Learning to Think the Unthinkable

5 lessons from the collapse of Lehman Brothers

September 7, 2018
Adrian Cronje, Ph.D., CFA
Chief Executive Officer and Chief Investment Officer, Balentine

The investment business will teach you nothing if not humility, and that was especially true for those of us in the industry during the Great Financial Crisis of 2007-08. Leading up to the crisis, our annual Capital Markets Forecasts from 2005 to 2007 warned of how richly valued markets were becoming and that investors should not reach for risk. We had also taken a more defensive stance across our strategies. As 2008 unfolded it was clear that the situation was deteriorating, but there was a general sense that it could still be managed by the authorities. That changed dramatically on September 15, 2018, when Lehman Brothers filed for bankruptcy. The worst possible scenario was happening, and it suddenly became clear that authorities had lost control of the situation.

In the immediate aftermath of that seismic event, it was astonishing to see the speed with which circumstances were changing, almost by the hour. Emotions were running very high, and concern quickly turned to blind panic.  This was not helped by the fact that top officials did not have a coherent game-plan for assuring the American people that the financial system was sound. At one point it seemed that, in an effort to shore up confidence, authorities were just throwing radical new policy ideas against the wall to see what stuck. It appeared that we were standing on the abyss, staring down the barrel of another Great Depression.

Reflecting back on these shocking events 10 years later—during which the U.S. stock market has tripled in value since its ultimate low—there are five key lessons for investors to remember:

  1. Learn to think the unthinkable. So much financial modeling often comes with false precision—for example, statements like, “This will happen with a 95% degree of confidence,” remain all too pervasive. In late 2008, we found ourselves dealing with a very low probability, extreme outcome. Of course, in the first years after the crisis, that led people to overhype and overreact to this point; there was a lot of talk about “black swans”[1] and the need to build investment processes around “left-tail events[2].” The key takeaway is that risk management should always be a multi-faceted approach with several lines of defense.
  2. Liquidity management is always the first line of defense in a holistic risk management approach. Ultimately, the Great Financial Crisis was more of a liquidity crisis than a solvency crisis. Those who were forced to sell assets at artificially depressed prices permanently impaired their capital base. That is why, at Balentine, we pay so much attention to cash as an asset class. We model out strategic cash reserves for our clients to ensure that, should the unthinkable occur—and things change so rapidly that you have very little chance to react—your financial goals are not jeopardized by being a forced seller to fund spending needs, capital calls, taxes, etc., for the duration of an extreme event. This may seem unnecessarily pedestrian as this epic bull market matures, but it will always be Balentine’s first line of defense in our holistic approach to risk management.
  3. Traditional diversification has its limits. It quickly became clear that, when markets panic and crash, there are limits to traditional diversification. All asset classes that looked risky went down together during the Great Financial Crisis. At Balentine, the anchor to our portfolio construction process is to think about asset classes grouped by common underlying risk—our “building blocks” approach. That means, for example, high-yield bonds should be compared with equities, not fixed income. Doing so would have led you to capitalize on one of the great generational investment opportunities when credit spreads blew out into the high double digits in early 2009 —a compelling proposition relative to earnings and dividend yields at the time.
  4. Capital markets lead the economy, not the other way around. In the span of a week, three of the most venerable names on Wall Street were either sold (i.e., Merrill Lynch), taken over (i.e., AIG), or declared bankrupt (i.e., Lehman Brothers). In the four weeks immediately following these events, the Dow lost a quarter of its value. The fact that all of this occurred before the National Bureau of Economic Research (NBER) declared we were in the midst of a recession is the best illustration that capital markets lead the economy, not the other way around. In fact, as I frequently share with audiences, capital market movements, when correctly interpreted, often provide early warning signals about the future environment. This is also why Balentine uses a market-based model approach.
  5. Proactive communication is paramount. One of the most effective ways that we found to prevent clients from succumbing to panic at just the wrong time—and, ultimately, making irreversible mistakes to their portfolios—was communicating with them on an almost daily basis. We were committed to honestly answering client questions, even when it meant that we (like the authorities) had to say, “I don’t know.” Our commitment to proactive communication helped us prevent clients from permanently impairing capital and allowed us to get them through to a point where markets recovered. Ultimately, that provided more runway for our unemotional, model-driven investment process to work. In addition to being more objective and repeatable than subjective assessments, this discipline is particularly helpful during a panic when it’s easy to succumb to emotional decision making.

Though I invested through the emerging markets crisis of the late 1990s and the burst of the tech bubble and 9/11 in the early 2000s, the weight of the situation following Lehman’s collapse was, and remains, unlike anything I’ve experienced in my career. These five lessons are the legacy that crisis leaves for the investment industry to address.

[1] A black swan refers to an event or occurrence that deviates beyond what is expected. They are extremely difficult to predict and can have major ramifications.

[2] A left-tail event is one in which the portfolio value moves more than three standard deviations from the mean to the downside, resulting in a unforeseen, severe negative outcome.

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