Wednesday, September 12, 2007

The Credit Crunch and the Stock Investor (You)

The past four weeks have been a doozy. No sooner did the Dow set an all-time record on July 19 above 14,000 than the markets went into a volatile tailspin. The Dow has had several days of 200-300 point moves. Overall the market is down about 6%-7% in the month since July 19.

Whats the best thing to do right now?

First, the background facts:

The tailspin was begun by sub-prime mortgage lending. Many such loans were defaulted. It is fair to say that the mortgage market went into a bubble, and that the bubble is now deflating or collapsing.

The sub-prime mortgage mess began a chain reaction that spread through the credit markets and out into the stock market.

(1) Sub-prime mortgages were bundled into packages (securitized) and sold to hedge funds, banks, and other investors. Hedge funds and financial investors not only purchased these securities, but did so with high leverage: As much as 70% (or more) debt. As mortgagors defaulted on loans, the collateral supporting the mortgage-backed securities collapsed.

(2) Thousands of variable-rate mortgages will reset to higher interest rates over the next few years. As they reset, more owners will default.

(3) The difficulties in mortgages spread to other credit markets. Bank loans to hedge funds were themselves sub-prime, although nobody called them that. Several hedge funds ran into debt crises of their own, and others will follow.

(4) The countrys largest mortgage lender, Countrywide Financial, veered near bankruptcy until it tapped a massive credit line to stay in business. Smaller lenders have failed. Some others will fail, including possibly Countrywide itself.

(5) The problem has spilled over into the stock market via several paths.
(a) Margin calls have gone out. Forced to raise cash, hedge funds and others have been forced to sell stocks.
(b) Many investors have panicked, pulling their money out of the stock market. Financial stocks have been particularly hard hit.
(c) Private equity deals are grinding to a halt, as the money to finance them becomes unavailable. Private buy-outs helped fuel the market run-up earlier in the year. That propulsion is over.

National banks around the world have been injecting massive amounts of money into the financial system to stave off panic and illiquidity. The Fed has done so several times.

On Friday August 17, the Fed surprised by lowering its discount rate (for direct loans to banks) by 0.5% to 5.75%, which is another way of adding money to the economy.

But so far, the Fed has not lowered the Federal Funds rate, the one that impacts most other interest rates and serves as a benchmark for millions of consumer and business loans. The Fed has kept that rate at 5.25% for over a year. Many economists are expecting the Fed to lower the Federal Funds rate to further ease the economy. But the Fed has been reluctant to touch it, as it tries to keep inflation to about 2% or less.

Pundits, economists, and investors are split about the big-picture importance of the credit crunch. (1) Some maintain a not too worried stance, pointing out that the mortgage market is a tiny fraction of GDP, and that even in a worst-case scenario of massive defaults, the economic impact will be smallmuch less than the savings-and-loan crisis of the 1980s. They feel that the markets will work the problems out on their own. (2) Others feel that the crisis is going to get much worse, last much longer, and affect a wide swath of the economy. They say that we dont yet know the depth of the crisis, how many huge sub-prime loans banks have in their portfolios, how tight credit may really get as lenders pull in their horns, nor how the entire economy is going to be affected.

Many stocks of excellent companies, because of the downturn, are at their lowest valuations in years.

Economic fundamentals are fine. The just-ending earnings season showed strong results. Many excellent companies are doing well, growing in a healthy fashion, depend little on debt, and have no weaknesses on their balance sheets.

What does this all mean to the average individual investor? Is it time to be greedy or fearful? Is it time to protect against further losses by selling stocks, or is it time to purchase first-class companies at rock-bottom prices? Are the past few weeks the beginning of a bear market, or just a correction? Will the Fed ride to the rescue with the right moves, or will they screw it up?

For the stock investor, what are the risks right now? Id say these are the top three:

1.The credit problem, already a crisis, may turn into a catastrophe. There are undoubtedly many dangerous loans out there that we dont know about yet, and the credit markets may seize up for many months.

2.The economy will tip into recession. Companies will fall not only in stock price but in actual performance.

3.The Fed will make the wrong moves, or it will wait too long to make the right moves.

Risks usually have counterparts: potential rewards. The top three most likely opportunities:

1.The worst of the credit crunch is already over. The credit machinery of the economy will emerge stronger, as lenders reinstitute old-fashioned sound lending standards, to the long-run benefit of all.

2.The Fed will make the right moves at the right times. The economy will continue growing. There will be no recession.

3.Investors will take advantage of the bargain prices in stocks, accepting inevitable short-term volatility for a while until the market settles down. They will do this believing that in a few months or a year, the market will return the prices of excellent companies to rational levels.

I believe that the second listthe list of opportunitiesis more likely to occur than the first list, although that is certainly not a slam dunk. Reasons:

Investors are likely to recognize that the credit crisis is ultimately limited in size, and that overall the economy is in good shape.

The low valuations on many excellent companies will prove compelling and prevail over the fear that the credit crisis will ruin the economy.

By its injections of money into the economy and by its rate-lowering action, the Fed has signaled recognition of the importance of maintaining real liquidity in the economy and the markets.

The credit crunch is already reversing, what with the Feds action Friday, the shuttering of some hedge funds with the worst difficulties, the reinstitution by banks of more traditional and conservative lending standards, and so on.

Heres what we are likely to see over the next six months:

More revelations of serious credit problems in various areas.

More hedge funds will collapse. Some banks and financial institutions will be revealed to have more exposure to worthless credit assets than previously thought. The stocks of these companies will fare poorly.

Commercial and consumer lending standards will become tighter. Cash-rich companies (who have no need for credit) will benefit in comparison to companies which need debt to operate.

Investor sentiment will yo-yo as different revelations come to light. Therefore, the stock market will remain very volatile for a while longer. Up and down days of 200+ points on the Dow will be fairly common.

The Fed may or may not lower the Federal Funds rate. They will continue to take other actions to insure liquidity in the economy.

Investors will be all over the map on whether this is a time to be fearful or greedy, but on balance, the tilt will be towards seeing this as a buying opportunity. As a result, the stock market will be higher in six months than it is now, perhaps back to its July 19 level if not higher.

Action steps:

1.To the extent you have cash to invest, look for excellent companies with strong balance sheets.

2.If you use sell stops, either set them wider than normal, or dont set them at all, putting your faith instead in the foregoing analysis. The wider sell-stops will allow room for volatility.

3.Because the conclusions above are not slam dunks, limit your stock investments to or 2/3 of your available stock money. Neither be fully invested nor flee the market.

Dave Van Knapp is the author of Sensible Stock Investing: How to Pick, Value, and Manage Stocks. Click on this link to go directly to the book's page on . Or click on this link to learn more about the book and its sytematic approach to investing specifically designed for individual investors: