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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