TOPICS > Economy

Financial Experts Examine Unsteady Stock Market

August 9, 2007 at 6:10 PM EDT

JEFFREY BROWN: At 9:30 this morning, the opening bell rang on Wall Street. Just minutes later, the Dow Jones Industrial Average had fallen more then 200 points. By day’s end, after some gains and even more losses, it was down 387 points.

In fact, since last month, when the Dow hit 14,000 for the first time, the market’s moves have been dramatic in both directions — but mostly downward — with triple-digit gains or losses on 10 different days. We begin with a look at what happened today with Gretchen Morgenson, a financial reporter and columnist for the New York Times.

Well, Gretchen, the problem today seemed to begin in France. Tell us what happened.

GRETCHEN MORGENSON, New York Times: Well, we’re starting to see the subprime mortgage problems that we’ve had in this country spread overseas. And in France, we had a very large bank — I think the largest — announce that three of its hedge funds could not let investors get out. They were stopping redemptions.

Then we had, of course, the European Central Bank infusing $130 billion, I think it was, into the system to try to ease some of the credit crunch that we are starting to see kind of ripple around the world.

JEFFREY BROWN: The subprime mortgages, remind us what that means.

GRETCHEN MORGENSON: These were mortgages that were made to people with risky credit, with sketchy credit, maybe perhaps not even a job or an income that they could verify. It was all fed by a demand for higher-yielding securities by investors around the world, insurance companies, pension funds, banks.

They all wanted to buy securities that could pay them a higher yield than, say, safer treasury bonds or, you know, high-yielding stocks. And so millions, billions of dollars was poured into mortgages that went to riskier credits, and now this is coming home to roost.

JEFFREY BROWN: Now, the French bank statement referred to a, quote, “complete evaporation of liquidity in certain segments of the U.S. mortgage and securities markets.” What does that mean, that liquidity problem?

GRETCHEN MORGENSON: What that means is that mortgages are no longer being made to these kinds of people, and even higher up the credit scale to folks who do have a job, do have incomes that can be verified. Those people even are having trouble getting mortgages now.

There’s a seizing of the credit markets because people are running away from risk. You know, five minutes ago, they were interested in taking as much risk as they can. Now, because everything’s starting to seize up, they can’t get out of these investments; they don’t want anything to do with them.

JEFFREY BROWN: There was talk of a clearing out of what you’re talking about as excess risk. Is that a way to think of it?

GRETCHEN MORGENSON: Absolutely. The problem partly, too, is that people don’t know what they own. A lot of these subprime mortgages were rated very highly by the rating agencies, AA, AAA. And so now you’re hearing about failures, defaults, delinquencies are rising, and you’re saying, “Gosh, I thought I had a very high-rated security here.” You don’t know what you own, you run away from it.

"Corporate loans are harder to get"

JEFFREY BROWN: And is the credit or liquidity problem affecting businesses, as well as homeowners or potential homeowners?

GRETCHEN MORGENSON: Yes, it is, and that's really the problem, I think, that people are starting to awaken to, that it is starting to hit the corporate markets. Corporate loans are harder to get. It's going to get more expensive to borrow money in the corporate markets.

This will also have an impact on the private equity firms that have raised billions of dollars to buy public companies, take them private. So that has been a great force upward in the stock market, these kinds of buyouts. Now, with money being more expensive to borrow, those kinds of buyouts are going to be fewer and fewer.

JEFFREY BROWN: And, finally, Gretchen, are the Wall Street people you're talking to expecting this kind volatility -- especially the downward type -- to continue?

GRETCHEN MORGENSON: Well, I don't have a crystal ball but I do think...

JEFFREY BROWN: I know, that was an unfair question. But what are they saying?

GRETCHEN MORGENSON: I do think we do have to work this out, and we're not anywhere near to having a response to this problem to getting credit back into the markets.

JEFFREY BROWN: All right, Gretchen Morgenson of the New York Times, thanks very much.


Advice from financial experts

JEFFREY BROWN: So what does all this mean to the average investor? What is one to do with all the turmoil?

And for that, I'm joined here by David Gardner, co-founder of the Motley Fool, a financial services company that offers investment and personal finance advice, and Jeffrey Kosnett, senior editor at Kiplinger's Personal Finance. Sorry, I'll get the names right, then we'll start.

David, what is an investor to do? Today is a scary day for a lot of people.

DAVID GARDNER, Co-Founder, The Motley Fool: Well, it is, and we just have to acknowledge that that's part of investing. Anyone who's done it for some time -- I've done it for 23 years. Many people have done it for more than that. But I can say that the best decision I've made is to buy and to hold and be patient.

And I want to key in to one thing Gretchen said. You know, she just said a lot of people don't know what they own. A lot of these money managers that they buy pools of mortgages that were highly rated, they thought they were getting something that would pay them, but some of them are defaulting. They don't know what they own.

And I think, for a lot of us, we need to make sure that we know what we own, Jeff, and, Jeff, as I think most Americans still haven't really gotten the financial education that helps them make good decisions. So I would just encourage all of us more than anything, don't sell today. Get informed tomorrow.

JEFFREY BROWN: What's your advice on a day like today?

JEFFREY KOSNETT, Senior Editor, Kiplinger's Personal Finance: Yes, I would agree with most of that. Investing is a long-term process. There have been plenty of times in recent memory when the market has been much more volatile than this.

Five years ago, July of 2002, Dow Jones started the month at 8,700. By the time that month ended, it was just about at the same place, but it had been at 7,700 during that time. That's a much bigger move in percentage terms than we had now. We had the WorldCom bankruptcy. The Enron thing was still winding up. We had AIG. We had many other companies having scandals. Compared to that, I think a French bank that can't redeem hedge funds is like a parking ticket.

JEFFREY BROWN: All right, so but the basics stay the same, you're saying. But what if your window is not so long-term?

DAVID GARDNER: Well, I think for most of us we need to make sure we do know our investment time horizon. And mine is still about, I hope, 40 or 50 years. A lot of our listeners tonight may have three years before they're hoping to retire.

Within five years of your plan circled on the calendar date of retirement, I believe you should be moving your money toward a balanced index fund, one that holds 60 percent in stocks, but 40 percent in bonds. Jeff, I don't know what you're doing with your money, but as we start to age and get closer to that magical day when we have freedom, I would highly recommend a lot of us consider moving toward a balanced approach to investing, mixing stocks and bonds.

But if we're more than five years away, I think you should stay patient and sit on your stock mutual funds or, if you're like me, own stocks directly.

JEFFREY BROWN: What do you see?

JEFFREY KOSNETT: I agree with that, also. One of the things about investing in stocks is that a lot of emotion that isn't directly related to the companies in the market comes into play. There is no earthly reason that a stock like General Electric or John Deere or Praxair or any of the great American industrial success stories should be sold in this manner simply because of problems with substandard mortgages, which, frankly, I'd like to know how many of these mortgages are really being defaulted on by homeowners and how many of them are speculators and investors and people that went out and bought 10 houses thinking that they could flip them. If they lose their money, they just turn themselves into a hedge fund, and, you know, so what?

The real issue here is that -- for an ordinary investor to understand is this. We've had airlines fail. We've had businesses go under. We've had problems in real industry. Wall Street kind of just winks and nods at that. But anything that involves hedge funds or credit or traders, they take it more personally. They're closer to the situation. They know other people that are involved in it. I think they magnify the effects a little bit.

You can't get in the way of that, so you just have to go on and continue, as Tom said, to put your money in your IRAs, in your mutual funds, and accept the fact that every now and then there's going to be some bumps in the road.

Looking at the long-term

JEFFREY BROWN: Well, let me move the age bracket up even further. What about the people watching who are retired, who are living off of the principal that they have? They would look at today and would say, "That principal is a lot smaller than it was yesterday."

DAVID GARDNER: It is. And I guess the good news is, a year ago, the Dow was 20 percent lower than it is today. So I think we can obsess over the market in the short term. The markets are crazy, man. I mean, yesterday the stock market was up almost 2 percent. As you were pointing out in the introduction, Jeff, it's been very volatile.

I guess my biggest advice to anyone of any age is: Don't get caught up in the here and now. Don't define your investment past or history or focus on a day or even a week. Look at a minimum increment of a year. We're definitely better off today than we were a year ago, and I believe five years from now we'll be happier with our stocks than we are today.

JEFFREY BROWN: What about annuities? I'm hearing more and more about that, people turning to them in their later years as a way to protect themselves against inflation and against the market.

DAVID GARDNER: Like a lot of financial options or vehicles where you can put your money, just make sure you know the fees that you're paying. A lot of people are paying a little bit too high a fee for the annuities that they're purchasing.

It can be a good investment, especially for people who need extreme safety -- and that is some of us -- but I think probably -- I saw Jeff nodding, too -- annuities are not one of our favorite investments at the Motley Fool. I would just say, for anybody who owns mutual funds, make sure you know what an annual expense ratio is. If you don't know what that phrase means, it's the percentage of your assets you're paying each year that disappears from the fund to pay your fund manager.

So understand what an annual expense ratio is. Rather than sell any stocks today or tomorrow, if you take that action and learn that, you'll do better over the next 20 years as an investor.

JEFFREY KOSNETT: I'd like to refer to one thing that Ms. Morgenson said. The urge for higher-yielding investments has been part of the extra risk that's going on that's unfolding now. Not all high-yield investments are very risky. It depends where the money is coming from.

You could invest some money in, say, a trust that owns a share of oil wells and gas reserves. You'll get a regular dividend that has everything to do with the price of oil and gas and not much to do with the mortgage market.

There are many other kinds of bonds and corporate obligations and passthroughs of income, real estate investment trusts, very healthy investments. If anything, the problem with some of these is the yield is too low because the price of the principal has gone way up. So it's hard to get a yield of more than 6 percent or 7 percent or 8 percent. But in Kiplinger's, we write about these things, and we've found many safe way to do this.

We also believe very strongly that, over the long period of time -- and I don't mean like 50 years; I mean any given five-year period -- the economy grows more often than it recedes, companies grow their earnings more often than they slump, and the economy does better, and therefore the stock market does better.

So when traders have a conniption over something, usually something else is going on behind it that eventually will come to the fore. Citibank's published some research that shows that just about 70 percent of the time within 60 days after a fall of about 4 percent, the market is back up to where it had started. And I don't think it's asking a lot to figure that this is going to ebb and flow for a while and, by the end of the year, we'll probably have the 7 percent or 8 percent or 9 percent gain that we've got now.

Assessing investor panic

JEFFREY BROWN: I'm wondering, given all your reassurances -- and I'm sure people appreciate the reassuring tone -- but what does history tell us about what investors actually do? I mean, to what extent do small and average investors panic?

DAVID GARDNER: What history tells us is that, because we're all afflicted by human nature, we tend to look backwards and make forward decisions based on what has already happened and what we've already seen. So if history is any guide, the biggest foe for a lot of us is what Jack Bogle, the founder of Vanguard, calls the "row boat syndrome."

As we paddle our way down into the future, the river of life, we're all looking backwards. When the market has been bad, we've watched that, and all of a sudden we say, "You know, I'm going to finally sell. It's been so bad." And then we do the opposite mistake. When it's been really good, looking backwards, we decide, "Now I'm finally going to get into the stock market. I've been swearing I would save more, and now I'm going to finally act on that."

And if instead of acting so often we just patiently use the stock market as a bank over the course of several decades -- and if you're 55 or 65 years old today, guess what? You're going to be living several more decades -- you'll be much better served by using the stock market as a bank buy and hold and add over time. It's worked for me and worked for a lot of people.

JEFFREY BROWN: The big mistake is people buy and sell at the precisely wrong time.

JEFFREY KOSNETT: I would add it's the professionals who panic.

JEFFREY BROWN: It's the professionals?

JEFFREY KOSNETT: Yes, they're the ones who spend a weekend getting all bent out of shape about what they think is going to happen on Monday morning.

DAVID GARDNER: Because they have short-term...

JEFFREY KOSNETT: Right, because it's their job. Ordinary people that work as teachers, and lawyers, and engineers, and journalists, and college professors, and whatnot, we're not spending all day looking at the stock market. We're not even thinking about it that often.

We think about it when the headlines tell us, like they will tomorrow morning, that the market had this big plunge. You don't see the same headlines, by the way, when the market has a big advance. You had to really look hard on Tuesday morning's papers to find the news of the gain on Monday that was every bit as much as the losses were last Friday.

So with that, you know, I think you just sort of have to take it for what it is. There's more risk than there used to be, because there's more money moving around faster, but it's the only game in town, and we have to continue to play it.

JEFFREY BROWN: All right, Jeffrey Kosnett, David Gardner, thank you both very much.