Stock Value Finder

Like most investors I have been watching the market closely for the past few weeks and the subprime mess continues. I wanted to write a post to detail some of my thoughts, and pose a few predictions.

Background

When putting this whole crisis into perspective many investors look at the real estate bubble as the start of the problems. It seems the real estate bubble peaked somewhere between the summer 2005 and the beginning of 2006. At the height of the peak many real estate sales were from speculator to speculator. With the buyer hoping an investor stupider than them would come alone. At some point this house of cards starts to fall apart which is what we’re seeing now.

Many people (newscasters included) have an impression that the subprime crisis is isolated to the real estate market. That a few real estate professionals will lose their jobs, and a few mortgage companies will go out of business, and suddenly everything will continue as normal. I don’t think this is the case at all. First because of the CDO and CMO markets. Secondly because housing touches most parts of the economy. We’re just now seeing the first signs that of the sickness with the mortgage REIT bankruptcies.

Ripple Effects (CDO, CMO)

One of the reasons the subprime crisis won’t be limited to the real estate sector is due to the securitization of mortgages. Everyone from Wall Street brokerages to pension funds to individual investors have been buying pieces of John Doe’s mortgage in the form of a security offering called either a collateralized debt obligation or collaterzlied mortgage obligation. A great explanation for both is found in the Wikipedia here: CMO CDO.

The main problem with CMO/CDOs is there isn’t really a good way to value them. Currently they are recorded as mark-to-market on the books of the hedge funds and pensions. Because the mortgage debt market is illiquid many hedge funds are holding securities on their books worth much more than they could ever sell them for. This is causing margin calls of some large funds. Because it’s difficult to unload the mortgage securities the large institutions are dumping anything they possibly can that’s liquid, in most cases common stocks.

Other ripple effects

While the CMO/CDO crisis is wreaking havoc on the financial markets most Americans are unexposed except through maybe a 401k or IRA. I believe the financial market risk from the subprime crisis is really only the tip of the iceberg. The real problem is all of the companies and people that relied on the housing boom for the general prosperity of the last few years. This stretches from HVAC companies to copper mines to the transportation sector.

I know from first hand sources that even though this is a very warm year the HVAC industry is hurting due to the housing slump. This puts pressure on companies that expanded too quickly in the industry for the last few years. They could be forced to lay employees off, or even go out of business.

Another hard hit sector is the transportation sector. Rail and trucks rely on transporting bulk commodities. A large area of demand for bulk commodities is housing and construction.

One other consequence of this crisis is that many people who are living well beyond their means won’t have access to free money in the form of home equity/low interest credit anymore. There could be a spike in bankruptcies of defaults on some loans.

What does this mean

I think this crisis has just started, and has the potential to lead to a recession in the near term. In the long term our economy will recover like it has for the past 200 years. The economy goes through cycles, and we could be entering the beginning of another down cycle. Although I happen to think this down cycle will last longer than the 2000-2002 cycle. If this couples with inflation we could be in for another scenario like the 1970s..high inflation, flat market

What should an investor do

To the investor who has been buying quality companies with a margin of safety to their intrinsic value it means SALE SALE SALE. This is the time to keep an eye open for companies to go on sale. I would tend to screen for quality and avoid the real estate sector. I think there are a few time bombs that have not gone off yet in the real estate arena.

Hopefully most investors have been keeping some powder dry for times like this. Speaking for myself I am fully invested currently, although I do plan on a few cash infusions in the new few months.

It’s times like this that determine the amount of risk an investor is willing to accept, short term losses are inevitable. A volatile market makes most investors nervous and they head to cash. This is the time when an investor should be scouring for opportunities to buy.

Best of luck to the investors who have the stomach to navigate choppy waters. Your returns will thank you in 10 years..