"…we are getting a Category 5 test of our financial levees."
So say the editors of the Wall Street Journal on today's opinion page. And they are right.
Today saw the market reaction to an important and unprecedented day in Wall Street history. Had you (or anyone) forecast six months ago (about the time Bear Stearns was rescued) that by September we'd see Fannie and Freddie nationalized, Merrill Lynch purchased for cheap by Bank of America (who'd already made a hefty number of acquisitions this year, including sub-prime leader Countrywide), one of the world's largest insurance agencies in AIG scouring and strip-mining its own turgid ranks for capital to survive, and one of the US's longest standing financial institutions in Lehman Brothers failing to find rescue and formally liquidate…and that the latter three would happen in a matter of a weekend, well, most would've thought that a rather unlikely scenario.
Yet, here we are.
We won't recap the weekend's action—you can read about the details through every major news outlet. Here are a few good places to start:
It looks and feels like Armageddon. But how much damage was really done? Stocks globally hit a new bear market low today—the S&P 500 dropped a lumpy 4.7%, one of the worst single day returns in many years, propelling markets closer to the average length and duration of a typical bear market.
Yet, all things considered, the effect hasn't been nearly as bad as many anticipated. Heading into the weekend, we noted a somewhat common attitude: Lehman is going down, but the Feds will save them and avoid systemic failure of broader capital markets. This in itself is a statement about just how much the US government has stretched the Paulson-pliable doctrine of "moral hazard," that folks at one point came to expect the Feds to be a perpetual backstop.
But put moral hazard aside for a moment and see that Lehman Brothers is for all intents and purposes vaporized, yet the world remains. Where many feared the implosion of a major institution would decimate the whole system, financial markets did not collapse nor grind to a halt. Instead, truthfully, things commenced in relatively orderly fashion. The world went on.
In short, the "category five" test of our "financial levees" showed a US financial system strong enough to weather a storm many believed threatened ruin.
The bottom line is weakened bank balance sheets continue to carry risk for certain institutions, as the Lehman failure demonstrated. Some others may very well fail (most true financial crises see many dozens if not scores of bank failures). Others may have to further dilute shareholders to strengthen their capital bases. Ultimately these lenders and financial instruments will be replaced with another generation to fill any void—that is the way of capitalism. And make no mistake—in time there will be big winners emerging from the rubble of the biggest losers. But, clearly, these aren't necessarily catalysts for systemic failure, which implies all corners of the financial system suddenly cease functioning.
Investors must stay disciplined and continuously come back to this question: Are markets headed down-a-lot from here? Today's wild action doesn't necessarily tell you either way. If anything, such big single day moves are often reminiscent of the high volatility experienced near a bear market finale. We've noted often in this space there are important reasons investors have to retain their gumption and not fall prey to panic selling.
Could there be more downside from here? Yes. In the short term—and especially in times like these—it's simply too difficult to time market gyrations. But when a strong upward trajectory for stocks appears remotest, often that's exactly what happens. It may be difficult to fathom today, but stocks are just as capable of moving up with the same magnitude. This is precisely the reason we call the market "The Great Humiliator." Days like these try to wring the last vestiges of hope from investors' hearts…only to shoot upward shortly thereafter and leave them behind. It's a no-brainer to stay in stocks today—the upward move of the bull's initial thrust could very well make today's action seem like a distant memory.