Decade long stock market recovery
For many investors, the 2007–09 mortgage meltdown and financial panic are the benchmark for a worst possible outcome.
The Dow Jones industrial average fell 54% in the 17 months from 9 October 2007– 9 March 2009.
Major investment firms including Lehman Bros, Bear Stearns, Fannie Mae, Freddie Mac and AIG either filed for bankruptcy or were rescued by government intervention after massive losses.
US unemployment soared from 4.4% in March 2007 to 10% in October 2009.
The Case-Shiller home price index crashed from 182.72 in January 2007 to 133.99 in February 2012, a 27% plunge.
Housing investors with only 10 or 20% equity were wiped out. Numerous hedge funds closed their doors or suspended redemptions. Investor losses were in the trillions of dollars.
The contagion spread to Europe and the Middle East.
Dubai World went bankrupt in November 2009 and a sovereign debt crisis raged in Europe from 2010–2015. It was the worst financial crisis since the Great Depression.
Decade long stock market recovery
The financial damage did not pass quickly.
From June 2009–September 2018, the US experienced the weakest recovery in its history.
Yet the damage did end.
From March 2009–September 2018, major stock indexes more than tripled. Unemployment fell from 10% in October 2009 to 3.8% in May 2018, the lowest level in 18 years.
The Case-Shiller home price index rallied to 204.44 in June 2018, a new all-time high.
Investors who did not sell at the bottom in March 2009 and held their positions had recouped their losses and made substantial profits besides by late 2018.
A bank CEO or investment maven like Warren Buffett could practically shrug the whole episode off.
Yet that’s not how most investors navigated the meltdown.
Investors bailed out of the stock market in late 2008 or early 2009 to preserve what capital they had left.
They did not come back to the stock market until years later, if at all, missing out on much of the recovery rally.
Bank CEOs got a bonus while Average Joe was bankrupt
Homes were foreclosed, denying the previous owner any participation in the bounce back that started in 2013.
Worst of all was the psychological damage and loss of trust.
Investors who suffered heavy financial losses saw bank CEOs keep their jobs and make multimillion-dollar bonuses by 2016.
There were no arrests for fraud, no trials and no accountability among the top CEOs. Investors gradually returned to markets, but with no confidence in Wall Street research or so-called wealth managers.
After 2009, investing was a self-help, dog-eat-dog pursuit where cynicism replaced confidence and bitterness replaced trust.
It may be difficult to envision a worse scenario than 2007–09 and its aftermath, yet such scenarios are not infrequent; they have happened many times in US history.
In the Great Depression, major stock indexes fell 80% from 1929–1932. In the Civil War, the Southern economy was decimated and never fully recovered until the 1970s, over a century later.
The Second World War imposed massive austerity on the home front and left over 1 million Americans killed or wounded on the front lines.
The Dust Bowl drought years on the US Great Plains from 1934–39 caused an internal migration of about 3.5 million people, mostly poor with few belongings packed into jalopies, from Oklahoma, Arkansas, Kansas and Texas to California and other states in search of work.
Many died from pneumonia or starvation.
Cascading system failures result in paralysis
America has seen far worse than the 2007–09 financial crisis.
This implies that consideration of a true worst-case scenario must be broader than a 50% stock market decline and a few bank failures.
The scenario should include financial disruption yet go beyond that as the consequences of greater scale in capital markets and faster contagion among networked institutions inevitably impact critical infrastructure and finally social order.
The more likely scenario is a financial crash associated with another catastrophic event, such as a power grid collapse or internet crash.
Such double catastrophes are not as unusual as many expect; in fact, density functions make them likely.
The Fukushima catastrophe in Japan in March 2011 is a perfect example where an earthquake led to a tsunami, which killed thousands, disabled a nuclear power plant and caused a partial radioactive meltdown and then finally crashed the Tokyo Stock Exchange.
It was a case of one critical state system (tectonics) triggering phase transitions in other critical state systems (hydraulics, radiation, capital markets) until the chain of criticality ran its course.
The wreckage of the Fukushima nuclear reactor (left) was part of a chain of critical state system collapses in Japan in March 2011 including earthquakes, tsunamis, radioactivity and a stock market crash.
Linkages between critical state systems are not merely situational, as in the case of Fukushima; they can also be by design.
If China intended to launch an attack on the US power grid, they would not do so on a sunny day.
They would wait for a day when stocks were crashing and then attack the power grid, a tactic known as a force multiplier that heightens fears when the lights go out.
Iran might see the chaos at play and decide it’s opportune to shut down part of the World Wide Web by disabling key nodes such as the data traffic hub near the airport in Fujairah, UAE.
The web and power outages might accelerate the stock market crash, although a more likely outcome is that the stock exchanges would be closed, a condition that further amplifies the panic.
Other catalysts should be considered, including pandemic, natural disaster, war and the out-of-the-blue failure of a major bank before the central bank ambulance can arrive at the scene.
While each of these is a low-probability event, the chance that none of them happens in the next several years is near zero, as illustrated by Bernoulli process statistics.
A catalyst triggers the cascade as one system’s failure causes another’s and the breakdown becomes widespread to the point of paralysis.
What investors need to consider is not the cause of a crash (it will be something), but the consequences.
How you react to the crash itself will determine whether your wealth will disappear or not.
The best course is to prepare for the crash in advance.
Don’t try to react when the world is reacting; that doesn’t work.
The best preparation is to consider an allocation to cash, gold, silver and hard assets such as land and natural resources.
If you’re overallocated to stocks, you’ll be stuck in the same ‘Buy high, sell low’ trap as investors in the last panic.
All the best,