Last week my office huddled together in the conference room to discuss the looming correction in the Dow Jones Industrial Average. A market correction is sometimes defined as a drop of at least 10%, but not more than 20% over a short period of time. The major difference between a bear market and a correction is magnitude and duration. Bear markets last much longer, and the magnitude of loss is greater. Last week, during a wild day of trading, the Dow briefly hit a level which was 10% below the high of 14,015 which we reached on July 19th. Fortunately, the market has shown a bit of strength--partially aided by some emergency policy decisions of the Federal Reserve Bank--and moved up a few hundreds points since its lowest levels. So what should you know? And what should you do?
First, you should have a basic understanding of why the markets have dropped so much so quickly. The primary reason is concern over the current quality of the credit markets. These concerns aren’t new--they’ve actually been around since about five years ago when interest rates were especially low and a large, dedicated force of mortgage brokers and loan officers helped organize thousands and thousands of these so-called “sub-prime” loans; referring to the less rigorous restrictions imposed regarding the credit scores, income levels, and current assets of the applicants.
At the same time, the evolution of financial markets, especially through hedge funds, have created avenues through which banks can sell off chunks of the default risk taken on through new loans to investors looking for some income in their portfolios. The New York Times had an article over the weekend which cleverly compared the default risk on many of these loans to a “joker in a deck of cards.” Most people don’t understand where, if it all, they are exposed to these sub-prime loans. Now would be a good time to explore some of the following ideas:
•Market volatility presents a real opportunity to understand risk and how much of it you’re taking on in both your retirement and personal portfolios. If you feel uneasy about these big swings, you may want to review your investment choices. If the volatility doesn’t bother you, you may actually consider becoming more aggressive (tactical asset allocation) now that market prices have pulled back considerably.
•This may be a good time to call your financial planner (yes, that may be me) to review your financial goals and objectives and be sure you still have a plan in place to get there.
•You might want to contact your mortgage professional, financial advisor, or anybody else that can help you fully understand your loan. If your payments are going to become “variable” at some point, you should figure out your risk exposure and double check if the mortgage you currently have is the right one for you.
Overall, my feeling is that both stocks and bonds are now priced at more attractive levels. I don’t believe we’re about to face a major recession or anything drastic like that. My view is that private equity firms and hedge funds have really created some waves in the market. The broader economy should be able to protect itself against further declines in price level. Remember, traders focus on the daily swings in stock and bond prices. Investors don’t.