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INVESTING IN THE STOCK MARKET - SIGNS OF TROUBLE?
by Hans
Wagner
TradingOnlineMarkets.com
February 16, 2007
When
investing in the stock market it is important to balancing the risks
with the potential rewards, if you want to beat
the market. Today, we face a world of low yields and relatively high
valuations. Most of the stock markets in the developed world are near
their long-term highs in terms of valuation. As many investors know and
numerous studies have shown stocks offer lower than normal returns after
reaching high valuations. This implies it will be more difficult to
balance the risks with potential rewards while achieving above average
returns. You might want to read Ahead
of the Curve: A Commonsense Guide to Forecasting Business and Market
Cycles
by Joe Ellis. It is an excellent book on how to predict macro moves of
the market.
Dividends are at the low end of historical yields, and bonds offer
little growth potential after accounting for inflation and risk. The
spreads between high-yield debt, i.e. junk bonds, and the best of solid
government debt are at historically low levels. The gap between US
government debt and emerging market debt fell to its lowest level
recently. A mild global recession would push the yield spreads back to
normal levels, thus making high-yield bonds or emerging market debt a
low-total-return asset.
It is not just in the world of stocks and bonds that valuations are at
highs. As a report from Goldman Sachs noted, how can someone pay $135
million for a Gustav Klimt painting? Almost $1,000,000 for a little
black dress worn by Audrey Hepburn in Breakfast at Tiffany's? How do you
buy an office building in New York with no leases expiring for ten years
for more than $1.2 billion with an internal yield of 4%, which is 50
basis points less than a 10-year US bond? And that is before maintenance
reserves! This illustrates that valuations in all sorts of markets have
reached new highs. The world’s markets are awash in capital looking
for a home.
With this growing liquidity, the world is experiencing an increasing
appetite for returns by investors at all levels as they chase those
yields down to a point where traditional risk-reward measures would
suggest the potential for problems.
A real example will provide some better understanding of this situation.
In the US, about 25% of the mortgages on new homes are what is known as
sub-prime mortgages. These are mortgages that are slightly less
creditworthy and therefore offer higher interest rates. Initially this
was a way for first time buyers and those just starting out in life to
own their own homes. While home ownership is important for anyone, first
time buyers should look carefully at the terms of the loans they are
considering. I encourage first time buyers to read Automatic
Wealth for Grads... And Anyone Else Just Starting Out by
Michael Masterson describes a complete program for recent college
graduates and any else just starting to achieve financial independence.
Then investors with money arrived on the scene looking for yield. With
all that liquidity investors had snapped up these mortgages. Investment
banks would buy those high-yielding sub-prime loans and package them
into something called Residential Mortgage Backed Securities. Now, a
sub-prime loan is not considered an investment-grade security. But when
you put a group of them together into a pool and break them up into
various sub-groups or tranches, you create high-grade bonds from
sub-prime debt. In fact, 80% of those grouped together get an AAA
rating, because that tranche gets the first monies paid back to the debt
pool. And it probably is pretty safe money. So far so good.
These investment banks keep slicing the pool into smaller parts,
eventually ending up with the final 4% getting a below-investment-grade
BBB rating. This is OK as it allows investors to buy the risk they want
and makes for a more liquid real estate market. But the investment
bankers are not content with these instruments. They pool all these BBB
tranches into yet another pool called a Collateralized Debt Obligation
or CDO. The rating agencies use sophisticated models to tell them that
with the increased diversification, 87% of these former BBB bonds can
now be sold as AAA or AA investment-grade bonds. Only 4% is considered
actual BBB debt. So we have taken an original security that is not
investment-grade and turned all but less than 1% into an
investment-grade bond.
This won’t be a problem, if all those mortgages pay off like they have
in the past. But recent research suggests that as many as 20% of these
mortgages sold in 2005 and 2006 are going to default or foreclose. New
Century Financial, a sub prime lender, had to buy back a number of their
sub-prime loans that went bad, causing the firm to experience
substantial loan losses, much larger than their reserves. Their stock
price fell more than 32% on the news. HSBC, one of the world’s largest
banks, announced set aside an additional $1.8 billion to cover loan
losses that were higher than expected. Other mortgage firms also
reported problems.
The
problem is the investment bankers set up the CDOs assuming that less
than 1% will default. If the number of defaults is even half of that
predicted, then someone is not going to get their full capital back, let
alone the interest. And we are seeing home foreclosures at record levels
in every part of the United States due to the large number of sub-prime
mortgages.
Why such a growing default rate? Because investors kept throwing money
at mortgage bankers, who found out they could sell mortgages with little
documentation. For instance, you could get a loan without actually
having to prove your income. So the bankers said, "Let's take the
fees and run. Bonuses all around for selling more mortgages." Now
there is anecdotal evidence that a small but significant portion of
these low-documentation loans had some items that were misrepresented.
Little things like whether you were actually going to occupy the home
and the basis of the income you expect to use to pay the mortgage?
So, who bought these CDOs? Well that is tough to tell. But remember all
that liquidity chasing yields mentioned earlier? Much of that liquidity
came from Asian and European institutions, which simply looked at the
rating on the bond and bought them. Also, remember all that oil money
looking for some place to go. The unhappy news many of these investors
are receiving will cause disruption in the markets. At the least look
for massive lawsuits and a major losses to start up by the end of this
year. Hopefully, there is sufficient liquidity in the global markets to
absorb the losses without causing a major financial problem.
As
investors we need to be aware of these events and the potential impact
they may have on the market. News like this can cause a panic in the
markets as investors get out of the higher risk stocks, looking for
safer places to put their money. Stay tuned as this over indulgence
works its way through our securities markets.
© 2007
Hans Wagner
Editorial
Archive
As
a long time investor, I was fortunate to retire at 55. I believe you can
employ simple investment principles to find and evaluate companies
before committing one's hard earned money. Recently, after my children
and their friends graduated from college, I found my self helping them
to learn about the stock market and investing in stocks. As a result I
created a website that provides a growing set of information on many
investing topics along with sample portfolios that consistently beat the
market. Feel free to visit the site at http://www.tradingonlinemarkets.com/
CONTACT
INFORMATION
Hans Wagner
tradingonlinemarkets.com
Manitou Springs, CO USA
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