Van Knapp on Sub-Prime Risk and Reward

Frequent contributor Dave Van Knapp of Sensible Stock Investing sent to me over the weekend an excellent report on the current situation. I read it with the intent to excerpt, but decided instead to provide it to you in its entirety, as it contains nothing irrelevant and is consistent with the view I’ve presented in outline form on this free site and in depth to Kelly Letter subscribers.

Subscribers and I remain firmly in bargain hunting mode, not rashly buying anything that drops, but setting and adjusting price targets as waves of sentiment roil the market. As Dave points out, there’s a chance to get extremely low valuations on excellent companies.

Here, then, is Dave Van Knapp on sub-prime risk and reward:

The past four weeks have provided a great example of stock volatility within a downward trend. No sooner did the Dow set an all-time record on July 19 by breaking 14,000 than the markets went into a volatile tailspin: Up-days and down-days have several times exceeded 200-300 points, but overall the market is down about 6%-7% since July 19.

This provides a terrific real-time opportunity to think about market volatility, corrections, and downdrafts — and then to act in accordance with your conclusions. In short, what’s the best thing to do right now?

Let’s set out a few facts:

  • The current tailspin was begun by sub-prime mortgage lending in the USA. Defaults on such loans have caused the mortgage market to partially seize up, meaning that less money is available, and only under more stringent conditions, than before the situation developed. It is fair to say that the mortgage market went into a bubble, and that the bubble is now deflating or collapsing.
  • The sub-prime mortgage mess began a chain reaction that has spread through the credit markets and out into the stock market. Important links in the chain include:
    • Sub-prime mortgages were bundled into packages (“securitized”) and sold to hedge funds, banks, and other investors.
    • Hedge funds (in particular) not only purchased these securities, but did so with high leverage: As much as 70% or more with borrowed money.
    • As mortgagors have defaulted on loans, the collateral supporting the mortgage-backed securities has collapsed.
    • Thousands of variable-rate mortgages will reset to higher interest rates over the next few years. We can expect that as they reset, some owners will default, unable to make their new higher monthly payments.
    • The difficulties in mortgages have spread to other credit markets. For example, the loans banks made to hedge funds were themselves sub-prime, although nobody called them that. In other words, because of the risk inherent in the hedge funds’ investments in securities based on sub-prime mortgages, hedge funds have run into debt crises of their own. A few have already collapsed, and others can be expected to follow.
    • The country’s largest mortgage lender, Countrywide Financial, has veered near the edge of bankruptcy, nearly running out of money to continue normal operations, until it borrowed a massive amount of money last week to be able to continue. Smaller lenders have already failed. Some others can be expected to fail, including possibly Countrywide itself.
    • The problem has spilled over into the stock market via several paths. One is that margin calls have gone out, predominantly to hedge funds who own highly leveraged stocks. Forced to raise cash, the hedge funds have been forced to sell stocks, contributing to the market’s overall decline. A second is that hedge funds (and others) have been selling stocks that they “own short,” because those positions have turned badly against them (i.e., they are in what is known as a short squeeze). Beyond that, many investors have panicked, particularly about financial stocks (banks, mortgage lenders, etc.), sending their prices into a disproportionate tailspin. Yet further, private equity deals are grinding to a halt, as the money to finance them becomes unavailable (private buy-outs are usually highly leveraged). Many market-watchers agree that private buy-outs helped fuel the market run-up earlier in the year. That propulsion is over, at least for a while.
  • National banks around the world, fearing a liquidity crisis, have been injecting massive amounts of money into the financial system to stave off panic and illiquidity. The Fed has done so several times over the past week or two, sometimes quietly, other times with fanfare and press releases.
  • On Friday, the Fed surprised by lowering its discount rate (for direct loans to banks) by 0.5% to 5.75%, which is another way of adding money to the economy.
  • But so far, the Fed has not lowered the more important Federal Funds Rate, the one that impacts most other interest rates and serves as a benchmark for millions of consumer and business loans. The Fed has kept that rate at the same 5.25% level it has maintained for over a year. The Fed’s next scheduled meeting is in September, although the Fed can act at any time. Many economists are expecting the Fed to lower the Federal Funds rate to further ease the economy. But the Fed, by its own statements, has been reluctant to touch that rate, because it is trying to keep inflation to about 2% or less. (Lower interest rates tend to encourage inflation.) Besides, overall the economy is considered to be in good shape.
  • Pundits, economists, and investors are split about the big-picture importance of the credit crunch. Some maintain a “not too worried” stance, pointing out that the mortgage market is a tiny fraction of GDP, and that even in a worst-case scenario of massive defaults, the economic impact will be small — much less than the impact of the savings-and-loan crisis of the 1980’s. They feel that the markets will work the problems out on their own, and some believe that the government has already gone too far in “bailing out” lenders and borrowers who participated in ill-advised loans. At the other end, some experts feel that the crisis is going to get much worse, last much longer, and affect a wide swath of the economy. Supporting this “very worried” position, they say that we don’t yet know the depth of the crisis, how many huge sub-prime loans banks may have in their portfolios, how tight credit may really get as lenders pull in their horns, nor how consumer and investor confidence — and ultimately the entire economy — are going to be affected.
  • Many stocks, because of the downturn, are at very low valuations, and many pundits believe that we have reached a once-a-decade buying opportunity despite potential short-terms risks.
  • Economic and company-specific fundamentals are fine. The just-ending earnings season showed strong results. Many excellent companies are doing well, are growing in a healthy fashion, depend little on debt, and have no weaknesses on their balance sheets.
  • Warren Buffett, Hall of Fame investor, has said, “The first rule is not to lose. The second rule is not to forget the first rule.” Most stocks have lost quite a bit in the past few weeks; investors would have been better off in cash rather than stocks, although that (of course) is old news now. Buffett has also said, “…Attempt…to be greedy only when others are fearful.” Obviously, there is some tension between these two principles. Those investors who are fearful are fearful because their stocks have been losing money and they cannot see a clear end to that.

What does this all mean to the average individual investor? Is it time to be greedy or fearful? Is it time to protect against further losses (by selling stocks), or is it time to purchase first-class companies at rock-bottom prices? Are the past few weeks the beginning of a bear market, or just a “correction” that will reverse itself as the credit mess unwinds and as investors regain confidence in the fundamentals? Will the Fed ride to the r
escue, on the one hand, or on the other hand (1) limit their intervention and allow the markets to penalize stupid investors or (2) focus too much on fighting inflation to the detriment of the economy and the stock market? What is investor sentiment likely to be, short-term, medium-term, and long-term?

What would Warren do?

The subject is risk management. That means taking actions to safeguard your money from the possibility that any investment decision is wrong — including decisions not to invest (which can cost you money you would have made had you invested) as well as decisions to hold onto investments or to invest even more.

If the subject is risk management, what are the risks right now? I’d say these are the top three:

  • The credit problem, already something of a crisis, will turn into a catastrophe. There are probably many dangerous loan situations out there that we don’t know about yet, and the trend will be for the credit markets to seize up for many months to come. That will continue to spill over and negatively affect the economy and the stock market.
  • The economy will tip into recession. That will also negatively impact the stock market. Companies will fall not only in stock price, but in actual performance. Rather than get conservative, some companies will throw risky Hail Mary passes and lose.
  • The Fed will make the wrong moves (which could be inaction or over-reaction), or it will wait too long to make the right moves.

Risks usually have counterparts: potential rewards. What are the possible opportunities given what we know now? My top three:

  • The worst of the credit crunch is already over. The credit machinery of the economy will emerge stronger, as lenders and borrowers learn from their mistakes and reinstitute old-fashioned sound lending standards, to the long-run benefit of all.
  • The Fed will make the right moves at the right times. The economy will continue growing, and no recession will result from this situation.
  • Many stocks are extreme bargains right now, and investors should consider this a buying opportunity — but be willing to withstand some short-term volatility (i.e., paper losses) for a month or three while the market settles down. It is a good time to purchase the stocks of companies that are sure to weather this storm, not to sell out. In a few months or a year, the market will return the prices of excellent companies that are now in the bargain bin to more rational levels. Today’s buyer will be tomorrow’s winner, not those who flee.

Prediction: The second list — the list of opportunities — is more likely to occur than the first list, although that is certainly not a slam dunk. Reasons for thinking this:

  • Investors are likely to recognize that the credit crisis is limited in size even as they cannot be sure about its duration nor about exactly where it is going to continue to pop up in the coming weeks.
  • The low valuations on many excellent companies are likely to prevail over the fear that the credit crisis will ruin the economy.
  • By its injections of money into the economy over the past week and by its rate-lowering action Friday, the Fed has signaled recognition of the importance of maintaining not only actual liquidity, but also the appearance of liquidity, in the economy and the markets.
  • The strength of practically all economic and company fundamentals — other than the credit crunch itself — is likely to prove persuasive on investor sentiment over the impact of the credit crunch.
  • The credit crunch — whether the worst is over or not — is already reversing, what with the Fed’s action Friday, the shuttering of some hedge funds with the worst difficulties, the reinstitution by banks of more traditional and conservative lending standards, and so on.

Conclusion: What is likely to happen over the next six months:

  • There will continue to be revelations of serious credit problems in various areas, both in the mortgage markets and in other credit markets.
  • More hedge funds will collapse. Some banks and financial institutions will be revealed to have more exposure to “worthless” credit assets than previously thought. The stocks of these companies will fare poorly even if the market as a whole rises.
  • Lending standards will become tighter for mortgages, commercial loans, loans to hedge funds, and the like. Cash-rich companies (who have no need for credit) will benefit in comparison to companies which need a high debt load to operate.
  • Investor sentiment will yo-yo as different revelations come to light. As a result, the stock market will remain very volatile for a while longer. Up and down days of 200+ points on the Dow will be fairly common.
  • The Fed may abandon (for a while) its tunnel-vision focus on keeping inflation to 2% if that proves necessary to head off a recession. They may or may not lower the Federal Funds rate, depending on conditions as they unfold. They will continue to take other actions to insure liquidity in the economy.
  • Investors will be all over the map on whether this is a time to be fearful or greedy, but on balance, the tilt will be towards seeing this as a buying opportunity. This “blended sentiment” will be based on the extremely low valuations (bargain status) of many excellent companies.
  • As a result of overall willingness to buy, the stock market will be higher in six months than it is now, perhaps back to its July 19 level if not higher.

Action steps:

  • To the extent you have cash to invest (either new cash or the proceeds of stocks you have recently sold), look for excellent companies with strong balance sheets to invest in.
  • If you use sell stops to protect on the downside, either set them wider than normal, or don’t set them at all, putting your faith instead in the foregoing analysis. The wider sell-stops are to allow room for the likely market volatility over the next few weeks or months.
  • Because the conclusions above are not slam dunks, limit your stock investments to 1/2 or 2/3 of your available “stock money.” Neither be fully invested nor flee the market.
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