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.

The Dow and the S&P are touching record highs. Not even the specter of rising interest rates can dampen this market. The last downturn in the market occurred in February and there was just a pause for it to catch its breath and run to record highs. Isn’t life wonderful?

 

Well, life isn’t so good if your mortgage lender is foreclosing on you and home foreclosures are rising. Take a look at Home Foreclosures Hit Fresh High which appeared in Friday’s Wall Street Journal. Deficiencies are on the rise and almost at levels last seen in the 2001 – 2002 recession. You’d expect foreclosures to be high during a recession, but not when the economy is growing. Even more ominous is the value of the collateral backing the mortgage. Home prices rose steadily from 2002 through 2005. Real estate was the place to be. Families moved into bigger homes (with bigger mortgages) and investors bought (speculated in) residential real estate. Those who stayed put refinanced, taking out money (and increasing their mortgage payments), as the value of their home increased. 

 

The State of the Nation’s Housing, a study released on June 11 by Harvard University’s Joint Center for Housing Studies, forecasts that home values will continue to decline over the next year. If the Harvard study is correct, more homeowners will find they have no (or negative) equity in their homes, giving them little incentive to continue making their mortgage payments. If interest rates rise, homeowners with adjustable-rate mortgages may not be able to make their payments, even if they want to keep their home. 

 

Beyond the human tragedy, voluntary or involuntary real estate foreclosures are bad for the economy and the stock market. So, as I’ve said before, use the strong stock market to re-balance your mutual fund investments. And, watch the riskiness of your investments. Don’t let a rising market lull you into taking too much risk.