Remembering 2008. Ten years after the financial crisis: what has changed?
Ten years has past after one of the biggest event that impacted the life of everybody on the world.
The collapse of Lehman Brothers on the 15th September of 2008 marked the beginning of what played out as the first real global financial crisis.
Although the Lehman crash was identified as the turning point of the crisis, it wasn’t definitely the cause.
The origins of the global financial crisis must be found in the complex dynamics that went on for years that involved real estate, relaxed capital controls, algorithmic trading, securitization, derivatives and wrong expectations that led to a big wave of irrationality that went on for decades and accelerated further after the dotcom bubble.
Post Crisis Policies
Soon after Lehman crash, several measures were promptly adopted by governments and central banks in order to limit its expansion and mitigate its impact.
The FED provided direct lines of credit to several financial institutions to help to maintain confidence and liquidity in the financial system, the government also gave direct aid to several companies (like pledging to inject up to $100 billion into Fannie Mae and Freddie Mac if needed and provide unlimited short-term liquidity if required and purchase mortgage-backed securities in the open market). Subsequent measures were the large bailout plans and government spending in order to provide some sort of stability and stimulate the economy.
The financial crisis soon became a credit crisis that extended to the real economy, causing a huge slow down with serious consequences on the entire world.
Central banks all over the world lowered interest rates and leveraged on monetary policy to boost the recovery and avoid stagnation.
Unfortunately, rates cuts proved not to be enough to fight the recession. For this reason, central banks (the FED first and the other central banks followed the example in the years after) moved to large scale asset purchases known as Quantitative Easing, or QE.
This opened a whole new chapter in the history of economics and we are living right now the benefits and the consequences of those monetary policy decisions.
Today, marks the 10-years anniversary of Lehman Brothers crash. We all remember the mess, the concerns and the negative effects that followed this event.
Right now the economy seems to be doing good and we feel that all that happened belongs to the past. Is that true?
Let’s dig deeper and see how the situation has changed since then with reference to some key indicators.
We could virtually discuss for hours to clearly understand every implication and correlation between economic variables.
I covered some topics in other stories, especially with regards with the current situation.
For now, I am going to give you an aerial view on the current state of the economy with the hope that it will be a stimulus to do further research.
We start by taking a look at the S&P 500 index. We can see that since its lowest point in March 2009 after the stock market crash, the index has gained over 320%.
If we compare the top before the crash with today’s valuation, right now is nearly 126% higher than the peak of 2008.
Just to put things in perspective and gain a better understanding of how high those valuations are, here’s the long-term chart of the index.
As you can see, the “bubble valuations” of 2007–2008 are nothing compared to today’s prices.
Is the economy doing so good? It may be possible.
Maybe the correct question should be: have fundamentals changed that much to generate this kind of valuations?
“Bubble valuations” of 2007–2008 are nothing compared to today’s prices.
Earnings and GDP
If you look at the earnings of the S&P 500 companies, you realize that they are just above the level of 2008, before the global financial crisis stepped in.
Although earnings overall increased compared to 2008, certainly haven’t increased that much to push the index 320% higher.
Probably the most interesting insight comes from the U.S. stock market capitalization to GDP ratio (that is the total value of the U.S. stock market divided by the GDP).
When stock markets become overvalued they become overpriced compared to their underlying fundamentals. Considering the ratio with the GDP allows to make a comparison with the entire economy to see if it is overvalued compared to the actual situation.
This is also known as Buffett Indicator after Warren Buffett claimed that this is “probably the best single measure of where valuations stand at any given moment.”
Well, the chart speaks clearly. According to this indicator, the stock market is overvalued relative to the actual economy, and it’s even more overvalued than before the dotcom bubble.
Right now its valuation is over 165% of the GDP, compared to 141% in 2006 and 152% in 1999.
Are markets overvalued? There is a good chance that they are and that’s the result of many factors.
Although some concerns may arise, this doesn’t mean that an imminent crash is coming. This may take years but one thing is sure: sooner or later there will be a major correction, prices don’t go up forever and we better keep that in mind.
There is no market bigger than the entire economy. Right now, the market capitalization is 165% of the GDP.
Prices won’t go up forever.
What’s the state of the housing market? In 2000’s, easy loans pumped up home prices and the participation to the market, with higher turnover on real estate transactions and increased debt based on growing real estate prices.
The subsequent transformation of loans through securitization, that led to the creation of massive amounts of mortgage-backed-securities, incentivized those mechanism and transferred the risk to financial markets worldwide.
After the crash, home prices dropped and a huge part of the value was wiped out while foreclosures skyrocketed.
In order to measure housing market is possible to refer to the Case-Shiller U.S. National Home Price Index, that takes into account repeat sales of single-family homes.
In 2005, Robert Shiller released the second edition of his book Irrational Exuberance highlighting some “early signs” that expressed skepticism over “the long-run stability of home prices”, describing the data as “a rocket taking off”.
After “the rocket took off”, we went through the largest crash in global real estate markets in recent history during the years 2006–2012.
Right now we just exceeded the top of the bubble in 2007.
Monetary Policy and Debt
Monetary policy is really a crucial variable in the economy and after the financial crisis it gained even more importance. It’s absolutely vital to take monetary policy into account when discussing today’s data and trends.
In order to fight recession, unconventional monetary policy measures were adopted. Monetary policy played a big role in supporting the recovery after the crash and that was possible because of the role of credit and debt in the system.
After the crash, we saw an unprecedented monetary expansion pursued through low interest rates and the purchase of assets by the central bank with the Quantitative Easing.
This provided liquidity in the system that had real effects on the output.
This is the chart of the monetary base, that represent the total amount of a currency that is either in general circulation in the hands of the public or in the commercial bank deposits held in the central bank’s reserves.
In 2008 it was $872 billions, after the crisis it went up to more than $4,000 billions. Basically currency supply more than tripled in 6 years and today is still higher than $3,600 billions.
This sounds like crazy but it is only one fraction, the most liquid one, of the total money supply. When you include less liquid assets such as savings deposits, money market securities, mutual funds and other time deposits, the amount surpasses $13 trillions.
This monetary expansion was definitely impossible before 1971, but since then the shift in the monetary system changed everything in the economy.
One of the main reasons why monetary policy works is because it makes it easier and less expensive to borrow money for everyone in the system: households, companies and the government.
When debt is easier and cheaper, it leads to a higher level of consumption and the economy improves. This is exactly the dynamic behind debt cycles.
This mechanism works great but also increases the total amount of outstanding debt in the system, and that’s something that is worth paying attention to because it is a key element of fragility.
Debt, in all of its forms, is a crucial variable in this mechanism. Most of the economic growth in the recent years was a result of an increasing debt (consumers, government and businesses). The point is that while it helps in first place, it puts a burden on the economy that could have serious negative consequences over the long-term.
This chart is representative of the total amount of debt and liabilities in all sectors of the economy.
The $54 trillions of debt of 2008 rose to the astonishing level of $68 trillion (+25%). If we look at the public debt the situation is even more scary.
The Federal Debt increased from $10 trillions of Q3 2008 to more than $21 trillions in 2018.
Today, the US Government has substantially twice the level of debt of 2008.
Those situations never end up well.
Right now we have low interest rates, but is important to remember that as interest rates gets progressively higher, interest payments on the debt will increase as well with effects on the long-term sustainability.
Government spending coupled with ultra-expansive monetary policy made up a huge stimulus for the economy and today we are seeing the results: the economy is growing, markets are up, unemployment is low, everything seems to be doing great.
Surely those measures had real effects in driving short term movements of the economy, but this doesn’t come without drawbacks.
Cheap credit and low interest rates allow investors to borrow money to speculate, both on financial markets and other assets. Holding of cash in the bank is discouraged in favor of speculation in riskier asset markets.
Bond prices are pushed up by lowered interest rates, this means lower returns and this in turns incentivize other forms of investment that are usually riskier. Companies can borrow cheaply in order to perform stocks buybacks, increase dividends and fund mergers & acquisitions.
The level of debt is an extremely important element, the higher the level, the higher is the fragility in the system. Interest rates are now low but as they increase debt becomes more expensive.
Ten years after the 2008 crash and the global financial crisis, the world has recovered and we currently are in the second longest economic expansion in history.
Several measures were adopted to fight the recession through intervention and regulation, confidence has progressively come back and the economy seems to be doing well.
While we are living these upsides, is important to remember that there is no guarantee that this is going to be the scenario during the next years.
As we saw in this article, there is a really good chance that the stock market is significantly overvalued, housing market prices are higher than 2008 and the level of debt, both private and public, is at record highs.
While the music is still playing, there are several indicators that suggest another view on this economic expansion. By adopting this perspective, the conclusion is that given the situation another financial crisis is inevitable and it really seems that we are in a bubble bigger than 2007–2008.
I am not making any prediction, it could be 3 months, 3 years or 10 years, it’s just a matter of time. The sure thing is that growth don’t last forever and stock prices don’t continue to go up indefinitely, sooner or later there’s going to be a major correction.
Economics has really complex dynamics, thousands of variables come into play and the evolution can’t be exactly predicted.
When we start to think that “this time is different” is the moment to stop and really reconsider the situation.
In the light of the experience of the global financial crisis, it would be better to ask ourselves some questions and further analyze the economy and investigate potential scenarios. Markets are emotional, that’s why crashes happen over a short period of time. In these periods, there are several opportunities for the investors with a structured decision making process that focus on the business and are in for the long-term.
This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.