction, home sales and housing-related consumer spending, and an alarming rise in foreclosures. The recent credit crisis had a very real economic underpinning, which was the failure of borrowers to make their mortgage payments. Given the nature of foreclosures, the scope of the problem has been unfolding slowly, originating in subprime but moving up the ladder of credit worthiness and affluence. No one knows yet where it will stop.

A second, related fundamental development is the broad de-leveraging now underway in everything from commodities to private-equity-led buyouts. As long as credit was easily available and packaged into seemingly safe, triple-A rated packages of debt obligations, anything could be bought, leveraged, and sold off to a higher bidder — much as homeowners who got into trouble could always re-finance or sell at a profit. Now that lenders have rediscovered the notion of risk, those days are over. Deals are already collapsing or being re-negotiated. But the other shoe has yet to drop. When it comes time to refinance or sell the bad deals of recent years, there won't be any buyers or lenders to cover up the mistakes. Investors in these overpriced deals, as well as the private-equity firms, investment banks and other lenders who made those deals possible, will face a day of reckoning.

Faced with these two fundamental threats to the economy, market historians might point to the savings-and-loan crisis of the late 1980s and early '90s and the 1989 collapse of the junk-bond market after the failure of a proposed leveraged buyout of UAL, parent of United Airlines. Both entailed some degree of financial panic, but also involved real economic issues. The S&L crisis unfolded over years, not days, and took a massive bailout from Congress. The collapse of the UAL deal led to a near halt in buyouts and mergers. There was a recession in 1990-91, albeit a relatively mild one. The S&P 500 peaked in July 1990 at 369 and reached a low for the year of 294 in October. During that stretch the S&P dropped 20%, which qualifies (barely) as a bear market.

I wouldn't want to overstate the analogy. I could argue the similarities and differences between then and now at some length, but one thing I can say with confidence is that the present isn't exactly like anything in the past. Let's assume that the housing/mortgage/debt crisis is bad, but not as bad as the S&L mess, which strikes me as a reasonable proposition. If the market dropped 20% in 1990, then I would expect a decline of something less than that now. The major market averages have already undergone 10% corrections, which suggest that further downside risk isn't all that great. Nonetheless, I remain wary of private-equity and hedge-fund stocks, investment banks and all but the largest and most diversified companies in the financial sector. I doubt the market has fully priced the likelihood of more bad news on the buyout front, just as it failed to anticipate the severity of the subprime defaults.

Yet I was very comfortable buying stocks recently, even if further declines are in store. While we're pondering history, it's worth considering that most bear markets don't begin with a "crisis" or a sudden plunge in stock prices. It would be so much easier for investors if they did, thereby announcing their arrival with fanfare. More often they creep up with slow, agonizing declines punctuated by occasional "suckers' rallies." No crisis or sudden selloff marked the beginning of the 2000-2002 bear market, which went on for over two years. Yet the bear market of 1990 set the stage for the massive bull market of the rest of the decade. When I wrote that the S&P peaked at 369 in 1990, that wasn't a typo. Seventeen years later, it's at 1450. Looked at from the long term, even the S&L bailout and junk-bond collapse of 1989-90 was a buying opportunity.