August 2007

August 27, 2007 11:00 a.m. When Will We Know It is Over?

Investment markets had a good week and seem to be returning to what was normal a couple of months ago. Is the worst of the financial crisis over? What are the signs that it might be over?

Last week things looked almost dire when the commercial paper market almost dried up. Financially sound companies drew against bank lines of credit because the yields demanded on their short-term debt suddenly went sky high. Buyers for commercial paper were nonexistent for a while. That situation largely has corrected. Stocks had a strong rise for the week, leading many to speculate that normal times are back.

I believe there are more hidden problems. Home Depot announced today that it would reduce the price for the sale of a subsidiary by $2 billion. There probably are such events to take place. Also, investment books are on the hook to place about $3 billion in high yield debt from commitments made before the financial market squeeze. Many hedge funds and other firms have not marked down their prices of mortgage products, high yield bonds, and other investments that were repriced in the last couple of months when investors rediscovered risk.

I don’t think the housing and related problems will cause a recession. They will reduce economic growth to a low level. International economic growth will continue and keep the U.S. from drifting into a recession. Financial companies, however, make up about 30% of the S&P 500 and a higher percentage of overall profits in recent years. The earnings of many of them will suffer from the financial markets upheaval.

While interest rate spreads no longer are at the record lows of earlier this year, investors still are not paid much for taking risk. The spread between high-yield bonds and treasuries still is below the long-term average. This reflects a forecast by investors of extremely low defaults, which I believe is too optimistic.

In some ways the worst is over. We have avoided a complete meltdown of financial markets. But it will not be a smooth road going forward. There will be bumps and surprises. One surprise for many people I think will be the number of overseas entities holding a lot of the risky U.S. mortgages. Some firms are deferring problems, hoping that they can be fixed. They will announce in coming months the problems could not be fixed. Market prices also do not reflect the profit and growth reductions from the recent events, and there still are not fully functioning markets for mortgage products and high yield bonds. There are bargains being created, but there is no need to rush in. We will discuss the opportunities in the next issue of Retirement Watch.

One key indicator to watch is the interest rate on treasury bills. In the flight to safety, this rate fell sharply as investors sold everything else to buy treasury bills. The interest rate has increased some, reflecting reduced demand. But the yield still is lower than before the crisis and much lower than the fed funds rate. If the t-bill yield remains stable or, preferably, rises, that will be a sign that investors are attracted to other investments. But if the t-bill yield stays low or falls further, that will be a sign that investors are hoarding cash.

August 27, 2007 11:05 a.m. A Review of Last Week

Last week was a big one for the markets. Stock markets around the world reversed course. A full 10% correction finally occurred, then U.S. indexes quickly recovered half of that loss. A number of analysts began to forecast that we would quickly return to Dow 14000.

Let’s look at last week’s results in a little more detail.

The winning sectors in the U.S. markets mostly were those that were doing well before the recent upheaval: Basic Industries, Basic Materials, Oil Equipment, Cyclical/Transportation, and Technology. Not on the list are financial services and real estate. These had modest gains for the week but clearly are the market laggards now.

The top-performing funds and ETFs, however, invest outside the U.S. This is consistent with the market leaders in the U.S. The sectors of American markets that did well are those that provide infrastructure for the rapidly-growing global economy. The global markets that did best last week were in emerging markets. Both Latin American and Asian emerging markets did well last week. Even many European markets had solid gains of 5% or more for the week.

This bifurcation will continue. Growth will continue at a higher rate outside the U.S. Both international stocks and the global U.S. companies will benefit.

August 22, 2007 01:50 p.m. Fast Turnaround or Biding Time?

Is the worst of the credit squeeze over, or is there more bad news to come? The stock and bond markets seemed to hit a climactic bottom last week, and investors are acting less panicky. The stock markets have calmed compared to their wide swings of the past few weeks. The temptation is to come out of our shelters and invest as though the crisis has passed.

I recommend continued caution for the following reasons.

• The stock market action has not been bullish on recent days when the indexes rose. Trading volume has been relatively low. There usually are fewer advancing stocks than declining stocks. Few stocks are hitting 52-week highs or new highs.
• The commercial paper market appears to have collapsed for now. Yields on the paper have skyrocketed. Several corporations have reported problems selling commercial paper and have opted for bank loans for their cash needs.
• The carry trade has not fully collapsed. Investors no longer want to borrow in Japanese yen (and a few other currencies) to invest the proceeds in the U.S., Australia, and other countries. The carry trade grew extensively over the last few years, much more than is reflected in the amount of unwinding so far. I think there is more selling to come.
• A floor was under the stock market because of investors purchasing stock with borrowed money. These investors included corporations buying their own stock, corporations acquiring other corporations, hedge funds, and leveraged buyout funds.
• It still is possible that corporate buyouts and acquisitions announced in recent months will not be completed because of an inability to obtain the financing.
• The decline in housing prices and activity will make consumers feel poorer and reduce their spending somewhat.
• The spreads in interest rates and other financial indicators are not at the levels usually achieved in times of crisis or distress. That could mean there is more bad news to come, or it could mean that this will be a slow-motion unwinding.
• I suspect there are more firms and investors that stretched the limits of low-risk, easy credit than have reported problems so far. I think there are more blow ups to come. Many of the subprime mortgages were purchased by overseas investors. Those defaults might be handle more quietly than they if the investors were in the U.S.

I don’t expect the unwinding to be a short event. It is more likely to take time. For example, the resets in rates on adjustable rate loans will occur steadily over the next 18 to 24 months. It will take time for homeowners to discover that they cannot afford the new payments or refinaince on more favorable terms. It will take longer for them to default on the loans. Likewise, it will take a while for the effects of reduced credit to impair business activity.

Don’t take this as a bearish forecast. I do not expect the catastrophe some are forecasting. It is more likely that the unwinding and readjustment will take an extended period. Economic growth and investment returns will be below their long-term averages for a while. We will earn higher returns than the market indexes with lower risk by locating undervalued assets.

August 22, 2007 01:55 p.m. Little-Known Players in the Crisis

Most of the media reports like to blame the credit bubble and housing market crisis on a range of villains. But two leading players in the events received very little attention. A few financial media discussed their role, but most of the public do not realize the significant role of these players and how they influenced key sectors of the economy such as home prices, the amount of credit available, and interest rates.

One player is the ratings agencies. Most people know that private firms provide credit ratings for corporations. These ratings classify as investment quality or something less and determine the interest rates paid on the bonds. These ratings agencies also provided ratings for the securities that consisted of mortgages and parts of mortgages. By stamping an investment grade rating on the securities, investors were induced to buy them. The process of bundling mortgages and selling them as investment grade securities provided large amounts of new capital for mortgages, boosting home prices.

Unfortunately, the agencies did not do a good job of rating the mortgage securities. In a number of cases they bought the argument that bundling a bunch of subprime mortgages with some high quality mortgages or other debt resulted in a high grade security. They also bought the argument that substantially increasing the number of subprime and no-documentation loans issued would not result in high default rates above historic levels.

Only after default rates began rising this year to the ratings agencies realize their mistakes. They suddenly downgraded a number of the mortgages. That began the spiral that resulted in the current credit squeeze.

The other players were the pricing firms. The mortgage securities and other creative securities do not trade on public securities the way stocks do. When they trade, it is informally among a network of firms that buy, sell, or act as middlemen. Each day, a price must be determined for each security, so the investor knows its financial position. Some investors use computer models to determine prices. Others use independent firms, giving their own investors and lenders that they are not manipulating the prices on their books. The agencies might use their own models or they might look at the prices for which the most comparable securities have traded.

Once default rates increased on mortgages, some of the models and pricing agencies were quick to slash the values placed on mortgage securities. This impaired the balances sheets or returns of investors in the mortgages. It also decreased confidence in the securities and made investors unwilling to purchase the securities at any price.

Through this process, two little-known players had a great influence on the current credit cycle.

August 16, 2007 09:50 a.m. Sector and Balanced Managed Portfolios Update

Yesterday’s market decline brought ProFunds Ultra Bull below its sell signal. We are selling the fund from our model portfolios today and recommend that you do the same.

The markets are creating a number of opportunities. We are not recommending new investments at this point, because the selling panic continues. In addition, while currently there are no signs of the housing market problems spreading beyond to the general economy, we want to be sure that remains the case before choosing new investments. Positive signs are that high yield bonds have stopped their slide for now; the credit freeze currently is restricted to mortgages. It could take months for clear signs to emerge that the credit freeze will not spread to the rest of the economy and for investors to regain confidence. The contraction in hedge funds and their access to leverage could make the market less volatile and prevent a sharp snap-back rally once the bottom is reached.

August 16 2007 10:00 a.m. Lessons from the Panic

It is fitting that the recent panic in the financial markets coincided with the publication of my latest book, Invest Like a Fox…Not Like a Hedgehog.

One facet of the book is the exposure of fallacies that underlie conventional investment strategies and lead to panics, bear markets, and major investment losses. Here are some points from past financial fiascoes that investors seem to forget.

An investor must accept that the unlikely and unexpected are likely to occur. The Wall Street Journal recently quoted a quantitative investment strategist as saying that once in a hundred year events happened three days in a row in the credit markets. The statistical models developed by hedge funds and other investors did not expect the recent series of events, believed they could not occur, and were not prepared for them. The markets involve people acting on their beliefs and fears. The unexpected always can happen. That fact can be anticipated, but the actual events and their timing cannot be. For that reason, we try to invest with a margin of safety and place sell signals on our more volatile investments or those that are reaching fair value.

The search for patterns depends on the data used and reach misleading conclusions. Statistics and models are helpful, but they cannot be relied on absolutely. Markets change. Everything that can happen in the future cannot be found in past data. What many people interpret as patterns involving cause and effect really are just random series of events. That is why we always are conducting research, testing accepted theories, and are willing to change our rules and theories when the evidence warrants.

Once a reliable investment rule or strategy is discovered, it soon will stop working. As more investors learn about it, their participation and knowledge changes the markets. In the recent series of events, lenders saw past patterns in the mortgage markets. But when many billions of dollars acted as though those patterns were immutable laws of finance, their actions changed the markets. The patterns changed.

Even reliable patterns do not have 100% probability. The investor who was quoted in The Wall Street Journal made two mistakes. One mistake was thinking that because a series of events happened infrequently in the past, it always would occur infrequently. His second mistake was in assuming that a historically rare event would not occur in his investment career. These are common investments mistakes.

Correlations change, especially at times of market stress. People thought they had diversified, safe portfolios because they used historic data to develop their portfolios. Unfortunately, correlations are not fixed. To take risks in a portfolio, an investor needs to be sure of good diversification and lack of correlation, such as our pairing of Hussman Strategic Growth and ProFunds Ultra Bull.

Factors outside the markets can determine the direction of the markets. People borrow Japanese yen to buy U.S. stocks, so the fate of the yen and Japanese interest rates influence U.S. stocks. A drop in housing prices and shrinking of mortgage capital affects consumer confidence and spending, and that influence stocks and bonds. That is why we avoid certainty and one-way bets in our portfolios. Balance, diversification, and a margin of safety are essential to deal with these possibilities.

August 13, 2007 12:20 p.m. A Mortgage Panic Primer

Many people do not understand the origins of the current mortgage crisis. Let’s briefly review the sequence of events.

For many years, mortgage lenders have sold those mortgages to investors. The lenders preferred to make their money from fees on the initial loans and servicing the mortgages during their lifetimes (collecting payments and pursuing delinquents). They did not want to take the risk of prepayments and defaults, or deal with the effects of interest rate fluctuations changing the values of the mortgages on their books.

To make the mortgages more appealing to investors, many mortgages are packaged into one bundle or security. That way, the investor does not have to evaluate mortgages one at a time, and a diversified portfolio of mortgages can be obtained with one purchase. Rating agencies would rate the mortgage packages just as they give credit ratings to bonds.

Computers and statistical wizardry allowed an additional step. Each mortgage could be divided into portion, or tranches. An investor could buy only the interest or only the principal payments. Also, an investor could purchase only the high risk portion of a package of securities, only the prime risks, or some other section. The packagers bragged that they could slice and dice a portfolio of mortgages any way the investor desired.

All the sophistication and apparent certainty greatly increased the demand for mortgage securities. Indexes of mortgages as well as options and futures were developed.

Hedge funds and other aggressive investors became particularly interested in these products, because there were many possible uses. They could earn higher yields than treasuries and set whatever risk to yield ratio they desired. Returns could be enhanced with leverage. Other strategies and uses are possible.

These securities are not traded on exchanges or other organized markets the way stocks are. There are several ways investors determine the value of the securities each do. Some use computer models, based on historic relationships between mortgage prices and other factors. Other funds use outside firms that provide pricing services. Some of those firms use models; others use market prices for whatever mortgages are trading to determine values.

This is where the system became vulnerable. The amount of mortgages traded is unique. Also unique over the last couple of years was the percentage of subprime mortgages issued and the extent to which people could borrow with little or no documentation or their income or assets. A final unique feature was the number of people who borrowed 100% or more of the value of their properties. Historic relationships and default ratios did not apply under these circumstances.

This year, as default rates and foreclosures began to rise and home prices fell, market participants began to re-evaluate their views of what the securities were worth. They used to believe that only a small percentage of debtors would default, and even if they did there was home equity backing the securities. Those premises were in doubt. Investors started to lose their appetite for the securities.

The main trigger to the panic apparently was in May when brokerage firms that were marking the prices of securities held by two Bear Stearns hedge funds substantially reduced the prices of those securities. The funds then had to inform their investments that they had significant losses. Investors began to request the return of their investments. The hedge funds either could not sell the securities or could sell them only at a fraction of their face values.

Once the news of these investments was made public, panic entered the markets and spread. The premises behind investments in all other risky investments also were questioned. Interest rates on all these investments rose. Reports were that for many securities there have been few or no buyers for a while.

If you want a detailed explanation of how such panics and financial crises can occur, read one of my favorite financial books, When Genius Failed by Roger Lowenstein. It describes the last major financial panic, the failure of the hedge fund Long Term Capital Management in 1998. The details are different, but the basic series of events is the same.

August 13, 2007 12:20 p.m. A Market Review

It is hard to believe, after reviewing all the media from the past week, that the major indexes actually had gains last week. It also is hard to realize that the indexes have very solid gains for the year and the last 52 weeks. Outside of a few high risk markets, especially the credit markets, many investments so far are only taking pauses in extended bear markets. This always could change, but there also is the possibility that the panic will be relatively short-lived and contained. While we can spin theories for either scenario, we cannot be sure which will be realized. That is why we should invest wherever there is a margin of safety, be diversified, and have sell signals for the riskiest investments.

To put recent events in perspective, here are how the mutual funds in my database performed over the last four weeks.

Rydex funds: The top-performing funds for the last month are those that sell short stock indexes and use futures to multiply the losses, with the Inverse Dynamic Russell 2000 leading the way. This shows that small company stocks have done the worst. The only funds in addition to those shorting U.S. stocks with positive returns for the month are U.S. Government Bonds and Dynamic Strengthening Dollar. The funds with the worst performance for the last four weeks are those that use futures to try to multiply stock index returns, with the Dynamic Russell 2000 logging a 17% loss.

ProFunds: This fund group has more international stock offerings. Its top performers are those that sell short international indexes and use futures to leverage their investments. The leaders are Ultrashort Emerging Markets and Ultrashort Japan. The funds with the biggest losses for the month are their counterparts, Ultraemerging Markets and UltraJapan. The only non-short fund with a positive return is Rising US Dollar.

Classic funds: Among these funds, the flight to quality made long-term U.S. treasury bond funds the top performers with returns from 2% to 3%. The first non-bond fund with a positive return for the month is Hussman Strategic Growth. The laggard funds are a bit surprising: Hennessey Cornerstone Growth and Undiscovered Managers Behavioral Value. The loses tend to be either international funds or U.S. funds invested in either emerging markets, small company stocks, or concentrations in the wrong U.S. sectors, especially financial stocks.

ETFs: The short funds and bond funds did the best in the last four weeks and are the only funds other than gold funds with positive returns for the period. The losers are leveraged U.S. stock funds, broker and financial sector funds, and Latin American funds.

August 8, 2007 12:20 p.m. Managing Fat Tails

Many investment managers are using near-apocalyptic terms to describe what has occurred in some of the markets in the last month. They are wrong to use such extreme terms, and I believe such comments are attempts to cover their mistakes.

Too many investors entered the markets this summer without historical perspective or risk controls. They tried to maximize returns and yields instead of remembering that markets are not always rational or efficient. Markets tend to have what the statisticians call “fat tails,” and that is why we always try to have a margin of safety and balance in our portfolios.

In a normal probability curve, there is a very low probability of extreme events happening. This is known as a normal or thin tail on the edges of the curve. Markets, however, have fat tails. Extreme events, both good and bad, occur with some regularity. That is why we kept our income investments in money market funds and kept the fully hedged Hussman Strategic Growth Fund in our Sector and Balanced Portfolios.

We didn’t know when investors would demand to be paid more for the risks they were taking, but we knew it would happen. We also didn’t know what would trigger the change in sentiment, so we knew that investors would not be able to sell their risky investments in time to avoid large losses.

As one hedge fund lawyer said in a recent issue of Barron’s, “It’s when the unanticipated happens that you have a problem.” Investors need to anticipate the unanticipated and prepare their portfolios.

If more investors had invested with risks in mind, they would not be feeling so overwrought and making unwarranted comments about the state of the markets.

When examined in perspective, the recent market upheavals were quite modest. The major stock indexes still have not had a 10% or greater correction since March 2003. The rise in rates on high yield bonds and corporate bonds merely restores their yield spreads with treasuries to a normal level. The spread had been abnormally small. Buyers dried up in those markets for a while, because they weren’t sure how far the spread correction would go. But journeying from an abnormally low yield spread to a normal yield spread is not cataclysmic, unless you invested assuming that markets would not return to normal.

Now, we are surveying the markets for opportunities. There will be a time when it pays investors to re-purchase investments such as high yield bonds, mortgage lenders, real estate investment trusts, and others that bore the brunt of the recent upheaval. We’ll be able to make such investments, because our portfolios were positioned to preserve most of our capital in a downturn and to take advantage of bargains when they appear.

August 8, 2007 12:30 p.m. A Lesson from a Master

Today the homebuilder stocks are up solidly. They are today’s market leaders. This occurred literally days after many analysts were stating that they saw no bottom in the residential housing market and housing-related investments could be poor investments for years.

In contrast, the Second Quarter Commentary from Third Avenue Value Fund (dated April 30, 2007 and delivered in June) stated that Martin Whitman’s fund had purchased positions related to U.S. housing. In the second quarter it bought USG, MDC Holdings, and Home Products International. All three stocks are dependent on the home building business.

Whitman didn’t try to find a market bottom or time the recovery. Instead, he looked at for companies selling at substantial discounts to their net asset values. “Obviously, I have no good idea as to how bad the current slump in residential housing will be or how long the depression will last.” Instead, he is a patient, long-term investor who knows a bargain when he sees it. If the stocks decline further, he says, the fund will average down in the stocks.

Contrast this approach with the many investors who purchase the investments that have increased the most in recent periods and are surprised when the investments fall sharply. Whitman beats the market indexes long term. He knows that a quality investment eventually be recognized by the markets. He is happy to buy an investment that is down and wait for a long time, sometimes years, for other investors to recognize the value and bid up the price. We strive to be like Whitman in our portfolios.