The recent events in the stock and bond markets drew everyone’s attention. No doubt you took a look at your investments and, perhaps, worried about one or two. Maybe, you made some changes to your portfolio. Let’s take a look at your experience and see if there are some lessons to be learned.

 

Did you lose sleep, literally or figuratively, over any of your investments?   This is the gut check measure of risk tolerance, not quantifiable, but accurate nonetheless. Investing is not an emotional decision, it takes hard work and discipline, but if you worry too much about an investment, it isn’t right for you. One of the hardest parts of investing is keeping your emotions out of it (i.e., taking a loss or selling your “favorite” mutual fund). Emotion will only cause you to buy at the market highs and sell at the lows. But, did your gut tell you to sell anything during the recent market correction? Rule number one of gut check investing is: if you lose sleep over an investment, it’s probably too risky for you. How do you know? This brings me to the second rule of gut check investing.

 

When making a decision to buy or sell a mutual fund, do your research.  Is it a sound fund? Does it meet your investment objectives? How would you feel about this investment if the market were headed in the opposite direction? Write down your reasons, put then in a drawer (or store them on your hard drive) and pull them out when you’re thinking about selling. The purpose of this exercise is to avoid being swept up in the euphoria of a bull market, and making too risky investments, or selling good investments, out of fear, during a market correction. Make your analytical decision, then ask yourself, factoring out the current market emotional climate, does it feel right? If you’re not comfortable, don’t buy the fund, or sell it, if you own it. This is the gut check buy/sell decision making process.  I want to emphasize the sequence.  Do your analytical work first, then sit back and see how you feel about it. The gut check buy/sell decision is a one-way process -- it can stop a buy, but it can’t stop a sell.

 

Sleep well. Sweat dreams.

Last week was the best week in the stock market since it reached its July peak. The market bobbed up and down along with its perception of the breath of the mortgage crisis. A $2 billion infusion into Countrywide rallied the market. When two mortgage lenders used the “R” word – recession – the market retreated. Then speculation the Fed will cut the key Fed Funds rate at its September 28^th meeting took hold and the market rallied.

 

What to expect this week? A quiet market. There will be a lot of nervous brokers sitting on the beach checking their Blackberrys. (Labor Day week expect to see a surge of Blackberrys in for repair due to sand damage.)  It’s going to take some time for the mortgage market (lenders and buyers of securitized mortgage products) to return to normal. Lending standards will be tighter, especially for subprime mortgages. The related problems in the debt market – private equity/LBO buyout financing, liquidity for securitized debt of all types (mortgages, loans, etc.) are continuing to sort themselves out.  Lenders and buyers of debt (investors) have to become confident that credit spreads are not going to widen further, and their contra party is solvent, for liquidity to return and the current problems to recede. 

 

While the debt markets seek their new equilibrium, investors will continue to speculate on the likelihood of a Fed Funds rate cut. I think the market will be disappointed on September 18^th. The Fed won’t cut rates because the economy is strong, except for the housing sector. Corporate earnings, ex-housing, are meeting or beating expectations and industrial production is solid, driven by global growth. Although consumer spending remains a question mark, international demand is taking up the slack. All-in-all this looks like a normal later stage economic cycle.

 

The market turmoil of the past few weeks has presented some investment opportunities. (The best opportunities present themselves during times of uncertainty.) International mutual funds have been hit hard. Many good funds are down 10% from their peak.  International growth continues to be strong. If you haven’t diversified your portfolio internationally, now’s a good time. Big Cap US mutual funds also should do well. The companies they invest in have significant overseas exposure. (See for World Stock Funds and Large Growth Funds for ideas.)

 

For the money market and CD investor, some interesting opportunities have presented themselves. Countrywide’s bank, for example, is offering savings accounts with 5.5% interest and one year CDs at 5.65%. Both are FDIC insured, up to the regulatory maximum. Other mortgage lenders are, or own, banks. If you shop around on-line you can find some very attractive yields on money market type instruments. Just remember to make sure they’re Federally insured.

There’s an old adage in the brokerage community that you should speculate for growth, not for income. Speculation isn’t the right word, but the broker who coined it (pun intended) probably wasn’t an English major (most brokers aren’t). The point is that you should take risk with investments which you expect to increase in value, i.e., stocks, but not with investments made to generate current income, i.e., fixed income securities. This is an essential maxim if you are dependent on that income. 

 

Greater income (return), always entails greater risk. It’s the way the world works. One rule of thumb is to compare your investment to others in the same class.   There’s a reason a money market fund has a higher yield than its peers – it’s taking more risk. The same is true for any bond fund. A second rule of thumb is to stick with quality.  Buy funds which invest in government securities or investment grade bonds. If you invest in long term bond funds, they will fluctuate in price due to changes in interest rates, credit spreads and the yield curve, but you will not run the risk of serious loss of income or principal. Anyone who stuck to investment grade bonds came through the recent/continuing mortgage debacle relatively unscathed. If you owned funds invested in US Treasures, you actually made money.   

 

Funds that invest in bank loans, junk bonds, and other low-rated or unrated debt instruments, or employ leverage to enhance their returns (see Leverage Land Mines) are too risky for the average investor. These investments need to be watched and analyzed similar to your equity investments and are not for investors who need a reliable income stream.

 

The above rules of thumb apply to equities as well as to debt. There are many dividend paying stocks which are relatively safe, and a portfolio of these would be safer than, for example, a portfolio of subprime mortgages.  I’ve been watching a mortgage REIT with a 20% current yield. It doesn’t have subprime exposure, has taken its write-downs and appears to have good liquidity. Good investment? Maybe, but I’d buy it because I thought the stock would appreciate as the mortgage market returns to normal. I wouldn’t buy it for its dividend.  I expect the dividend will be cut because no stock can yield 20% for long. Carry this thought through to the equity income funds you own or are considering and remember: the higher the current income, the greater the risk that it’s unlikely to continue.

 

“Speculate” might not be the right word when talking about reaching for income, but it gets the point across. Take your risks in the stock market and don’t stretch for higher income because you might end up with none.

 

Actually it was a dapper middle aged male with a neatly trimmed beard who spoke. When the Fed chief cut the discount rate Friday morning, the market breathed a sigh of relief.  The implication is that Fed will take additional action, if necessary.  The liquidity crisis will be contained. Earlier last week, the major averages retreated 10% from their July highs (and all-time highs for the DJIA and S&P 500), an “official” market correction.

 

The market may bump along for a while, September and October are typically the worst months of the year for the market (although this was not true in 2006). High volatility will be the norm and the market may well test the lows it reached last week, but there will not be another leg down. We should expect more bad news from hedge funds and other participants in the junk mortgage and securitization markets but the damage will be limited to those players and will not drag down the rest of the market.

 

Corporate earnings, except for financial companies that operate in the effected parts of the credit market, have continued to come through. Morgan Stanley’s current estimate for S&P earnings growth for 2007 and 2008 is 8.6% and 11.6%, respectively. (The consensus is for greater earnings growth in 2008.)

 

Won’t the slowdown in the housing and mortgage markets drag down earnings growth, you ask? Let’s look back at the late 1980s. The S&L industry was shut down due to insolvency brought about by bad real estate loans. Remember the RTC? The damage to the banking system was greater and more direct then, than now. (There is a difference between a hedge fund, and a Federally insured savings institution, becoming insolvent.) The economy grew in the ‘80s, despite the problems in the banking system, and it will continue to grow in 2007 and 2008 as long as the housing market does not materially weaken.

 

The stock market was not overvalued (at least not by much) at its July peak. To be conservative, let’s suppose that the market was fairly value at the beginning of the year (See Earnings Matter). Assuming a constant P/E ratio and Morgan Stanley’s earnings estimates, sometime next year the S&P 500 should reach 1,700 and the Dow should reach 15,000. My caveats to this prediction are to continue watching new jobs creation and retail sales. A downturn in either could be a precursor to a recession and the market will react accordingly.

 

It’s time to rebalance your mutual fund portfolio. Those of you who rebalanced into Treasuries in July are particularly fortunate. Now you should rebalance back into equities.

The stock market is gyrating like a yoyo, and with each down stroke it’s heading lower. What’s an investor to do? Let’s start by dissecting the cause – it’s not as simple as a slowdown in housing or defaults in the subprime market, and these are unrelated (for the most part) events.

 

The housing market was headed for a correction regardless of the events taking place in the subprime market. New home starts were running at twice the historical average during 2003 – 2006. Granted, some of this was fueled by a relaxation (or abandoning) of underwriting standards in the subprime market but it also was the culmination of aging baby boomers buying second homes, low interest rates, and a strong economy.   Speculators in areas such as southern Florida and easy credit just pushed it over the edge. We would be in a housing slowdown regardless of the subprime problem, although this will exacerbate it, and a weak housing market will continue at least through 2008. Investors: avoid homebuilders.

Mortgage lenders and financial companies in related businesses generally are leveraged and, in many cases, rely on short term debt to finance their operation. The concerns over the creditworthiness of their businesses, not the level of defaults in the subprime market, have caused much of their funding to disappear. This is the biggest risk for many finance companies. All finance companies are paying the piper for problems in the subprime market - lax underwriting standards and mortgage obligations that borrowers can’t meet.  This problem was not caused by rising interest rates. Interest rates have gone up very little over the past year. The problem was artificially low teaser rates, the ability to skip payments, interest-only payments for a period of time and other contractual mechanisms which induced (or seduced) buyers to take on a bigger mortgage than they could afford. Do your homework in this sector to determine which companies have funding problems, subprime and related mortgage exposure, and which don’t. It’s not obvious. These problems will take a good year to sort out and companies will be destroyed or seriously damaged in the process. Investors: Avoid originators, servicers, buyers/holders of paper, fixed income funds, and mortgage REITs which are highly leveraged or focus on the subprime mortgage market.

 

Banks generally hold some, but not a significant amount of, subprime mortgages relative to their total portfolio. The bigger risk for certain money center banks is their exposure to bridge loans and take-out financing guarantees for the many billions of dollars of private equity deals that are pending. The hit the banks took on the Chrysler deal is a good example. This problem will work itself out by the end of the year. Banks with private equity financing exposure could have one or two bad quarters. Banks without this exposure will do fine. Investors: Buy banks without big private equity exposure now. Wait one or two quarters to buy banks with exposure to private equity. 

 

Brokerage houses generally have subprime and private equity exposure, as discussed above. Investors: Give them one or two quarters to sort out their problems before you buy.

 

Mutual fund managers, investment advisors, and REITs that own income producing have little or no subprime exposure (again, do your homework on the specific investment to make sure). These stocks have taken a hit. Investors: Buy now.

 

Mutual fund investors: review the holdings in your funds and make the appropriate adjustments.

It’s hard to believe, but the Dow, S&P and NASDAQ all closed up for the week. Friday was a roller coaster day in the markets and, as they gyrated up and down, it was too close to call as to whether the indices would finish the week plus or minus. 

 

The Europeans are taking our credit problems more seriously than are we, witness the downward movements on their stock exchanges and the amount of liquidity the European Central Bank poured into the system. The fact that Europe is effected by our mortgage and securitization problems demonstrates the interconnectivity of world financial markets.

 

The Fed injected funds into the US financial system. (The Fed is acting responsibly, notwithstanding what Jim Cramer says. As much as I respect Jim, the Fed has no obligation to bail out hedge funds or attempt to eliminate – which it couldn’t do anyway – market corrections.) The Fed is essentially providing liquidity to the overnight financing market. These internments, Repos, will rollover again at the beginning of this week. If the market calms and the Fed can withdraw its excess liquidity, then the current stock market correction should be over. If the credit markets remain so illiquid that the Fed has to be the lender of last resort, then the stock market has another 2%-3% decline in store, along with continued high volatility. 

 

Speaking of stores, last week’s retail sales numbers were disappointing, particularly for chains catering to teenagers.  When have you known teenagers to curb their spending? One month’s data doesn’t make a trend, but we should add retail sales to new jobs creation for clues as to whether the economy will keep growing or slip into a recession (and the stock market declines another 10%). 

 

Right now, let’s wait to see what the Fed has to do this week before we declare the correction to have run its course.

Income is hard to come by these days. Treasuries are yielding less than 5%. The bond market is in disarray, credit spreads are widening (meaning the price of existing bonds is declining) and there are serious liquidity issues (which also impact value). 

 

Have you considered Real Estate funds? Many have current yields in the 5 - 8% range (primarily REIT – Real Estate Investment Trust – funds).  Now, let’s be clear on this. These are equity funds and equity funds carry greater risk, and have greater volatility, than bond funds. (Of course, investors in subprime mortgage funds have found out that debt funds are not without risk!)  However, equity funds also offer the potential for increasing income and capital appreciation (see Too Much Income can be Hazardous for Your Heath).

 

Real Estate funds cover a lot of territory and you want to make sure you know how your fund invests.   I went to the MUTUALdecision Top Ten Real Estate funds list and selected two: CGM Realty and Cohen & Steers Realty Focus I (Cohen & Steers are the godfathers of real estate funds).  Take a look at their holdings. CGM’s biggest holdings include two international mining companies, two real estate brokerage companies and one REIT. The Cohen & Steers fund’s largest holdings are all US REITs. Both are excellent funds but they have very different investment strategies. CGM is more capital appreciation oriented where as Cohen & Steers is more income oriented. The moral to this story is that you have to drill down into a funds’ portfolio to make sure it’s right for you. (In addition to looking at the stocks it owns, be sure to check for leverage, see Leverage Land Mines.)

 

Income oriented investors should focus on REIT funds (although, I'd aviod funds that hold mortgages right now).  REIT stocks, in general, have declined more in price during the current market correction than has the Dow or S&P 500. Some argue that REIT stocks were overvalued. Whether or not that was true, many high quality REITs are now yielding in excess of Treasuries.  Historically, this has been a good entry point.  Of course, many high quality REITs are still yielding in the 2 – 4% range, so the correction in the REIT market may not be over. And, one of the drivers of REIT stock prices – buyouts by private equity firms – may be ending.  (For more information on REIT funds see Real Estate Funds are in a Class of Their Own.)

 

On balance, though, this appears to be a good time for income oriented investors to own REIT funds.  Pick a good fund and you’ll get high current income and an investment whose value and income stream will increase over time.

 

Last week was another down week for the stock market, attributed to problems in the subprime sector rippling through the debt market. The jobs report also was a disappointment. The Dow, S&P 500, and NASDAQ are down 5.8%, 7.7% and 7.7%, respectively, from their July peak (all-time highs for the Dow and S&P). These declines exceed the February – March correction and they should because they’re reflecting more serious problems (the Feb. – Mar. adjustment was a reaction to a pullback in the Chinese market).

 

What to expect this week?   More of the same. Subprime is finally getting the attention it deserves (even though the problem has been around for months). The market for securitizations is shaky (and all loans, not just subprime mortgages, are packaged and resold in securitized form). The big question is what will the Fed do when it meets on Tuesday? Answer: leave rates unchanged. This will be a disappointment for some and force others to accept reality – the debt market troubles and jobs report are within the bounds of normal economic variations and the Fed won’t (nor should it try to) react to small bumps in the road. 

 

The market will work its way lower this week approaching a10% decline from its July peak.  This works out to: Dow 12,600, S&P 1,400, NASDAQ 2,450. (10% is the average correction in a bull market, then it starts heading higher.) The question is: will this be a gradual process (i.e., 100 and 200 point down days) or will we have capitulation and a 500 point down day on the Dow and similar declines on the other indices (and a possible overcorrection and buying opportunity)?

 

There are two risks to the bull market correction scenario:  1. Problems in the debt market become worse – more Bear Stearns-type funds go under or the securitization market shuts down.  2. The new job creation index continues to weaken, because of more layoffs in the home building industry. If either of these events occur, we’ll be facing a possible recession and a 20% market decline.

 

The new jobs created/employment question will take weeks to unfold, and the problems in the debt market appear to be contained, so I’m betting on a 10% correction right now.

One of the mantras of mutual fund investing is to look at a fund’s turnover before you buy it. The implication is that a high turnover is bad. (Turnover is the percentage of a fund’s holdings that are traded during a year. Funds can have a turnover greater than 100%, which means that their average holding period per investment is less than one year.) Many mutual fund screening tools have portfolio turnover as one of their filters and you can usually find a fund’s turnover (expressed as a percentage) on the fund’s snapshot page or by doing a little digging on the fund’s website.  

 

Here’s the first argument as to why turnover is bad. Higher turnover results in higher expenses because of higher transaction costs. This is true both for stock and bond funds, although turnover is even more relevant for bond funds. Why?  Transaction costs are greater and trading spreads are wider for bonds (except for US Treasuries) than for stocks.  And, the upside potential of a bond or bond fund is limited, as compared to a stock or stock fund, particularly for short maturities and high quality, so transaction costs have a greater impact on returns.

 

Tax inefficiency is the second argument as to why an investor should avoid mutual funds with a high turnover. If you hold your mutual fund in a taxable account, rather than in a tax-deferred account such as a 401-K or IRA, the fund’s taxable gains (and losses) are taxed to you in the year they occur. The higher the turnover the greater the likelihood that these gains will be short-term and you will be taxed accordingly.

 

I’ll add my own reason to look at turnover. Just like the kid who couldn’t sit still in school, higher than average turnover might suggest a nervousness or lack of conviction on the part of the fund manager. Portfolio turnover varies by asset class. For example, small cap growth stock funds generally will have higher turnover than big cap value funds. So, turnover is somewhat relative. Some fund screeners allow you to sort for funds with turnover equal to the average for a particular fund type or you can look at the turnover ratios for funds within the same group and estimate what’s the norm. Unless your fund’s turnover is much greater than its peers, you shouldn’t worry. 

 

High turnover is bad, right? Wrong. For two reasons. The turnover expense is part of a fund’s overall expense and all funds are required to disclose their expense ratios. (A fund’s expense ratio is another sort in most fund screens and appears in its snapshot, oftentimes very near its turnover.) Unless a fund creates a lot of unwanted taxable income for you, its total expenses are of greater concern than its turnover, and a fund’s expense ratio pales in importance when compared to its return (see Calories Don’t Count). Once you’ve set your risk level, the best investment is the fund with the highest return, even if it has a higher turnover or higher expense ratio than its peers.

 

Return always comes first. Don’t forget its after-tax return. So buy mutual funds with the highest returns consistent with your risk level and investment objective, and consider putting those funds with high turnover in your tax-deferred account.