By Doug Fehr, CFA, Director of Investment Research, Securities America

The recent market volatility has generated numerous questions from investors. Three of the more common ones are as follows:

 

1. I heard that IndyMac bank recently failed. Is the banking system in a crisis today?

 

First, let me say that before placing money with any financial institution-bank, savings & loan, insurance company - care should be taken to ensure the financial stability of that entity. In the larger picture, what’s being characterized by the media as a banking crisis is still very much related to the overbuilt housing market, falling home values and those businesses that operate primarily in the mortgage business. Fortunately, many banks and financial institutions do not originate mortgages or invest little in mortgage securities. But, as initially stated, do your research.

 

This question stems from the recent failure of IndyMac, which initial estimates show may cost the FDIC $4 billion as they work to establish solvency and insurance guarantees on saver’s accounts. IndyMac, however, was a spinout from a large mortgage originator, Countrywide Financial, and technically was a savings and loan. This meant that it was heavily involved in using savings deposits to underwrite mortgages. In fact, IndyMac was primarily involved in the riskiest mortgages, those jumbo loans not able to be packaged as bonds through the government sponsored enterprises, Fannie Mae and Freddie Mac.

 

In one sense, we may begin to compare today’s events to the savings and loan (S&L) crisis of the 1980s. Some S&Ls utilized unsafe lending practices to high risk mortgage borrowers, much like today’s mortgage crisis. In the end, almost half of the 3,200 S&Ls were closed or merged into more solvent thrifts. The U.S. General Accounting Office estimated that the S&L crisis created losses of $160 billion, $125 billion of which was paid for by U.S. taxpayers. These are significant losses that were absorbed by the U.S. economy. How did the markets react?

 

At that time, the S&P Financials sector fell -21% from June 30, 1989, to June 30, 1990, and was the worst performing sector of the market, much like today. In comparison, ending June 30, 2008, the past 12 months showed a loss in the S&P Financials of -42%. The Russell 1000 Value Index was down -8% in the period ending 1990 versus -18% for 2008. The price paid for the S&L crisis by taxpayers and investors was certainly high. However, the S&P went on to positive returns during much of the subsequent ’90s.

 

A positive note for the healthy banks today is that we now have an upwardly sloping interest rate environment. In simple terms, this means that banks can again make money the old fashioned way: by lending out their money at interest rates higher than what they pay to depositors.

 

2. How is today’s rise and fall in home prices different from the tech bubble of 2000?

 

Today is very different from the tech bubble eight years ago. The similarity stops after the fact that all bubbles occur where exuberance replaces rational thinking. Despite a large inventory of available houses for sale, the affordability of homes is approaching long-term averages from once lofty levels. For example, the affordability ratio in Phoenix has been approaching six times home prices to income, after soaring to nine times as recently as 2006. The Housing industry appears to be reaching a bottom, as shown by the S&P/Case-Shiller Home Price index. From April the index, which measures housing values, is down about 18% from the July 2006 high. This fall is miniscule in comparison to what happened to internet and technology stocks in 2000. Today, many of the tech companies are no longer in existence or are nowhere close to recovering value lost in 2000. In contrast, despite values being lower than their peaks, home prices are still higher than five and 10 years ago.

 

The key difference is that homes, for the most part, serve a different purpose than risky stocks. A majority of homes are purchased for the long term – not for a quick churn-and-burn profit. Granted there may be hundreds of neighborhoods in areas such as Florida and Las Vegas where this was not the case. But again, the majority of homes are owned for the long term, by people with jobs who have a vested interest in making the payment and keeping their home.

 

3. What’s going on with inflation?

 

If inflation is defined as “too much money, chasing too few goods,” we are in the midst of having both ends work against us. The “too much money side,” or excess capital, has been supplied by the Fed and other countries’ central banks in response to the potential economic threats in 2001 (9/11) and 2007 (subprime mortgage defaults). The “too few goods” would be depleting natural resources like oil and substituting products such as food-used-for-fuel. In retrospect, we have benefited from a very low inflationary world since about 1980 in many commodities as well as consumer goods. Gas and certain other goods may need to establish a new price level. We should anticipate a higher equilibrium price – i.e. things won’t be as cheap as they used to be.

 

One problem with human emotion during times like this is that one fear, no matter how real, emboldens our other fears. Not only are we worried about energy prices, but also global warming, nuclear proliferation, landfills closing, Tiger Wood’s knee surgery, etc. - none of which have much to do with well-positioned, solid companies making profits. In the worst case, these fears may cause investors to miss out on attractively valued investments today. From 1990 to 2006, the average return of the S&P 500 was 8.5%¹, annualized. Missing the 10 best market days reduced the average return to 5.5%¹. Would we have like to avoid the losses in the past 12 months? Of course. But, where appropriate for the long term, let’s not put ourselves in a position to miss any future gains.

 

 

1. Estrada, J. “Black Swans and Market Timing”, Nov 2007

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Please note that the opinions expressed here are those of Doug Fehr, Director of Investment Research, Securities America Advisors, and should not be construed as investment advice and are subject to change with market conditions. All economic and performance information is historical and does not guarantee future results. Data come from the The Federal Reserve, Standard and Poors, WSJ.com, Morningstar.com and Reuters and are current as of July 21, 2008.