The Financial Crisis II: Parallels to 2007-2008

01/15/2012 12:01 am EST

Focus: MARKETS

Douglas Roberts

Managing Principal, Channel Capital Research Institute

The current financial crisis that began in 2007 still continues, albeit in a different form. Nothing has been truly resolved. How does this affect the markets in 2012? Will the rally continue or will a downward spiral start again, or are we perhaps in a broad, extended trading range? We may find these answers to the future by examining the past.

Parallels to 2007 in 2011

There were several similarities between the equity markets of 2011 and 2007:

  • Both seemed to bottom in the middle of August. There was a fear that the financial world was going to collapse. In 2007, this was due to the implosion of the sub-prime mortgage market. In 2011 it was due to the European financial crisis.
  • After the bottom occurred in 2007, there was a strong rally that recovered all the lost ground, thus ending the year on a positive note. This seems to be very similar to the rally that we experienced in 2011. We bottomed in August and experienced a very robust but volatile rally since then.
  • Market leadership in the latter part of 2007 was also quite different from earlier in the year. Earlier that year, smaller companies in terms of market capitalization were the leaders in performance. After the market bottom, it was the larger companies that assumed the market leadership position. Large technology companies were the best performers. This was very similar to the situation in 2011.
  • Similar coordinated central bank intervention occurred at the end of 2007 as at the end of 2011. This appeared to resolve stress of the sub-prime mortgage crisis, and the financial markets rallied into the end of 2007 and briefly into 2008. Then, the rally fizzled and required additional central bank intervention. 

The Key to the Markets: Central Bank Neutralization of Threats!

Systemic bank uncertainty lay with the sub-prime crisis in 2007 and currently lies with Europe today. There was limited transparency regarding the financial institutions holding this debt. In 2007, this led to a domino effect that spread through all the world's financial markets.

In 2007, the Federal Reserve and other global central banks began to adopt a looser monetary policy in response to the sub-prime mortgage crisis. They assumed that the standard monetary response would be effective in containing the crisis and preventing the domino effect described above.

Initially, it appeared to be working. This is what triggered the rally in the latter half of 2007. Then additional problems, such as the bankruptcy of Lehman Brothers, became difficult to contain using standard monetary policy tools.
 
Monetary policy will need to be loosened even further, including possibly a massive intervention to at least postpone financial Armageddon to a later date. Nothing will be truly resolved, but the game of "kick the can down the road" can continue. 

The Lehman Bankruptcy

The Lehman Brothers bankruptcy on September 15, 2008 could be called the "tipping point" of the financial crisis. The biggest danger of Fed and global central bank policy is that it reacts to a deteriorating economy but does so too slowly. This is what happened in 2007-2008. The Fed began to ease monetarily in response to the financial crisis but at a very slow pace because of inflationary pressures.

As the markets began to deteriorate, the Fed appeared almost powerless to reverse the downturn. The deterioration quickly began to domino across all the worldwide financial markets. This was only stopped when the Fed and the government began to take extraordinary measures.

On the day prior to the Lehman Brothers bankruptcy on September 15, 2008, the S&P 500 closed at 1,251.70. This is very close to where the index is trading as I write this in January 2012. Thus, all the extraordinary measures by the Fed and the government have only succeeded in keeping the index flat over the last several years.

A Trading Range

If the Fed had not allowed Lehman Brothers to go bankrupt and had acted more quickly in terms of monetary easing, one can argue that the end result might have been the same with regard to the financial markets, but the trading range would have been much narrower. We would not have had such a severe bear market, but the end result might not have been very different.

As of January 2012, we currently seem to be in a broad trading range on the S&P 500. If the Fed makes a mistake like in 2008, the index could drop significantly lower. If it undertakes major stimulus program such as QE3 or if the European Central Bank issues European Bonds, we could challenge the highs experienced this year. However, if the Fed continues on its present limited course of action without making a serious mistake, we may be locked into this volatile but frustrating trading range for the near future.

Unemployment and Recession

The economic situation was much brighter in 2007 than today. The unemployment rate was almost half of what it is today. In general, the situation was looking like a severe recession in 2007, not the dire economic conditions of today.

Recent economic reports indicate a weak expansion, but not a situation in which the country is in recession. As I have mentioned, the improvement has only been marginal at best relative to the fiscal and monetary stimulus and the amount of time that it has taken for this to occur. Although these numbers are still in positive territory, many are still quite uncertain about the future and believe that without further government intervention, we could slip back into a recession.

Any improvement in the economy has been quite limited with only a small segment of the population participating, leading to what we described as "two economies." One has seen a rebound, but the other has not really experienced much improvement.

This has really not borne any resemblance to the "V-Shaped" recovery that many were forecasting. It is much closer to the jagged "U-Shaped" economic recovery that we predicted.

I have said previously that this is quite different from earlier recoveries. In most of those earlier cases, government stimulus merely "primed the pump" until the private sector took over. Now, government remains "the lender and spender of last resort." 

The Threshold of Pain

We have seen a familiar pattern in the crisis regarding fiscal and monetary stimulus. As the government institutes some program, we see an economic recovery. Then, when the program ends, the economic figures recede. This is true in cases of spending programs such as infrastructure or tax incentives as well as quantitative easing. The end result is still the same.

The real question becomes the threshold of pain required for the government to institute one of these programs. I have noticed that the level of pain required is lessening as we are in an election year.

This is not unique to the current situation and seems to be following the familiar election year cycle.

Quantitative Easing

If the economic situation remains so depressed, why do the financial markets rally? The answer is liquidity. This liquidity has been created by the Federal Reserve along with the other central banks. In addition to the effect on earnings and refinancing mentioned earlier, it also increases the price of risky assets, otherwise known in Wall Street terms as the "Risk Trade."

We saw this last year with the introduction of QE2. Operation Twist seems be continuing this. Although the financial markets have rebounded from the lows in 2009, quantitative easing has had a relatively minor effect on the real economy. Thus, many people view quantitative easing as merely a benefit for the banks and the wealthy, one which adds significant costs for the average individual. In this environment, there may be substantial resistance to a QE3.

Potential Threats

There is unrest in the Mid-East today, unlike in 2007. The Arab Spring is turning into an Islamic Winter. Iran is also continuing with its nuclear program despite US opposition. If it continues on schedule, it is possible that it could pass the point of no return within the year. There are rumors that the Israeli government may be planning a strike on Iran to prevent this.

Thus far, the situation appears to be contained. However, the potential for the outbreak of hostility still remains.

There could also be serious problems if the budgets required by the super committee failure are instituted. Many are assuming that Congress and the President will at least resolve this with temporary spending measures. This is by no means certain.

The Fed and the Treasury Markets

The fear of holding any risky assets has resulted in a flow of funds into Treasury securities. The supply of US dollars is controlled by the Federal Reserve which can print US dollars at will to satisfy its debt obligations and maintain low interest rates. The value of the US dollar might suffer considerably, and there could be substantial inflation. This may be linked to the current rise in gold prices.

For those who claim that such a scenario could never occur, one must remember that during World War II the United States was able to maintain very low interest rates during a time of severe inflation. However, there were substantial restrictions on trade and commerce. Owning gold was also prohibited.

Forecast: 2012 Will Depend Upon Government Stimulus!

If there is not a major shock to the global financial system such as the ones described above, the rally should continue. We should not exceed the highs in any case without a government stimulus package.

With regard to the rest of 2012, it will depend upon government stimulus. If the Fed acts, we will either be in the trading range or rally higher depending upon the size of the stimulus. Any of the shocks described above could damage the financial system quite substantially. As long as the Fed and the government are able to counteract these threats successfully, the situation may not deteriorate massively.

These threats are significant. If the Fed makes a mistake like 1931 or 1987, serious problems can occur. The United States equity markets are particularly vulnerable since many of the sources and solutions to these problems are largely outside of our control.

Doug Roberts is the Chief Investment Strategist for the Channel Capital Research Institute (www.ChannelCapitalResearch.com ), an independent research firm focusing on investment strategies using the Federal Reserve's impact on the financial markets, and is the author of Follow the FedR to Investment Success. He held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

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