Who is Ben Stein? He’s a lawyer, a political commentator, President Nixon’s speechwriter, the economics teacher from Ferris Bueller’s Day Off (click here for a clip of his role) and even a self-proclaimed economist. He has been so successful at selling himself as an economist that he landed a coveted role writing a weekly column about finance and the economy in the NY Times. He has since moved on from that assignment, but I have seen him recently talking economics and markets on Fox Business.
Why does this matter? Because on August 7th in 2007 Ben Stein penned an article in the NY Times titled Chicken Litttle’s Brethren, on the Trading Floor. You can click the title for the full article or just let me briefly summarize the crux of Stein’s argument: when the article was written, the subprime mortgage market was experiencing some cracks and the equity markets had sold off some 6% from their highs. Mr. Stein basically argued that the subprime mortgage market, at only 13% of the total mortgage market, was too small to cause damage to the broader economy and stock market (“these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.”).
The rest, as they say, is history. The S&P 500 peaked a few months later in October of 2007 and proceeded to sell off 60% over the next year and a half. The problem, as we all know now, was in large part due to the problems with subprime lending.
What’s noteworthy about Mr. Stein’s argument is not that he inaccurately calculated the implosion of the subprime market that was really only just beginning during that summer of 2007. 99.9% of us made a similar mistake. As Michael Lewis documented so well in his book The Big Short, there were only a handful of people that recognized the impact of the credit problem and actually had the conviction to trade on their belief. No, what’s striking about Mr. Stein’s argument is how naive it was to dismiss the interconnectedness of financial markets in addition to the emotion/human psychology that drives investors to hit the sell button. As an “economist” he should have been aware of leverage ratios at banks. As an actor he should have seen the movie It’s a Wonderful Life with its bank run scene.
Fast forward to today. Over the weekend “The Trader” column in Barron’s described reasons to dismiss the “wall of worry” in today’s markets. Ebola, the end to QE, etc. Well reasoned arguments, for sure, about these concerns. But here’s what was said about Europe:
“The next worry is deflation in Europe spreading to the rest of the world. First, sustained deflation is not common and Europe isn’t there yet. True, the euro zone is recessionary in some countries and basically is showing no growth as a whole.
‘Yet, how is this different?’ asks Chris Hyzy, chief investment officer of U.S. Trust. The euro-zone economy has shown 1% growth to 1% contraction for the past three years. On the margin, Europe is a negative factor, adds Dan Morris, global investment strategist at TIAA-CREF, but the U.S. isn’t a trade-dependent economy. U.S. exports are about 13% of gross domestic product, half of Germany’s ratio.”
There’s the 13% figure again. Obviously it’s by coincidence that we see this identical statistic as the one referenced in the aforementioned 2007 article. But it’s eerily reminiscent of Stein. What’s really at stake is not the relatively small exposure that the U.S. has to the Eurozone, but how a such a small percentage can metastasize based on fundamental issues (implosion of European banks will impact U.S. banks) and a spreading of fear should the worst happen.
It’s too early to panic. But there are signs of real risk in the Eurozone as growth continues to slow. If problems persist, a policy response by the European Central Bank President Draghi will likely stave off any potential disaster for the near term. However, that response involves convincing 18 European countries–including Germany–to commit to such a response. At this point, we can’t be overly confident that this will happen, and thus, the Eurozone remains our largest fear for equity markets.