What if everything you thought you knew about investing was wrong?

A lot of It is.

Please Remain Seated

You’re in a theater, catching the latest blockbuster. At first you notice nothing but car chases and explosions on screen. Then the person next to you leans over: “Do you smell that? Smoke.” A voice comes over the loudspeaker: “Everything is fine, ladies and gentlemen; please remain in your seats until the situation is resolved.” So you do as you’re told.

Of course you don’t! Your instincts for self-preservation cut through the crap, and you get out.

When it comes to crises in the stock market, investors are told to ignore their instincts for asset preservation. Admittedly, in the financial world, where there’s smoke there is not always fire — but if you smell something wrong, put down the popcorn and start paying attention. With that in mind: here’s a story for you. No explosions, just a few crashes.

The Tech Wreck

In 2000, investors pounced on tech start-ups with manic energy. No business plan? No problem! If a company said internet, new paradigm, networking, and other trendy nothings often enough, they were golden. Until they weren’t.

I started out as a professional financial advisor in March 15, 2000 — one week off the Dow and NASDAQ peaks. Over the next three years, the market went down. And down. And down. Market euphoria is a dangerous high: people think the markets can’t come down. But they can, and when they do, it’s brutal.

This is the foundation on which I started.

The Sequel

Now, fast-forward to 2006: housing is the new tech. Instead of internet and new paradigm, it’s subprime, can’t fail, and who doesn’t pay their mortgage? Home prices soared, and banks rubberstamped NINJA (no income, no job, no assets) loans for eager buyers.

At the time, I was with my first employer. I caught a whiff of smoke. I asked my manager if I could put an assistant on some research; I wanted to collate clients’ investments into a one-pager. If something went wrong — wrong? What could go wrong in this market? — I could see who owned what and what we needed to sell first.

When my assistant couldn’t get access to the firm’s software (insert circuitous corporate reasoning here), I couldn’t accomplish what I wanted to, what I thought was vital for our clients. It was a good time to move on to a new employer.

So, now it’s 2007, and we’re hearing rumblings of a financial crisis. Two hedge funds — which, at the end of 2006, had an estimated value of $1.5 billion — collapsed virtually overnight. Guess what? They’d invested heavily in subprime loans and collateralized debt obligations (CDOs).

As Margot Robbie reminds us in The Big Short: “Whenever you hear ‘subprime,’ think ‘sh%#!.” By the end, that’s essentially what these funds were.

We had a problem, and it was going to be much bigger than the firm.

A $40 Trillion Cliff

What do we think of when we hear “subprime”? That’s right: default rates on these mortgages crept from 2 to 3 to 4 to 5 to 6 percent. On a conference call with Countrywide Home Loans in May, 2007, CEO Anthony Mozilo announced that all lines of business were down. Defaults were up across the board. It wasn’t just subprime. It was Alt-A, jumbo loans ($400,000+), commercial loans, Class A loans… they were all teetering on the brink.

The media was chattering about defaults going from $200 billion in write-downs to $4 trillion. In three weeks. Now, when banks take in $1, they lend 10 times that. It’s called leverage. If you take $4 trillion in bad loans off the table, that’s $40 trillion in lost lending power. One more ridiculous monetary figure for you: the global GDP for that year was $48 trillion. $48 trillion - $40 trillion = one hell of a crash.

All this solidified my theory: I’d smelled smoke before. Now I could feel the flames. We had to take steps to try to protect our clients from the worst of it.

Time to Exit the Theater

In May of 2007, we got out. We sold every stock we could for anyone who’d let us. In October of that year, the market hit its peak; while those were strong months, there was an undercurrent of trepidation. Not that anyone wanted to say it aloud: the C Suite made sure to reassure us: everything is fine. The company’s in great shape with $30 billion on hand, in cash. There is no problem, it’s all right.”

Days later, the CEO “resigned.” The Successor went on a media blitz, reassuring investors that, yes, everything is fine. $30 billion in cash. Nothing to see here.

But then other firms wouldn’t loan overnight anymore; people started taking their money out of the firm. The cash balance went from “everything’s fine” $30 billion to $2 billion in a weekend. It was over. As I write this I can still feel those anxious moments like they’re happening right now.

When the market bottomed in March 2009, it was down 57 percent. The US GDP fell 4.3 percent, unemployment doubled¹, the real estate market lost $7 trillion², and retirement accounts lost $3.4 trillion. The effects were not contained to the United States; countries dependent on foreign investment dollars, credit, and markets for their exports suffered right along with us (and, in some cases, they felt more pain and still have not recovered, i.e. Puerto Rico, Detroit, Chicago).

No Time for Conventional Wisdom

By exiting when we did, we stayed the bleeding at just 17 percent. We also had 24 accounts positive. Because we had such strong convictions that the crash was coming, we were fortunate to get out near the top instead of adhering to the conventional wisdom to “ride it out.” We also had some investments that made money as the market went down.

Former Secretary of Defense Donald Rumsfeld once said, “When surprise occurs, such as when the economy enters an unexpected recession...the natural reaction is to immediately ask who made the ‘obvious’ mistake. It is much easier to believe that our leaders are incompetent than to accept the less pleasant reality that ours is a world where uncertainty and surprise are the norm, not the exception.”

In this case, there was not only incompetence, there was blatant fraud³. But, yes, our world, and the stock market as a microcosm, is one in which uncertainty and surprise are to be expected. And if we can expect them, we can learn from them. And if we can learn from them, we can be less surprised, and more prepared, next time.

Footnotes

1. https://www.federalreservehistory.org/essays/great_recession_and_its_aftermath
2. http://www.pbs.org/wgbh/frontline/article/how-much-did-the-financial-crisis-cost/
3. http://money.cnn.com/2009/03/16/real_estate/mortgage_fraud/

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