A look back at investment markets in 2008

 In Finance & Investments

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INVESTMENT MARKETS IN 2008

The reasons why 2008 was the year in which global equity markets collapsed are complex. However, we can now understand the basic causes.

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What happened

In 2006 and 2007 US banks were lending very freely. They decided (by way of poorly regulated mortgages) to lend to a large number of people on low incomes to allow them to buy houses they couldn’t afford. Sales forces were given misguided incentive packages to promote these ‘sub prime’ loans.

This debt was then ‘securitised’ by the primary lenders who sold it to the Wall Street banks which then packaged it into complicated financial products which were sold on to secondary markets. The situation became critical when house prices started to plummet and borrowers began to default. Individuals and financial institutions all over the world found they were holding ‘investments’ based on a huge amount of bad debt and no one knew exactly who was exposed to what.

Central banks did not react quickly to the early danger signs and the resultant fallout caused the failure of the major US bank Lehman Brothers which precipitated a near collapse of the global banking system. To make matters worse, the banks stopped lending to each other and to businesses in general and this has been a significant brake on economic activity.

Stock markets

The previous bear market started early in 2000. Between 2000 and 2003 the FTSE 100 index fell by more than 50%.

In March 2003 we reached the point of ‘capitulation’ when investors who had lost confidence in stock markets felt that share prices would not fall any further and began buying. This fairly long cycle was less noticed by investors, although the fall in share values was just as bad overall.

The main difference this time is that the decline in share values is driven principally by one factor, a collapse of liquidity in the financial system. The current bear market has developed much more quickly.

Bear Markets

Recoveries from bear markets generally take one of various forms, for example:

• The U shape – a slow methodical reversal which gradually transitions into a market rebound.

• The V shape – a quick sharp reversal which marks the start of a powerful rebound. This happened in 2003.

• The hockey stick shape – where the downward trend ends sharply but without the immediate upward surge.

The hockey stick is the most probable scenario for the current situation because there are too many unknowns to predict a U or V shaped recovery. Share prices stopped falling steadily in mid October 2008. Markets then stabilised but we are still seeing a lot of short term volatility.

Conclusion

The perception of the leading market analysts is that share prices have already been discounted to factor in the effects of the recession. However, this time, investors are more nervous about where we are in the cycle and have not started buying again in large numbers. We may not see any signs of sustained improvement in real asset prices until perhaps late 2009.

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