October Newsletter

Economic Reality, understanding what is happening and the effect on your investments.

A Quick primer on credit, securitization and derivatives:

Obviously, credit and mortgage issues have become household talk now, but I thought it would be helpful to explain a bit more about the underlying issues.

To begin with we all realize that coming out of the dot com bust of 2002 the economy needed a boost. To help things the Fed lowered rates and kept them low for many years to ignite the economy. Cheap money led to easy mortgages, credit card loans, home equity loans and business loans. We became a "credit" driven nation. And why not? With low interest mortgages and 0% credit card rates it seemed like a no brainer to take the money.

As with any bubble it eventually ends and make no mistake the credit expansion in this country over the past 6 years has been a massive bubble. The problem that we are facing is that with some fancy financial engineering banks and wall street in their quest to make money discovered that you could package up pools of these loans into securities and sell them (or stick them in off balance sheet vehicles) and at the same time leverage up to ratios of 20 to 1 or higher. This all worked great as long as people paid their monthly payments and the value of the underlying debt stayed level or kept growing. Unfortunately, the brightest minds forgot to calculate what happens when you are highly leveraged and the value of your portfolio (ie: houses) begins to fall.

Credit is a big problem but even bigger is the Derivative market that is intertwined with it. According to the Bank of International Settlements the total outstanding notional amount tied up in Derivatives is close to $600 Trillion (yes trillion). While this may be a foreign sounding word to many, derivatives allow someone to speculate on the future price of something without owning the underlying asset. They also are used by people to hedge risk or insure their underlying investment. Once again everything works fine until highly leveraged companies begin to go under, this is what we saw with the Fed bail out of AIG. This was a company so intertwined with the derivative market of "insuring" these Mortgage Backed Securities that the government could not let them fail. The domino effect would be severe. (Warren Buffet said in 2003 that derivatives were the financial weapons of mass destruction and would eventually take down financial institutions. If only they would have listened.)

So here we are:

We have now entered a point where we have hit the limit on credit and the banks cannot continue to lend like they were. You will also see credit card companies pulling back on all those offers that clog your mailbox each week. Ditto for home equity loans. This is a credit contraction and unfortunately it is going to lead to deflation and a recession. (we are in a recession now, it just takes another quarter for the government to acknowledge it) In the grand scheme of things it is a necessary process as we purge the over dependence on credit from our economy and get back to sustainable levels.

The government has two options at this point, the first is to flood the market with capital by reducing interest rates again hoping to reinact what they did in 2002 / 2003 or just let the issues work there way through. If they reduce rates in the hope of spurring inflation then maybe we get a shallow recession and things get back to normal in 6 months. The flip side is that they can reduce rates but they can't force banks to lend or consumers to borrow. And if the consumer takes a break then we will have to go through a bit longer recession.

What's going to happen to the stock market?

I wish that I had a crystal ball and could predict how we will fare over the next year, so without that then we have to layout the best case and worst case scenario.

Best case is that we hold here and try to recover. I am not real optimistic that it is going to happen but have to be open to it. The Fed is going to have to unload all their weapons to keep this market up. That includes an interest rate cut, a bailout to get credit flowing again and a desire by the consumer to continue spending.

Worst case is that after bouncing around for a week or two reality sets in and the market begins to price in deflation, recession and lower GDP. This means that we could see this thing 10% lower at a minimum by year end. If this happens the drops will be dramatic and last for probably 6 to 9 months before we hit bottom and the Fed bailout package takes hold. Then we begin on the road to recovery as the economy reinflates.

What do you do?

Hindsight is great and everything always seems so clear as you see the progression of how we got here. Unfortunately, there is an old saying that no one makes money in a bear market, not even bears.

The question you must ask yourself now is what would bother you most: missing a 10% rally to the upside if you were completely out of the market or if you stayed fully invested and the market were to drop another 10%?

I don't profess to know what will happen and have gotten beat up like everyone else over the past couple of months. I do have a feeling that it will take sometime to purge the excesses out of the system before we can enter the next great bull market. Any make no mistake, we will recover and move forward but it is going to require patience and fortitude because we have a ways to go.

Try to keep your spirits up and don't dwell on the negatives. There are a lot of folks out there that are in much worse situations. And remember that when the news is at its worst is when the market will be bottoming and we will be on the road to recovery.

Let's see what the government unleashes this weekend and how the market responds. I don't think that either party wants to face what could happen if they don't produce some solutions quickly!