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Stock Market Calms Down After Two Weeks of Turmoil

Cause? Debt backed by mortgage loans from borrowers with poor credit

August 26, 2007       Leave a Comment
By: Jerry Cole - Retirement, Investment

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Stock Market Clams Down
After Hectic Two Weeks

The markets calmed down this week. It was a welcome relief from the turmoil of the last couple of weeks.

What caused all the turmoil?

The same kind of excess that often causes turmoil.

It wasn't a terrorist attack or a natural disaster, thank heavens. It was just a sector of the market getting ahead of itself again. In the 1990's it was the technology stocks soaring to unrealistic levels and the bubble bursting with the resultant heavy losses.

This time it was investor's heavy appetite for risky debt. The debt backed by mortgage loans from borrowers with poor credit histories and junk bonds sold by low rated companies.

But who was buying all this risky stuff?

The big players on Wall Street that are not as regulated as most of your standard investment avenues; that's who. These players come in the form of hedge funds and so called "quantitative" funds. These funds are for sophisticated investors and carry heavy minimum investments.

Under the National Securities Markets Improvement Act of 1996, hedge funds can accept investments from any individual who holds at least $5 million in investments. A minimum of $1 million or more is often required of hedge fund investors. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals.

Hedge funds are unregistered, private investment pools where there is an agreement signed with the sponsors of the hedge fund. With the exception of antifraud standards, they are exempt from SEC regulations under federal securities laws.

Thus the sponsors are generally not subject to any limitations in the management of the fund, such as limits on the composition of their portfolios. They are also not required to disclose information about their holdings and performance, but often do so voluntarily.

When you borrow to purchase securities through your broker, there are strict limits on how much you can borrow. Mutual funds that engage in certain investment techniques such as the use of options and futures, must have their positions "covered". This means they must own the underlying securities. There are no limits restricting the use of leverage, i.e. borrowing, to purchase securities in hedge funds.

Leverage is very rewarding when the investment goes your way. If you buy a stock for $50 and sell it for $100 a year later, you've made 100% on your money. If you add $25 of borrowed money to $25 of your own to buy a stock at $50 and sell the shares at $100, your profit is $50, but you've made 200% on your $25.

However, let's say you put up $50 and borrow an additional $50 to buy a stock at $100. The stock falls to $25. Your real loss is $75 - the $50 you have to pay back and an additional $25 you lost in the fall of the stock's price.

When the loans started going bad in the subprime market, and the buyers of the securities sold to finance those loans stopped buying, credit got tight. This put pressure on the hedge funds and some hedge funds had to start unloading positions. If they had to sell at less than they bought, the leverage they may have used worked severely against them.

Then you have the quantitative hedge funds or "quant" funds. These funds use statistical models to find winning trading strategies. These have been some of the most successful and fastest-growing funds until recently. Their computer models look for every price differential in the markets which the traders use to make lightening fast moves. The only trouble was - they all owned many of the same stocks and their models told them to all sell at the same time.

These maneuvers by the big boys do effect the every day investor because they had a profound effect on the credit markets. This in turn spooked stocks because rising borrowing costs could effect spending and therefore corporate profits, and therefore the overall economy.

You have to stick to the fundamentals. Know your risk tolerance and diversify. Keep an eye on the major cycles. We are still in a period of relatively low inflation and low interest rates. That usually bodes well for the stock market.

I invite your questions.

Or Contact Jerry Cole at:
509 Center Ave, Suite #102, Bay City, MI
(989) 892-5055

(The opinions expressed are solely those of the author and not Gen worth Financial Securities Corporation.)

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Jerry Cole - Retirement, Investment

Jerry Cole has been a Financial Planner for almost 30 years in the Tri-City area and holds and MBA from USC.
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