One Year Later, Lehman Aftershocks Still Linger

What a difference a year seems to make.

After a furious market run off March lows, the dark days of September 2008 seem to be fading in investors' rearview mirrors. Yet it has been just one short, albeit eventful, year since the 158-year-old Wall Street icon, burdened with billions in bad real estate holdings, filed for Chapter 11 bankruptcy protection after failing to raise new capital or rouse a possible suitor. On the same day,  Bank of America (BAC) agreed to acquire a faltering Merrill Lynch under government pressure in a now-controversial deal.

In a matter of days, the U.S. government was then forced to step in and save a teetering  AIG (AIG). Remaining investment banks  Goldman Sachs (GS) and  Morgan Stanley (MS) were declared bank holding companies in a move to access government loans.  J.P. Morgan Chase (JPM) rescued Washington Mutual after the latter went in the record books as the biggest U.S. bank failure ever. And the Bush administration signed on the dotted line for a $700 billion rescue package.

The market was already jittery: Bear Stearns had collapsed just six months earlier and  Fannie (FNM) and  Freddie (FRE) had but days prior entered into government conservatorship. Nerve-wracked investors hit the panic button, redemptions forced further selling, and the vicious cycle sent the market down over 20% in the fourth quarter and another 10% in the first three months of 2009.

But by March, unprecedented government intervention, interest rates slashed to the bone, and a massive $787 billion fiscal stimulus bill finally flipped the market's switch. As investors stopped pricing in a doomsday scenario, the market began to perk up. Since March 9 lows, the S&P 500 has advanced over 50% as the economy stepped back from the abyss and indicators began to--if not improve--at least moderate their declines.

But as bullish sentiment takes hold and risk appetite begins to grumble, some nagging questions still linger on the anniversary of Lehman's collapse. Some noted investors have less-than-rosy outlooks, even as the market marches upward.

"It is amazing how short investor memories really are," says Jeffrey Gundlach, TCW CIO and manager of  TCW Total Return Bond (TGLMX). "One would have thought that the type of freefall that was experienced in September-October and then again with less velocity ... earlier this year would have made a lasting impression, but most analysts have basically gone back to business as usual."

The Risks Still Out There
Despite widespread concerns about future inflation rising from the government's massive spending, Gundlach points to a more-imminent specter of deflation as today's bigger concern. "Why is the economy showing some signs of life?" he asks, "Well one of the reasons is ... the 'Cash for Clunkers' program. What is that telling you, though? It is telling that you can increase car sales, but only if you effectively slash the price by $3,500 or $4,500."

And financials aren't out of the woods yet. "If we had very bad news coming out of commercial real estate, you could have all of a sudden a drying up of liquidity again. You could have an inability of companies to borrow in the short-term credit markets. That could lead us back down," says Ariel's vice chairman, director of research, and  Ariel Focus  (ARFFX) manager Charlie Bobrinskoy.

He says upticks in prime mortgage delinquencies are also a concern. "There are a lot of people that are current on their mortgage payment, but only barely," he says. "If we get a further tick down in housing prices, people may throw the keys back to their lenders."

Repercussions of the government's big spending and questions about its exit plan also bring a few clouds to the horizon.

Gundlach says the government's response has been effective at limiting the short-term pain, as would be expected with the magnitude of the intervention. "However, the government's programs do not address the long-term problems or the structural problems. In fact I am of the opinion that the government's actions in the last 12 months have added to the structural problems and the long-term problems, which is really all about excessive debt."

PIMCO co-CIO and CEO Mohamed El-Erian meanwhile gives the government an "A" for effort, but says the outcome has fallen short of that. Specifically, he argues, a focus on crisis management has meant a shortfall in forward-looking crisis prevention. "The policy response has succeeded in cutting off the tail event, which was another depression ... but it has not completely negated the impact of the crisis. So while things are better, while the financial system has normalized, we are still going to be cleaning up after this financial system for a number of quarters."

Opportunity Where?
After a strong run, Morningstar analysts see the market overall as fairly valued. Meanwhile, conservative investors are finding decent yield hard to come by.

"I know a lot of people are worried about inflation, worried about raising interest rates and they say, maybe I should go into short-term securities," Gundlach says. "It seemed to me that [those investors] would be better off owning just true cash rather than short-term securities because short-term securities don't yield anything."

Echoing his colleague Bill Gross' prediction of a new normal, El-Erian sees "a world of lower growth overall and particularly in the Anglo-Saxon economies, which were most dependent on finance ... so the U.S. and U.K." Ultimately, he says, a world of lower growth translates into a world of lower returns. "We don't like that, but that is the reality."

At Morningstar, the data tell us that the rally--while lifting all boats--has lifted low-quality fare higher. As a result, wide-moat companies and funds with higher-quality portfolios, while lagging their peers, could offer a nice remaining upside with some downside protection for a rainy day.

Hear more from El-Erian, Gundlach, Bobrinskoy, and Morningstar analysts as we look back over a startling year, and forward to the challenges and opportunities ahead.

Morningstar Views
A Harrowing Year for Investors
One year after Lehman's fall, is the thrill ride over, or more spills to come?

Why Smart Investors Were Burned in the Crisis
One year after Lehman's collapse, Morningstar's Matt Warren reflects on the government's decision, investors' pain, and the future for I-banking.

Easy Money Already Made in Financials
One year after Lehman and six months into a furious rally, Morningstar ETF analysts Scott Burns and John Gabriel say investors need to tread carefully in the sector.

Morningstar Archives: Looking Back on Lehman
Commentary from before and after Lehman Brothers' bankruptcy shocked global markets.

Data Digging
How the Big Banks Have Fared Since Lehman
One year after the collapse, how did the biggest banks hold up and what's the outlook?

Top and Bottom Fund Categories: One Year after Lehman
Plus results from the largest equity and fixed-income funds.

Financials-Heavy Funds Make a Comeback
A year after Lehman's collapse, we chronicle the dramatic reversals of fortune for financial-heavy funds.

Corporate Bond Premiums Recover to Pre-Lehman Levels
The market's faith in corporate creditworthiness has rebounded in the year since Lehman's collapse.

Manager/Advisor Views
Gundlach: Excessive Debt Still a Culprit
TCW CIO Jeffrey Gundlach says consumer debt led us into the downturn and government debt--although supporting the current upswing now--will ultimately prolong the pain.

Gundlach: Deflation Is Today's Threat
Even though inflation risk down the road remains an issue, deflation is the fire to fight today, says the TCW CIO.

Gundlach on Getting Decent Yields Today
The TCW CIO says investors should take a pass on very short-term securities and non-dollar currency, and take profits in very high-risk assets such as the lowest tiers of junk bonds and the mortgage credit markets.

El-Erian: Good Crisis Management, but Not Enough Prevention
The PIMCO CEO and co-CIO says longstanding structural weaknesses still have to be addressed and over-regulation is a risk.

El-Erian: The Crisis Is Not Over
The PIMCO CEO and co-CIO says investors may not appreciate that the crisis is defining a new normal that we'll have to get used to and navigate.

Ariel's Bobrinskoy on the Market Risks Remaining
Ariel director of research Charlie Bobrinskoy says we've backed away from the abyss, but commercial real estate and continued mortgage defaults are still risk factors.

Muldowney: Why Didn't We See It Coming?
Tom Muldowney, a registered investment advisor and a managing director of Savant Capital Management, on whether we could have known Lehman would be the first in a series of falling dominoes.

Muldowney: Gauging Risk After Lehman
Three years ago, times were good, money was cheap, and markets were expanding. We took an awful lot for granted.

Muldowney: Did Buy and Hold Die with Lehman?
Buy and hold, coupled with asset allocation, still makes sense.

Muldowney: Get Back in the Market
Whether you get back in all at once or gradually, it's better than sitting on a lot of cash.

Discuss
One Year Later: How Are You Investing Differently?
How has the crisis changed your perspectives on risk, your investing philosophy, and your portfolio? Join the conversation.