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Posts Tagged ‘investments’

It isn’t hard to put a list together outlining the challenges that this country faces. Probably my top 3 on a list would be unemployment and the government’s inability to do anything about it, the trillions of dollars worth of debt not just here but all over the world, and then the foreclosure crisis.

What isn’t getting much attention is the problem that is lurking under the surface. It is also the one issue we want to keep under control. So far, the government had been able to manipulate interest rates to the point where they have been kept under control.

The picture above shows the 10 year treasury interest rate between 1962 and today. You can see how rates went real high during the 60’s and 70’s. Then in 1980, interest rates started to fall. For 30 years interest rates have fallen. In 2008, they hit the lowest level. As of late, it looks like rates could be heading back down to those levels. Currently, we are 20% above those low interest rate levels in 2008. Since April 10th of this year, the 10 year treasury rate has fallen -32%.

Remember that interest rates and the prices of bonds move in opposite directions. While interest rates are falling, bond prices are rising.

As I wrote in this article, my concern is that we have a huge bond bubble forming. A bubble occurs when everyone invests into some sort of investment because collectively they think that this is the best place to be. In this type of environment, investors just cannot get enough. They do it in such a large way that the price of the investment gets way out of line with its true value. At some point, the bubble bursts and prices come back down to their real value. Just think about what has happened to the prices of real estate after the real estate bubble popped.

Here are a few bubble facts for you:

Last year, 375 billion dollars was invested in bond funds. Between 1998 and 2008, 425 billion was invested in bond funds. In one year investors poured almost as much money in bond funds as they did the prior 10 years.

Last Friday, the Wall Street Journal reported that companies are on pace to have a record year in issuing junk bonds. Investors are flocking to the riskiest bonds issued because they can get higher interest rates or yields.

It looks like we are experiencing bond fever on Wall Street. The problem is that if the bubble bursts, then that means interest rates will soar. Soaring interest rates is the last thing that we need in a world plagued with debt. The Federal Reserve Board knows that and because of that fact have done everything humanly possible to manipulate the prices of government bonds. Let’s just hope that this grand experiment works.

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Being in the business of money management, you are almost held hostage to financial television. You have to watch a certain amount of it to catch breaking news. Besides the CNBC cheerleaders celebrating Dow 10,000, that level is nothing more than a round number with 4 zeros. Sorry, President Obama, it is neither a milestone nor evidence that your economic stimulus package is working. However, that was a nice sound bite this past week.

So the question arises why can’t I just acknowledge the bullish case and join in with the madness of the crowds? Well, it comes down to those pesky fundamentals. They represent reality and not the fantasy world where the politicians reside and everyone else that has skin in the game live. The reality is that the economic backdrop does not support what is occurring in the stock market. As I have written before, it is going to be quite the rude awakening when those lights come back on and the clean-up of the after party begins.

Every week we get more reality. Soon enough it is going to be tough for this market to block it out. Last week we received the latest on the foreclosure crisis. During the last 3 months, 937,840 people received a foreclosure letter. That means 1 in 136 homes were in foreclosure. That is also the worst 3 months on record. All of this is going on at the same time that the government has rolled out all types of programs to prevent this from happening. This of course is just one example of reality. The real estate markets cannot even begin to bottom and recover while this is occurring.

Potentially further the problem is the fact that we are starting the second wave of adjustable rate mortgage adjustments. The re-setting of adjustable rate mortgages are a main contributor to the foreclosure crisis. You can read about it here.

There is some good news. Yes, I did utter the words “good news”. Businesses are figuring out how to work in the new normal. Beyond some improvement in the economic numbers the only thing that has been positive has been the stock market. Banks are still not lending and consumers are still in lock down mode and unemployment is still at dangerous levels.

Even within that backdrop, businesses are figuring out how to start getting deals done and activity is picking up. So, I don’t think that we are going to find ourselves again in the economic meltdown where everything comes to a grinding halt. Businesses are figuring out how to navigate in our new normal. The strong businesses will become stronger. The bad business models will go away. Well, the ones that are not on government life support.

So, how do you handle this environment? It is standing advice. You watch the amount of risk that you are taking with your investments. Know the risk, be comfortable with the risk, and have a plan B in the event that we run into trouble again.

As for this week, watch corporate profits. Minus the earnings report for Alcoa, the market didn’t particularly care for many of these reports. The Dow should be heavily impacted (one way or another) as many of the Dow components report this week.

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 As an investment manager, I am constantly looking into the future and evaluating indicators to determine which investments make the most sense.  Since originally warning of the risk in stocks back in 2007, my indicators have not given any signs that the risk for being in the stock market has changed.  As long as the bear market is around, investors really need to be careful regarding the amount of money that is invested in stocks and stock-based mutual funds.

 

What has to change for stocks to be a prudent choice again?  Although there is a laundry list of reasons for investors to be cautious, one risk remains at the top of the list.  It has been the driving factor for the credit crisis.  Until we get past the foreclosure crisis, I believe this bear market will remain in control.

 

In the simplest of explanations, the foreclosure problem can be explained this way.  For years, the mortgage industry gave loans to people who could not afford them.  For example, Joe wants to buy a home.  He goes to the mortgage company and finds out he can qualify for up to a $100,000 home.  The mortgage company determines that loan amount by looking at Joe’s income and expenses.  Joe can afford the $1,000 a month mortgage. 

 

The mortgage industry thought that it would be a good idea to come up with loans other than a 30-year or 15-year mortgage.  With these new loans, that $1,000 a month payment would purchase a much bigger house.  In fact, it is possible that the $1,000 a month payment could buy a house valued at as much as $400,000.

 

In order to accomplish that magic number, the mortgage company had to make a few adjustments to the traditional loan.  First, they arranged it to where Joe just paid the interest for that month versus interest and principle.  This one little change made a big reduction in the amount that he had to pay. 

 

Second, they were able to give him an adjustable rate feature.  This gives Joe a much lower payment the first 3 years or so.  However, that rate adjusts after the first 3 years and the $1,000 goes up to $2,500 a month.  By then, the mortgage company rationalizes with Joe that he can simply refinance the mortgage and get the payment more manageable.

 

So, imagine millions of people just like Joe taking out adjustable rate mortgages and facing a higher mortgage payment in the future.  This is what has happened.  Millions of adjustable rate mortgages had a payment change and the consumer couldn’t afford the mortgage anymore.  They couldn’t refinance the home because the home was now “under water” or worth less than the mortgage.  This is what led to the foreclosure crisis. 

 

So, if we had hundreds of thousands of people facing higher payments in the year ahead, would it be reasonable to assume that we could have a high number of foreclosures? 

 

Well, this is what I wrote to my clients in 2007.  I showed the following graph which pointed out the billions of dollars of mortgages that were about to have higher monthly payments. You can see by this graph that during the first quarter of last year, the largest number of mortgages changed.  As a result, we had the beginning of the worst of the foreclosure crisis last year. 

   

 

Unfortunately, that was round 1 of the foreclosure crisis.  That graph only represented sub-prime mortgages.  Now, we have all of the other types of mortgages whose monthly payments will change coming due this year and into next year.

 

  

This graph shows that we are at the beginning of payment changes for mortgages that will not peak until 2011.  It looks like we will not be out of this problem until 2012. 

 

When you have waves of foreclosures, you have problems with the banking system and everything that is tied to those mortgages.  It gets much more complicated.  To make the problem more challenging, a good percentage of these homeowners owe more than the house is worth.  Look at the following percentages of homeowners with the various types of mortgages:

 

73% homeowners with Option Adjustable Rate Mortgages owe more than the value of the house.

50% homeowners with Sub-prime Mortgages owe more than the value of the house.

45% homeowners with Alt-A Mortgages owe more than the value of the house.

25% of Prime Mortgages owe more than the value of the house. 

 

Contrary to what the Government and Wall Street want you to believe, the risk is still extremely high for the economy and the stock market.  What has plagued the stock market is still the problem. 

 

So what is the bottom line for investors?  There are two things to consider.  First, make sure you understand the amount of risk that you are taking in your company 401(k) plans.  Remember the easiest way to define risk is by looking at the overall percentage of your plan that is invested in stock-based mutual funds or individual stocks.  Second, if your money is with a financial advisor, find out what their strategy is in the event that the bear market is not over.  If they have no strategy and instruct you to just “ride it out,” move your money to an advisor that can manage money in a bear market. 

 

It has never been more important to understand risk than today.

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In the book Manias, Panics, and Crashes:  A History of Financial Crises, Charles Kindleberger writes about the various financial panics that have occurred throughout the world over time.  There is one consistency that exists amongst all of the examples written about in the book.  There was always a lender of last resort.  The lender of last resort is the country that steps in and saves the country in crisis.  We have been the lender of last resort and we have needed a lender of last resort before.

 

Well, guess who the lender of last resort is in this financial crisis?  We are the lender of last resort for ourselves.  Yes, the Federal Reserve made it clear in their announcement last week that they were going to make available another trillion dollars or so to save the system.  That is just another trillion dollars on top of an estimated $14 trillion already committed.  We don’t talk in billions anymore.  Trillion is new billion.    

 

If no one else will step in to save us, we will just print our way out of this mess.  Bernanke is running a huge Ponzi scheme.

 

The Fed has just assured us that this problem will get even bigger.  Never in the history of mankind has this type of self prescribed bail-out EVER worked. Washington talks as if the economy will bottom out sometime early next year and we are off to the road to recovery.  Just like that – POOF – and the financial crisis and all of its trillions of dollars left in its wake will be just that OK.

 

For this reason, it is going to be dangerous being a buy and hold investor.  Although I do think that we have a very strong bear market rally that we may have already started or is on the horizon.  The primary market is a bear market where buy and hold investors will just give back anything that they made during the bear market rally.

 

You have 3 choices over the next however many years that we face this mess.  First, you can just go along with the ride and buy and hold.  This strategy will put you in harms way every time an irresponsible decision is made in Washington.  Second, you can just go to safety by placing the majority of your investments in safe investments.  I think that strategy is better than the first.  Third, you can learn to identify risk and develop a game plan for when to invest and when to be safe. 

 

Of course, that is the purpose of understanding price levels (which is the focus of the Prudent Money Outlook).  Last week the market failed to make it above a crucial price level and is obviously very leery of the politician’s game plan to be the lender of last resort.  I believe that the market is leery when President Obama goes on the tonight show where he just jokes and laughs while people are losing their jobs and homes.  Of course, he also has those weekly cocktail parties (Wednesday night Happy Hour) at the White House every week.  It is nice to throw weekly parties while the rest of the country is hurting.  Have you ever stopped to think that we are paying for those Wednesday night cocktail parties?

 

This morning, the market is opening up very favorably to the latest bail-out attempt announced by the US Treasury.  It will be important to see how the market holds up from here.   

 

So here we find ourselves watching these price levels again.  We are trying to figure out the following question – Is this the start of a meaningful bear market rally or is it a break in the selling and we are about to decline down to the S&P 500 price level of 600? 

 

The price levels to watch are 741 and 800 to 825.  Any price level below 741 is extremely bearish and would suggest a decline down to 600 and anything above 800 to 825 would indicate that we are in a very strong bear market rally that could stick around for a while. 

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Today on Prudent Money, I talked about how extremely important it was to reduce your risk when it comes to your investments.  You can listen here for the podcast.  I also didn’t even get to remotely cover the topic today as I would have liked.  So, I am working on a special paper on the subject which will go out this week in the Prudent Money Newsletter. 

Make sure that you sign up for the newsletter so that you will receive it in your inbox.

I want to stress that making sure you understand your risk in this environment is extremely important.  Unfortunately, the mutual fund industry scares you into believing that you should never change your investments and definately never sell stocks because you might miss out.  I want to make sure that you are looking at this the right way and not the way that the financial services industry wants you to view it (which makes them the most money).

The problems in this economy and financial markets are many and they run deep.  That is still the case after the Government has thrown billions of dollars of our money at the problem.  The problem is that the crisis just doesn’t go away.  AIG announced today that they will report a loss of $60 billion for LAST QUARTER.  They will need another $40 billion or so.  How about we continue to pump more of our money into a horrible business model?  After all, we are going to continue to keep propping up the car industry.

Finally, we are now proud owners of 40 to 50% of  Citigroup.  Throwing even more taxpayer money at this problem will probably not make this problem go away.

That was just Monday’s news!

So, we are not in just a normal cycle and you shouldn’t view your investments as if we are experiencing normal risk.

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