Wealth Building Lessons

The past few weeks have certainly been pretty volatile in the stock market. After hitting new highs for the past several months, all the market indices plummeted on July 17th. Its now mid-August and the markets have dropped significantly since then. Not only the US stock markets, but markets all over the world have dropped in unison. Last Thursday (August 16th) saw a retest of the lows created earlier in the year. On that day mutual funds recorded outflows of $19.9 Billion dollars as nervous investors pulled the plug on their investments. As mutual fund managers have to give money back to their investors, they often need to liquidate their positions at the worst time. The bad stocks have dropped the most, so in order to raise the most capital, the sometimes sell the good stocks that have appreciated a lot. This caused huge drop in almost every asset class.

Apparently the sub-prime problems, which according to Ben Bernanke were contained, weren’t really contained after all. Dozens of mortgages companies have closed doors this year. Two of Bear Stearns multi-Billion dollar hedge funds became worthless after investing in sub-prime mortgage-backed debt obligations that were falsely labeled as AAA-rated. Several other hedge funds that invested in these collateralized debt obligations in Europe and Australia have also frozen withdrawals while they try to calculate the value of the holdings. They may turn out worthless as well. This prompted a global liquidity crunch scare that spooked the markets resulting in the stock market sel-loff and the flight to the US Treasuries.

Stocks of Mortgage Companies and Financial Institutions have been severely punished over the past 2 weeks. Many of them disclosed that they had significantly underestimated the number of defaults in the sub-prime and Alt-A mortgage portfolios.

Washington Mutual recently announced that the jumbo loan interest rates would start at 8%. In California, with the median home price being over $500,000, a large chunk of the loans are jumbo (any loan that’s over $419,000 is termed as jumbo in California) loans. As rates go from 6% to 8%, the 2% jump in payments represents a 33% jump in the monthly payments. This means less people will qualify for these loans and real estate prices will fall more than they already have. There’s absolutely no chance that the real estate market in California or in other grossly inflated areas will improve next year.

Home building stocks also dropped like a ton of bricks, as they all lowered their earnings forecasts and some were even rumored to be facing bankruptcy. With the Housing sector being such a significant portion of the GDP, it slowing down is not good for the economy.

A money management company called Sentinel that manages around $1.6 Billion also stopped allowing withdrawals on its Money Market accounts, after saying turmoil in the credit markets made it impossible to trade without incurring losses. They’ve also filed for bankruptcy protection.

As if there wasn’t already enough bad news around, an analyst said that Countrywide might face bankruptcy. This caused a run on Countrywide Bank, with people camping overnight to get their hands on their money. Even for amounts that were well under the FDIC insured limits of $100,000 per account!

This is a sure sign of widespread panic among the general population.

With the market dropping so much and being rather volatile (with huge swings in opposite directions), does it make sense to invest in the stock market right now?

There’s an old saying about buying when there’s blood on the streets. People tend to over-react and sell when stocks are the cheapest. Well according to a bloomberg story last week,

“ ‘Blood is hitting the streets, everyone seems to be panicking, and there’s reason to panic,’ said Patrick Chang, who helps manage $4.5 billion at CIMB-Principal Asset Management Bhd. in Kuala Lumpur.”

Thursday did see a huge drop in the markets, but they rallied back strongly and closed close to the opening levels. The dramatic reversal was viewed as a positive sign. “It was very, very encouraging,” says Price Headley, chief analyst at BigTrends.com. “It’s a strong indication that the worst is over.”

The rebound was significant because it was sparked by many ingredients that are typically associated with market bottoms.

•Fear, the opposite of greed, was in abundance.
The Volatility Index (or VIX) hit its highest level since October 2002, when a three year bear market ended.

•Signs of capitulation were visible.
Stocks typically don’t hit rock bottom until people get so scared that they sell stocks — even strong ones with no reason to go down — in a panic. Often, the indiscriminate selling gets overdone, creating opportunities. That was the case Thursday when more than 1,100 stocks on the New York Stock Exchange hit fresh 52-week lows. Only eight notched new highs.

•The most-hated stocks rallied.
The financial sector has been at the center of the debt crisis, and its stocks have been decimated. But they rallied back, helped in part by short sellers who had to reverse their negative bets when the stocks started going up. Bear Stearns, which lost a third of its value on news that two of its hedge funds that invested in risky subprime debt were worthless, rallied 13%. Goldman Sachs, which has also suffered double-digit hedge fund losses, jumped 3%. JPMorgan Chase rallied 6%.

Friday’s follow-through which was spurred by the Federal Reserve’s announcement of cutting the discount rate 0.5% may indicate that the worst is over.

However, if more bad news comes out we may see further market drops in the near future - especially if the economy goes into a recession. However, most people believe that Ben Bernanke will keep liquidity high and interest rates low in order to keep the economy chugging along, so hopefully things won’t get too bad.

The stock market will be extremely volatile over the next few months, with September historically being the month with the lowest returns. But if you have a long term horizon, the current market drop has provided many buying opportunities. Especially for stocks in sectors that are not correlated to the financial markets but have been beaten down nonetheless.

According to newsletter editor Dan Ferris,

Real investors use market panics to take big positions in great businesses they understand. We’ve been waiting for the right time to buy – in some cases for decades. Case in point: Warren Buffett has been pouring capital into this market already. According to a Tuesday filing with the SEC (reflecting purchases through June 30), Buffett’s Berkshire Hathaway has added significantly to its stakes in WellPoint and UnitedHealth (the two largest health insurers in the U.S.). Buffett also increased Berkshire’s holdings of PSIA pick Johnson & Johnson (JNJ) by 9.2% and quadrupled its holdings of drug-maker Sanofi.

And we end with a good video on how the financial markets actually work.

Related Reading:

1. The Creature from Jekyll Island : A Second Look at the Federal Reserve

2. Rocking Wall Street: Four Powerful Strategies That will Shake Up the Way You Invest, Build Your Wealth And Give You Your Life Back.

3. The Dhandho Investor: The Low - Risk Value Method to High Returns.

4. The Intelligent Investor: The Definitive Book on Value Investing.

5. The Essays of Warren Buffett : Lessons for Corporate America.

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