Subprime / Market Update

SeanInsights

As you might expect, the last month’s accelerating market decline has generated a few client inquiries, but surprisingly few considering the ever-banging media drum of doom-and-gloom. I imagine that if the market continues its slide, there will be more calls yet (which I’m always happy to take!), but still I thought I would try to address a few of the questions proactively.

The three questions I have already heard a few times have been:

1. What is going on?

2. Am I worried yet?

3. Should we make any changes?

What is going on?

At its core, the issue is that too many lenders were making loans to too many people who never would have qualified for a mortgage under traditional requirements. These were risky loans at best, and there has been a fair amount of ink spilled over the last year or two about the increasing default rate of borrowers unable to keep up with their (often adjustable rate) mortgages. Making matters worse, these loans were packaged (and re-packaged) into what are called mortgage backed securities (MBSs), often and reassuringly highly rated by the major bond ratings agencies, and were bought and sold (on a leveraged basis) by many large hedge funds.

As it has become apparent that many borrowers won’t be able to pay back the loans, everyone wants out (i.e., to sell the loan packages), but no one wants to buy. As a result, the large holders of these subprime loan packages (often hedge funds and other big institutional investors) have recorded huge losses, and many of the lending firms that originated the loans (like Countrywide) are now also in a cash flow bind due the decreased credit availability and due to having, in some cases, accepted back at a loss the MBSs they had originated. All of this has had two effects: first, it has reduced the amount of credit available in the world markets for continued loan making, which is important for liquidity and ongoing economic activity, and secondly, it has raised concerns about a resulting economic slow down and its effect on stock market valuations. Since markets abhor uncertainty more than anything, and how much of an effect this will ultimately have is unclear, the markets are reacting as they are, which is quite negatively, and probably as much, if not more, based on fear as on a solid empirical basis.

So that’s the “what’s happening” part. (Two editorial asides: Editorial aside #1: In many respects, at a macro level, this is very similar to the tech bubble of the late ’90s in that it’s a very good illustration of too much money floating around being put to questionable use. In the late ’90s, people were just throwing money at any company that had “.com” after its name and the resulting bubble eventually popped. This time around, too much liquidity – partially the Fed’s fault, I think – found its way into the hands of people willing to make bad lending bets with it, and what is happening now is a result of that. Editorial aside #2: I’m already hearing the plaintive wails of politicians wanting an inquisition into “how this happened and how we’ll prevent it from happening again.” I think these are the probably the same politicians who, less than 10 years ago, decried the strict and “unfair” lending requirements that prevented less-than-qualified borrows from buying homes. Hmmm, political inconsistency – now, there’s a surprise.)

Am I worried yet?

I am not worried about the market events at all, except to the degree they may invite some short-term focused clients to make a bad decision along the way. Even with this week’s market movement and the weeks that have preceded it, the Dow (and probably most client account values) are just back to where they were earlier this year. So, as it stands now, we’ve given back the last several months’ worth of meteoric, and perhaps, unsubstantiated gains, but the year-to-date returns for most client accounts and the markets are essentially flat for the year (and very positive over the last two, three, and four years). Over the last several years, the equity markets have, by and large, gone straight up, and there’s been almost no downward volatility, which makes the last three weeks all the more unnerving for many. In five year stretches where the markets have zoomed practically straight up, people often forget that the market can and does go down.

I think it’s possible, if not likely, that this gets uglier before it gets better, but I’ve never been one to focus on one month, one quarter, or even one year returns and projections. Instead, I focus on a three-to-five year windows of time, knowing full well with every client and every portfolio that there will be a worst case year along the way. Doing so usually prevents piling into hot asset classes at the worst time and also prevents bailing out at the bottom. I know there are going to be years when clients are upside down in their accounts to the tune of 15% – 35% (yes, 15 – 35%!) but I don’t take those any more seriously (except for the psychological pain they may cause you and my other clients) than I do the run-ups of 15 or 35% that markets occasionally provide (and have provided over the last several years). If only investing was a one-way street!

It’s also worth keeping in mind that, on average, the market has gone down about 20% or so every 5 years for some catastrophe-du-jour – that is just an inextricable part of the investing “experience”. Over reasonably long periods of time, however, the market has delivered positive returns, and I don’t see any reason to believe that that won’t be the case going forward. [In the middle of market turmoil, I think that worrying things will never get better is a little like worrying that the sun won’t come out again because it’s been cloudy all week – eventually there will be a day when the sun doesn’t come up, but I don’t think any of us will be here to see it.]

What should I do?

With all of the above said, I know it’s difficult to sit on the sidelines and watch a train wreck unfold, although in half of the would-be train wrecks — even those that appear to be mid-crash — they often never fully materialize and/or are quickly recovered from, and so my philosophy and my general approach is to calmly take the bad with the good, knowing that over-time, the ups always have, and always will, I believe, trump the downs.

I have never had a client hurt over the long term by staying with a well thought out, well diversified portfolio as you and almost all of my clients have even when the markets have gone through dramatic declines as they did in 2000 – 2001. Those who have stayed put and allowed the markets to do what they do, which is go up, then down, and so on, have faired well. However, I have had several clients who have jumped out, at either the wrong time, or jumped out at the right time but not gotten back in at the right time, who have really shot themselves in the foot, in some cases costing themselves tens, or hundreds, of thousands of dollars.

Also . . . and this is very important, remember that for those early in retirement or approaching retirement – you probably have a retirement investment horizon as long as, or perhaps longer than, the amount of time you spent accumulating all the money you now have. So, try to avoid making “one-year decisions” with what is essentially 20- and 30-year money.

And so, in the end, I have not made (and will not be making) any changes to my personal allocation as result of these gyrations, do not recommend any changes to yours, and I remember, as I hope you will, that for broadly diversified portfolios, what goes up will always go down, and historically has always gone back up again.

As always, I am more than happy to talk through all of this with you, if that would be helpful. Please don’t hesitate to call just to talk or if there is any way I can be of service.