Smart401k Blog

Over the weekend I went to my first Missouri (MU) football game.  Prior to the game I had the opportunity to tailgate with a lot of MU fans, the majority of them I didn’t know.  Being a diehard KU (Kansas) fan I expected a lot of razzing and friendly bickering.  Instead, once people found out what I did for a living, football was the last thing people wanted to discuss.  Instead everyone wanted to talk about the market and their retirement accounts.  It seemed everyone I spoke to was unsure if they were properly allocated and if they should be moving their money to cash accounts.  I would explain to them that it’s a tough time to be in the market, and watch our accounts go down, but believed we have to remain committed to our investment strategies (assuming they are based on solid asset allocation strategies).  Historically, the market has rebounded strongly after reaching a trough.  On average it rebounds by approximately 30% within 12 months after finding the market bottom. Within two years of the hitting the market bottom, the S&P 500 average increase is roughly 55%.  These figures really got their attention. 

It was very important for them and for you to understand that no one can predict what the future will hold so it’s imperative to have a properly allocated and diversified investment strategy based on your risk tolerance and time until retirement. This doesn’t mean picking all the funds available to you, but rather building a portfolio that includes all the major asset classes (Lg Cap, Sm Cap, etc).  For someone nearing retirement age, they should probably be more conservative, while someone with 20 or 30 years until retirement can stand to continue to invest more aggressively.  

I know it’s tough with how the market is, but now more than ever it is time to have a good game plan and stick to it.  People should approach investing like coaches approach football games.  Coaches set a game plan going into the game and stick to it.  They review hours upon hours of game film and monitor the strengths and weaknesses of their team and opponent and create a strategy that gives them the best chance of success.  During the game, coaches make minor adjustments, but don’t throw their game plan out the window at the first three-and-out or turnover.  It seems people create game plans but then throw them away at the first signs of market turmoil.  If you’re not sure how to come up with a game plan for your retirement or are worried that your game plan doesn’t fit your retirement goals, feel free to contact us to talk through your situation. 

Needless to say, the football analogy connected with a lot of the people I talked to and I had a lot of new friends. Unfortunately for me, they were all MU fans.      

As always, if you have any questions or would like to discuss your account, feel free to call us at, 1-877-627-8401.

Jeff Studebaker, Investment Advisor

In my previous post on the current financial crisis, I reviewed the players involved in the crisis.  I also covered how an overheated real estate market and lax lending standards were the tinder that helped fuel the financial crisis we’re now smack in the middle of.

In this post I’ll talk a little bit about what happened to all of those mortgages once a borrower closed on a house/apartment/condo and how they added to the fire.

Historically, banks originated loans and held them on their balance sheet as assets.  They made money by lending at a higher rate than they paid on customers’ deposits.  Since the banks were holding the loan on the balance sheet (i.e. they were hurt if the loan went into default or otherwise underperformed) they were generally very selective in the loans they made.  This began to change when many of these banks and other lending institutions began to sell the mortgage loans they originated to financial institutions who would package them into mortgage backed securities (MBS) a type of asset-backed security. 

These structured securities allowed the originating bank to book a profit on the loan quicker and also freed their balance sheet and enabled them to make more loans.  Since the originating bank was no longer at risk if the loan went bad many began to relax their lending standards.  In order for banks to sell their loans, the loans just had to meet the minimum standards of the Federal Housing Administration (FHA) — an entity whose stated goal was to boost the rate of homeownership in the United States.

Financial institutions then created the MBS and sold them to institutional investors who desired a “stable” asset that produced a regular level of income.  The idea behind mortgage backed securities was that if you pooled a large enough number of mortgages you were actually decreasing your overall risk by diversifying through large numbers of individual loans and over various geographic areas.  In other words, one bad loan wouldn’t ruin your day.

In addition, mortgage backed securities were divided into “tranches” based on risk level and interest rate, allowing buyers to make purchases based on level of risk they were willing to accept.  The process for rating these tranches was similar to other fixed income securities. Rating agencies like Standard & Poor’s and Moody’s would give the tranches with the least risk investment grade ratings (think GE and Berkshire Hathaway debt), while slapping lower ratings on riskier tranches.  So in many cases, a pile of high risk sub-prime loans were magically turned into supposedly high-quality, investment grade fixed income securities.

After securitizing and selling the loans, these financial institutions were able to buy more loans and repeat the process over and over again.  As the real estate market continued to boom, all parties involved got hungrier and hungrier for more and more loans.  Everyone involved was happy until the real estate bubble started to deflate.  As defaults began to rise, the buyers of the MBS’s started to see losses that they weren’t expecting to see from such a supposedly high grade security.  Buyers quickly stopped buying the MBS’s, sticking the financial institutions with a bunch of unsalable mortgages. That caused the financial institutions to stop buying new loans, which in turn meant that the originators had to hold them on their balance sheets and quickly curtail their new lending.  In the end, this meant that a new home buyer suddenly had a lot more trouble finding a loan, which helped slow the pace of home buying.  With new buyers kept at bay, home prices started to fall and those who had overextended themselves to buy a property found themselves without clear path to safety.  It’s not too hard to see how this situation can feed on itself and create a downward spiral.

So now we have between $1 and $1.5 trillion dollars in sub-prime mortgages that no one wants and a large number of buyers who can’t keep up with the payment on loans they shouldn’t have taken out. The result? A frozen market.  Individual and corporate balance sheets are now full of loans they don’t want, which restricts their ability to spend or lend additional money.  And the spiral continues…

As always, please feel free to add to the commentary and ask any questions you might have.

Scott H

In the headlines

A look at some of the market movers over the past week:

• South Korea announced that it is launching a bailout program of its own
• ING received a $13.4 billion lifeline from the Netherlands government
• President Bush announced a series of global economic summits to address the current economic slowdown
• The Federal Reserve launched a new plan to help stabilize money market funds
• Fed chief Ben Bernanke spoke out in favor of a fiscal stimulus package
• Asian countries considered a massive program to shore up the region’s economic situation
• Apple managed to report good numbers despite the difficult economic environment
• Yahoo! announced big layoffs along with their quarterly report
• Consumer sentiment continues to be underwhelming
• Credit Suisse announced a big third quarter loss
• Goldman Sachs announced that it will cut 10% of its staff
• Foreclosures are still dangerously high but may be showing signs of slowing
• OPEC countries agreed to cut production in an effort to support the fast-falling price of oil
• Former Fed Chairman Alan Greenspan testified before Congress on his part in the financial crisis

Commentary

The market stats for the week were all too familiar for investors. Three out of the five days were down days, four out of the five days had moves of 3% or greater, and the week finished down just shy of 7%.

News-wise, coverage focused on the worldwide economic uncertainty. Though financial markets appeared to loosen up to some extent sparking a big gain on Monday, economic reports throughout the week — including a decline in third quarter GDP in the UK — were sobering. Earnings reports throughout the week were mixed, though even positive reports were overlooked by investors as they continued to focus further into the future.

At this point it is unclear exactly where the market is taking its direction from. Down more than 40% from a year ago, it would seem that even a significant recession has already been priced in. Reports have been making rounds that significant liquidation selling from troubled hedge funds has put downward pressure on markets, while even healthy hedge funds and mutual funds may be selling in anticipation of investor redemptions. At the same time, individual investors, worn down from the market’s wild volatility, may finally be throwing in the towel and selling.

Looking ahead

Last week I began this section by saying:

The more volatile and emotion-driven the markets become, the more difficult it is to predict what factors will play significant factors in its movements. That said, the news events that will cause the most commotion on the markets next week will likely be those that are unscheduled such as new information on the bailout progress.

It’s hard to come up with something more applicable this week. Volatility has continued and we’re somewhat at the mercy of a spooked market right now. Investors will continue to process economic data to try and figure out just how bad the economic downturn will be.

That said, at a time like this it’s important to keep in mind that the stock market and the economy do not typically move coincidently. Economic readouts give us a picture of current and recently passed activity levels. The stock market, meanwhile, tries to anticipate economic activity in advance. This means that stock market declines will precede the bottoms of economic declines and stock market recoveries will likewise precede economic recoveries. So even if the economic picture gets worse from where it currently stands today, that does not necessarily mean that stock market will.

Going into next week we have a heavy calendar on both the earnings and economic fronts. There are a handful of economic reports that could significantly impact the markets. On Monday and Tuesday we’ll see September new home sales and October consumer confidence, respectively, and both are expected to show declines from the prior month. On Friday we’ll see personal income, personal spending, and another reading on consumer sentiment.

The two highlights of the economic calendar, however, will take place right smack in the middle of the week. On Tuesday, the Federal Reserve will make its October policy statement. Based on implied probabilities calculated by the Federal Reserve Bank of Cleveland, the expectation is that the Fed will cut rates by anywhere from a quarter point to three quarters of a point. The following day, an advanced reading on third quarter GDP will be released. After a jump of 2.8% (annualized) that was driven by government stimulus payments in the second quarter, the briefing forecast is for an annual rate of 0.3%, while the market is expecting a decline of 0.5%.

Week after week we will continue to bring you a weekly recap and a look ahead to the next week. However, it’s important that our weekly coverage of news and events is not translated as a short term focus from an investing perspective. We continue to be firmly focused on the long term when it comes to investing, and while the current period is certainly trying, we expect that investors holding their investments, and continuing to invest, over the next five to ten years will benefit handily from the eventual market recovery.

This year has been a rather tumultuous year for investors, with the past month being extremely volatile. The Dow Jones Industrial Average is down more than 35% year-to-date as of Oct. 24. I believe fear has been responsible for a significant portion of the market’s return as investors are overly focused on the health of both our financial system and the economy. I like all of the advisors at Smart401k read and learn as much about the market as we can. One of the things that I have noticed has been the steep selloff in the high yield bond market.

For those of you that are not familiar with high yield bonds (aka junk bonds), they are corporate bonds that have been assigned a credit rating below investment grade by Moody’s or Standard & Poor’s (The two main credit rating agencies).  Bonds with a credit rating of BBB or lower from S&P and Baa or lower from Moody’s are considered high-yield bonds.  Because of their lower credit rating, these bonds generally pay a higher yield than investment grade bonds.  (For more information on bonds click here)

Similar to the stock market, the high yield bond market has been plagued by fear.  This fear has resulted in a steep decline, approximately 25% YTD as of Oct. 24^th, in the Merrill Lynch High-Yield Master II Index, a common benchmark for the high yield bond market.  According to Moody’s, the market has priced in a rise in the default rate to almost 20% which would top the record of 15.4% set during the Great Depression in 1933. The uncertainty in the market has also pushed the yield spread over U.S. Treasuries from around 3% a year ago to over 15%.

A number of bond fund managers, including Dan Fuss from Loomis Sayles, have observed the decline as well and see the current market as an investment opportunity. Mr. Fuss recently gave an interview with Morningstar and said that the current bond market is the best buying opportunity he has seen since 1974.

Please note, I am not advocating or a recommending high yield bonds but rather wanted to write about an observation of recent events. Please feel free to contact us if you have any questions regarding high yield bonds or if you have any questions about your account.

Buck Wendel, Investment Advisor

I wanted to let everyone know that our Chief Investment Officer, Adam Bold, has put together an impressive panel of mutual fund managers for his radio show this weekend.  I  think this is a great opportunity to learn about the market from the perspective of the guys who are making the buy/sell/hold decisions for their funds.

Scheduled to appear are the following managers:

Dan Fuss - Loomis Sayles Bond and Loomis Sayles Strategic Income

Don Hodges - Hodges

Kent Croft - Croft Value 

Michael Cuggino - Permanent Portfolio

If you aren’t a regular listener go here to find out when it will air in your area. If you aren’t able to listen on Saturday, they typically post excerpts from the show within a day or two on the show website www.mutualfundshow.com.

Good listening,

Scott H