Tuesday, November 27, 2007

What Happens When the Easy Money is Gone? Go Global!

Consumers can no longer tap their homes to support their lifestyle nor can they run up their credit cards forever (credit card debt is reaching a historic high). The subprime mortgage debacle has made it difficult for consumers to withdraw funds from their homes and caused housing prices to fall. Add in a falling stock market to this mix and the American consumer must be feeling less wealthy. Historically, a falling housing market has caused consumers to rein in their spending. As credit continues to dry up, the American consumer will have to begin living within their means. That could make things uncomfortable for a while and leave the U.S. economy in a bind.

In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.

The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.

Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.

In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.

Thursday, November 15, 2007

Market Volatility is Normal

If you listened to the news media this summer you might have thought the sky was falling. The sky is fine and the markets are sound, we are just experiencing the return of normal volatility. Yes, the markets go up then down and up again but this is normal. I love the chart below because it illustrates how volatile the markets usually are in any one year. For instance, in 1998 the S&P500 index (ex-dividends) generated a 27% return but at one point during the year the index was down 19%. The index has generated on average an annual 10% to 11% return despite suffering an average mid-year drop of 12.7%. The moral, stay focused on the long term (at least a three year if not 10 year time horizon) and ignore the day-to-day gyrations of the market.

If the graph is tough to read then click on it. The graph will then appear larger.

Thursday, November 8, 2007

How Bad is the Housing Market? Pretty Bad

The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay.
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.
With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.

With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending, which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.

Sunday, November 4, 2007

Earth quake Insurance

Here is a link to an article in the San Jose Mercury News in which I'm interviewed regarding earth quake insurance.

http://www.mercurynews.com/personalfinance/ci_7366738

Hope you had a beautiful weekend and didn't feel the latest 2 plus tumbler this afternoon!

Libby Mihalka, CFA
The Financial Pragmatist

Friday, November 2, 2007

Third Quarter 2007 Performance

The Third Quarter was another roller coaster ride that almost defied gravity on the downside and upside. The average general domestic stock fund was up 1.2 percent, according to Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.
International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions. A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).
Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares generated 3.1% third quarter while the S&P400 MidCaps and the S&P600 SmallCap ishares fell. International large caps also outperformed international small caps this quarter for the first time in years.
Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares were up 5% for the quarter while the S&P500 Value ishares gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares holding their value.

The reintroduction of risk was very apparent in the bond market, with high quality bonds rising in value and low quality falling. Scared by the upheaval in the credit markets, investors began piling into high-quality bonds, drove the Lehman Brothers Aggregate Bond Index up 2.8%, and caused yields to fall. For example, the yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries (flight to quality) also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated (junk) corporate bonds, to post a modest 0.12% loss for the quarter.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.
Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index rose a more modest 6% during the quarter and 10% for the year.
Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.

Libby Mihalka, CFA