Herb Morgan (Efficient Market Advisors, LLC) submits: U.S. and world equity markets experienced indiscriminate selling Friday, while investment grade, high quality debt markets experienced strong performance. Friday's sell off comes amid an extraordinarily strong earnings season. Clearly, market participants are fixated on sub prime lending concerns.
Sub prime mortgages are nothing new; lenders have made high risk mortgages on Real Estate nearly forever. Today, most mortgages are sold to Wall Street firms who package them into Collateralized Mortgage Obligations (CMOs). The CMOs pool the mortgages and further cut the portfolio into traunches. Each traunche owns similar pieces of each mortgage but are pre-assigned various levels of defaults. The vast majority of defaults are assigned to the last traunche commonly referred to as the equity traunche.
The equity traunche carries a very high current yield while the "A" traunche carries a low yield and a high credit rating. The equity traunches are sold to investors, primarily hedge funds. The hedge funds borrow money to buy what is an already extremely leveraged product.
Recently, the brokerage firms that lend money to hedge funds (yes, the same brokerage firms that sell the equity traunches of the CMOs), and have begun to reevaluate the value of the collateral. The end result will be very bad news for hedge funds that invest in this area, along with the banks and brokerage firms that have lent them money. It is for this reason that financial stocks have led the way during this recent decline.
The Federal Reserve will meet next week and may or may not make a decision to rescue financial markets. Keep in mind that the Fed views their role as one of engineering price stability, rather than rescuing private companies.
Over the coming weeks, markets will separate financial companies based on their exposure to the subprime scenarios.
One minority school of thought: the equity market selloff in the face of strong corporate profits is a leading indicator of a severe economic slowdown. I don't currently share this view. In fact, should core PPI and CPI numbers continue to moderate, I expect the Fed to cut interest rates (not next week) fueling a strong rally in stock prices.
The S&P 500 index has experienced broad draw downs in the past. Each selloff was ultimately followed with equity markets reaching new highs. Since 1975, the S&P 500 index has experienced only nineteen draw downs in excess of 5%. With the exception of the August 2000 - September 2002 sell off of nearly 45%, the average of those selloffs was 10.28% over 3.9 months. More importantly, the subsequent recovery took an average of just over four months.
Savvy investors will look beyond the current environment and make decisions now to benefit from the eventual recovery. Those with longer time horizons should consider increasing equity exposure if prices deteriorate further.
Opportunities that may present themselves to us in the coming months as spreads continue to move towards a more normalized level:
* Senior Loan Asset Class - ING Prime Rate Trust (PPR)
* High Yield Bond Asset Class - iShares Iboxx High Yield (HYG)
* Real Estate Investment Trust Asset Class - iShares Cohen & Steers REIT Index Fund (ICF)
And for those looking for a pure equity play, consider: