Reality, understanding what is happening and the
effect on your investments.
Quick primer on credit, securitization and derivatives:
credit and mortgage issues have become household
talk now, but I thought it would be helpful to
explain a bit more about the underlying issues.
begin with we all realize that coming out of the
dot com bust of 2002 the economy needed a boost.
To help things the Fed lowered rates and kept
them low for many years to ignite the economy.
Cheap money led to easy mortgages, credit card
loans, home equity loans and business loans. We
became a "credit" driven nation. And
why not? With low interest mortgages and 0% credit
card rates it seemed like a no brainer to take
with any bubble it eventually ends and make no
mistake the credit expansion in this country over
the past 6 years has been a massive bubble. The
problem that we are facing is that with some fancy
financial engineering banks and wall street in
their quest to make money discovered that you
could package up pools of these loans into securities
and sell them (or stick them in off balance sheet
vehicles) and at the same time leverage up to
ratios of 20 to 1 or higher. This all worked great
as long as people paid their monthly payments
and the value of the underlying debt stayed level
or kept growing. Unfortunately, the brightest
minds forgot to calculate what happens when you
are highly leveraged and the value of your portfolio
(ie: houses) begins to fall.
is a big problem but even bigger is the Derivative
market that is intertwined with it. According
to the Bank of International Settlements the total
outstanding notional amount tied up in Derivatives
is close to $600 Trillion (yes trillion). While
this may be a foreign sounding word to many, derivatives
allow someone to speculate on the future price
of something without owning the underlying asset.
They also are used by people to hedge risk or
insure their underlying investment. Once again
everything works fine until highly leveraged companies
begin to go under, this is what we saw with the
Fed bail out of AIG. This was a company so intertwined
with the derivative market of "insuring"
these Mortgage Backed Securities that the government
could not let them fail. The domino effect would
be severe. (Warren Buffet said in 2003 that derivatives
were the financial weapons of mass destruction
and would eventually take down financial institutions.
If only they would have listened.)
here we are:
have now entered a point where we have hit the
limit on credit and the banks cannot continue
to lend like they were. You will also see credit
card companies pulling back on all those offers
that clog your mailbox each week. Ditto for home
equity loans. This is a credit contraction and
unfortunately it is going to lead to deflation
and a recession. (we are in a recession now, it
just takes another quarter for the government
to acknowledge it) In the grand scheme of things
it is a necessary process as we purge the over
dependence on credit from our economy and get
back to sustainable levels.
government has two options at this point, the
first is to flood the market with capital by reducing
interest rates again hoping to reinact what they
did in 2002 / 2003 or just let the issues work
there way through. If they reduce rates in the
hope of spurring inflation then maybe we get a
shallow recession and things get back to normal
in 6 months. The flip side is that they can reduce
rates but they can't force banks to lend or consumers
to borrow. And if the consumer takes a break then
we will have to go through a bit longer recession.
going to happen to the stock market?
wish that I had a crystal ball and could predict
how we will fare over the next year, so without
that then we have to layout the best case and
worst case scenario.
case is that we hold here and try to recover.
I am not real optimistic that it is going to happen
but have to be open to it. The Fed is going to
have to unload all their weapons to keep this
market up. That includes an interest rate cut,
a bailout to get credit flowing again and a desire
by the consumer to continue spending.
case is that after bouncing around for a week
or two reality sets in and the market begins to
price in deflation, recession and lower GDP. This
means that we could see this thing 10% lower at
a minimum by year end. If this happens the drops
will be dramatic and last for probably 6 to 9
months before we hit bottom and the Fed bailout
package takes hold. Then we begin on the road
to recovery as the economy reinflates.
do you do?
is great and everything always seems so clear
as you see the progression of how we got here.
Unfortunately, there is an old saying that no
one makes money in a bear market, not even bears.
question you must ask yourself now is what would
bother you most: missing a 10% rally to the
upside if you were completely out of the market
or if you stayed fully invested and the market
were to drop another 10%?
don't profess to know what will happen and have
gotten beat up like everyone else over the past
couple of months. I do have a feeling that it
will take sometime to purge the excesses out of
the system before we can enter the next great
bull market. Any make no mistake, we will recover
and move forward but it is going to require patience
and fortitude because we have a ways to go.
to keep your spirits up and don't dwell on the
negatives. There are a lot of folks out there
that are in much worse situations. And remember
that when the news is at its worst is when the
market will be bottoming and we will be on the
road to recovery.
see what the government unleashes this weekend
and how the market responds. I don't think that
either party wants to face what could happen if
they don't produce some solutions quickly!