The Investment U e-Letter: Issue # 709
Monday, September 10, 2007 Financial Panic: A Warning On Financial Crises From Alan Greenspan… and George Santayana
by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club Last week, Former Fed Chairman Alan Greenspan told a group of academics in Washington, D.C., that "the behavior we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land-boom collapse of 1837, and certainly the bank panic of 1907." That sounds pretty ominous. Unless, of course, you don't know what happened during those times of financial panic and why. If that's the case… well, as the philosopher George Santayana famously said, "Those who cannot remember the past are condemned to repeat it." So let's take a moment to refresh our memories… Four Financial Panics The Panic of 1837 This was one of the most severe financial crises in the history of the United States. Built on a speculative fever in land (sound familiar?), the bubble burst on May 10, 1837, causing a five-year depression that included the failure of many banks and record high unemployment. Some historians blame the economic policies of Andrew Jackson for this bust. However, it is unlikely Greenspan was drawing any parallels to the Bush policies - wrongheaded as they are in some ways - but rather to the housing mania of the past few years which is now playing out in an ugly way. The Panic of 1907 This was another emotional episode, a financial crisis where the stock market fell 50% from its peak and the economy wound up in recession. Best remembered for the panic-stricken runs on banks and trust companies, the severity of the downturn led to the formation of the Federal Reserve in 1913. This crisis proved too big for the U.S. government to handle. Fortunately, J.P. Morgan organized a team of wealthy bank and trust executives who secured international lines of credit and bought the stocks that frightened investors were despondently selling. This was not the first financial panic since 1837, incidentally. There were three others in the 34 years preceding this one. Black Monday I was a portfolio manager on Black Monday (October 19, 1987) when the Dow plummeted 22%. The surprising thing about this crash is that the cause is still a mystery. After all, no government failed, no currency crashed, and nobody was shot. I remember the market just gapped down at the opening and never looked back. Much of it was caused by program trading, of course. So curbs were instituted and Greenspan himself rode to the rescue with a dramatic rate drop. Taking a page from his book, Bernanke surprised the market with a half-point drop in the discount rate a few weeks ago. Hedge Fund Collapse Lastly, Greenspan's mention of 1998 refers to the collapse of the hedge fund Long Term Capital Management (LTCM) and the ensuing turmoil in world stock and bond markets. Founded by John Meriwether, the former head of bond trading at Salomon Brothers, LTCM generated 40% annualized returns in the first few years, but managed to lose $4.6 billion in less than four months in 1998. It turns out the fund's complex mathematical models were no match for the East Asian Financial Crisis of 1997 and Russia's default on its sovereign debt in 1998. World stock and bond markets were sent into a short-term tailspin, thanks in part to the fund's size and massive leverage. Fortunately, Greenspan organized a group of Wall Street banks that enabled an orderly liquidation of the troubled fund and financial markets quickly recovered. Financial Panic: Expect the Unexpected So what are the lessons to be learned here? - History shows that financial panics are less rare than many investors believe.
- The government and/or the Federal Reserve usually steps in to lessen the economic and financial pain, but only after many investors have sustained substantial losses.
- As Nassim Taleb has written in "Fooled by Randomness" and "The Black Swan," financial panics are usually one of a kind, impossible to predict and arrive like a bolt out of the blue.
So what does an investor do with this knowledge? How Investors Can Handle Panics Obviously, you can't run your portfolio in perpetual fear of financial calamity. But you can expect the unexpected. For starters, that means paying close attention to the biggest disclaimer in the investment industry: past performance is no guarantee of future results. No matter how well the stock market, a money manager or a mutual fund has done in the past, tomorrow is a new day. That may well mean that returns will be better than you expect. But right now Alan Greenspan is hinting just the opposite. Oxford Club members are already prepared, with their portfolios divided among non-correlated assets: stocks, bonds, commodities, gold shares, real estate trusts, and inflation-adjusted Treasuries. But keep some cash on hand, too. If a genuine panic ever materializes, you don't want to find yourself without the wherewithal to take advantage of it. In short, caveat emptor. Good investing, Alex Today's Investment U Crib Sheet - To see how Oxford Club members divide their assets, here's the perfect mix of stocks, bonds, commodities, and real estate investment trusts (REITs).
- Where's the best place to keep your short-term cash? With money market yields relatively competitive, your best bet is to pick a fund with ultra-low expenses. That's where you gain an edge with your cash holdings. Here are four money market funds from Vanguard. They each have competitive rates and dirt-cheap expense ratios. Learn More.
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