A Different Playing Field
By Jeff Liguori
When markets slide, investors’ knee jerk reaction is to draw parallels to difficult markets in the past.
The most recognizable episode in recent history is the Great Financial Crisis (GFC) of 2008-09. The S&P 500 peaked in October 2007, followed by a crushing sell off that bottomed out in March ’09 — but not before losing 56% of its total value, a near total collapse of the financial system, and several high-profile bankruptcies.
A significant contributor to that grueling bear market was the decline in home prices. Real estate was a bubble that overinflated; the ‘pop’ led to a meltdown in our financial system due to intricate investment products linked to mortgages, over-leveraged home buyers, and inordinate risk assumed by some large investment banks. When that very large balloon deflated, there was no place to hide until the buyer of last resort — our federal government — stepped in with a bailout.
“This is not that housing market. When it cools – and it will – there should be enough demand to maintain stability.”
There are some eerie similarities in today’s investment landscape. Home prices have trended drastically higher as pent-up demand, fueled by excessive liquidity and a strong economy, has caused a buying frenzy in many markets. Speculation, specifically in crypto currency and “meme” stocks, prompted unsophisticated and inexperienced investors to buy assets about which little was known. The quick success of those speculators was widely publicized through social media, which caused a feedback loop that then further inflated the bubble as it drew more neophytes into the ‘game.’ We’ve seen this movie before, and it doesn’t end well.
Following the playbook of the GFC, should we expect a high-profile bankruptcy of a major financial institution, or a collapse in the housing market, or — heaven forbid — both and maybe more? We keep hearing that we’re in a bear market and a recession is all but guaranteed, so what now?
First, from a macro economic standpoint, today’s economy is quite different than what we experienced 13 years ago. Take real estate. Yes, home prices have skyrocketed and the market for buyers is possibly as tight as it has ever been. But the number of homes being bought with cash is at the highest level since 2005; transactions not subject to financing by the buyer represent almost one quarter of all transactions. For perspective, cash transactions at the peak of the market in 2007 were almost 40% lower than they are today. Mortgage debt is almost always the greatest liability for a consumer; that liability was significantly higher during the 2008-09 recession. And bank-lending standards today have made it more difficult for less creditworthy consumers to take on mortgages because of the Great Financial Crisis. This is not that housing market. When it cools – and it will – there should be enough demand to maintain stability.
The number of first-time home buyers, or housing formation, declined during the 2010s, mostly due to a combination of younger adults living with their parents, and a move toward urban centers where renting is more prevalent. But one of the consequences of the pandemic, that was impossible to predict, was the spark in housing demand. Major employers allowed workers to work remotely, which enabled growth in desirable suburban and rural real estate markets. We may be on the doorstep of housing formation trend that persists for a very long time, a long-term positive for the economy. Prices should normalize in the near term, but demand for housing remains intact.
The real crisis may be a lack of supply. But that is an article for another time.
Second, speculative bubbles are a natural consequence of a strong economy. We have all seen or heard of the Tik Tok millionaires, who seemingly made their fortune overnight, then spread the get-rich-quick gospel on social media, thus influencing more risky behavior — the very definition of a bubble. However, when equity markets decline substantially in a short time — the tech-heavy Nasdaq was down nearly 32% for the year in June – this risky behavior gets flushed out.
Look at this statistic, courtesy of Sundial Research: On June 16, 90% of the stocks that comprise the S&P 500 were down on the day. This occurred five times in the in the seven trading sessions leading up to June 16. There are zero historical precedents for that level of selling over a seven-day period, which is a sign of capitulation by inexperienced investors, necessary for a bottoming process in stock prices.
Many variables contribute to economic weakness, and with the Fed raising rates to battle inflation, it may lead to a recession. How quick is hard to predict. But this is not 2008. Consumer balance sheets are much healthier, with manageable levels of debt relative to income. Stocks have already discounted many of the negatives associated with tighter financial conditions and higher inflation.
As investors we move from fear to greed and back again. Strong emotions that are exploited by the media. Perhaps the Fed can navigate through this, or some type of peaceful settlement occurs in Ukraine, relieving inflationary pressure, and the adjustment in all asset prices is just that — a necessary adjustment in a healthy economy. Perhaps we should instead be thinking of long-term opportunity. That scenario doesn’t seem to be the narrative today, which, as a contrarian, makes me think it is more likely than not.
Jeff Liguori is the co-founder and chief Investment officer of Napatree Capital, an investment boutique with offices in Longmeadow as well as Providence and Westerly, R.I.; (401) 437-4730.