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Back to Main Article Page Excellent Time to Survey Lay of Land  
In light of today's 400+ point loss, this is the perfect time to contemplate where we've been, what is brewing now, and how that bodes for the future. As a starting point, I am re-posting the pith summary of our most recent Butler Financial Client Note. Exec Summary of BFS, Inc. YR END / YR FWD 2007 Note to Clients Market Close 12/26/06: Dow: 12,407. S&P 500: 1416. Nasdaq:2413. EFA: 72.36. EEM:112.99. 10 yr Bond: 4.6% yield 1) Equities remain the place to be – albeit in a global stock market 2) Over-weightings to International & Hard Assets remain 3) US Bond Market is to be avoided 4) Past three years of low to no volatility in equity markets is over 5) Year in a Phrase: It’s all about the dollar 6) Keep an eye on alternative investments impacting markets Complete article at: BFS, Inc. 2007 Client Note OK, first "the numbers" after today's lively market activity: Close 2/27/07: Dow: 12,216. S&P 500: 1,399. Nasdaq: 2,407. EFA: 73.63. EEM: 107.90. 10yr. Bond: 4.51% _____________________________________________ Now let us consider: A worthy historical fact about market behavior; A note on the bond market; and Why the "subprime lending market" may be a much bigger problem than China. Marketwatch (online) 2/11/07 excerpt of story by Jonathan Burton: Stocks usually aren't so generous for so long. The Dow Jones Industrial Average has gone without a 2% decline for seven months, the longest stretch since 1954, and it's been about four years since either the Dow or the Standard & Poor's 500-stock index suffered a 10% correction, which is only the second time that's happened, according to Ned Davis Research. 1) As we noted, "three years of low to no volatility will not continue". Well, as of today, it's over, and really this is not that big a deal, except that recent up markets have a way of softening some of us. Today's market activity brings us back in line with "Nature" & cycles of historical market behavior (also known as "mean" and "regression from the mean". Sometimes Nature makes these adjustments in a violent fashion (if you live in Colorado, you know the wrath of the winds, the snow, the sun, and drought). Markets are no different. BFS, Inc. comment: We have positioned portfolios with this in mind: that market declines of 10% or so will come, and we have been "overdue" for a regression back to the mean. Also, regarding portfolio management during such a volatile time, it is prudent to avoid speculative investments - and that includes investments that APPEAR to be speculative. This morning, The Chinese Red Chip 25 falls into that speculative basket. More companies and sectors will likely follow suit (i.e. see Subprime Lending story below). 2) The bond market was up today, and has been rallying this year. Not only that, but it has been "coupled" with the movement of commodities. This follows the logic that when commodities rise in price, that increased cost of goods (increases consumer prices and) "slows" the economy. That is deflationary and hence bullish for the bond market. This is very interesting "behavior", and contrary to a more "traditional" view of the rise in commodity prices (and hence consumer prices) as inflationary. During today's trading session, commodity prices fell hard to the downside, while bonds rallied to the upside. The new-found "friends" parted ways. Longer term though, this will be a compelling dynamic to watch. We remain of the school that says a) Rising commodity prices are inflationary and b) Inflation is negative for the bond market. In the immortal words of Louis XIV, We shall see what we shall see. 3) The "subprime" lending story first broke big on Feb 8th, when HSBC Bank said that more funds needed to be set aside to cover defaults on subprime loans (and then Congress -uncharacteristically - wasted no time in dressing down bankers for lax underwriting). We think "where there's smoke there's fire", and that the roiling Chinese stock market served PRIMARILY as catalyst for today's worldwide market declines. The housing/mortgage market is a much deeper, potentially ubiquitous CAUSE of market behavior (at least stateside), and is just beginning to play out. Here's why: Carrick Mollenkamp wrote this in 2/8/07 Wall Street Journal article, "In Home-Lending Push, Banks Misjudged Risk": London-based HSBC, the world's third-largest bank by market value and one of the biggest subprime lenders in the U.S., is one of several lenders to stumble in its dealings with low-end borrowers. Subprime mortgage lending surged over the past several years, and these days, subprime mortgages comprise about 12% of the roughly $8.4 trillion U.S. mortgage market, up from 7.5% of the market in late 2001, according to First American Loan Performance, a San Francisco research firm... - (Then later in the same article) - The mortgage market in the U.S. is a complicated web of mutually dependent businesses. Mortgages are frequently bought and sold several times over, and the default risk often lands far from the institution that originated a mortgage. Banks and mortgage brokers size up would-be borrowers and make the loans. These lenders sell many of the loans to mortgage wholesalers, which gather them into pools and flip them to large financial institutions or banks like HSBC. Some of these buyers, including Wall Street investment banks, package the mortgages as securities for sale to investors, a process known as securitization. Here is more on the matter from Justin Lahart, in 2/22/07 WSJ article, "Why Investors Still Get Caught in Subprime Trap": Federal Reserve governor Susan Bies said in a speech that subprime adjustable-rate mortgages originated in the past 12 to 18 months account for 7% to 8% of total mortgages outstanding. The sector is troubled, but it is just a "sliver" of the broader mortgage market. Her figures -- based on staff analysis of First American Loan Performance data -- are a subset of the overall subprime business. She's not including fixed rate subprime mortgages in her calculation. Inside Mortgage Finance, a trade publication, has a bigger number. Taking adjustable- and fixed-rate mortgages together, subprimes account for 13% of all mortgages outstanding -- or $1.28 trillion out of $10.03 trillion, as of the third quarter. The Judgment: We continue to believe that equities are the place to be, albeit with companies that have an eye to quality and the world economy. But first the housing/mortgage markets will have to have its own "reckoning", and it appears that we are right at the beginning of that. Please bear in mind the home mortgage market is HUGE. $10 Trillion for mortgages does NOT include all the "derivative" financial products that have sprung up alongside the "mother" investment: this market may well be as big as the stock market itself! America appears poised for both some inflationary pressures and tepid economic growth, but our thesis remains the same: that the world economy will continue to perk along, with or without US. In fact, we believe this is the advent of a Truly World Economy. With regard to risk management, we are continuing to diversify portfolios according to currency (i.e. Euros, sterling, yen, CAN $), quality (blue chips at right price), dividends (at home and abroad), and hard assets (precious, industrial, energy). Much of the rotation of "financial chi" or financial life-force will continue to go to those markets that are rich in natural & human/labor resources. Along the way, like now, there will be need to clean up or at least refine the mechanisms of those markets, if not significantly upgrade them. That will add to volatility. And volatililty, in closing, is our friend. It creates opportunity. It prunes the trees and reveals anew "best in class" (at decent prices). We like that.
Jolly hunting, and best regards,
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