The past two years in capital markets have been hard on many pension plans, both defined benefit and defined contribution. No asset class escaped a rapid and drastic markdown in value—except for U.S. Treasuries.

And then, almost as quickly as it started, the panic was over and many asset markets witnessed a massive bounce back. Did investors overreact? Was the bounce back unsustainable? Are there more risks out there than ever before? The answer to almost all of these questions is probably no. But there’s a qualification: understand the risk and manage it.

But that’s the conclusion. To begin at the beginning, markets have seen corrections, along with grinding bear markets. The last one was from 2000 to 2002. The aftermath was relatively mild in most places—except in the U.S., where fears of an extended Japan-like deflation caused the Federal Reserve Board to push short-term interest rates to new lows. (A collateral casualty was over-optimistic pension plan return assumptions.) Some, as stocks declined by 50%, still held to a belief in 9% returns.

The Great Moderation
The era, reports Fritz Meyer, senior market strategist at Invesco in Denver, was hailed as evidence of the “Great Moderation.” As developed economies shifted more and more from manufacturing to services, monetary policy did not necessarily result in abrupt slowdowns.

“The notion is that because the U.S. economy and Canada’s economy and, in fact, all developed economies have become much more service [economies], economic volatility and cyclicality decline over time,” Meyer explains.

“The theory at the time was, well, maybe it’s just true that unless something extraordinary happens—let’s say, unless you have an exogenous shock to the system—there’s no reason to expect any recession and so we’ve taken the cyclicality out of the long-term rate of growth.”

However, within this Great Moderation there were subtle shifts—at least in the U.S. Outside of the resource industries, there was little capital spending. Instead, consumers took over the steering wheel, taking advantage of low mortgage rates to refinance their debt and spend anew—often for bigger houses.

“And so it took an exogenous shock—although it wasn’t exogenous. It took something that came right out of left field, which was subprime mortgages, I think, to really knock the economy off the rails,” continues Meyer.

What was only an American problem quickly became a global one, thanks to the magic of securitization. Subprime mortgages were only a tiny part of the asset base of the banks. But they had an outsize effect, says Meyer. They halted an apparently smooth glide upward in stock prices.

“Stocks had gone up for many, many years, unfettered, so we were due for a correction. But I wouldn’t call this a correction; it was a waterfall decline,” says Roy Borzellino, chief investment officer at SEI Canada in Toronto. The fact that the market collapsed was really caused by a couple of things. It was caused by an implosion of credit, combined with a collapse in the real estate markets, and a bit of a cyclical recession. Those are three compelling events in any business cycle, and they had a very strong confluence when they acted together.”

The Great Recession
The confluence of events spared few, with assets plunging 50% from the peaks. For nine months there was a steady drumbeat of new one-year lows, if not five-year lows, making the decade one of the few in which not only did stocks not outperform bonds but in fact had negative returns (Canada and emerging markets excepted). Did investors overreact?

“In the fourth quarter of 2008, we saw a big correlation in many stocks,” says Andrew Marchese, head of Canadian equities at Pyramis Global Advisors in Toronto, “a level we had not seen since 1931. So all equities were being treated equally, which shouldn’t happen. We saw that almost happen in the crash of 1987, but the levels that were reached in terms of daily correlations of price returns in the fourth quarter were basically levels we saw in 1931. Moreover, if you look at high-yield spreads, the blowout in them in the fourth quarter was a seven-standard-deviation move. Mathematically, you’re talking about a lottery-like event.”

But he wouldn’t call it an overreaction. “Fear is sometimes a self-reinforcing type of emotion, and, clearly, the world was concerned about a deflationary crisis but didn’t quite know what that meant. In the fourth quarter of 2008, the only asset class that really worked was cash.”

The fear was justified, adds Meyer, when even General Electric was having difficulty rolling over its commercial paper—90-day notes that pay slightly more than T-bills.
But where there’s fear, there’s also a potential upside.

“We understood that there was tremendous opportunity here and that equity markets were undervalued,” explains Borzellino. “We saw that because our investment horizon is a little bit longer term. But for investors who have a shorter-term investment window, they were acting rationally.”

What seems rational, however, may not always be prudent for investors, between selling at the bottom and missing opportunities. In retrospect, many asset managers spoke of market pricing in “end-of-the-world scenarios,” with default rates as high as those in the Great Depression era.

“It was up to the consultants and advisors to guide them and say, ‘Yes, it’s not exactly a great time right now in the markets, but we’re actually going to go through a lot of things that should help repair the markets,’” says Sadiq Adatia, chief investment officer at Russell Canada in Toronto. “There has been a downturn that has obviously impacted portfolios, but we can’t be looking behind. We have to be looking forward, and, as such, we should be steering for that recovery that will be happening down the road.”

And then markets unfroze, with a sharp rally in March 2009. Was that rational? Was it sustainable? “Time will tell,” says Marchese. “Certainly, you’ve had a reflationary move in the stock markets.”

Marchese believes that monetary stimulus deployed by many countries has had a powerful effect in fending off deflation. And he’s not the only one.

“I wouldn’t bet against the recovery that started in 2009,” adds Borzellino. “I think that’s an asymmetrical bet. There are too many tailwinds that are promoting stimulus and a recovery.” Now he thinks stocks look undervalued, thanks to the correction in April and May this year.

Great, What’s Next?
If stocks are fairly valued now—no longer the blue-plate specials they were in early 2009—is it safe to invest? That puts the burden on earnings growth, which, in turn, depends on growth in GDP. Meyer sees hopeful signs in earnings growth, which is what equity investors are actually buying. But the global recovery is uneven.

Massive stimulus programs by governments of all kinds protected, or at least buffered, declines in consumer spending. What happens when the stimulus comes off? Already some European states are moving toward austerity, hoping to duplicate Canada’s achievement in the 1990s of a balanced budget. But most observers are discounting fears of a double-dip recession.

“As you look at the economic data around the world, including Europe, it doesn’t look as though we’re headed for a double dip,” says Meyer. “And clearly, here in the U.S., it makes sense to continue to believe that you’re going to see 3% GDP growth. Well, 3% GDP growth is pretty darn healthy, especially in the current context—if we have that, in other words, if that story holds—then there’s no question that a very powerful earnings recovery will continue. And we’re already into the early innings of this earnings recovery.”