Lessons Learned from the Greek Tragedy

(MoneyWatch)  The equity market rally that began in March 2009 was stopped dead in its tracks by the crisis in Greece. After closing at 1,217 on April 23, the S&P 500 Index dropped to as low as 1,066 (a loss of about 12 percent) on May 6 before closing at 1,136 on May 14.

Once again, risk had reared its ugly head. And many investors began to panic (as usual). On May 7, we discussed why it's wrong to think things like "It's obvious this is going to be bad for stocks. I need to sell." Today, we'll discuss the question, "When will things get back to normal?"

Each year the market provides us with many lessons, or, what more appropriately should be called remedial courses -- because the market teaches the same lessons over and over again. Paraphrasing Harry Truman, there's nothing new in investing, just the investment history you don't know. The Greek crisis is just another example.

Because most investors don't know their history (dooming them to repeat the same mistakes), they're unaware that crises occur with great frequency. The following is a list of just some of the crises that have occurred since 1973.

• In 1973 oil prices soared, causing the worst bear market since the Great Depression.
• In the early 1980s, the Latin American debt crisis threatened to bankrupt many major U.S. banks.
• In 1984, Continental Illinois National Bank and Trust became insolvent. (At the time, it was the seventh largest bank in the United States.)
• In 1987, the S&P 500 Index dropped almost 23 percent in a single day, the largest one-day percentage decline in stock market history.
• From 1989 through 1991, we had the Savings & Loan crisis, during which 747 S&L's failed.
• In 1990, the Japanese asset price bubble collapsed, a bubble from which Japan has yet to recover.
• The early 1990s witnessed a major Scandinavian banking crisis that engulfed Sweden, Norway and Finland. Their economies experienced even larger asset price and credit upswings in the late 1980s than did Japan and had more severe macro downturns after the asset price and credit cycles turned.
• September 16, 1992 came to be known as Black Wednesday as speculative attacks on the British pound forced the Bank of England to withdraw from the European Exchange Rate Mechanism.
• In 1994, we had an economic crisis in Mexico that led to the devaluation of the peso. The U.S. government eventually lent Mexico $50 billion to help prevent the crisis from spreading.
• 1997 brought the beginning of what came to be known as the Asian Contagion. There were devaluations and banking crises across Asia.
• On August 13, 1998, the Russian stock, bond and currency markets collapsed. Annual yields on ruble bonds were over 200 percent. From January through August, the Russian stock market lost more than 75 percent of its value. That, in turn, led to the next crisis.
• In September 1998, we saw the collapse of the largest hedge fund in the world: Long Term Capital Management. The Federal Reserve had to organize a bailout to prevent another contagion.
• In March 2000, the dot.com bubble burst. Ten years after reaching more than 5,100, the NASDAQ is trading at less than half its peak.
• September 11 changed the world forever. The NYSE remained closed until the Sept. 17, the longest closure since 1933. When it reopened, the DJIA fell 684 points (or 7.1 percent), at the time its biggest-ever one-day point decline. Around the globe, economies went into recessions and equity markets crashed. The bear market continued through 2002. Equity markets around the world experienced their worst losses since 1973-74.

• And, finally, we had the U.S. financial crisis that began in 2007.

So we have 15 crises in less than 40 years, or about one every three years. Experiencing crises is the norm, not the exception. And note that this list isn't even close to being all-inclusive. It ignores many other "minor" events like the two Iraqi wars, the SARS virus that threatened to shut down world trade, North Korea gaining and testing nuclear weapons and so on.

And how did stocks perform during this period filled with crises? From 1970 through April 2010, the S&P 500 returned 10 percent per year, and the MSCI EAFE Index returned 10.1 percent.

The Greek crisis was a reminder both that stocks are always risky and that crises are "normal." In fact, it's the regularity with which crises occur that makes stocks such risky investments. And that's why stocks have historically been priced to provide a large equity risk premium. If crises were rare, equity investing would be less risky, the equity risk premium would be smaller, and equity returns would be lower. In other words, bear markets are a necessary evil.

As much as we would like to think otherwise, none of us has a clear crystal ball to protect us from financial crises. Thus, the right strategy is to recognize that financial crises and the bear markets that accompany them will occur, and they will likely continue to occur with great persistence. The only things we don't know are the sources of future crises, when they will happen, how long they will last and how deep they will be.

Therefore, you're best served by having an investment plan that accepts the inevitability of such events and having the wisdom to know that the best strategy is learn what Warren Buffett learned: "We continue to make more money when snoring than when active."