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Investing in the Stock Market - Signs of Trouble ?

Stock-Markets / Analysis & Strategy Feb 17, 2007 - 04:37 AM GMT

By: Hans_Wagner

Stock-Markets When investing in the stock market it is important to balancing the risks with the potential rewards, if you want to beat the market . Today, we face a world of low yields and relatively high valuations. Most of the stock markets in the developed world are near their long-term highs in terms of valuation. As many investors know and numerous studies have shown stocks offer lower than normal returns after reaching high valuations.

This implies it will be more difficult to balance the risks with potential rewards while achieving above average returns. You might want to read Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis. It is an excellent book on how to predict macro moves of the market.

Dividends are at the low end of historical yields, and bonds offer little growth potential after accounting for inflation and risk. The spreads between high-yield debt, i.e. junk bonds, and the best of solid government debt are at historically low levels. The gap between US government debt and emerging market debt fell to its lowest level recently. A mild global recession would push the yield spreads back to normal levels, thus making high-yield bonds or emerging market debt a low-total-return asset.

It is not just in the world of stocks and bonds that valuations are at highs. As a report from Goldman Sachs noted, how can someone pay $135 million for a Gustav Klimt painting? Almost $1,000,000 for a little black dress worn by Audrey Hepburn in Breakfast at Tiffany's? How do you buy an office building in New York with no leases expiring for ten years for more than $1.2 billion with an internal yield of 4%, which is 50 basis points less than a 10-year US bond? And that is before maintenance reserves! This illustrates that valuations in all sorts of markets have reached new highs. The world's markets are awash in capital looking for a home.

With this growing liquidity, the world is experiencing an increasing appetite for returns by investors at all levels as they chase those yields down to a point where traditional risk-reward measures would suggest the potential for problems.

A real example will provide some better understanding of this situation. In the US, about 25% of the mortgages on new homes are what is known as sub-prime mortgages. These are mortgages that are slightly less creditworthy and therefore offer higher interest rates. Initially this was a way for first time buyers and those just starting out in life to own their own homes. While home ownership is important for anyone, first time buyers should look carefully at the terms of the loans they are considering. I encourage first time buyers to read Automatic Wealth for Grads... And Anyone Else Just Starting Out by Michael Masterson describes a complete program for recent college graduates and any else just starting to achieve financial independence.

Then investors with money arrived on the scene looking for yield. With all that liquidity investors had snapped up these mortgages. Investment banks would buy those high-yielding sub-prime loans and package them into something called Residential Mortgage Backed Securities. Now, a sub-prime loan is not considered an investment-grade security. But when you put a group of them together into a pool and break them up into various sub-groups or tranches, you create high-grade bonds from sub-prime debt. In fact, 80% of those grouped together get an AAA rating, because that tranche gets the first monies paid back to the debt pool. And it probably is pretty safe money. So far so good.

These investment banks keep slicing the pool into smaller parts, eventually ending up with the final 4% getting a below-investment-grade BBB rating. This is OK as it allows investors to buy the risk they want and makes for a more liquid real estate market. But the investment bankers are not content with these instruments. They pool all these BBB tranches into yet another pool called a Collateralized Debt Obligation or CDO. The rating agencies use sophisticated models to tell them that with the increased diversification, 87% of these former BBB bonds can now be sold as AAA or AA investment-grade bonds. Only 4% is considered actual BBB debt. So we have taken an original security that is not investment-grade and turned all but less than 1% into an investment-grade bond.

This won't be a problem, if all those mortgages pay off like they have in the past. But recent research suggests that as many as 20% of these mortgages sold in 2005 and 2006 are going to default or foreclose. New Century Financial, a sub prime lender, had to buy back a number of their sub-prime loans that went bad, causing the firm to experience substantial loan losses, much larger than their reserves. Their stock price fell more than 32% on the news. HSBC, one of the world's largest banks, announced set aside an additional $1.8 billion to cover loan losses that were higher than expected. Other mortgage firms also reported problems.

The problem is the investment bankers set up the CDOs assuming that less than 1% will default. If the number of defaults is even half of that predicted, then someone is not going to get their full capital back, let alone the interest. And we are seeing home foreclosures at record levels in every part of the United States due to the large number of sub-prime mortgages.

Why such a growing default rate? Because investors kept throwing money at mortgage bankers, who found out they could sell mortgages with little documentation. For instance, you could get a loan without actually having to prove your income. So the bankers said, "Let's take the fees and run. Bonuses all around for selling more mortgages." Now there is anecdotal evidence that a small but significant portion of these low-documentation loans had some items that were misrepresented. Little things like whether you were actually going to occupy the home and the basis of the income you expect to use to pay the mortgage?

So, who bought these CDOs? Well that is tough to tell. But remember all that liquidity chasing yields mentioned earlier? Much of that liquidity came from Asian and European institutions, which simply looked at the rating on the bond and bought them. Also, remember all that oil money looking for some place to go. The unhappy news many of these investors are receiving will cause disruption in the markets. At the least look for massive lawsuits and a major losses to start up by the end of this year. Hopefully, there is sufficient liquidity in the global markets to absorb the losses without causing a major financial problem. 

As investors we need to be aware of these events and the potential impact they may have on the market. News like this can cause a panic in the markets as investors get out of the higher risk stocks, looking for safer places to put their money. Stay tuned as this over indulgence works its way through our securities markets.


by Hans Wagner

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at

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