A Volatile Stock Market

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A Volatile Stock Market: Here’s How to Respond to the “Attack of the Ninjas”

by Alexander Green, Chairman, Investment U, Investment Director, The Oxford Club
Monday, August 13, 2007: Issue #700

It was just a few weeks ago that the Dow was hitting 14,000 and the S&P 500 was reaching new all-time highs.

How quickly things can change. The Dow has had 11 triple-digit moves up or down over the past three weeks. And the stock market volatility is likely to remain high in the near future. So the important things you need to know are:

What is happening? Why is it happening? What should I do now? Let’s take a look at all three.

Volatility in the Mortgage Sector

I’ve been writing for three years now about the dangerous cocktail of low interest rates and rock-bottom lending standards. (Over $800 billion in subprime mortgages were originated in 2005 and 2006.)

Lenders weren’t just making tons of loans to folks who were poor credit risks. They weren’t even bothering to assess how much risk they were taking. Many, in fact, were selling “ninja loans” – loans that required no income, no job, and no assets. Only a pulse, it seems, was required.

Of course, this worked out okay as long as home prices were rising. Borrowers who fell behind could simply sell their homes at a quick profit.

Those days are now gone. Subprime loan defaults doubled to 19% in 2004, according to Inside Mortgage Finance. And they’ve skyrocketed as the housing slump has worsened.

At first, the market took this in stride. But when it became clear that the mess in the subprime mortgage sector was spreading to both higher-quality mortgages and other parts of the credit market, investors began voting with their feet.

Confidence was already hurt a few weeks ago when Bear Stearns announced big problems at two of its hedge funds with too much exposure to the mortgage sector. But the market took a real body blow on Thursday after French bank BNP Paribas said it would freeze $2.2 billion in three funds because so many mortgage-backed securities had simply gone “no-bid.”

This chilling news didn’t take long to ripple though equity markets worldwide, setting off what threatened to become a genuine financial panic. The Dow plunged nearly 400 points. Other markets around the world sold off quickly as well.

Had the Fed not acted to calm the markets on Friday – injecting $38 billion in liquidity – we could have had an extremely ugly session. This morning the Bank of Japan put $5 billion into the markets, while the European Central Bank added $65.3 billion, after providing more than $200 billion last week. Despite the positive reaction by the markets, we’re not out of the woods yet.

While the Fed is ready to inject more liquidity as necessary, it may also cut rates at the next Open Market Committee Meeting or sooner.

Opportunities for Conservative Investors

Investors would cheer a rate cut. So any market weakness could quickly turn into a rally. But for how long? The truth is the market is acting in a highly unpredictable manner right now. Short-term traders run the risk of getting whipsawed.

That doesn’t mean you shouldn’t trade. It just means you should expect to see some wild swings in the days ahead.

However, there are opportunities for conservative investors now, too. Here are two I’ve mentioned before that look especially attractive now.

The first is StreetTracks Dow Jones Global Titans Index Fund (AMEX: DGT). It’s an exchange-traded fund that holds the world’s 50-largest publicly traded companies.

Companies like Coca-Cola, Nestle, Toyota Motor, Roche Holdings and Samsung Electronics are just a few of the major holdings. And talk about mega-market caps

The smallest Global Titan is Dell Computer at “just” $59 billion; the largest company in the index is ExxonMobil, a beneficiary of the big boom in energy prices this decade, commanding a fat $368 billion market capitalization.

Right now the world’s biggest corporations, enjoying fat profits and flush with cash, have been buying back their own shares in record amounts. If any companies are going to ride out the current market environment successfully, it’s these.

High-Income Fund Bargains

And don’t forget to look for bargains in the high-income sector. I like the Western Asset Global High Income Fund

This is an extremely flexible fund that can invest in high-yield or high-grade bonds, governments or corporates, in any market, anywhere in the world. As market conditions change, the fund can adjust its strategy to take advantage of fluctuations.

The fund currently yields 8.3% and trades at a 10% discount to its net asset value. As the credit crisis subsides, I expect the net asset value to rise and the discount to shrink, creating a slingshot effect. This income fund should easily deliver a double-digit return over the next 12 months.

Good Investing,

Alex

Today’s Investment U Crib Sheet

The Vanguard Inflation-Protected Securities Fund (VIPSX) is another way to smooth out the bumps in your portfolio over the long run. Here’s how it’s performedagainst the S&P over the recent rough patch in equities. (Notice the inverse relationship.)

The Vanguard Inflation-Protected Securities Fund

A blend of stocks, bonds, real estate and precious metals will produce the highest total return in the long run. Here’s the ideal mix. And for more on asset allocation using Vanguard’s low-cost bond funds, here are four more ideas, including a tax-exempt option.