Before what has been called the ‘Great Recession’ by many pundits, economic prosperity flourished in the United States and overseas. The S&P 500 Index, perhaps the most widely accepted gauge of the American equity markets, multiplied over twelvefold during the last two decades of the 20th century. An investor that placed $1000 in an index fund would have seen their original investment grow to over $12,200 during this period. Aside from the Nikkei 225 Index of Japan, most of the developed world’s other major stock indices saw a similar growth in wealth. In addition to burgeoning equity markets, world GDP rose at a rate between 3.5 and 4 percent per annum. As citizens of the largest single economy in the world, Americans saw their standard of living as measured by GDP per capita rise from $12,179 in 1980 to $35,058 by 2000.
A beneficiary of this exorbitant period of growth, the U.S. housing market saw a similar boom. Since its inception, the S&P/Case-Shiller Index can tell the story pretty well. Between 1987 and 2005, the index grew at a rate of almost 13 percent each year.
The graph above represents the monthly values of the S&P/Case-Shiller Index, which is a national measure of home prices, from its inception in January 1987 to June 2011. Home prices peaked in mid-2006 and fell rapidly after then, leaving many homeowners with mortgages greater than the total value of their homes.
Another way to interpret this data can be seen by calculating the doubling time of home prices. The S&P/Case-Shiller Index can be thought of as a measure of the average value of a single-family home in America. By using the estimated formula below, we can approximately determine that the average American saw their home price double every 5 years during this time period.
Doubling time (in years) = 70 ÷Percentage growth rate (yearly)
Perhaps even more financially devastating, the American investment banking system experienced heavy losses from investments in mortgage-backed securities, specifically those linked to subprime borrowers. The value of this type of derivative was degraded as home values declined. A report by the International Monetary Fund valued these losses at $4 trillion dollars. As this occurred, the value of all outstanding collateralized debt obligations also declined, creating huge losses for investors, including pension funds, mutual funds, hedge funds, and other types of investment vehicles. This decline in wealth was evident in every major stock index in the world. In the U.S., the Dow Jones lost nearly 37 percent of its total value in 2008, making it the worst year since the onset of the Great Depression. The European markets experienced an average loss of 38.1 percent, while Asian markets were hit even harder – losing, on average, over 50 percent. Hardly any investors were left untouched by this sequence of events due to the extreme amount of systemic risk that was present in the global economy.