More lessons from the global financial crisis; Backflip into a cenote

1) In yesterday's e-mail, I noted that last week marked the 15th anniversary of the market bottom during the global financial crisis.

I also recounted how in 2008 I met someone who opened my eyes to how bad things were going to get. This led me to reposition my fund much more defensively and warn everyone who would listen about the looming calamity. I concluded by sharing three lessons from the months leading up to the crisis.

Today, I'd like to pick up the story where I left off. The following chart will help illustrate my point. It starts on October 1, 2007, just before the market peak, and ends on April 1, 2009, not long after the market bottom:

The first thing to notice is how slowly the market collapse – which eventually exceeded 50% – unfolded. I didn't even start to figure out how bad things were going to get until February 2008... But at that point, the S&P 500 had only declined about 13%.

By the time I developed and started to disseminate my initial presentation in May of that year, laying out what I'd concluded and how I'd repositioned my fund more defensively, the market had actually rallied and was only down 9% from its peak.

For the next four months into early September, the market was somewhat resilient, which was shocking given that I was closely tracking the collapse of the U.S. mortgage market, the largest debt market in the world.

And then the dominos started to fall...

First, on September 6, mortgage giants and "government-sponsored enterprises" Fannie Mae and Freddie Mac essentially went under and had to be taken over by the government (officially, they were put into "federal conservatorships").

Then, on September 15, iconic investment bank Lehman Brothers filed for bankruptcy. With $639 billion in assets, it remains the largest bankruptcy in history.

A day later, with insurance giant AIG also teetering on the edge of bankruptcy, the Federal Reserve bailed it out with an $85 billion two-year loan.

With the global financial system shaken to its core, the stock market had to have crashed more than 20%, right? Wrong!

Look at the chart above... The market barely fell at all during these fateful weeks in September, as investors concluded that the damage was limited to a few financial firms and that the government would step in to protect them.

But they couldn't have been more wrong. I knew it because I'd done the work and was tracking the data, not listening to the false assurances by government officials that they had everything under control.

As a result, I played the first phase of the crisis perfectly, remaining defensively positioned, with my many short positions (which profit when stocks decline) offsetting the losses in my long book and, critically, generating cash I could deploy.

By December, the S&P 500 had fallen more than 40%, and investors were panicking... So I turned bullish. I was even featured in a 60 Minutes segment that aired on December 12, 2008 called "The Mortgage Meltdown" (video here and summary here).

At the end of the segment, when Scott Pelley asked me whether the stock market was going to "continue plunging as we've seen in the last several months," I replied:

Actually, we're the most bullish we've been in 10 years of managing money. And the reason is because the stock market – for the first time I can say this in years – has finally figured out how bad things are going to be. And the stock market is forward looking. And with U.S. stocks down nearly 50% from their highs, we're actually finding bargains galore. We think corporate America is on sale.

Well, I was absolutely right that stocks were cheap. But as you can see from the chart, I was a full three months too early in calling the bottom. And that sure was painful, as the market fell another 25% from the end of 2008 through March 2009.

During the initial drop in the market, I'd correctly positioned the hedge funds I was managing very defensively. But in the final part of the crash, in the first 10 weeks of 2009, my funds were falling just as much as the market because I'd turned bullish too early, buying stocks and trimming my short book.

So what are the lessons here?

1. Most market crashes don't happen quickly.

The COVID-19 crash in 2020, when the S&P 500 tumbled 34% in a little more than a month from February 19 to March 23, was very much the exception.

Usually, there's plenty of time to do your research to reach the right conclusion about whether a pullback in the market is another "buy the dip" opportunity or a precursor to a big market collapse.

2. Investors overshoot to the upside and the downside.

Investors are, of course, human, and thus often act based on emotion rather than reason. This causes markets to overshoot in both directions. During bull markets, with the media cheering, buying begets more buying. During market panics, the opposite occurs. The headlines are grim... and selling leads to more selling, both for emotional reasons (investors panic and want the pain to stop) and practical ones (margin calls, etc.). Just look at how astonishingly cheap stocks got in October 2002, March 2009, and March 2020...

3. It's difficult, if not impossible, to precisely time the bottom.

After the market fell more than 40% from October 2007 through the end of 2008, I thought it couldn't possibly fall any further... but then it fell another 25%.

Rather than spending a lot of time trying to do the impossible, accept the fact that you'll never get the timing exactly right. Be prepared to buy more on further declines and always keep in mind that, as philosopher and logician Carveth Read once said, "It is better to be vaguely right than exactly wrong." (This is true when buying individual stocks as well.)

On Monday, I'll continue this story and other lessons that can be learned from it, so stay tuned...

2) As you read this, I'm on a flight back from the Bahamas, where I've been fishing and free-dive spearfishing.

Yesterday, my group pulled up on a beach on a small island, hiked to a beautiful blue sinkhole (also known as a cenote), and jumped in from an outcropping. Good fun! Here are pictures (I posted a video of my backflip on Facebook here):

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.