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Lessons From the Financial Crisis

Take economic forecasts with a grain of salt.

We are at a fascinating yet hazardous point in the market cycle. Many investors have become accustomed to lofty valuations and low volatility, making the recent reversion to “normal” conditions feel anything but normal.

Asset managers and investors alike seem to be doing mental gymnastics to justify their views. The number of market commentaries and outlooks seems to have spiked, with plenty of analysis available as we welcome 2019. It is at this point we want to stop and reflect, adding some much-needed perspective for investors who feel compelled to act during such stress points.

To start, we should be able to agree that few investors had the foresight in March 2009 to predict where we would be today after a nine-plus-year bull market. In fact, if you knew in 2009 what lay ahead, your level of disbelief may have been as strong as if someone told you in September 2007 that the market would soon lose half its value before turning around. This has many inherent lessons, but none more than the avoidance of short-term thinking and the importance of starting valuations.

The Decade Since the Crisis
Let’s rewind to March 2007. This was considered to be a goldilocks period as the world looked as healthy as ever—although, as we now know, this assessment of economic health was grossly inaccurate. A false sense of prosperity can be illustrated in countless ways; however, one of the more compelling is to reflect on the March 2007 Monthly Bulletin from the European Central Bank. Key statements are in bold:

“Looking ahead, the medium-term outlook for economic activity remains favorable. The conditions are in place for the euro area economy to grow solidly. As regards the external environment, global economic growth has become more balanced across regions and, while moderating somewhat, remains robust, supported in part by lower oil prices. External conditions thus provide support for euro area exports. Domestic demand in the euro area is also expected to maintain its relatively strong momentum. Investment should remain dynamic, benefiting from an extended period of very favorable financing conditions, balance sheet restructuring, accumulated and ongoing strong corporate earnings, and gains in business efficiency. Consumption should also strengthen further over time, in line with developments in real disposable income, as employment conditions continue to improve.”

Does this sound slightly familiar? We are not picking on the ECB—it was just one of many institutions whose experts seemingly fell into the trap of recency bias. The notion that we place too much emphasis on short-term trends is unequivocally important because it is one of the most common and recurring traits that cause financial market cyclicality. If you are not already cynical of short-term projections, maybe the ECB bulletin from the bottom of the market (February 2009) will also help:

“The uncertainty surrounding the global economic outlook is exceptionally high, especially as financial market volatility has soared. Overall, the risks for growth are clearly on the downside. They relate mainly to the potential for the turmoil in the financial markets to have a more significant impact on the real economy. The depth and duration of the global economic downturn will depend crucially on the speed at which the financial crisis can be resolved. Other risks relate to concerns about the emergence and intensification of protectionist pressures and to possible disorderly developments owing to global imbalances.”

This reinforces both the danger of paying attention to short-term economic and market noise and the importance of being independently minded. Practically, it also means being circumspect about what information we consume and how we consume it. In this regard, we at Morningstar focus on in-depth research as we offer an outlook for markets. As a staunch supporter of investors, we must be focused on offering an additive and honest appraisal. This includes a principles-based approach and the humility to admit what we don’t or can’t know.

The Power of Starting Valuations
Let’s think about what we can know—specifically, the power of starting valuations. To help illustrate this point, consider three valuation points: September 2007 (circa market peak), February 2009 (circa market trough), and today.

Most investors would agree that optimism breeds overconfidence and fear breeds panic— creating the opportunity to “buy low, sell high”— and we can see this in the numbers. In 2007, for example, the market optimism pushed more capital toward equities, with the cyclically adjusted price/earnings ratio expanding to as high as 26.7 and well above the long-term average. This contrasted with the gloomy days of March 2009, when fear caused a mass exodus from markets and the cyclically adjusted price/earnings ratio fell to just 12.3. All else being equal, this implied that the average investor was willing to pay approximately double for a given dollar of earnings because the backdrop felt safer in 2007.

Put into the context of an investment strategy, one of the best paths is to stay the course and ride the wave. Yet for those with willpower, a nice little trick is to see the world upside down. If you feel worried or scared, others are likely feeling the same and selling, so try to think of all the reasons why the outlook may be positive and view the pessimism of others as an opportunity to buy low. To the contrary, if you feel confident, others are likely becoming greedy, so try to imagine all the negative possible outcomes and see this as a risk and sell high.

Easier said than done, of course, but the key is to resist being scared out of an investment and instead position portfolios in a way that acknowledges valuations. In this regard, we can see from the exhibit that—on most valuation measures—the market is still closer to the 2007 peak valuation levels than the 2009 trough. Of course, the future carries a lot of uncertainty, yet today hardly looks like a great buying opportunity yet.

  - source: Morningstar Analysts

Key Tips to Become a Better Investor
If an investor can grasp three concepts—avoiding predictions, thinking probabilistically, and acknowledging valuations—they are arguably well on their way to achieving their financial goals. Here are a few other tips we think are relevant at moments like today:

  • Remember that investing is best done as a long-term pursuit. The journey will inevitably have ups and downs; however, staying the course should prove a fruitful experience.
  • There are no silver bullets. By investing in a portfolio that is positioned for multiple outcomes, not just one, you can increase the chances of reaching your and your clients’ goals.
  • True risk usually comes from the things we can’t see in front of us. The risks that are openly discussed in the media tend to be priced in by the market quite efficiently.

It is also important to understand the sensitivity to the key drivers of returns, as this is often misunderstood and sadly misapplied. Just like in sport, where there are recognized drivers of repeatable success, it is important to realize that the drivers will differ depending on the role one is trying to fulfill. In offense, skills like speed, agility, and innovation are all important. For defenders, skills typically rely on intelligence, communication, and leadership. The ranking of importance will differ depending on the specific role being fulfilled. The same applies in financial markets. Each market will have commonality in the key drivers, although each faces its own nuances. Dividend sustainability, value creation, earnings sustainability, corporate governance, and valuations all play an important role for any equity market. Therefore, it is not as simple as comparing the emerging-markets price/earnings ratio of 12 times versus the U.S. at 18.4 times. In fact, it is characteristically dangerous to compare an apple to an orange that way.

As investors we must separate the systemic from the idiosyncratic, understanding which drivers are unique to a single asset class. We can only achieve this by prioritizing analysis over action and insulating ourselves from the market noise that surrounds us.

We believe a holistic approach that balances asset-class nuances and market valuations is the best way to improve our understanding of markets. This may mean comparing each asset to its own history or peeling back the layers to compare the common drivers. Furthermore, and arguably more importantly, we must focus on what we’re trying to achieve, maximizing the probability of reaching our goals.

Bringing It All Together: Where Are We Now?
As we consider probability, it is important to remember that investors operate in an environment characterized by uncertainty. We, therefore, typically underestimate the range of potential outcomes. Consequently, we should not focus on any one particular outcome, but instead, consider the aggregate reward for risk that is available across the capital markets. As we do this, it seems clear to us that, despite recent falls in asset prices, the aggregate reward for risk remains less attractive than normal. Perhaps we shouldn’t rule out further lessons from 2008. 

This article originally appeared in the Spring 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.