This Is Not 2008

The threat of a recession is on the minds of investors. Some traditional measures of the yield curve are inverted and, in the past, those have preceded recessions. The link between an inverted yield curve and a recession has so dominated recent financial news that for some investors it's no longer a matter of whether we get a recession, but how long until it starts.

What these investors are ignoring is how different recent circumstances are from the environment that preceded prior recessions.

Think about the Panic of 2008. The bubble in home prices in the prior decade pushed national home values more than $6 trillion above "fair value" (based on the normal relationship between home prices and rents). At the time, that over-valuation was the equivalent of about 50% of annual GDP.

The process of unwinding that massive over-valuation happened when bank capital ratios were significantly lower than they are today. And, more importantly, the unwinding happened when banks had to use overly strict mark-to-market accounting standards that required them to value mortgage-related securities at "fire sale" prices regardless of how solid the actual cash flow was on many of these instruments.

Pretty much everyone agrees that housing isn't grossly overvalued like it was in the years before the Panic. But some think we now have overvaluation in the stock market, so a downdraft in equities will play at least part of the role previously played by real estate, perhaps like back in the 2001 recession.

The problem with this theory is the capitalized profits model we use to assess "fair value" on the stock market says stocks were substantially over-valued at the peak of the first internet boom before the 2001 recession but are still under-valued today.