The Last Two Stock Market Corrections Happened Like This

First there was the dotcom bubble when the NASDAQ reached an intraday trading high of 5,132.52 before closing at 5,048.62 on March 10, 2000. The NASDAQ lost half its value in 2001 and reached an all-time low of 1,108.49 in October 2002. It wasn’t until April 23, 2015 when the previous new high was reached.

Then there was the subprime mortgage crisis that began to unravel on October 9, 2007, when the S&P 500 closed at a record high of 1,565.15, and then proceeded to drop over 56 percent to 676.53 on March 9, 2009. It wasn’t until March 28, 2013, that the S&P 500 finally surpassed its prior record set in 2007 by closing above 1569.

Source: Google, S&P 500

We are seven years into a post housing bubble recovery. The roughly 5 percent correction we’ve seen so far in 2016 may just be the beginning. Nobody really knows for sure.

What investors may wish to consider is compare the current economic situation with the historical downturns as an illustration of where the market may stand today, although past performance should not be considered a precursor to what the future may bring.

Increasing Internet Users And Handset Penetration

Back in 2000, investors focused on the metric “eyeballs.” In other words, how many eyeballs could an Internet company attract, whether they generated any revenue or not. One issue with this methodology was that Internet usage was shown to bel relatively low. Only 122 million out of an estimated 300 million population were Internet users, or roughly 40 percent. Today, statistics show at least 80 percent of the United States’ population are internet users based on the chart below.

Source: Statista

Another big technology shift since 2000 is the development of the smartphone. The first iPhone was launched on June 29, 2007.3 Soon after the iPhone was introduced, the Dream, by HTC was launched using the Android operating system, which was purchased and further developed by Google and the Open Handset Alliance. Such devices enabled millions of people to do more than just make voice calls.

Take a look at mobile phone penetration since 1996. Notice how during the dotcom bubble handset penetration was below 38 percent. Today, handset penetration is more than 100 percent given some people have more than one. With a massive installed based of technologically savvy users accustomed to making stock trades or hailing a car with their phone, the dollar potential today is quite different from back in 2000.

Source: Statista

And then there’s the Apple effect. With a market capitalization of over $500 billion, Apple is the world’s most valuable company, based on market value of its outstanding shares. They joined the Dow Jones Industrial Average in early 2015 and sport a trailing twelve-month P/E ratio of just 10X, compared to a 100+X multiple that America Online (AOL) and other previous generation tech giants traded on back in 2000.6 Alphabet Inc. (i.e. Google) is a close second, which briefly surpassed Apple’s market cap recently in early February.

Not only are valuations much more reasonable today, so are the balance sheets as well. Apple has an estimated $200 billion in cash. Facebook has roughly $20 billion in current assets. Google has about $80 billion in current assets. The list of strong balance sheets goes on and on.

What About The Housing Market?

Before 2008, credit was easy. Many banks pushed consumers into the subprime mortgage loans, defined as individuals with poor credit scores, who as a result of their deficient credit ratings, may not be eligible to quality for conventional mortgages.

According to a paper written by the St. Louis Fed, 18 percent of loans that were originated in 2006 and 14 percent of loans that were originated in 2007 were either past due for more than two months or were already in foreclosure within one year after the loans were originated. In comparison, only 2 to 6 percent of loans originated in the years from 2001 to 2005 were delinquent or in foreclosure during the first year after origination.

In hindsight, it‘s clear that banks and their negative amortization and teaser loans, and in some cases, not conducting proper background checks on consumers (such as verification of income and employment), directly led to a cascade of non-performing mortgage loans that brought down the real estate market.

Source: U.S. Government Publishing Office

Getting a new mortgage or refinancing an existing mortgage today is a much more difficult process as the government requires much more documentation from the borrower. In addition, banks are held to higher tier 1 capital ratios as protection from potential insolvency. A bank’s tier 1 capital ratio measures its financial health by comparing its core equity capital to total risk-weighted assets like loans.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. This is not the same as expected losses, which are covered by provisions, reserves and current year profits. In the Basel III agreement, the minimum tier 1 capital ratio is 6 percent. In simple terms, the government wants banks to have higher ratios to protect consumers.

The two big challenges for mortgage applicants are the Qualified Mortgage (QM) rule and the Ability-to-repay rule established on Jan 10, 2014.

Qualified mortgages follow requirements set by the Consumer Financial Protection Bureau. Before a borrower can qualify for a mortgage, the lender must have performed a concerted effort to help ensure the borrower has the “ability-to-repay” the loan, also known as the ATR rule. For example, a qualified mortgage can’t include an interest-only period, negative amortization, balloon payments, excess upfront points and fees, or a loan term longer than 30 years.13

This is where it gets more difficult for borrowers, both in documentation and dealing with lenders. In practice, this means banks and other mortgage originators have to validate a borrower’s income, assets, credit history, monthly expenses, and employment situation.

The bottom line is that getting a mortgage today is much more difficult than pre-housing crisis.

Cycles Are Inevitable

Looking beyond the large corrections since 2000, the chart below indicates that booms and busts are an inevitability in the stock market. After each correction, however, the stock market has proved resilient by coming back strong.

Source: Morningstar

An important factor in building a robust investment portfolio is maintaining a consistent investment strategy during good and bad times. The next important factor is making sure your positions and stock weightings are aligned with your original goals and risk tolerance. During violent upward and downward moves, position sizes may move farther than expected.

As Warren Buffett said, “time in the market is more important than timing the market.”14 May the next stock market correction treat us more kindly.

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