Tyler Muir finds that neither war nor deep recession darkens investor sentiment like sudden turmoil in the financial system
There are plenty of ways to upset the stock market. But when UCLA Anderson’s Tyler Muir dug through 140 years of global market history, he found that nothing terrifies investors like a banking crisis.
To put it another way, financial-system meltdowns such as the one in 2007–08 provide much better buying opportunities for long-term stock investors than events that might seem scarier on their face — deep recessions and wars, for example.
In a paper published in the Quarterly Journal of Economics, Muir reviewed some key measures of financial-market and economic performance in 14 developed countries since 1870. He charted what happened to those measures in the wake of four different kinds of “shocks” to the system: recessions, deep recessions, wars and financial crises.
Muir defines a financial crisis as a banking panic or other calamity centered in the banking system. He counted 67 such events among developed nations since 1870. Although financial crises often lead to or coincide with recessions, most recessions happen for other reasons: 209 of the post-1870 recessions studied by Muir occurred without banking panics.
To gauge investors’ reaction to each of the four different types of market shocks, Muir looked at how much stock dividend yields rose and how much “credit spreads” widened. A jump in a stock’s dividend yield over a short period usually means the share price is plunging, because the fixed dividend is rising as a percentage of the falling stock value. Credit spreads, meanwhile, measure the difference between yields on low-risk government bonds and higher-risk bonds such as corporate issues. In times of economic turmoil, investors typically demand much higher yields to buy riskier debt.
Overall, Muir found major disparities in how markets reacted to financial crises compared with recessions, deep recessions (defined as the worst third of recessions) and wars:
- The peak increase in dividend yields during financial crises averaged 43 percent, nearly twice the peak increase during wars (23 percent) and in recessions that occurred without a financial crisis (also 23 percent).
- The rise in bond market credit spreads was even more dramatic, averaging 66 percent during financial crises, or more than six times the average increase during the worst recessions, the paper says.
- The flip side of the surge in dividend yields and bond yields during financial crises is that prices of stocks and bonds plummet. Asset prices fell in every episode of recession, war and financial crisis Muir studied, but “the decline in financial crises is substantially larger than the decline in fundamentals” of the economy, the paper says.
Indeed, even as Muir found that dividend yields and bond yields rose sharply during financial crises, by one key yardstick the underlying economy fared better during those crises than during deep recessions. The average peak-to-trough decline in consumption across an economy was 8 percent during a financial crisis, much less than the 11.5 percent drop during deep recessions, Muir’s data show.
Then why do banking panics trigger so much fear — and damage — in financial markets? In an interview, Muir said one possibility is that failing or financially crippled banks worsen markets’ situation by losing the ability to act as “stabilizers” for asset prices.
That may have been a factor in the 56.8 percent drop in the Standard & Poor’s 500 index during the U.S. bear market of 2007–09, amid banks’ mortgage meltdown. That was the largest market loss since the 83 percent plunge in 1930–32, when the U.S. banking system was crumbling following the 1929 stock market crash. (The financial crises beginning in 1929 and in 2007 are the only two U.S. crises Muir counts in the last 100 years.)
Muir also allowed that, “whether rational or irrational,” investors who witness a financial crisis may feel less certain about the economy’s ever getting back to normal than they do in the darkest moments of recessions or wars.