April 15, 2008

Market update

Most companies are reporting first quarter earnings in the next few weeks. The effect of mortgage defaults, bank lending cutbacks and the general economic slowdown should become much clearer as earnings are announced.

Disappointing earnings could cause more stock market volatility than we have seen in the past month as the market began to settle down. As GE showed us last Friday, as disappointing earnings caused its share price to drop 13% in one day, investors who blindly thought that blue chip stocks were safe got a rude awakening.

With this kind of risk still out there, even though I expect the market to get stronger over the next few months, I am not about to throw caution to the wind. For this reason we are holding our growth strategies steady with only 50-60% exposure to the stock market and the balance in bonds and money market funds.

Flexible income keeps perking right along showing small, steady gains. We still hold 1/3 of that strategy in the money market because if the stock market continues to recover as I expect, investors may move out of bonds and into stocks, putting downward pressure on bonds. So, I am being cautious in this strategy as well.

Dodging Disaster in the Mortgage Market

My last newsletter mentioned my plan to move our managed accounts back into a traditional money market fund from the ultra-safe Treasury accounts we have used since November. The risk of money market funds losing money is back to being very remote after a period of great uncertainty.

Market risk occurs when the value of holdings fluctuates. This is what most of us think of when we think about risk. Anyone who has ever watched the stock market can respect its market risk. Values can change rapidly.

Money market funds don’t hold stocks, just bonds and other IOUs that mature in one year or less so all of their holdings are very close to maturing at full face value.

Bond resale values are primarily affected by changes in interest rates. By having bonds that mature at face value almost every day, money market funds eliminate the interest rate risk that other bond holders face. Money market funds rarely have to sell, they just wait for their holdings to mature at full face value.

“Ultrashort” bond funds are like money market funds on steroids. They hold bonds with an average maturity of about 2 years. This is still very short in a market with bonds up to 30 years to maturity. They are longer and therefore riskier than money market funds, but they also pay more interest to compensate for that risk. In the last few years, savers poured tons of money into Ultrashort bond funds looking for higher interest rates.

The chart below shows the recent pricing of Schwab Yield Plus³, an “ultrashort” fund. These have been promoted (not by me) as being places for one’s “safe money”.

“Schwab Yield Plus, once the company’s most popular bond fund, had pitched itself as a safe alternative to cash. But it stuffed mortgage backed bonds into it’s portfolio to plump up performance, and they have turned toxic. Yield Plus is down 24% so far this year.” – Wall Street Journal, April 11, 2008.

All those investors, and their advisers, focusing solely on low interest rate risk overlooked the default risk which everyone finally became aware of late last year. But having maturities “only” 2 years away, doesn’t help if defaults are occurring right now.

The reason I mention this fund is to show the size of the risk that was just over the horizon back in November when I changed our money market fund to the safest possible choice. Admittedly I was fuzzy about the extent of the risk, but clearly things were not right and I don’t’ like to take chances with our “safe money”.

Many of these same mortgage-backed investments that were in Schwab Yield Plus ended up in money market funds all over the country. The risk was indeed enormous!

Due to the very short average maturities most of you have with me, 46 days for the money market fund, all the holdings from a year ago have matured and been replaced. Since the default risk has became well known that has been avoided in the new investments.

We have successfully dodged this particular bullet. Now we can move back into the higher yielding money market fund that we have normally used.

Don’t thank me. Just tell your friends about the work I do.

What is a Credit Score?

It has been a little over 15 years since a little known company called Fair-Isaac invented the FICO credit scoring system and standardized the credit reporting business. Higher scores can translate to lower interest payments, but what factors make up your credit score? Not many of us know.

According to myFICO.com, the percentages in this chart reflect how important each of these categories are in determining your FICO score.

FICO tells us that the importance of these categories can shift from person to person, so there is obviously more involved than meets the eye.

Real Estate Rebound?

I don’t think so.

In the past few weeks I have had several people mention to me that they wanted to buy distressed real estate because prices seemed too good to pass up. When prices are averaging 18% below where they were a few years ago, as reported in Phoenix, I can understand the attraction. Everyone loves a good deal.

Six months ago I reported on a new investment that points to what big-money investors expect to happen to housing prices in 10 metropolitan areas around the country. The pricing of the S&P Case-Shiller Housing Index indicates that, nationwide, further average price declines of 19% should be expected between now and November of 2012. 12% of that decline is expected in the next 18 months.

Granted these are just estimates, but they are made by the wealthiest people in the country putting their money where their mouth is. Sure, they could be wrong, but they didn’t get all that money by being wrong too often.

My point is, if you like real estate prices now, you will really love them in a couple of more years. If you buy now, be prepared to be “under water” for a few years before a bottom is reached and prices begin to rise again.

We talk in my Yavapai College class about real estate’s big risk being illiquidity. If things don’t work out as planned you may not be able to sell without taking a big loss. The hedge for illiquidity is to have a lot of other highly liquid assets. You may have to hang on for a few years, putting more money into the property for taxes, upkeep and mortgage payments, while you wait for the market to improve. If you have the ability to raise cash you will have the staying power to hold onto your property. If not, you risk becoming another statistic as the real estate bear market unfolds.

I used to keep a quote taped to my computer that was from an early editor of the Wall Street Journal, whose name escapes me now. It goes “The graveyards of Wall Street are littered with the bodies of investors who were right too soon.” I think this pertains to real estate as well as stocks and bonds.

Caveat Emptor

3. This is not an offer to sell this security. This fund is mentioned merely as an example of the amount of risk that previously went unheeded in this class of investment. A prospectus will be provided upon request.