A Mid-Quarter Briefing From Clarus Financial
In Wall Street the only thing that’s hard to explain is next week.
- Louis Rukeyser
Summer 2007
As I have spoken with some of you over the past few weeks, the topics of the markets recent volatility and subprime mortgages have come up in conversation. So, I thought it would be good to communicate to all of you about these events. In that light, I have some observations about two speeches from government officials on the last day of August, comments on the market’s volatility and for those wanting to know more detail; a few bullet points about “subprime” mortgages.
First, in an encouraging sign last Friday, both the President and Fed Chief Bernanke gave speeches addressing these very issues. President Bush’s proposal to use the FHA to help some borrowers avoid home loan defaults was an uplift to the markets. While largely a symbolic move, I believe it will help keep Congress from rushing in with massive amounts of our money to bail out questionable lending practices – a good thing in my opinion.
The second speech, from Uncle Ben (Bernanke), also lifted the markets due to his acknowledgement that the credit crisis may have a broader impact on the economy, which the Fed would keep in mind relative to future monetary policy. It was his other statement however, that caught my ear. He said “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.” Spoken like a true free market capitalist, his statement reminds everyone that underneath all the negative and voluminous news rests the American experiment – a free people exercising their liberties in a land teaming with opportunity. Sometimes when the envelope of those liberties is pushed beyond its natural limits, the markets will efficiently and sometimes violently step in and remove the excesses.
The markets fell in August, right? At least that’s what the tone of the financial news would lead you to believe. In fact, with the exception of a 1.81% loss in foreign stocks1, US stocks were up 1.44% and are up close to 5% for the year.2 Surprisingly, US bonds were also up 1.23% in August, with the exception of muni bonds slight loss of 0.43%.3 June and July were negative months though as traders looked at the uncertainty of the impact of sub prime mortgages, a credit crunch and the implosion of the housing bubble. Wall Street dislikes uncertainty and as some certainty about short term impacts to the economy evolved in late August; Mr. Market had some very large daily point gains.
These large market movements, both up and down, were the second topic many of you asked me about recently. It is true that markets do not go up in a straight line and that there have been periods known as bear markets, where declines of over 20% occur. (The most recent was from 2000 – 2002.) But the volatility experienced lately is at its highest level since Sept. 11, 2001 – right in the middle of that last bear market. This is a period of readjustment that may take some time to work through and a time where professional traders can be profitable. It is not a time for making significant changes to your investment plans based on reactions to recent events. We have been “looking under the hood” however, to determine if there have been any funds and managers with significant exposure to the subprime market in general and making changes where appropriate for you.
No one knows how this will shake out and that the present isn’t exactly like any event in the past, but as markets fully assess the impact of subprime defaults and future adjustable rate mortgage (ARMs) rate resets, they will revert to responding to corporate earnings and GDP more than reacting to the daily headlines. Generally speaking, GDP and earnings are doing pretty well as evidenced by July’s GDP number being revised upwards from 3.4% to 4.0%. That piece of good news barely received a head nod by the talking heads on CNBC – shocking.
Finally, for those of you who are dying to know exactly what a subprime mortgage is and why they are affecting the markets, I offer the following bullet points:4
What is the subprime mortgage market?
- A subprime mortgage is generally characterized as a loan to borrowers who have tarnished credit profiles as primarily determined through evaluation of the borrower’s FICO score, which is used to assess creditworthiness.
- Subprime loans currently account for approximately 12% of the outstanding securitized mortgage market.
- The primary product used in the subprime loan is the adjustable rate mortgage. With an introductory low rate for an initial fixed period, these mortgages allow the borrower to qualify for the loan based on lower monthly payments. In a period of rising interest rates such as we are currently experiencing, payments can rise considerably once the fixed term expires.
Why is this affecting the markets?
- Until recently, subprime loans were a favorite of money managers given their relatively high degree of return, investment grade credit rating and previously strong fundamentals. As defaults increase, and the credit rating and strong fundamentals deteriorate, there is a scramble to rid portfolios of these securities.
- Companies at risk include those who issued the loans, but also thousands of companies who purchased pools holding subprime paper to meet their cash requirements.
- The markets are reacting by tightening credit, which could lead to slowing economic growth, which could adversely affect the market.
Labor Day weekend marks the un-official end of summer and Wall Street’s return to work in full force. September and October, however have been historically weak months, so we may be in for more volatility. I believe as certainty continues to develop about the effect of subprime on the economy, the focus will shift back to fundamentals like corporate earnings and overall growth. If earnings are strong and forecasts are good for future results, we might yet see the year end positively. As Lou Rukeyser used to say in closing his show, “As always, no promises from the management.”
Please feel free to call us if you have any questions about this letter or if there is anything else we might help you with.
Sincerely,
Greg Busch, CFP
Clarus Financial, LLC
2August 2007 total return as measured by the Russell 3000 broad market index
3August 2007 total return data from Lehman Brothers Global Family of Indicies 4Data from SEI Investments Management Company Aug. 28,2007
This newsletter and the ideas expressed herein are my own and is provided for informational purposes only, and does not constitute an offer or solicitation to buy or sell any security discussed herein.
Information and any statistical data contained herein is obtained from other sources which we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. All opinions expressed and data provided herein are subject to change without notice.
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