Looking Back at Signs of the Credit Crisis

Though analyzing the past can never guarantee the future, it does at time help provide some indications of what is most likely to come. At issue today is how to determine whether we're going to have a repeat of the 2007/2008 market crash.

We believe that we will at least have a major sell off or two in the future, ala the period of the 1970s as seen below, which was discussed in more detail in our piece on secular bull and bear markets.


You can see a lot of ups and downs--a lot of volatility over the years in nominal terms, while in gold-adjusted (real) terms, the market continued to crash. Note that we have seen a very similar pattern since 2000, with the exception of the period where the credit markets dried up in 2008 and caused the massive sell off into March of 2009 (note that the chart below needs to be updated for further market advances since early August.)


So the question we have now, like all investors, is what we can expect from stocks moving forward.

As we've discussed many times, for the most part, the US stock markets are well overvalued. They continue to trade up on momentum, not fundamentals.

As we've mentioned before and as seen in our technical analysis, as a general rule for gauging US stock markets, we actually use the S&P 500 for analysis. The reason is that the S&P contains more companies and more completely determines the makeup of the US economy. In fact, the S&P 500 can be broken down on a sector basis as follows:

Sector.......................Percentage Makeup of S&P
Financial Services...........20.3%
Healthcare......................13.4%
Industrial Materials........12.2%
Hardware.......................10.8%
Consumer Goods..............9.7%
Consumer Services...........8.8%
Energy.............................6.5%
Software..........................4.5%
Business Services..............3.9%
Media...............................3.9%

Given that a major theme here at Dredd is the indebtedness of the Western countries and the corresponding transfer of wealth to emerging markets, we can see that most of the S&P probably should not be doing well. The US' primary export for years now, due primarily to the domestic consumer economy and the reserve currency status of the dollar, has been financial services because there was always a demand for dollars. Well, that seems to be going away over time. Healthcare cannot be exported to other nations and is being nationalized. Consumer goods and services will probably remain in the tank for a while as consumers cut back spending. Because of lax consumer demand, business services will remain weak domestically, but may do okay if they adjust to serve more global demand. Thus, the expectation will be that the S&P as an index will have to go lower (some stocks will outperform--notably those that have strong export fundamentals like commodity producer stocks). The S&P P/E ratio is way out of line with reality because the current rally is based on the hope that the future economy will improve. It is our belief that once the reality hits the markets that this is not going to happen quickly, we'll see the markets roll over again. As we mentioned last week, that may be in early 2010. Other commentators like Faber, whose latest interview we posted earlier this week, believe it may be a few years out before the market turns over (technical analysis will improve our odds of knowing!).

Of course, there is the uber-bear faction of the market that believes that the market is about to turn over because the credit crisis is waiting in the wings. This is entirely possible--we don't discount that. However, if we take a look back at 2007 and 2008, we can identify some telltale signs that credit market activity was locking up. These indicators need to be watched carefully. If they start to signal another credit crisis return, we would want to diversify all assets into dollars and gold...

Credit Crisis Indicators of 2007 and 2008
First, let's define what a credit crisis is. Wikipedia has a reasonable definition to work with (bold emphasis is ours):

• A credit crunch (also known as a credit squeeze, finance crunch or credit crisis) is a reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates has implicitly changed, such that either credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises).

In short, there was too much leverage in the system where asset prices were bid up based on credit. When housing in the US collapsed, many of the derivatives based on those asset values locked up. That essentially killed any loans among major institutions because it was (and still is) unclear which institutions were solvent, and thus able to pay back loans. This, in turn, forced a further sell off of assets (deleveraging) in order to pay off outstanding margin calls. There was a forced demand for dollars created, which drove the value of the dollar up, and any outstanding money in the markets went into the safest assets out there--US Treasuries and gold. Fundamentally, it was a panic sell off that forced the value of gold and dollars up at the expense of everything else. The issue we wish to address is how to determine if this event will happen again by reviewing what happened in 2007 and 2008.

The charts below state it all, really. The chart below shows the daily US dollar index from October of 2007 to present. We show the dollar because it was the major dollar rally that forced asset markets down.

You can see we've divided the crisis into four periods: Pre Credit Crisis, Warning Period, Credit Crisis, and Post Credit Crisis.

The first technical indicator that something was not right was the TED spread.

What is the TED spread?

• The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.
• Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR.
• The size of the spread is usually denominated in basis points (bps). For example, if the T-bill rate is 5.10% and ED trades at 5.50%, the TED spread is 40 bps. The TED spread fluctuates over time, but historically has often remained within the range of 10 and 50 bps (0.1% and 0.5%), until 2007. A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn.

The chart above does not have a long view of the TED spread, so we've included the 5 year chart below as a reference.


You can see that on August 10, 2007, the TED spread jumped above 1 (or 100 basis points). Referring back to the top chart, you can see the 10-Year to 2-Year US Treasury spread suddenly spiked in late March of 2007, just as the dollar was bottoming (entering the trading range noted by the red rectangle). That bottoming pattern for the dollar lasted several months. (Note that the Bob Prechter interview clip from August 11 we posted stated that Bob believes the dollar is bottoming now again. We're not so sure...)

The dollar bottomed out until mid July, 2008 and broke out of the rectangular consolidation area (see why technical analysis can be valuable?), forcing commodities and everything else down. Those signs should have been enough to force most to sell out. If not, there were a few other signs like a sudden rise in the gold/silver ratio and a crash in junk bonds as seen below.

In summary, there was a lot of time and many indicators that things were going awry in the credit markets. Careful attention to the charts would have provided ample time to move to safety.

So, does this mean it's all sunshine and rainbows from here? Hardly. It's clear that the central banks are trying to stay on top of the liquidity issues, but the debt problem for the average consumer remains. Unemployment is rising. Stocks are generally overvalued.

While it's possible we may see a return to the credit crisis of 2007/2008, we believe we will have ample time to avoid a repeating scenario by watching these indicators. In the meantime, there are other reasons why stocks may go down, but the credit markets will probably not be the reason this time.