It was 10 years ago that the Global Financial Crisis exploded with the bankruptcy of Lehman Brothers, the AIG bailout, introduction of the Troubled Asset Relief Program (bank bailout), forced bank mergers and many other events all in the September-October 2008 period. No matter one’s investing experience, it was a scary period for investors. At the time, there were serious questions about the survival of the U.S and global banking systems. Governments and central banks were forced to break tradition, create new powers and save firms that probably did not deserve to be helped.

We note that 10 years later the performance of the U.S. stock market shows just how resilient the U.S. economy truly is. While it might seem hard to believe, the S&P 500 Index has a total cumulative return of 210% (or 12% annualized) from September 30, 2008 to September 30, 2018. During that same period, the Russell 2000 Index has a total cumulative return of 187% (or 11% annualized).

What Has Changed Since the Last Market Cycle?
Perhaps the most important change over the last 10 years has been the reduced leverage in the banking system as U.S. and foreign banks have been forced to raise their capital levels and reduce leverage to help prevent a recurrence of the 2008 crisis. As a result, the financial system is in a much stronger position to withstand an eventual economic slowdown. Not only have our financial institutions reduced leverage, U.S. households have also reduced their personal leverage. The percentage of income being used to service debt is well below the levels of the mid- to late-2000s as many consumers are not buying second homes, boats, cars, TVs, etc. with unhealthy levels of debt. In addition, we do not see obvious signs of investors pushing asset values to unsustainable levels such as the tech bubble in 2000 or the housing bubble in the mid-2000s. While this is not a definitive list, we believe these three changes show how the U.S. economy is in a stronger position than during the last bull market.

However, Some Things Have Not Improved
Unfortunately, one of the biggest drivers of financial crises has not and will not change: human behavior. Investors are driven by two opposing emotions, fear and greed. At some point, greed will push asset values well beyond their intrinsic value. And when the crowd realizes this, fear will cause asset values to drop below their intrinsic value. This cycle will repeat itself well beyond any of our lifetimes. The second, and more problematic, issue is the unwillingness of federal, state and local governments to address their long-term obligations such as debt, pension and healthcare benefits. While the U.S. federal deficit is smaller than it was in 2009, the federal debt has doubled over the last 10 years. Funding for Social Security and other obligations is woefully low. These issues are often significantly worse at the state and municipal level. At some point these issues will result in higher interest rates, higher tax rates and/or reductions in benefits. These will likely have a broader economic impact, but predicting when that impact may occur is difficult.

A Closing Word on Capital Gains
As this will be the last newsletter of the 2018 calendar year, we want to circle back to some of the comments we made in our July newsletter, specifically around portfolio turnover and capital gains. We have long prided ourselves on being buy and hold investors, not “fast money” looking for a quick trade. We have a relatively low level of portfolio turnover in our strategies which is consistent with our search for companies that we believe can outperform the market on a risk-adjusted basis over the next 3-5 years.

Please note that our low historical turnover and a bull market that is nearly a decade old has resulted in large capital gains in many of the holdings in our client accounts. This year, our portfolio turnover may be higher than our historical averages and that may result in client accounts realizing more capital gains than is typical. If you have a taxable account managed by us, please do not be surprised if your 2018 capital gains are higher than prior years. If you have any specific tax concerns that we should know about, please be sure to contact us.

—Adam Engebretson
Senior Portfolio Manager
October 2018

Kopp Investment Advisors 8400 Normandale Lake Boulevard Suite 1450 Bloomington, MN 55437 Tel: 952.841.0400 / 800.333.9128