Friday, August 10, 2007

Should You Be Worried?

It's been a volatile year to say the least. This is the third time this year I've felt that I should make a post addressing the recent gyrations of the market, something I rarely do.

I think I've instilled into my clients the notion that in the short term stocks are risky and that they will fluctuate, sometimes a lot, sometimes a lot in a short period.

No matter how much or how many times I communicate this message, it occasionally will get lost during an extended bull market. This year, if anything will hopefully reinforce my communications that stocks can be risky in the short term.

Most of you are probably hearing panicked reports in the media about the sky falling in the Sub-Prime mortgage market. Most probably don't even know what "sub-prime" means (that is o.k.).

Most people are familiar with the "Prime Rate", it is the rate that banks give their most credit-worthy customers (at least in theory). "Sub-Prime" represents those borrowers who are not the most credit-worthy, in fact they have bad credit. It used to be that people with poor or bad credit could not get a loan. However, as the real estate market marched ever higher the ability to borrow from banks became easier - the thinking by the banks being that even if the borrower couldn't make the payments there would still be equity in their home and a foreclosure wouldn't likely happen. In addition, banks would sell their loans that they made to "sub-prime" borrowers (they sell most loans). These loans would end up in portfolio's of hedge funds, insurance companies, and in some cases, everyday Joe's in the form of Mortgage Backed Securities (we won't get into these right now).

Basically, borrowers with bad credit could get credit again and it wasn't difficult. This created more home buyers which led to more homes being purchased and ever higher home prices. The problems began when short term interest rates started heading higher and the adjustable mortgages that Sub-Prime borrowers had been sold, began to adjust too payments they couldn't afford. This combined with the fact that because short term rates were higher, there were less borrowers and less buyers. Also, real estate prices can only go so high, at some point (sometimes a ridiculous point) people won't pay an additional dollar for a home (try a $600,000 townhome in Orange County that is less than 1,000 square feet and over $10,000 a year in property taxes....).

Home prices stagnated, borrowers who had just taken loans had no equity and as their payments begin to adjust they can't make the payments. Suddenly foreclosures start to spike, panic sets in and borrowers stop lending to bad borrowers, which creates an even worse affect - more foreclosures and more panic.

All of this was easily predictable (in fact predicted by me several times).

So that is how we got into this mess, but is the mess really that big?


Sub-Prime doesn't represent a major portion of our economy, the problem is how Wall Street has reacted to it. They have shut off the credit to even good borrowers out of fear (sometimes justified, but mostly not) that the good borrowers will go bad.

This has hurt the markets in the past few months and it may continue to hurt the markets, I don't know.

What I do know is that the Dow Jones Industrial Average started the year at 12,500 and is in the 13,000 range right now. In other words, despite all the problems, we are still higher than we were at the beginning of the year. Of course, that could change in a single day, but the reality is that the global economy is still strong and stocks aren't overvalued (like they were in 2000).

Stocks will fluctuate, that is what they do, if they didn't we wouldn't get higher returns.

My advice is to not panic, simply go on with your daily life and don't waste time worrying about the day to day gyrations of the stock market. It will work itself out in the long run and those who don't panic will emerge the winners.

Scott Dauenhauer CFP, MSFP, AIF