The Current Situation in the Markets

haus_proudOctober 8, 2008

I have found it useful to think about the current situation by comparing it to an auction of a fine work of art, say a prized painting of the impressionist era. At the auction, savvy buyers will look at the painting and bid on it based on their knowledge of its worth by comparing it to similar works that were recently sold at auction. And they would take into account its condition, the esteem in which the artist is held among connaiseurs in the art world and any other factors that they think is important -- perhaps expectations that such a piece will increase in value because it is rare, etc.

Based on these considerations, the bidders will make offers in the auction, but then things tend often to get out of control. Bidders may want the piece badly and be willing to pay more than they think it is worth, and sometimes a bidding frenzy starts. By the time it's over, the piece has sold for a lot more than experts expected.

This scenario is not at all unusual, and similar thing happens often in the stock market where a lot of money from a lot of investors get put into the stock market (or particular segments of the market) and before you know it, the stock market is "overvalued." People who own "overvalued" stock don't want new investors to know that it is overvalued because then the new investors will not buy it. So the popular overvalued stocks get bidded higher and higher. Eventually, reality sets in the the bubble bursts. That's the way markets work. And you have to be prepared for periodic adjustments by waiting them out. You cannot "time" the market because it is too unpredictable. No one knows when the market will go up or for how long.

But let's get back to the fine painting scenario for a minute. Suppose in the course of the bidding, a rumor starts that the painting is a forgery, or that the artist is not really as highly esteemed as generally believed. Then the "value" of the piece will plummet, and the auction will fail. It may even devolve into a scandal.

That's what has happened in our markets worldwide. This is, in my opinion, not a "garden variety" bubble, but one based on assets in vitally important investment banks that were misrepresented. These banks are vitally important because they grease the wheels of commerce by lending and borrowing among themselves and to businesses large and small all over the country and worldwide. And much of what they do is based on TRUST, trust in their solvency, and confidence in their ability to pay up if/when push comes to shove. Unfortuantely, many if not most banks in the US and outside the US got caught up in "opaque" instruments, instruments whose value is not transparent. And eventually the bubble burst.

I believe this bubble is different for at least 2 reasons: (1) It is based on fraud, pure and simple--misrepresentations of the true value of instruments.

(2) The fraud was driven by an enormous bubble in the housing market. This is different from a bubble in, say, dotcom stocks or other stocks, because these can be sold quickly on the open market. But a housing bubble involves homes that people live in, and they cannot be easily sold. To complicate matters, many homebuyers made imprudent purchases -- they bought at inflated prices with little or no money down and they took adjustable-rate mortgages that obligated them to make much higher monthly payments 1 to 3 years after they signed up. Then, just as the new monthly payment schedule became reality, the value of their house dropped by 20-50% because the bubble in the housing market burst. So these people are stuck owing more money than their house is worth, and often unable to make the new higher monthly payments. Many of course expected that they would sell their homes at a profit before the new payment schedule kicked in, but of course that did not happen.

Now the mortgages of these houses are given a fake inflated value, when they are often practically worthless. Who owns these mortages? No one knows, or if they know, they're not telling. The mortgages were sliced and diced, combined with other securities in such complicated "sophisticated" ways that no one understands them or can track them down. But what we do know is that this fraud became widespread, while people who should have known better looked the other way. So the banks who own these fancy fraudulent instruments cannot sell them, and the whole financial system on which we depend has come close to a grinding halt.

Four months ago, when I saw that this was not a "garden variety" bubble, I reduced my investments in stocks by half. My only regret is that I didn't reduce them by more. So I am sitting tight with a lot of cash, and plan to start making "periodic installments" into the market to sort of dollar cost average some time soon. As a retired person in my 70s, I am in "wealth preservation" mode. Unlike my son, I do not have 25 years to recover from the present downturn. But I know I need stocks because they compensate for inflation, but I'll watch them very closely and invest in them cautiously.

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Do you think this recession will last the usual two to three years -- or longer, since it is world-wide? Lots of economies are predicted to limp along with near-zero growth for 2009. (Not Russia, nor China, nor India. Buy into their economies?)

    Bookmark   October 8, 2008 at 5:51PM
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Well there is always lots of "investing" advice. I have a client who was so worried that her money was losing to inflation that she took a recent inheritance and invested it in bonds and stocks that really took a dive. I had suggested she pay off her house, her car and her credit cards before she worried about inflation. Apparently when she went to deposit the money in the bank, she was directed to the "financial planner" at the bank who assured her that my advice was short sighted and lawyers don't know much about investing.
This recession is world wide if you notice what overseas banks & stock markets are doing. Russia, China & India
and even France that doesn't use much credit are moving to prop up or secure their credit markets.
It depends on where you get your news from I guess.

    Bookmark   October 8, 2008 at 8:01PM
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I think the world markets are in an "inflection point" which means they are changing direction. We won't know the nature of the new trajectory for some time. There is reason to predict that this recession (if it has already started) will be a good deal longer than recent ones because they involve a real estate bubble. It stinks.

    Bookmark   October 8, 2008 at 9:04PM
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haus proud - I agree with your analysis of the real estate bubble, and combined with the crude oil price runup this summer really started the current downturn.

It's my opinion however, that the real elephant in the room is in the credit default swap market. Because these financial instruments are totally unregulated and have absolutely no transparency, nobody can know who owns what and how much. I believe that's what is causing the mistrust between the big banks and the reluctance to lend to each other. I don't pretend to know how these things work. I do know there's a huge amount of money involved and a lot of it may be tied up in worthless paper.

The link below is the most current news story I could find on the subject.

Here is a link that might be useful: SEC head asks for reins on credit default swaps

    Bookmark   October 9, 2008 at 3:49AM
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I have to take it all back re: Russia. I had read that their expected growth was at seven percent; India and China even higher. Ours is so small you need a microscope to see it.

    Bookmark   October 9, 2008 at 9:36AM
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After all the book-cooking, subprime lending,and CEO's who seem to run companies for their own good, one wonders if many investors will just chaulk up the existing state of the stock market as one big Ponsi scheme.

As a life-long investor, I'm tired of being scammed by people who just GET money instead of EARNING it.

If I was in my 70's, I sure wouldn't invest any more money in the stock market. Once it has gone down this far, it will probably take 5 to 10 years before you make up the value of what's been lost. Income is more important to you than growth. I would use that cash to invest in Treasuries and because you are taxed on those, I'd back that up with a muni fund so that you won't owe taxes on any of that monthly interest. Muni rates last month were 3.75%. Muni funds were always a great way for older people to get much needed income. In these times, they also seem like the only thing that is in the black.

    Bookmark   October 9, 2008 at 11:30AM
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>>If I was in my 70's, I sure wouldn't invest any more money in the stock market.If you were in your 70's, I assume you would have a more conservative mix of stocks/bonds anyway.

I think emerging markets will continue to see some growth, but you need to be aware that both Chinese and Russian governments manipulate their stock markets extensively without any of the (yes, sometimes ineffectual but still extant SEC) transparency we have in the US and Eurozone markets. They are not for amateur investors; if you invest there you need to pay good attention to international business news.

Our CDO problem has spilled over to foreign investors because the Fed encouraged them to buy more US assets back when the dollar was strong. I think we do far more harm to ourselves by not teaching the basics of finance and investing to everyone while still in school, than almost anything else.

IMHO: Is there a crisis? Yes. Is the Fed and Treasury this time (as opposed to 1929) doing the right things? Yes. Will it take time - several quarters, at least - to see the results? Yes.

The "bailout" (I hate that word) hasn't worked hasn't gone into effect yet. The guy proposed to run it still has to be vetted by the Congressional oversight committee. If they don't like him, that delays the whole thing yet again.

The markets panic because they are supposed to look forward, but right now they are frozen in a "day-to-day" mode. The general trend is down because the hedge funds are going to have to sell their holdings for redemptions from spooked investors. Forced selling always creates a lower Dow. It will pass, it always does.

It wasn't pleasant watching our portfolio drop 26% during the years 2000-2001. But it recovered to the point where our 20-yr ROI remains in the 11% range despite the three quarters of 2008. We are still holding six-figure gains compared to what we held at the end of the bear market in Dec 2001.

If you are working and still contributing to a retirement plan, the market noise should not and need not affect you. This is assuming you have a properly diversified portfolio that will give you less risk with reasonable returns over the long-term. All this nervousness is the reason why I was against privatizing Social Security accounts; most people simply do not have any stomach for risk, nor can they see the long-term even though they may not need the money for 10 or 20 years yet.

However, this is a very difficult time for those who are in retirement or planning to retire in the next 24 months. Without a DBP (defined benefit pension), VUL (variable universal life), or annuity policy set up, there aren't many people who can cut their expenses back 30% immediately and survive.

    Bookmark   October 9, 2008 at 12:58PM
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The fact that many stocks and funds are downgraded at this very moment is not helping either. Many large pension funds have rules what kind of stocks (rating wise) they are allowed to hold. This adds another pressure, to sell and prices to fall, to the market :(

    Bookmark   October 9, 2008 at 5:50PM
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Whee! Wasn't this morning an exciting roller-coaster ride? And we have the rest of today to listen to the gears chugging our cars up, up, up a little; then...another DIP...some more chugging... We must be too high in the air to bail now! We're moving too fast in the dips to get off. After this afternoon we'll have until Tuesday to finish fwowing up before we get back on.

DH and I luckily missed much of the dot-com crash pain because we were taking money out of portfolio to build a house. I'm happier paying RE taxes locally than sending bigger gobs to Washington and Springfield, IL. The house feels cozy; more satisfying than sniffing the ink on brokerage statements. Even after the RE bust we are still ahead in that department for now. The portfolio had recovered, too. After this craziness shakes out...who knows?

    Bookmark   October 10, 2008 at 11:05AM
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