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Why the stock market crisis is different this time

History may repeat itself, but this market crisis is different from most, says a U.S. advisory, and only patient investors are liable to find profits.

With much of Canada in the grip of a long winter, a false spring or two is to be expected. The temperature goes up, a few stalks poke through, then winter jumps up and slaps them down again, like one of those movie villains who’s supposed to be dead but isn’t.

The same thing happens in Virginia, says Mr. Bob Carlson. Writing in Bob Carlson’s Retirement Watch, he describes how a few warm days brought people out in T-shirts and shorts, and daffodil stalks out for an early peek. A few days later, it was back to heavy coats and no flowers.

There was a false spring last fall, too. It happened in the markets. Many investors concluded that the mortgage and credit crises had been cleaned up in a few months. “They began buying riskier bonds and piling money back into the stock market,” says Mr. Carlson.

“They regret the moves now and are suffering losses from their premature exuberance.” Forewarned by that experience, what should investors have in mind as they look for the real resolution of this crisis?

They should be careful not to rely on the usual benchmarks, says Mr. Carlson. Because this time, it really is different.

No risky assets at any price

This is not a normal recession or slowdown in economic growth. “Anyone who uses history or fundamentals to evaluate these markets is running a big risk,” says Mr. Carlson.

We are in a liquidity event, he explains. These have happened before, but they bear little resemblance to what usually happens when the economy slows down. Most negative phases in the economic cycle are triggered by the central banks raising interest rates to drain liquidity out of the system and bring inflation down. When interest rates go back down, the economy fires back up.

Not this time. “In a liquidity event,” says Mr. Carlson, “the markets stop working.” Investors avoid risk and don’t buy risky assets at any price. They want treasury debt (Government of Canada bonds here) and a few other safe assets.

Forced to sell

The specific cause of a liquidity event will vary, of course, but the general causes are similar. Investors might worry about a problem in the system (like the collapse of Drexel Burnham Lambert in the 1980s). Or they might lose confidence in financial reports (as in the wake of the dot-com bubble in 2000-2002). Or they might not be sure how much risk there is in an investment… and that is the main problem today.

When asset prices fell, the balance sheets of lenders and investors both shrunk. They stopped lending and started calling in loans. “Investors are being forced to sell investments purchased with debt they cannot roll over or refinance,” says Mr. Carlson.

We aren’t just talking about the average investor next door, either. According to MIT professor Andrew Lo, the large stock selloffs this past November and January probably occurred because “one or more hedge funds had to liquidate portfolios to meet redemptions or pay debt.”

The so-called fundamentals don’t count this time, either.

The delivery system is broken

“Most professional investors I talk to say that in the mortgage and other hard hit markets prices are much lower than fundamentals warrant,” points out Mr. Carlson. The prices reflect much higher default rates than have occurred or are ever likely to occur.

“Yet the markets are not working,” he adds. Uncertainty is keeping investors away. While prices for most assets are low, they could fall even lower as credit continues to shrink. (Nor should we let a flurry of good days in the market lull us into thinking happy days are here again.)

This liquidity event is different in one other way, as well. It is unusual in both its length and severity, says Mr. Carlson. Past liquidity events disrupted a few sectors and were resolved pretty quickly. This one is creeping into sectors beyond its original victim, housing and mortgages.

Once it was considered just a subprime mortgage problem. But as more and more balance sheets were affected, there was less money to lend. “As a result,” says the editor, “the credit delivery system is broken.”

It will be resolved

The good news is that this crisis, like all the others, will be resolved. But it is not clear which actions will bring that resolution about, Mr. Carlson says. “High interest rates did not cause the problem and lower rates will not resolve it.” In fact, as short-term rates have been pushed down in Washington, long-term rates and lending standards have become tougher.

There is another piece of good news: some current market prices do reflect a lot of bad news. Historic declines have already been priced in. Some well-heeled long-term investors with names like Warren Buffett and Wilbur Ross are buying opportunistically.

The risk of buying now is that we just don’t know when a liquidity crisis like this will end. “It is based more on psychology than fundamentals,” says Mr. Carlson, “and mass investors psychology could change at any time. There is also headline risk. As a forced sale ratchets prices down another level, other investors are forced to sell.” Bear Stearns, anyone?

There is no telling how long this price spiral could last, says the editor. But prices for some assets are appealingly low. “For patient investors who can afford to wait a few years for a recovery, this is a good time to begin selective buying,” states Mr. Carlson.

He is not calling an end to the crisis or saying that the markets have reached bottom. Even if they have, it is unlikely that the economy and markets will bounce back with strong, sustained growth just yet.

“It is just possible,” he concludes, “that lenders and investors have learned something about risk management this time and will be more prudent. If so, economic growth and investment returns would be lower than in the past. That means that as investors we must look harder for opportunities instead of relying on major market trends to give us solid returns.”

Most of the people we consult around here are fed up with false springs and hope the next liquidity event doesn’t involve snow. They’re perfectly willing to be patient with the markets, but not with the weather.