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Sunday, 26 August 2007

Bogle: 'Hope Will Return'

The stock market continued its volatile run Aug. 16, with the Dow Jones industrials plunging more than 300 points after problems at mortgage lender Countrywide Financial (NYSE:CFC - News) confirmed investors' fears that the worst of the credit crunch isn't over yet. And just as suddenly, major indexes zoomed back in the last hour of trading to finish the day little changed. Amid the scary market action, what's an individual investor to do?

BusinessWeek Associate Editor Emily Thornton asked that very question of John Bogle, founder of the Vanguard Group and a pioneer of index investing. The fund-industry veteran, who recently wrote The Little Book of Common Sense Investing, recommends at least two pieces of sage advice: First, be sure to keep an adequate portion of your portfolio in bonds. Second, try to remain calm: Bogle says it's possible the stock market could slide by another 15-20%.

Edited excerpts from their conversation follow:

We're seeing such problematic credit and stock markets. What do you think individual investors should do?

I would divide individual investors into two classes. If they're speculators, they will be scared and it may get worse and they should probably get out. But I don't feel confident in that advice because I don't give speculators advice!

We clearly have a problem with confidence in the market. Equally clearly, as all market cycles go, we have gone from hope, to greed, and now we're going to fear. Eventually hope will return. And very eventually greed will return. But I think it's going to be a while before we have the kind of greed that we have witnessed in this recent era reappear.

On the other hand, if I was going to give advice to an individual investor -- and I make a very important distinction here -- if they have come into this market and have invested the way people should invest, and that means they have a little bond position if they're young, and an average bond position if they're in their middle years, and a substantial bond position in their retirement years, then I would do absolutely nothing. They will be protected by the fact that bonds are going up and bonds generate income. No one will take that income from them. They should just hang in there and do nothing.

Even if I was pretty confident that the decline will continue -- and I think it's more likely than not -- you've not only got to get out right, you've also got to get in right. You must be right twice. So if you get out now, and the market goes way down another 15 or 20%, which is quite possible, they will be so scared they won't get in. So I'm a stay-the-course person. Personally, I'm about 60% bonds and 40% stocks. I haven't changed a single thing in my portfolio. I'm largely indexed on both sides. I haven't made a significant change in my portfolio in six or seven years. On a day like today, I may be worth as much at the end of the day as I was at the beginning because the bonds are up 1% and the stocks are off 2%-3%.

I'm very comfortable when these things happen. I don't much like them. But on the other hand, we have a system where there has been much too much easy credit and aberrant behavior, with rating agencies giving unbelievably casual high ratings to these mortgage-backed bonds. People are apparently able to collect all the poor bonds that don't have great chances of repayment, put them in a portfolio, and by fooling around, nobody knows exactly how, with the order in which they pay off, they're able to create a portfolio that is 90% triple-A bonds out of a portfolio that is in fact 99% C bonds or mortgages.

You pay a price for all this and we're paying the price now.

Why shouldn't I take all of my money out of all of these bond and stock indexes and just put it in cash or a CD?

First of all, you'll probably end up paying a lot of capital gains taxes. And you might be right. But on the other hand, what are you going to do next? A good bit of this decline has occurred. If you could get out and get into CDs when the market was 10% higher than it is now, that would have been a nice thing to have done. But people weren't thinking that way then. You're always bullish at the highs and bearish on the way down. So you're buying at the highs and selling at the lows. What sense does that make? I would say never do 100% of anything. An intelligent investor might take 20% out of his stock position, wait a week, and see what happens. But with these wholesale changes, you're going to get whipsawed. You're going to be in cash and the market is going to come back, and then you'll pay a higher price to get in than you got out today.

It's not a good idea to time the market. In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses. And the stock market is nothing but a giant distraction in that quest to acquire returns that business earns. It overmagnifies everything. Investors get scared. Their advisors get scared. And you get exactly what we're having -- a bit of a mess.

How would you compare today's troubles, which are more credit-driven than stock market-driven?

You know the old saying that all happy families are alike, but all unhappy families are unhappy in their own way? The same conditions never prevail from one market to another one. This is rather serious. We know we have a world that operates on credit. Too much credit and too loose credit. So we have a price to pay for getting too irrationally exuberant.

Why wouldn't you be surprised if the stock market dropped another 15%?

The market takes on a certain momentum and it could happen. I didn't say it would happen. I said it could happen. In a stock market, believe me, anything can happen! Confidence changes. You measure confidence by the price-to-earnings multiple and it's probably gone from 18 to 16 here, down about 10%. The long-term average is around 15.

I'm an observer of this. I don't know what to do myself. But I don't feel any need. I doubt I will change my stock-bond ratio for the rest of my days.

Some people are saying we could see a repeat of what happened to the stock market in 1987. Do you think that's the case?

1987 was nothing, really. Think about it. In a short period -- one day -- it was pretty much all over. The market went down a little less than 25%. But by the end of the year, it was up 3%. 1987 was an up year in the market. I don't think this one will be. But if people are saying that it could be like 1987, they should pray that it is!

Are you surprised that even money-market mutual funds have been affected by this credit mess?

Not the money-market mutual funds as such. It's the ones that offer you a higher yield. Money-market funds, as far as I know, every one is still valued at a dollar. But in this business, everybody is always trying to sell you something. If money-market yields are low, then (they say) here's a money-market fund where you have a yield that's more. How do you have more? You buy lower quality paper. This is not complicated. And you pay a price. When people are gambling in their money-market fund, they've got to be very foolish.

I'm an indexer. I own the market. And I'm happy. Markets come and go. In my book, I use a quotation that I stole from Shakespeare. A day in movements of the market are like "a tale told by an idiot -- full of sound and fury, signifying nothing." I'll say this seems to be signifying a final, at long last, reversal of the easy credit, and the sloppy credit analysis, that has characterized the recent era.

By Definition, We Remain in a Downtrend

A few concise answers to your questions:

As far as your money market funds, they all invest in different ways. You should call the manager and find out if they own any paper tied to subprime lending. So far, I have not seen any problems but as you know, ghosts can come out of the closet.

The HOUSING business is in the 2nd or maybe 3rd inning of its downtrend. I find it amazing that calls for a bottom continue. Who do these people think they are kidding? It does not have to end in a crash. My thinking has been that we would have a slow bleed over time as prices have to come down in order for inventories to come down. As far as Miami, forget it. I will be looking to buy a few condos for $7,900 in a few years as the maniacs are putting up another 20,000 units in the middle of a condo depression in South Florida.

The FED did what they are NOT supposed to do...their move was purely to lift the market. How do I know? They made the move on option's expiration day...forcing the hands of the shorts and the puts. Why not wait until Monday? It is now scary that the Fed is trying to game the markets. This move was not to help Aunt Mary and Uncle was to help the hedge funds that were getting massive order to prevent a meltdown.

Yes...I saw that action on Thursday and yes, the move off the Fed cut started Thursday...not Friday morning. Why do I say that? Simple! There was massive illegal insider trading on Thursday...but no one will get caught because as usual, no one is watching. The evidence: out of nowhere, FINANCIALS were bought in big blocks...and the Fed struck the next morning. I would love to hear the tapes of the Bernanke/Paulson phone calls before the rate cut. THE NEWS WAS LEAKED...CASE CLOSED! Do you think anyone is going to audit the "out of nowhere" massive FINANCIAL stock buying? Doubt it! Even people that are not skeptical have to raise their eyebrows at Thursday's action. Did you notice that on Friday, there was not a shred of bad news announced by anyone? HMMMM!

The rate cut is meaningless. Nobody borrows through the discount window. It was a move to stir the markets...that's it. The move actually hurt the economy because the 10 year yield was up sharply.

The FED now has ammo with the Fed funds rate. They WILL lower rates...but only IF stock markets continue to get hit. They are more worried about a financial meltdown brought on by Alan Grenspan, lenders, investment bankers and the hedge funds than the economy. I have told you for months this Fed was just plain stupid and just reactive to the news. They are not proactive and never get in front of any problems. Now...finally...finally, they admit there are problems. I highly doubt we will ever hear the word "contained" again. This, just 2 days after the Fed said they would only cut rates in the event of a "calamity."

If I was short, I would be scared every night going to sleep because you won't know if the FED will cut rates the next morning. The hint: watch for a rate cut after the next big down day in the market.

The charts are horrible. If this market is going to go higher, there will be a whole lot of repairing to do first. Now that the market has had a 600 point pop...I suspect we get some backing and filling. I am doubtful we can get a V-like move up...but with the FED throwing money out of airplanes, I recognize anything can happen.

Barron's got it all wrong. It is not about someone's performance when giving out 3,000 stock picks on TV. It is the fact that anyone in their right mind believes that being touted on 3,000 stock picks could provide any value whatsoever.

I do not think this economy is in recession. I believe many areas of the economy are in recession. If we are indeed in a recession, the market will snuff it out and start another leg down.

No...this market has not had a follow-through day by definition, we remain in a downtrend.

Yes...the Mets are starting to open up a lead in the East. OK...shut up Gary.

Gary Kaltbaum

How You Can Survive The Correction

Paul Katzeff

The sell-off hurts. The S&P 500 was off about 7% from its July 19 intraday high through Monday's close.

That leaves the big-cap index up a scant 1.92% for the entire year.

So we're in a wrenching correction. The sparks for this conflagration are the credit crunch and fallout from the subprime meltdown.

Many investors have been wondering if they should bail out of the market -- before their accounts dwindle further. Should they go to cash?

The question is especially urgent for people near retirement.

The trouble with exiting is that the medicine is often worse than the ailment.

People don't get back into the market in time. As a result, they miss the start of the next rally. That means they lose a big chunk of gains.

"If you're getting hurt by this downturn, it means you weren't able to foresee the sell-off," said Stuart Ritter, a financial planner at T. Rowe Price. "What makes you think you'd be any better at foreseeing the start of the next rally?"

In fact, growth you miss out on is a bigger loss than whatever setback you suffer in a downturn, says Ritter.

Still, investors obsess over how much they lose from a market peak. They overlook their long-term gains, he says.

Market timing makes more sense with individual stocks. Three out of four stocks move in the same direction as the market. And a stock can dart way above or way below the market average. Failing to trade in step with the market can be ruinous to those not committed to keeping losses small. A stock can take many months to come back from a plunge, or never recover at all.

But risks shift with a broad portfolio of stocks. Just as the stock market has recovered from every bear market, so do stock funds diversified across several industries.

The average bear market has taken the Dow industrials down 31% and has lasted 13 months, according to the Stock Trader's Almanac. From bottoms, it has always marched on to new highs.

Buy And Hold

So with funds you should focus less on protecting your capital from sell-offs and more on not missing gains that the next uptrend brings.

Look what happened to investors who were out of the market on days it scored its biggest gains from 1969 through 2001, a period of 8,100 trading days.

If they missed out on just the 10 best days in that time, $10,000 they invested at the outset grew to $74,000, according to T. Rowe Price. If they missed the 40 best days, their end balance was $24,900.

But if they had stayed in the market through its ups and downs, their end balance would have been $124,700.

Some studies show that missing the worst days can provide an even better return than making sure you're in on the best days. But the kind of risk is the same. If you're wrong or get whipsawed in and out of the market during volatile times, you miss big chunks of uptrends. You may end up buying high and selling low.

"Unfortunately, people get shook up by short-term volatility," Ritter said. "Too many of them think they're better off if they try to dodge short-term ups and downs."

A buy-and-hold strategy works better. Take the 50 years that ended Dec. 31, 2006. If you stayed invested in stocks in the S&P 500 during any 10-year period in that half-century, the worst you would have done was gain an average annual 1.2%.

In the most lucrative 10 years, your annual gain would have averaged 19.2%. That was the decade through 2006. The average annual gain was 11.3% for an all-stock portfolio.

Time is on the side of long-term investors. The average bull market has taken the Dow up 84.6% and lasted nearly 25 months.

But what's the best course of action for someone near retirement?

Don't put money you'll need to spend soon into stocks, Ritter says. "Money you need within two years should be put into a money market fund, not stocks," he said. "Return is lower, but so is volatility."

Money you don't need right away should be allowed to grow.

"We tell people to plan to live 30 years in retirement," Ritter said.

Has Market Turmoil Shattered the Investing Rules?

By Gregg Wolper

The past month's stock-market gyrations seem to have everyone on edge. If you've managed to remain calm, congratulations--that's the way to succeed as a long-term investor. If you've been shaken, that's understandable, too. It's tough not to be, given the drumbeat of dramatic news reports about collapsing mortgage firms and 200-point drops in the Dow.

Even more unnerving than the stock market's slide itself is the notion that the recent turmoil has taken an unprecedented and completely unexpected turn. From several fronts we've heard that the markets are behaving in strange, wild ways. The implication: All the assumptions previously underpinning standard investment theory have gone up in smoke.

For example, the manager of a long-short fund, which is designed to handle all sorts of market conditions, explained in The Wall Street Journal his fund's unimpressive showing by saying recent events were "an anomaly." In a Financial Times article, Lehman Brothers explained that its computer models were "behaving in the opposite way we would predict and have seen and tested for over long periods." Later, that same article noted that the computer models running an institutional Goldman Sachs fund had called the confluence of market events so unusual it could happen only once every 100,000 years.

Similarly, according to The Wall Street Journal, some managers "said they were surprised the sell-off was spread so widely across various sectors of the market--from stocks to bonds, to commodities such as gold--which usually tend not to move in tandem. The correlation meant that no matter where they had invested, they would take a hit."

Scary stuff, no? Panic might indeed be called for if every sector was, in fact, behaving in new and irrational ways, and if there truly was no place to hide. Fortunately, neither of those claims is true.

I don't doubt that shocking, unprecedented things have happened to mortgage-bond traders or others at the immediate center of the storm. But it's important to note that the investments favored by the masses generally have performed just as one would expect--and that most time-tested investing tenets remain intact.

Moreover, hiding places weren't hard to find.

Safe Haven?
Bonds don't always provide shelter when stocks are falling. Bonds (even Treasury securities) and stocks can decline in value simultaneously, most commonly during periods of sharply rising interest rates. In such periods, the rising rates make the coupon payments on existing high-quality bonds less valuable, sending the bonds' prices down. Meanwhile, those same rising rates increase the cost for businesses that must borrow in order to invest, and they make it less likely consumers will borrow in order to spend. As a result, stocks can fall as well.

Even at such times, though, bonds typically suffer milder losses than stocks. More important, in many other situations higher-quality bonds actually rise when stocks fall, as frightened investors overloaded in equities turn toward alternatives they consider less risky.

The managers' statements above would seem to indicate that this standard relationship had disappeared. But bond-fund investors know better. Over the one-month period through August 16, while every one of Morningstar's diversified stock-fund categories, domestic or international, suffered painful losses of at least 7.7%, the long-government bond category gained more than 2%. The intermediate bond group (the biggest bond-fund category, which includes core corporate-bond funds) and intermediate government category also landed in positive territory, posting gains of more than 1% each.

In other words, investors who had bought straightforward bond funds for protection against a stock-market swoon got exactly what they hoped for.

Keeping Their Balance
How about old-fashioned balanced funds--those that split their investments between stocks and bonds? And target-date funds, the newest of balanced-type offerings, which have taken the fund world by storm? These, too, behaved as one would have expected over the past month. The conservative-allocation category (funds that own a mix of stocks and bonds but tilt more toward bonds) lost just 3.5% on average over the month-long period. The funds we classify as moderate-allocation, which have higher stock allocations, also provided the expected results under the circumstances. They lost more than their conservative cousins--down 6.4%--but less than any of the diversified stock categories.

The reassuring patterns go further. The target-date funds designed for the youngest investors are the most aggressive, and those geared for older investors are the most conservative. So you'd expect the former to have suffered the worst losses and the latter to have held up best--and for all of these funds to have fared better than all-stock funds. (That's because these portfolios tend to include bonds and cash in addition to stocks.) Sure enough, the groups' results over the past month fit that pattern almost exactly. Those funds targeting 2000 through 2014 lost a little more than 4% on average, the middle range of target funds lost a bit more, and those aiming for 2030 and beyond lost the most but still outperformed nearly all the pure-stock categories.

High-yield bonds also behaved as theory would have it. Conventional investment wisdom holds that the prices of such "junk" bonds, which have below-investment-grade ratings, should behave partly like high-quality bonds, which respond primarily to interest-rate movements, and partly like stocks, in that the changing outlook for the particular company or sector has a substantial effect on the price. And over the past month, the high-yield category lost 3.6%, one of the weakest showings among the bond categories but far better than any stock category.

The Other Extreme
So much for those funds that were supposed to hold up fairly well. How about the other end of the spectrum? Conventional wisdom states that in exchange for their higher potential gains, emerging-markets funds also pose a greater risk of loss than do foreign funds that focus on developed markets. That goes double when such funds have been on a heated rally for years, as they've been since 2003.

So what happened this time? Over the past month, emerging-markets funds suffered the worst losses of any Morningstar categories, with diversified emerging-markets funds losing more than 16% and the Latin America category plummeting roughly 21%.

Don't Rip 'Em Up
Not every type of fund reacted in expected ways. As Russel Kinnel explained in a Fund Spy column last week, some ultrashort-bond funds performed much more poorly than most would have predicted. Precious-metals funds sank sharply. Surprises could be found in certain other corners of the investment world as well, especially in the more esoteric realms explored by quantitative hedge funds and the like. By and large, though, true surprises in more standard areas were much less common than the startling media reports would lead one to believe.

Of course, such reassurance only goes so far. Even if your bond funds held up well, it's no fun watching your stock funds fall. But we can at least take comfort in the fact that we need not rip up those investing guidebooks just yet.

Concentrate On A Few Winning Stocks

Marie Beerens

Most portfolio management theories claim that diversifying your portfolio is important to limit losses.

But a portfolio is hard to manage when it holds more than a few stocks.

"The more you diversify, the less you know about any one area," IBD Chairman and Founder William O'Neil wrote in his book, "How to Make Money in Stocks."

"The best results are usually achieved through concentration, by putting your eggs in a few baskets you know well and watch very carefully," he said.

If you have too much on your plate, you may miss warning signs on some stocks that may have peaked or are giving back profits.

So, what's a reasonable number of stocks to own in one's portfolio? If you have $10,000 to invest, two or three will do the trick. With $25,000, you can expand that to three or four. Even if you have $100,000 or more, five or six stocks should be sufficient.

If you see a stock that you think has strong potential, consider getting rid of your weaker performers and use the cash to buy it.

If you notice that one of your stocks is doing well, add shares to it when a secondary buying opportunity comes up. This can be when the stock rebounds from a first or second pullback to its 10-week moving average or while it's still within 5% of a proper buy point.

When you keep track of only a few stocks, you'll have a better grip on their price-volume action, current news and potential sell signals. Then, you can keep a watch list of other candidates if you need to swap stocks.

In the current market correction, it's best to wait on the sidelines. You can build a list of stocks you like to get them when the market finally rallies. It's better to have a few winners than a large portfolio of average or underperforming stocks.

Social Networking Hits Investing

By David Bogoslaw

For most equity investors, the wild market volatility of the past few weeks has been cause for gritted teeth and palpitating hearts. But a few who have become active in online trading communities took some solace in the fact that they at least had found a place where they can see how other investors are riding out the storm.

"Just the fact that I'm seeing people in there buying calls (an equity option that bets on rising prices) and common stock has definitely given me confidence that the individual is buying on the dip, which is basically what I do, and it's always good to get some reassurance that other people are doing the same thing," says Jim Collins, who opened an account at in January.

Like many other parts of the Internet, online trading sites are more and more turning into collaborative experiences. Only one of the better-established discount online brokers, E*Trade Financial (NasdaqGS:ETFC - News), has made a foray into collaborative Web 2.0 capabilities with its acquisition of investment community Web site ClearStation in 1999, but a handful of newer brokers have made social networking a cornerstone of their platforms.

Getting Personal

Incorporating social media, or social networking, features such as message boards, blogs, live chat rooms, and podcasts works to the mutual advantage of both brokerages and their customers, says Brian O'Malley, a senior associate in the Menlo Park (Calif.) office of Battery Ventures Partners, a Boston venture capital firm that invests in emerging technology companies. Customers want guarantees that they're getting credible information from trustworthy sources, and brokerages realize their business will suffer if they can't ensure the legitimacy of the information and users on their Web sites.

The rise of trading sites centered on social media is seen by some as part of a backlash against the mass e-mails people used to get from unknown people promoting penny stocks and more often than not looking for a quick pop. But it also reflects growing demand for two-way flows of information.

"We see today's consumers aren't content to sit back and have their entertainment sent to them, or their news or, increasingly, to have financial advice sent to them," says Donato Montanaro Jr., co-founder and chief executive of TradeKing, which launched in December, 2005. "They demand to be part of the conversation that impacts their lives, and we are empowering that conversation." Investors in TradeKing include Battery Ventures Partners, and O'Malley sits on TradeKing's board of directors.

Investors Who Network Trade More

TradeKing allows all of its members to have their own blogs through which they can share investment strategies, or even thoughts about the political landscape that may affect future market conditions. The site's key innovation is its Certified Trades capability, which allows users to reveal what they have bought and sold and at what price.

Montanaro, who cut his teeth on trades as a licensed broker before being put in charge of all online trading at Quick & Reilly in the mid-1990s and founding SureTrade, is convinced the site's social networking features encourage actual trading. Roughly 2,000 to 2,500, or just under 5%, of TradeKing account-holders are really active, either blogging or publishing their trades. "That 5% makes up just over 10% of the site's revenue, so clearly investors who network more trade more," he says.

Customers pay a $4.95 commission for stock and ETF trades, and $4.95, plus 65 cents per contract, for options.For the first 13 months after the launch, there were just over 1,000 people who became really active and stayed active on TradeKing, and that has more than doubled over the past six months. Zecco Trading,, a division of Equinox Securities and part of investment community, which launched last October, says it has been adding 1,500 new trading accounts a week for the past few months.

How Safe Are the Sites?

The number of funded and active customers at, which launched to its first customers in late 2000, has tripled from about 15,000 to 45,000 over the past 18 months. Granted, compared to the number of people with accounts at established discount online brokers, it's still very early days for the newer trading sites that are betting on the market potential of social networking.

The growing popularity of these sites raises questions, however, about the kinds of protection they offer investors from scams such as "pump and dump" schemes, and what they provide in lieu of suitability rules that registered investment advisers are required to follow. Those rules are meant to ensure that investors stick to appropriate trading strategies that match their financial circumstances.

Montanaro and Mike Massey, the company's director of community development, stress that TradeKing, as a brokerage regulated by the Financial Industry Regulatory Authority (FINRA), cooperates with regulators and updates them about new features it's thinking about adding to the Web site. Last August, it launched the certified trades function, which allows customers to see what other account-holders who choose to participate are trading, how many shares they're buying or selling, and at what prices. Perhaps more important, the certified trades feature assures customers that TradeKing knows that those participating are real people and has validated their identity.

The Electronic Paper Trail

"We know if someone blogging is the CEO of Whole Foods (NasdaqGS:WFMI - News) and is blogging about Wild Oats (NasdaqGM:OATS - News) and we know that he's got a greater than 5% interest in Whole Foods," Montanaro said, referring to the recent controversy involving the chief of the No. 1 organic supermarket chain. "Being a regulated entity, this would be a really stupid place to perpetrate a scheme because you're creating a trail attached to your name with a regulated entity," he adds.

Massey says his team reviews every blog entry and takes steps to remove comments that can be construed as unethical or potentially harmful to investors. "We try to be as light-handed as possible. In one or two instances, we have removed the user and taken down the content (he posted)," he explained. TradeKing says it has no specific suitability rules beyond the warnings listed under the disclosures and terms and conditions tabs on its site, which customers are supposed to read before opening an account.

Zecco Trading takes it a step further by requiring prospective customers, as part of the application process when opening an account, to fill out a suitability form that lists their investment history, income, experience using various types of financial instruments, and the options strategies they've used in the past. Based on those responses, Zecco Trading assigns each account-holder a specific level of options permission, which he needs to stay within when choosing strategies, says Tim Krause, director of risk management at Zecco Trading.

Something in Common -- the name stands for zero commission costs -- offers free stock trading through Zecco Trading to customers for their first 10 trades a day and 40 trades a month. Options trades cost $3.50, plus 60 cents per contract. Its biggest revenue source is interest earned on margin borrowing by its customers, says Gabriel Dalporto, Zecco's chief marketing and strategy officer.

Zecco Trading also allows customers to see what other customers are buying and selling as part of the individual user profiles, which also include preferred trading strategies. Users can contact each other and form relationships based on shared stock interests or investment approaches.

For Tom Sosnoss, president of, 80% of those transactions are options. It's the very complexity of options, which don't lend themselves to clear black-and-white solutions, that encourages participation in an investor community. Although it has a Web-based platform, most of thinkorswim's functionality is in its software and 95% of its customers use the software, which is free.

Not Another Facebook

Through a sophisticated technology platform that includes live audio, enabling customers to go into separate rooms to discuss a particular strategy, thinkorswim, a unit of Investools (NasdaqGM:SWIM - News) that launched to its first customers in late 2000, emphasizes investor education, which it's confident generates more transactions.

"The thing that intrigues customers is they like to be challenged intellectually," Sosnoss says. "When they're challenged, options traders become a successful community."

But Sosnoss eschews the idea of "social networking," which makes him think of his teenage kids surfing Facebook. He believes the reason people are communicating on is to learn how to be more effective traders, not to gain a sense of community for its own sake. "We build trading networks. Really what it is, we build technology that drives domain knowledge. The way you do that is you provide a network for customers to interact with you, as well as with each other," he says.

Listening to the Feedback

But O'Malley at Battery Ventures Partners argues it's hard to start with technology and assume that people will adopt it. "You have to start with well-understood social practices. Then you try to take technology to facilitate those practices and adjust the technology as you roll it out, as you see how people are using the technology," he says. TradeKing has been refining the technology on its Web site since it launched. Many of the new features it will add in mid-September, such as the ability to turn on the certified trades function without revealing the amounts bought or sold, are based on customer feedback on the blogs.

Until now, TradeKing user Jim Collins hasn't used the certified trades feature. "The actual dollar amount is something I'm not comfortable showing, but if they get that functionality (to hide the amounts) up and running, I'm ready to go," he says.

Future innovations that Zecco and TradeKing are working on will allow investors to form groups centered around common stock interests or trading strategies. And farther down the road, TradeKing plans to roll out a tool that allows users to search returns on investment and see which customers have been most successful over time.

One sign of the refuge some nervous investors are taking in online investor communities is the jump in volume of option trading at TradeKing on especially bumpy market days, says Montanaro. "They get some comfort and validation. People enjoy seeing both sides of experiences when markets are especially turbulent," he said. But Montanaro makes it clear that any technological innovations that TradeKing adds will be to drive higher usage and therefore greater profitability.

A Tip From a Friend

Collins, who worked for 10 years on the sell side for brokerages like Lehman Brothers (NYSE:LEH - News) and Donaldson Lufkin & Jenrette (since acquired by Credit Suisse (NYSE:CS - News)), said he's been getting investment ideas from people commenting on his blog posts. When he reported an interest in engineering and construction companies and that he had a "huge win" from buying options ahead of Foster Wheeler's (NasdaqGS:FWLT - News) first-quarter earnings, somebody recommended Perini (NYSE:PCR - News) to him.

"(In the second quarter), the earnings went through the moon. I sold it with a 100% gain yesterday," he said. "Without that comment, I probably would never have unearthed Perini. That's a tangible example of an investable idea."

Whether these sites can truly unleash the wisdom of the crowd for market players remains to be seen. But you can bet that in investing, as in other corners of the Web, the urge for community will grow stronger -- and the bigger players in online trading may have to respond to upstarts like TradeKing and Zecco.

Sunday, 19 August 2007

"Stupid" investors, rejoice!

Ben Stein
Economist, writer, lawyer, and actor

No one is too stupid to make money in the stock market. But there are many who are too smart to make money.

To make money, at least in the postwar world, all you have to do is buy the broad indexes domestically--both in the emerging world and in the developed world--and, to throw in a little certainty about your old age, maybe buy some annuities.

To lose money, pretend you're really, really clever, and that by reading financial journalism and watching CNBC, you can outguess the market day by day. Along with that, you must have absolutely no sense of proportion about money and the world at large.

For example, right now we are stewing over what everyone calls "the subprime mess" and going crazy, mourning all day and into the night--falling over ourselves to get all of the misery right, to paraphrase Evita. I'm writing this on Aug. 13, 2007, and in the past four or five weeks, the markets of the U.S. have lost some 7% of their value, or about $1 trillion.

But read on: The subprime mortgage world is about 15% of all mortgages, or $1.5 trillion worth, very roughly. About 10%--approximately $150 billion--is in arrears. Of that, something like half is in default and will likely be seized in foreclosure and sold. That comes to about $75 billion. Roughly half to two-thirds of that will be realized on liquidation, leaving a loss of maybe $37 billion. Not chump change by any means--but one-thirtieth, more or less, of what has been knocked off the stock market.

The "smart" investor nevertheless reads the papers, bails out, heads for the hills, and stocks up on canned foods. He gets a really big charge out of reading in the press that there are also problems in the mergers and acquisitions market and that some deals will not go through because there are problems raising the funds for the deal. He does not see that the total value of the U.S. major stock markets (the Wilshire 5000) is roughly $18 trillion. The value of the deals that have failed in the private equity world is in the tens of billions or less. The loss to investors--what the merger price was compared with the normalized premerger price--is in the billions. It's real money, and I could buy my wife some nice jewelry with it, but it's pennies in the national or global systems.

The "smart" investor also reads that the Fed has injected, say, $100 billion into the banking system in the last week or ten days, and says, "Aha! The whole country is vaporizing. Look how desperate the system is for money!" What he does not see is that the Fed is always either adding or subtracting liquidity and that recent moves are tiny in the context of a nation with a money supply in the range of $12 trillion. No, the "smart" investor is far too busy looking for reasons to run for cover and thinks he can outsmart long-term trends.

The stupid investor knows only a few basic facts: The economy has not had one real depression since 1941, a span of an amazing 66 years. In the roughly 60 rolling-ten-year periods since the end of World War II, the S&P 500's total return has exceeded the return on "risk-free" Treasury long-term bonds in all but four ten-year periods--the ones ending in 1974, 1977, 1978, and 2002. The first three of these were times of seriously flawed monetary policy that allowed stagflation, and the last one was on the heels of the tech crash and the worst peacetime terrorist attack in the history of the Western world.

The inert, lazy, couch potato investor (to use a phrase from my guru, Phil DeMuth, investment manager and friend par excellence) knows that despite wars, inflation, recession, gasoline shortages, housing crashes in various parts of the nation, riots in the streets, and wage-price controls, the S&P 500, with dividends reinvested, has yielded an average ten-year return of 243%, vs. 86% for the highest-grade bonds. That sounds pretty good to him.

The "smart" investor, in a bunker in the Montana wilderness, keeps his money in gold bullion. After all, he's heard that home prices are falling slightly nationwide and a lot in some areas (he ignores areas of rising prices like San Francisco and New York City). He says that this will discourage the consumer and lead to a severe, bottomless recession. He even has bald people on TV telling him he's right to worry.

The stupid investor, the guy who just lies on his couch, knows that the consumer is always about to stop buying and never quite does. Maybe someone in his bowling club has told him there has only been one year since 1959 when consumer spending fell--and that was barely, in 1980. Somehow, if the consumer could keep spending after the bursting of the tech bubble wiped out $7 trillion or so of wealth, maybe the consumer can keep spending even if the subprime "mess" wipes out roughly half of 1% of that tech-bubble loss and the stock market has a fit. And maybe he knows that, even if there is a recession, recessions rarely last more than two quarters, and the economy and the stock market revive mightily after that--and that buying stocks in a recession is a good idea, not a bad idea.

Now, the alert reader may at this point be saying, "Hey, that `stupid' guy who's really smart is a long-term investor. That's why he's doing so well." Correctamundo, alert reader. There used to be a saying: "Bulls make money and bears make money, but hogs get slaughtered." I am not sure that was ever true, but it sure ain't now. The real story is that long-term investors who have some sense of proportion make money. Short-term investors who live and die by the sweep-second hand of the $300,000 watch get rich fast and poor fast and sometimes are slaughtered faster. I have no advice for them except that the next train may be bringing in someone a little younger who's a little faster on the draw and a lot hungrier, so they'd better enjoy their Gulfstream while they have it.

For the rest of us, the stock market is cheap on a price-earnings basis, profits are fabulous, Mrs. Clinton and Mr. Giuliani are far from being socialists and in the long run, both here and abroad, stocks are a lovely place to be. I have no idea what the S&P will be ten days from now, but I am confident it will be a lot higher ten years from now, and for most Americans, that's what we need to think about. The subprime and private equity and hedge fund dogs may bark, but the stock market caravan moves on.

Wednesday, 15 August 2007

Credit contagion

Is the worst over? Fortune's Peter Gumbel offers a 10-point guide to understanding two harrowing weeks - and what's likely to happen next.

PARIS (Fortune) -- Relax! There's really no need to panic! That's the soothing message being put out this week by key players in financial markets after two harrowing weeks in which credit markets in Europe all but dried up, prompting massive injections of funds into the system by the European Central Bank, the U.S. Federal Reserve and the Bank of Japan.
Overnight borrowing rates have come back down after spiking wildly and stock and bond markets have been bouncing back around the world. The European Central Bank, which continued to inject funds into the market on Tuesday, albeit less than one-tenth the amount at the peak of the crisis last week, says that money-market conditions are "normalizing." And Tuen Draaisma, Morgan Stanley's chief European equity strategist, for one, recommended in a note to clients that they should go "overweight" in equities because "we may already be at the point of maximum bearishness and uncertainty, which by definition is the right moment to buy."

So is the worst over? Even the most die-hard optimists concede that it'll take a lot more than a few days of calm to restore confidence among financial institutions and retail investors. "The market is concerned pretty much across the board," says Gerry Rawcliffe, a managing director in the banking group at Fitch Ratings in London.

Here's a 10-point guide to what we know and don't know about the troubles, and what the repercussions are likely to be:

Why did America's subprime mortgage woes have such a big impact on world financial markets?
Because these mortgages were lumped together in packages and sold as asset-backed securities all over the world, particularly in Europe. Often the initial securities were themselves put into new packages, leveraged up and resold as so-called collateralized debt obligations (CDOs). They are a sort of derivative play on the underlying mortgages, just as futures and options are a play on stocks and commodities. Big banks have whole securitization departments who create these instruments. They do so to profit from the difference between the long-term returns these investment vehicles produce and their more plain vanilla short-term borrowing, and to earn fees.

Who bought them?

Everyone, and that's the problem. The CDO market has exploded in recent years: More than $100 billion worth of structured cash CDOs were issued in the fourth quarter of last year alone, according to CreditFlux Data+, a London firm that tracks them (and that doesn't include the even more arcane "synthetic" CDOs). Banks, institutional investors and hedge funds have been the main customers, but some retail investors have also bought into them through the asset-backed securities, or ABS, funds that some of the biggest European banks sell to the public. Everyone who bought these securities was given the same pitch, namely that they were a relatively safe bet, since much of the paper had AAA ratings, but offered higher returns than regular corporate bonds.

So what went wrong?

The number of delinquencies in the U.S. subprime mortgage market has been rising and is now substantially larger than anyone expected - about 14 percent of the total, up from about 10 percent in 2004 and 2005. That means there's a strong likelihood that some of the securities holders, especially those where the underlying mortgages were taken out in the past couple of years, are sitting on losses.

Those troubles have been massively compounded by the aggressive use of leverage in CDO packages. When U.S. blue chip financial players like Bear Stearns and then a variety of European banks began reporting problems, panic quickly gripped the markets. That turned into a vicious circle: These debt instruments have now become impossible to price because nobody wants to buy them any longer. And since they can't be priced, the size of the losses aren't clear, which in turn has given rise to more rumors about financial players in trouble. Banks in continental Europe especially simply stopped lending to one another, which is why the liquidity dried up in the credit markets as a whole and the European Central Bank had to jump in.

How big is the problem, really?

Nobody is quite sure. Patrick Artus, an economist at Natixis in Paris, reckons the total damage inflicted by subprime woes is a relatively manageable $45 billion, which is the difference between the expected rate of mortgage delinquencies and the current much higher rate. Another French bank that is an important player in the derivatives market, Sociéte Générale, reckons that even if things really turn sour, the worst will be losses of about $100 billion. That may sound like a lot, but it's the equivalent of about 1 percent of the total market capitalization of the S&P 500.

Such calculations highlight the real issue here, that the panic has been due more to a collapse of confidence than to any financial cataclysm. "We're still primarily looking at a liquidity crisis rather than a credit or a solvency crisis," says Fitch's Rawcliffe.

Is it really over?

No. The market "remains very, very fragile," says a top executive at one of the leading European banks. Some confidence has been restored into the international banking system and its overnight lending patterns by the big injections of central-bank funds, but nobody has yet dared to start buying that subprime paper in any sizeable quantities. And because there's so little transparency about who is sitting on what size losses, the rumors continue to swirl.
Nouriel Roubini, an economics professor at New York University's Stern School of Business, who has long warned about the risk of financial contagion, reckons some other parts of the U.S. housing market including home equity loans and second mortgages are starting to display what he calls the same "toxic characteristics" as the subprime sector. More optimistically, Neil McLeish, the chief European credit strategist at Morgan Stanley, says that, "we have passed the absolute peak of that anxiety and uncertainty." But even he believes that credit market conditions will be more difficult in the coming months and, "there is still some risk of additional volatility" at least for the next month or so.

Who are the biggest casualties?

Banks and financial market players across the world are starting to come clean about their exposure and losses, partly in order to help restore confidence in the market. The losses incurred by Wall Street titans Bear Stearns (Charts, Fortune 500) and Goldman Sachs (Charts, Fortune 500), which this week announced it is putting $2 billion into one of its hedge funds, have received the most publicity. Outside the United States, firms such as insurer AXA (Charts) and BNP Paribas in France have frozen or shut problem funds, while a range of banks including NIBC of the Netherlands and Commerzbank in Germany have detailed their exposure and expected losses.

The biggest international victim to date is a mid-sized German bank called IKB Deutsche Industriebank that its peers, including a government-owned bank, stepped in to rescue earlier this month, taking over $11 billion of credit lines and putting up a $4.7 billion funding package. IKB had been an aggressive player in the CDO market, through two off-balance sheet firms that it used to pump up its commission income and advisory fees. In the end, its exposure to dodgy securities through these two firms far exceeded the bank's liquidity and equity capital.

Is anyone safe?

Not completely, but barring some huge problem nobody yet knows about, major banks seem in the best position to weather this storm because they have the strongest balance sheets and are able to refinance their operations most easily thanks to the extra liquidity that central banks have put into the market in the past week. "Being a bank and having access to the central bank (credit) windows is key at the moment," says the top European banker.
Hedge funds are another story, as the Goldman Sachs-run one that was bailed out this week shows, although some of these funds foresaw the troubles and have been aggressively shorting the subprime sector and any securities relating to it.

Why didn't central banks cut interest rates in response?

Some critics of the European Central Bank, especially in France, are saying that its interest rate policy, which has consisted of regular rate hikes to counteract inflation, has partly fueled this crisis. "One can ask if the ECB isn't becoming a prisoner of its rate-increase strategy," Thierry Breton, the former French finance minister said this week. But bank economists are generally more supportive and say that the ECB acted smartly with its three consecutive days of huge money-market interventions - the biggest of which was a whopping $130 billion injection last Thursday. "It's a demonstration of the financial system operating as it should," said James Nixon, a London-based economist at France's Société Générale, who says that the troubles primarily affect the financial sector rather than the wider economy.

While the Fed did cut rates in 1998 during the last derivatives meltdown, involving Long Term Capital Management, central banks may not need to this time if markets continue to calm down. Indeed, the big question now is whether the ECB and the Bank of Japan will go ahead and raise rates in the next month, as they had signaled before the crisis. Roubini isn't sure, and thinks that the Fed may well move to reduce U.S. rates quite soon. "The likelihood of a cut in rates is now much higher," he says.

What does this mean for the world economy?

So far, not all that much - but keep your fingers crossed. Growth in Europe and Asia remains buoyant, even if the U.S. outlook is unclear. Some borrowing by companies and individuals is bound to get more expensive as markets adjust and restore a risk premium. But "it's not obvious that the repricing will lead to an economic slowdown," says Société Générale's Nixon, although there's a possibility that Britain's economy, which has thrived because of its heavy dependence on financial services, may be vulnerable. Roubini thinks the United States will bear the brunt of what he sees as an inevitable slowdown of consumer spending related to the housing woes, and reckons that this could ultimately spill over to the global economy if it's sufficiently severe. "The effect on the real economy in the rest of the world depends on whether there's a hard landing in the U.S." he says.

Will there be any regulatory fall out?

This is almost inevitable, especially in Europe where it's now clear that many of the purchasers of these securities didn't fully appreciate the risks they were taking. Look for the first moves to come in Germany, where bank bail-outs are exceedingly rare. The last time a bank got into serious trouble there was in 1974, when the Herstatt Bank collapsed after some disastrous forays into foreign-exchange trading that bear some similarity to IKB's woes. Regulators quickly followed up with an overhaul of the national banking system. It's not clear that IKB's rescue will have the same dramatic repercussions, but it's already prompting tough questions about how a mid-sized bank could end up with such an enormous exposure to risky assets via an off-balance-sheet firm.

"I suspect that at the end of this, regulators will ask themselves if this very rapid expansion (of transactions involving asset-backed securities) has been a good thing for banks, or if the risk comes back to haunt you," says Fitch's Rawcliffe. Watch also for credit agencies to come under pressure to do a better job at assessing the market risk of exotic financial instruments.

Tuesday, 14 August 2007

For Some Consumers, Credit Crunch Ahead

by Andrea Coombes

Mortgage lenders going bankrupt, hedge funds evaporating, the stock market gyrating wildly: What does it all mean for you and me?

There's no denying that the financial markets are on edge and volatile, and some companies are in difficult straits, triggered in large part by rising foreclosures in the subprime market and the effect on investments tied to those mortgage loans.

But the degree to which the current situation affects individual Americans depends a lot on what you've got planned in coming months.

If you'd like to tap into the mortgage market -- buy a house, refinance your mortgage, take a home equity line of credit -- the recent turmoil will directly affect what kind of loan you can get and how much it will cost.

For many borrowers now, "it's more difficult to get a mortgage loan," said Mark Zandi, chief economist with Moody's "You have to have a better credit score, you have to have more equity," he said.

Interest rates are rising on some loans, and lenders are going to demand strong proof of income and employment. "They're doing everything more carefully. They're more circumspect in extending credit," Zandi said.

But if you've got a fixed-rate mortgage, a good job and no plans to make changes, many economists say that the biggest risk to you right now is owning a non-diversified investment portfolio. Despite the worrisome stock-market volatility, the Dow Jones Industrial Average as of Friday afternoon is still well up from its drop in late February.

"We're going to go through a period of disruption in the markets ... but the fundamentals of the stock market have not changed," said Peter Morici, an economist and professor at the University of Maryland's Robert H. Smith School of Business.

"If you already have a mortgage and you can make your payments, you're cool, and if you have an IRA, Keogh or a 401(k), just leave them alone," he said.

But no one can predict the future, and economists vary widely in their outlook, with some saying a recession is nigh and others saying the economy is in for a soft landing.

"Clearly the big worry is that the stock market starts a big, long bear trend. I don't think that's likely because a lot of fundamentals in the U.S. and global economy are still pretty good," said Nariman Behravesh, chief economist with Global Insight in Lexington, Mass.

To investors, "I would say, 'don't panic,'" he said.

Job market hit?

Still, there may be trouble ahead for Americans in other areas.

Thanks in part to the subprime mess, companies are finding it harder to get financing for some deals. Right now, companies are mainly unable to finance their riskiest deals, but if the credit crunch should spread and hit most companies, average Americans may feel the pinch -- in the job market.

"Businesses that can't get credit or have to pay more for capital will be less aggressive in their investment and hiring," Zandi said. "The job market is weakening and I think will weaken further as a result of recent events."

To forestall a credit constriction, central banks in the U.S., European Union and Canada are pumping more money into their systems. "This whole subprime mess is creating a lot of uncertainty," Behravesh said.

"For investors, it's like you're in a minefield. You don't know where the mines are so you freeze up, you stop doing anything." The central banks' money influx is aimed at easing those fears, and if that fails, a move to lower interest rates may be next, he said.

For his part, Zandi notes the economy is still in growth mode, but the rate of growth is slowing. In a note on Thursday, Zandi wrote that "the odds of a recession over the next six to 12 months have risen from one-in-six to one-in-four."

"I do think most everyone will be touched in some way by the meltdown" in various parts of the mortgage market, Zandi said in a telephone interview.

Homeowners who aren't in the market for a loan may still find their home value decreasing as the tightening of credit constricts home sales, and that plus a volatile stock market "could affect a household's wealth and their perception of their wealth and how aggressively they spend."

Mortgage crunch

Homeowners who can afford their mortgage payment can simply sit this turmoil out, some note. But those eager to buy a home or tap home equity are jumping right into it.

The investors who buy mortgage-backed securities are eyeing rising foreclosure rates among subprime and even some "good credit" mortgage borrowers, and responding by refusing to buy loans. That, in turn, means lenders are tightening up their underwriting standards. Only those borrowers who fit certain criteria are likely to find the loans they want.

Plus, if you're hoping to max out your home equity with, say, a second mortgage, your lender might be a little more leery of a high loan-to-value ratio. For homebuyers, gone are the days of getting mortgage loans with just a 5% down payment and no proof of income, economists said.

And if you've got great credit but live in an area where home prices average more than about $417,000, you'll pay higher mortgage rates right now, even as those who borrow smaller loan amounts are enjoying mortgage-rate declines on those loans.

The investors who buy mortgage loans in the secondary market "really drive the bus in terms of what's available in the mortgage market," said Greg McBride, senior financial analyst with "Those investors are now pricing for risk to a greater extent than they've done in recent years" and they see greater risk in the larger, or "jumbo" loan area.

The average rate on a 30-year fixed-rate conforming loan -- conforming loans are for less than $417,000 -- dropped to 6.66% while the average rate on jumbo loans rose to 7.35% last week according to Bankrate's survey of 100 banks, pushing the spread between the two rates to 69 basis points, up from 28 basis points in just two weeks.

Prospective home buyers who'll need a jumbo loan may want to sit on the sidelines in hopes those rates ease back a bit.

Meanwhile, homeowners need to ensure they understand the terms of their mortgage loan. "The key is planning ahead," McBride said. "Don't get blindsided by a big payment increase."

Some "prime borrowers are still in the position that they can refinance at attractive fixed rates and avoid the type of huge payment increase that's impacted so many subprime homeowners," he said.

Note that getting a home equity line or loan is going to be "a little bit harder and a lot more expensive. It's going to require some digging by the consumer," said Ron Chicaferro, a Scottsdale, Ariz.-based real-estate industry consultant who recently retired as president of Thornburg Mortgage Home Loans Inc.

Consumers are "going to have to start making phone calls, they're not going to be able to rely on a mortgage broker running around doing this. It'll be working on the Internet, making phone calls to their bank. That's the first place they should start," Chicaferro said.

Investors: 'Don't panic'

What's an investor to do? Many say this is the time to stay put, as long as your portfolio is well-diversified.

"It's a great reminder that volatility is part of the game when it comes to investing," McBride said.

"If your portfolio is invested in tune with your long-term objectives, it's much easier to stomach the short-term volatility, and if your portfolio is out of whack, maybe you decide you don't have the stomach for this kind of volatility," he said. That might mean turning to cash investments. "Money markets and CDs are yielding well over 5%, risk free," McBride said.

Investors should not panic, Behravesh said. "I would urge a little caution. If they're going to move anything, I would say make a few sensible moves into maybe less risky assets, but I definitely would urge people not to panic."

Others say investors should be " risk-averse," said Nouriel Roubini, chairman of Roubini Global Economics in New York. "Try to stay away from risky assets and see whether this is just a temporary thing and see whether the economy is going to slow down or have a hard landing," he said.

"In my view, the real economy has been slowing down for a while and this financial turbulence is going to make the real economy worse," he said.

Even as some are pointing to an opportunity to buy cheaper financials stocks, Roubini says now is not the time, noting that there is still "a high degree of uncertainty of where these [subprime-related] losses are, I think you're going to see financial firms increasingly saying, 'yes, we had exposure,' and there will be losses that are going to emerge day after day that will keep these valuations low and falling," he said.

Un-squeezed credit

The credit squeeze has not spread to other forms of consumer credit. With credit cards, car loans and other consumer credit, McBride said there's been no noticeable change in access to credit or rates.

"You're not likely to see much movement in those rates or restriction to capital without some deterioration in credit quality" -- and that's not happening at this point, he said.

But others see problems ahead, particularly for borrowers who have less-than-perfect credit ratings. "Even in those [credit card and auto-loan] markets you have the process of securitization of these loans," Roubini said.

"You're going to have a credit crunch across any securitization market. That's going to tighten credit conditions for consumers across the board."

That's a squeeze some homeowners are already feeling. Homeowners who "bought at the peak [and] milked every last dollar of equity out of the home, then they could well be upside down," McBride said.

"In that case, lenders won't touch it with a ten foot pole. That's a tough spot and it's not one that has a whole lot of easy answers," McBride said. "If you owe more than your house is worth, good credit or not, lenders will be reluctant help bail you out."

Andrea Coombes is MarketWatch's assistant personal finance editor, based in San Francisco.

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Monday, 13 August 2007

Effect of US subprime crisis could be diluted: analysts

FRANKFURT (AFP) - - The US home loan crisis looks set to continue gripping world markets but the effect could be diluted because the risk is spread among investors around the globe, analysts say.

The European Central Bank pumped 155.85 billion euros (212.98 billion dollars) into the eurozone banking market on Thursday and Friday as central banks across the globe rushed to ward off a global credit crunch linked to the US subprime loan market.

A crunch would make it harder and more expensive for businesses and consumers to get loans and cash.

The potential for instability to spread fast when markets re-open on Monday is high, analysts agreed, but most thought the main bourses would weather the storm.

Gilles Moec, senior economist at Bank of America, said: "One of the big issues is that no-one has any real clue of the amount of subprime loans which have been purchased by foreigners.

"The big question is what is the overall amount and this is bad for the markets because if there is one thing that the markets hate, it is uncertainty."

He said however that there was a paradox -- although there was negative market sentiment, the risk appeared to be spread around the world.

"This shows that the risk is not concentrated in any one place and this is a good thing for the market," Moec said.

Subprime loans are offered at high interest rates to Americans who have a poor credit rating and might otherwise be denied credit.

Andreas Huerkamp, a Commerzbank analyst, predicted the crisis would blow over.

"There are strong parallels with the crisis in the mid-90s so you have to be a brave investor to buy shares at the moment," he said.

"But history shows that everything will be forgotten in six months and the market will recover."

The US Federal Reserve and Japanese central bank had made similar interventions to ensure that the markets continued to function normally, with the Fed injecting 62 billion dollars into the market.

The Frankfurt-based European Central Bank, the guardian of the euro, said its decision to pump money into the market was a "fine tuning" operation.

The "fine tuning" on Thursday had involved injecting 94.8 billion euros, more than the bank had released after the September 11, 2001, attacks on the United States.

The cash injections enable commercial banks to borrow from the central bank to satisfy their liquidity needs.

Howard Archer, chief UK and European economist at Global Insight in London, said that if the central banks did their job, the markets should stabilise.

"As long as the central banks succeed in calming markets down, the chances are that the impact of financial market volatility on the real economies should be small," he said.

"Importantly, the underlying fundamentals for the UK and Eurozone economies are still pretty good, so hopefully this will help to limit the overall economic fallout."

Big investors fleeing risk

LONDON (Reuters) -- Big-money institutional investors have turned more risk averse than at any time since August last year, taking positions they typically do not reverse quickly, State Street data showed Friday.

The U.S. financial services firm said its clients, who keep some $13.04 trillion with it as a custodian, have moved into what it called a "safety first" regime.

This is characterized by moving from emerging to developed market equities, embracing bonds and unwinding currency "carry" trades.

Institutional investors tend to take a longer-term view of markets than other investors, so shifts in their strategy can have a significant impact on a market's recovery.

The firm said that since September last year investors had been taking positions reflective either of abundant liquidity or leverage opportunities.

"A quick move back to risk-seeking is unlikely given ... previous history ... and the backdrop of markets," State Street said in a note.

Specifically, the latest data showed risk averse moves such as a sharp fall in demand for emerging Asian equities.

State Street said that a month ago, flows into emerging Asia equities were in the 65th percentile, meaning that they had been larger on only 35 percent of occasions over 10 years.

In the latest data, however, they were in the 5th percentile - almost the lowest level of demand seen since it started collecting data.

Similarly, institutional investors have been unwinding the carry trades in which they have borrowed in low-yield currencies such as the Japanese yen to invest in assets in higher-yielding currencies.

The latest data showed flows into yen rising. A month ago, they were in the 13th percentile. This rose to the 39th percentile in the latest report.

State Street said the risk-averse moves may reflect not just a search for safety but a cashing-in of winning trades.

It also noted that "safety first" was not the most risk-averse regime that it uses to characterize its clients' actions.

That would be what it calls "riot point" and is marked by indiscriminate equity selling.

Saturday, 11 August 2007

ETFs - A Superior Trading and Investment Vehicle

By Doug Tucker

The ETF, or Exchange Traded Fund, has grown from consisting of a handful of broad-based index products, to now consisting of hundreds of products representing almost every conceivable investment theme or idea. Volume has expanded on many of the issues, making them some of the most liquid trading instruments around.

It seems clear that the debate between choosing a traditional mutual fund or an ETF is clearly in the corner of the ETF. ETF fees are much lower than mutual funds, and even factoring in the small brokerage commission applied to an EFT, the savings in fees will make up for the commission many times over. And, some brokerage firms that deal in no load mutual funds will charge a commission to get out if not held a certain length of time. There is no restriction on the holding period of an ETF. And with and ETF you won't get hit with capital gains distributions, so, with the exception of dividends, you get to control when you pay capital gains, short term or long term. You can get in and out during market hours instead of just the close, and there is the ability to easily trade on the short side with most of the active ETFs, with no uptick rule. And there are options available for outright purchases, or for hedging, or for other option strategies. Also, there are ETFs that have leverage, and some that will be inverse to their index, so a long-term short position could have long-term capital gain potential.

The comparison between ETFs and CEFs (closed-end funds) is a bit different. With CEFs, which are somewhat similar to ETFs, you have a security that can trade on its own supply demand; therefore the fund can go to a premium or a discount to its net asset value, sometimes substantially. With CEFs there is also the chance of dilution if the firm wants to issue more stock, usually with an offer for existing shareholders to purchase more shares at a predetermined price. While brokerage commissions will be the same as with an ETF, the management fees will usually be higher with CEFs. CEFs will often target a more specific type of investment, whereas ETFs are usually more broadly index based. However, that has been changing over the last couple of years.

There are more and more ETFs being issued almost daily with very specific objectives. You can find an ETF for almost any country, style, sub-sector, commodity, and even for currencies. There are so many ETFs coming out, it is getting hard to sort through the list. One way to pare down the list is to look at monthly average trading volume. Liquidity is certainly an issue, as some of the newer, narrowly focused ETFs have very low trading volumes, with correspondingly wider bid ask spreads, while the most popular choices are extremely liquid, with a penny or so spread between bid and ask. In time the best will survive, and many too-specific issues will disappear.

In my opinion, some of the too narrowly focused issues defeat the purpose of investing or trading in ETFs.In comparison to individual stocks, there are valid arguments on both sides of the issue. One theory favoring stocks is that you can just pick the best stocks in whatever group or index you are interested in, and not be weighted down by the dogs of the group. That's true. Of course, that depends on you being an excellent stock picker. Roughly 85% of professional, full time mutual fund managers can't beat a benchmark such as the S&P 500. Individual part time investors think they can do better than professionals.

I'm not so sure.It is difficult enough to pick the direction of a market. Much of the movement of a stock will be influenced by the overall market direction. Some say stock movement is about 70% dependent on overall market direction. I can't verify that number as being correct, but it seems in the ballpark. Picking an individual stock on top of picking market direction adds a second variable.

If 70% of a stocks movement is influenced by the overall market, and 85% of professional stock pickers under-perform benchmark stock indexes, it doesn't seem worth the effort to try to sort through the list of thousands of stocks for the small chance of making a larger gain.It is always gratifying to pick a stock that goes up 200% while the overall market is only up 8%. How many stock picks do this? It is easy to fool ourselves into thinking we know something other people don't when we do pick a big winner. But what is the net result of all the stock picks over a period of years.

How many stock picks are down 10% with the market up the same 8%? If you diversify your portfolio, it will probably average out. If you diversity enough, and your stock picking is good, you will probably mirror the indexes. If your have a couple of stinkers in your portfolio then you will probably under-perform the indexes. If you add human emotion and refuse to get out of the stinkers until you break even on those, you might end up severely under-performing the indexes. We all have the same information to work with. It is the information we don't have that will blindside us.

It is only our biases and our opinions on the information that we do have that will influence our trading decisions. And, of course, there is a lot of guessing, as long as we do it with the appearance of authority. Is stock picking with the limited amount of information that we have the best approach?Since most professionals try to beat the indexes and fail, it seems less likely that individual investors can beat the indexes in the long run. So does one have to accept average returns in an index fund if stock picking proves not to provide the desired returns? Not necessarily.

Another approach is to try to beat those returns with a combination of asset allocation and market timing. By not focusing on individual stocks, one is not as concerned with company specific issues such as earnings release dates and guidance disappointments, or with worrying about CEO option backdating, or bookkeeping irregularities, or many other assorted insider problems. Without having to baby-sit a portfolio of individual stocks one can better analyze and assess broader, more accessible issues such as which sectors are trending, which countries are in bull or bear markets, which styles are leading and which are lagging. Superior returns on the more active ETFs can also be enhanced by the use of option strategies which have liquidity and pricing advantages over many individual stocks.

If your stock picking performance over the long run has not kept pace with the main benchmark indexes, you might try picking a small number of active, liquid ETFs representing different sectors of the economy, different countries, different styles. Then concentrate your efforts on that small basket. Try to determine which are trending up and which are trending down. Trade accordingly. Rebalance on a regular basis. You might find you've created your own hedge fund without the high fees.

The Lie That Will Kill Hedge Funds

By Jim Cramer Columnist

It's all in the marks.

Unless you have run a hedge fund, you have no idea what that means.

So I will explain it to the uninitiated. When you run a hedge fund, you are always seeking capital. You can seek money directly from institutions or individuals, or you can do the easiest thing and seek money from those who are offering it: "fund of funds" managers who, specifically, look for managers to place other people's monies. This cohort of investors had just gotten started in about my seventh year as a hedge fund manager, and they were always plying me with capital. I tried it for a while, but the ones I had, and they were substantial, demanded too much of my time and, I thought, forced me to make shorter-term decisions than I liked. I valued my independence too much.

So I sent their money back. Lots of people thought that was foolish. Lots wanted to grow their funds gigantically because they figured that was the way to get rich, quick. I was an idealist, and I wanted it to be a like a club where someone had to nominate you to get in. I wanted it that way because I didn't want any heat from them, and as long as I didn't seek them out, I didn't have to worry about pleasing them beyond the numbers. Anyway, few people run money as I did. Maybe none. Most take the fund of funds' money.

Fund of funds managers interview and bracket managers into different groups: high-growth stocks, even-oriented managers, arbitrage, market-neutral, short, long, etc. They put them in buckets and measure them against others and then they go back to their real clients and say "here is the menu," or "here is what we recommend." When I was in the game, by far the most popular were the "market-neutral" and "arbitrage" funds because they could absorb any amount of money and play all around the world without being hostage to "the market." They make money no matter what, which is the definition of what you are supposed to want if you are a client. These managers can take advantage of the vast discrepancies that exist in the markets worldwide and borrow a lot of money to exploit them.

That's hard if you are a pure stock guy. It is true that Pepsi (PEP) is cheaper than Coke (KO) on a price-to-growth metric. (Coke grows slower than Pepsi but has a higher multiple.) But does that mean you can go long Pepsi and short Coke and the twain meets? I wouldn't bet that way. But how about this? American Home Mortgage (AHM) issues $1 billion in mortgages that Citigroup (C) packages. American Home isn't a "deposit" institution with a broad range of businesses to fall back on. It just issues mortgages, 2 and 28, teaser, little documentation, etc., etc.

Citigroup pools all of those mortgages and offers them into a bond that yields 7%, say, as a blend of the payments. A market-neutral and an arbitrage fund manager might say, "OK, I have $1 billion under management. I will go to Citigroup and borrow 10 billion and invest in these kinds of bonds." They yield 7%, I am borrowing at 5%, I get 2% on all I lever up, which can produce, risk-free, a lot of return. It sure seems risk-free; the bonds are "highly rated" by S&P and Moody's, which gives me ample protection. I am not doing anything reckless. I am doing what every other manager in my class, the biggest and most profitable class, is doing. But the strategy isn't risk-free.

Only Treasuries are risk-free. Now I am showing a really consistent rate of return because of that trade and dozens like them -- regardless of the stock market. So funds of funds drool and throw money at me and I keep buying more mortgage-backed securities and borrowing Treasuries. I can handle trillions! Houses go up in value, mortgages get paid, employment's strong; that's all that matters. The bonds pay. But housing stops going up in 2006. I keep buying the bonds, but I keep reading there are defaults. I don't see it. My traders don't see it. Everything's seems very ethereal.

And then in June, Bear Stearns (BSC) , doing this strategy at its funds, gets told the bonds are moving down in value and it must put up more collateral. But it doesn't have much cash and all of it is deployed. So it sells some bonds to meet the call. But nobody wants the bonds; everyone reads the papers and knows that defaults are mounting. So by the time it finishes selling the bonds, which now have no natural buyers, the collateral is gone. The funds close. That happens in June. In July, the funds of funds get their reports and they see that, let's say, one of the funds is down 10%. They immediately put two and two together and they figure, "Wow, we could have a Bear on our hands."

They go to the manager with redemptions. But things are much worse than they seem. The "marks" -- meaning what the bonds in their portfolio are marked or priced at -- is some last sale price, presumably around par because they don't trade. A redemption notice forces the trade. There are no buyers. That's how a Sowood could be down 10% at the end of June and 50% a few weeks later. The marks are all lies.Nobody is getting anywhere near the price of the bonds, which has become subjective anyway because of the number of defaults within the bonds. All over the Street, these redemptions are happening. All over the Street, those doing these strategies are being wiped up.

There are not enough people who were short this stuff to buy it at what might turn out to be pretty good prices unless all the mortgages within the security are going to be wiped out. I would bet that half of these funds are gone this year. They represent trillions of dollars. You will hear a lot of chatter about "the resetting of risk premium" right now. And it is true. But what's really going on is lying prices. These strategies didn't take into account the risk of default. The agencies didn't take it into account. The packagers didn't. The homebuilders that relied on it didn't.

Because these same hedge funds were also the buyers of high-yield bonds for private equity -- same trade: borrow money against Treasuries to capture the differential -- they don't have the capital to buy the corporates. Again, discussed as "repricing of risk," when what it really is is defrocking of marks. But that would reveal the whole industry as glib and unthought-out and complacent, which is what it really was. This process is playing out everywhere, and the government isn't going to bail out these hedge funds. The good news is that it will happen fast.

The money will come out, the losses will be big, but these hedge funds will all be closed by year-end. Trillions will vanish. But then we will start all over again. Once this whole process is understood, the casualties, including some banks and some homebuilders and almost all mortgage companies except Countrywide (CFC) because it has a bank and lots of other businesses and is not a pure broker, will be taken. By November, this will be over. The stock market will rally before it is finished and the Fed will act to save a Washington Mutual (WM) and we will rally huge.

Let it play out. It's happening with Mach 5 velocity, so you won't have to wait too long. Some days stocks will rally because the pressure will look like it's over. Other days it will return. No one who did this strategy will survive. But then we will thrive.

Sooner rather than later.

Subprime fallout draws comparisons to past crises

NEW YORK (Reuters) - The turmoil sweeping the U.S. subprime mortgage market is starting to resemble some of the biggest financial crises of the past 100 years as its fallout infects credit conditions worldwide. While most analysts say it's too soon to hit the panic button, parallels to past crises are starting to fall in place: a domestic credit crunch, contagion to international markets and more volatility, followed by bank intervention.

On Thursday, the European Central Bank pumped a record 94.8 billion euros ($130.6 billion) into Europe's money markets, citing U.S. subprime mortgage problems. The Bank of Canada later injected C$1.455 billion ($1.37 billion) to help with liquidity shortfalls, while the U.S. Treasury said it "remains vigilant."The subprime situation has inspired comparisons to the collapse of Long-Term Capital Management and the Russian sovereign loan default, both in 1998, as well as to the U.S. savings and loans crisis of the 1980's. Some have even found similarities to the early stages of the Great Depression of 1930's.

"This process is a very old and familiar process," says Jack Malvey, chief global fixed income strategist at Lehman Brothers. "These are regular currents in capital markets -- there's a break in the chain from the weakest link and there's a ripple effect." In this case, the "weakest link" are subprime borrowers, those with checkered credit histories who were granted loans during the U.S. housing boom. They were the first group to miss home loan payments or default.

The risk is now widening to so-called Alt-A mortgages, a pool of alternative loans made to A-rated borrowers that could not meet typical prime borrowing terms. As with past crises, the problem is also moving beyond domestic borders to affect global markets. Most view the current situation as a natural adjustment after years of easy money. They say it has not yet reached the stage that LTCM reached in 1998, when the Federal Reserve was forced to initiate a bailout of the hedge fund to stave off a wider financial collapse. Malvey says the current credit squeeze is not necessarily a sign that the financial system is in trouble. What's happening is a washing away of excess that fed an unprecedented binge of leveraged buyouts and lax lending to unqualified borrowers. Like in any great flood, weaker players will get washed away, while stronger players will remain standing.

Malvey says the current squeeze may resemble the so-called Banker's Panic of 1907, exactly a century ago. That crisis started with the failure of New York banks after financial innovation led to excesses. It ultimately triggered wider panic throughout global markets. Similarly, dozens of mortgage lenders have closed or curtailed business in recent months, and a flurry of deals to finance LBOs through debt have been canceled or put on hold due to their exposure to subprime loans. The cap on new bond sales started to loosen on Wednesday, as $15 billion in new debt was sold, the highest daily volume this year, according to Bank of America. Even so, "this isn't over," said Mark Zandi, chief economist at Moody's Inc., a unit of Moody's Corp. that provides economic research. "The correction is in full swing and there is the potential that there is another shoe or boot to fall."


So how does the current environment measure up? In a report this week, Lehman rates the current credit tightening as a "7" on a scale of "1" (minor) to "10" (terrible). Malvey sees room for improvement and advises investors to start buying high-quality debt now. Mortgage-backed securities, asset-backed securities, high-grade corporate bonds are cheap at current levels, according to Lehman. Those debt securities will be more valuable by December 31 than current valuations, Malvey said.

"All credit crises belong to the same species but each has its own DNA," said Malvey, who cites the 1998 Russian default and LTCM crisis; the Middle East War and Arab oil embargo from 1973 to 1975; and the 1981-82 recession as the worst of recent crises. While world economic and corporate fundamentals are far superior in 2007 than was the case during past market upheavals, Malvey concedes that events could get worse. "We're maybe in the third or fourth inning," Malvey said.


Josh Rosner, a mortgage expert from Graham Fisher, a New York-based investment research firm, forecasts that losses from deteriorating U.S. subprime loans will surpass the S&L crisis in the 1980s. While most analysts say it is premature to equate the current credit squeeze to past crises, they generally agree that the seeds of financial disruption have been sown. Whether they come to fruition depends on the severity of future mortgage defaults and the ripple effects of those losses. Rosner forecasts more than $200 billion in total losses to investors and homeowners, compared with about $125 billion in losses from the S&L debacle.

"In terms of ultimate losses, it will be worse," Rosner said. "It's a bleeding into the system, a drag on the economy over the life of these mortgages." The worst losses on mortgages originated in 2006 won't even start to have an impact on the market until the end of 2008, Rosner said. "That's all the analysis you need to know things will get worse," he said.

Why Economists Are Jittery about the Stock Market

By Paul Krugman, The New York Times. Posted August 10, 2007.

In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what's happening now. During the crisis in '98, I attended a closed-door briefing given by a senior Federal Reserve official, who laid out the grim state of the markets. "What can we do about it?" asked one participant. "Pray," replied the Fed official.

Our prayers were answered. The Fed coordinated a rescue for L.T.C.M., while Robert Rubin, the Treasury secretary at the time, and Alan Greenspan, who was the Fed chairman, assured investors that everything would be all right. And the panic subsided.

Yesterday, President Bush, showing off his M.B.A. vocabulary, similarly tried to reassure the markets. But Mr. Bush is, let's say, a bit lacking in credibility. On the other hand, it's not clear that anyone could do the trick: right now we're suffering from a serious shortage of saviors. And that's too bad, because we might need one.

What's been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time -- in particular, financial instruments backed by home mortgages -- have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the last few years, which in retrospect were as irrational as the dot-com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowed people without the usual financial qualifications to buy houses, and the eagerness with which investors bought securities backed by these loans. But investors also snapped up high-yield corporate debt, a k a junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit -- not all at once, but in a series of blows. First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds: two months ago the yield on corporate bonds rated B was only 2.45 percent higher than that on government bonds; now the spread is well over 4 percent.

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns, the investment bank. Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow Jones industrial average -- the rule rather than the exception for the past two weeks.

But yesterday's announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of "the complete evaporation of liquidity in certain market segments" -- that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can't sell its mortgage-backed securities, so it can't raise enough cash to make the payment it owes to institution B, which then doesn't have the cash to pay institution C -- and those who do have cash sit on it, because they don't trust anyone else to repay a loan, which makes things even worse.

And here's the truly scary thing about liquidity crises: it's very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates -- and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed's trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn't do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn't do much if the cash stays in the banks' vaults.

There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don't work. But for a variety of reasons, not least the current administration's record of incompetence, we'd really rather not go there.

Let's hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn't count on it.

© 2007 The New York Times

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