Calm Waters Turn Choppy

After an extended stretch of mostly smooth sailing, investors have encountered some decidedly choppy waters in early August. But while last week's wild stock market ride may have caused some queasiness, it can also serve to reinforce two key lessons of investing: first, financial markets hate uncertainty; and second, market disruptions can, and always will, occur. And while we always monitor and evaluate market events and the effect they have on your portfolios, we do so in the context of a much bigger picture. Whether last week's turmoil represents a quick downpour or the first phase of a more serious credit storm, it is imperative for long-term investors to put sensationalized headlines aside and keep recent events in perspective.

Credit bubble a key factor in market volatility
A number of factors combined to make early August one of the most chaotic periods of market activity in recent memory, but the key driver was a deflation of the credit bubble. Simply put, too much money (liquidity) was available to borrowers of dubious credit.

The most tangible example to consumers—and perhaps the biggest headline grabber—has been the subprime mortgage market, whereby high-risk borrowers have used exotic mortgages and a low interest rate environment to purchase homes that they might not otherwise have been able to afford. Lenders did little to verify that these borrowers could, in fact, repay the loans, and, in industry parlance, they became known as NINJA loans (no income, no job or assets). Wall Street firms grouped packages of these loans into debt instruments and sold them to investors of all types. Due to their riskier nature, these packaged debt instruments offered better-than-market yields and were prime fodder for pension funds, institutions, and, in particular, hedge funds, which often use leverage to increase even further their exposure to the potential ups (and downs) of these securities.

The combination of a cooling housing market and rising interest rates caused many of these high-risk borrowers to fall behind in loan payments, leading to a flurry of defaults and foreclosures. This, in turn, caused a sharp decline in the value of the packaged securities, whose prices are directly linked to the repayment of the underlying loans. As prices declined, demand for these securities (and the hedge funds that invested in them) dropped precipitously, creating a downward spiral. Several hedge funds, including high-profile offerings from Bear Stearns and Goldman Sachs, suffered severe losses or were forced to shut down.

How the credit bubble—and its effect on hedge funds—affects the average investor
Against this backdrop and a barrage of negative news reports, the question has become, “How does the murky world of hedge funds apply to you and me?” Historically, financial markets have reacted drastically and negatively to any kind of uncertainty, and the recent case has certainly been no different. The 2.95-percent decline in the S&P 500 on August 9 was the second worst one-day decline since March 2003.

The uncertainty looming over financial markets going forward is just how severe and widespread the ripple effects from the current subprime mortgage problems will be. Most significantly, the stock market's concern right now is that tightened credit standards around the globe will restrict access to capital for both consumers and businesses, which could have cascading negative consequences on the U.S. and global economies. Indeed, it is likely that the week of August 6 was not the end of the story—over $521 billion of adjustable rate mortgages are poised to reset to higher interest rates in the first half of 2008, as compared to only $197 billion in the first six months of 2007. The market will probably react—quite possibly overreact—to every bit of news that is released.

Following a disciplined approach in response to turmoil
With history as a guide, however, a disciplined approach in times of turmoil seems the most prudent course to follow. Previous market disruptions—sparked by events such as the oil embargo (1973), the Russian debt default (1998), the bursting of the tech bubble (2000), and terrorist attacks (2001)—seemed catastrophic at the time but now appear as blips in the long-term trend upward. In each case, the global economy rebounded, companies continued to prosper and increase earnings, and stock prices reacted in positive fashion. When the current credit situation is viewed from a historical perspective, we anticipate that it will be no different.

As the situation plays out, we will maintain our disciplined and deliberate approach to managing your investment portfolios and consider any changes that are deemed appropriate. More importantly, we appreciate the trust you have placed in us.

Disclosure: All indices are unmanaged and investors cannot invest directly into an index. Past performance is not indicative of future results. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks.