Why the share market is in turmoil... and why it matters to your portfolio...
Hey guys,
No doubt you've heard lots about the share market dropping and the instability in the market at the moment. If you're like a lot of people you're wondering what all the fuss is about.
Here's my 5 point understanding of the situation. I'll keep it really simple which will mean that some may disagree with parts of my explanation or feel that I have missed some important bits out. But in the interests of simplicity I have done so deliberately.
Point 1 - Mutual funds and broker firms with lots of money make loans to people with poor credit histories in the US
Imagine you're an individual who pays money into a pension fund each month and that money gets pooled and then loaned to someone with really poor credit. Someone who is so bad that they are willing to pay a higher interest rate (The "sub-prime" market)
It's great while housing prices are shooting up and the economy is galloping but what happens when times start to get tough and interest rates start to rise? Quite simply -- these people begin to default. So your pension fund which should have been safely growing now has to wear the losses of these defaulting individuals.
Now imagine this on a massive scale with billions of dollars (US dollars) at stake.
So you might say 'Why don't they just repossess the defaulting properties?'
Imagine that the reason the defaults are happening is because interest rates are high and the market is slow. This means that there is already excessive supply and lagging demand. So the bank dumps all the repossession properties on the already slow market, increasing supply for a limited demand. This is how we can see massive drops of up to 20% in value.
Now make no mistake, these lenders don't want to repossess houses. They would much prefer to come to an arrangement and receive something rather than potentially very little. Always remember that the lenders' primary motive is to lend money, not to own or repossess property.
Point 2 - Companies with bad judgement are denied further credit
It's said that most people are 90 days away from bankruptcy. Imagine if you lost all your income but still had all your expenses. How long could you survive? It's the same with the companies that are having problems with the sub prime market.
» Firstly, investors and shareholders get wind of the problems and withdraw money and sell shares
» They're then unable to lend the money held in peoples' accounts because it has been withdrawn
» Then they cannot attract more money to lend out and make money because no-one trusts their ability anymore!
The vicious circle begins and with no cash flow they are soon asking for help...
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Point 3 - The US Federal Reserve drops interest rates and makes money available
In order to keep the economy 'flowing' the federal reserve in the US, dropped interest rates and offered loans to these institutions to ensure they continue to trade. Remember that if they go into bankruptcy, people lose their jobs, social security increases and other nasty spirals and ripples emerge.
I say spirals and ripples because this is where it can affect us.
Put yourself into an investor's shoes. A US. company is having a lot of problems with bad debts and the investor wonders if the UK company they invested in is going to have the same problems or worse because they've lent money to these very same people that have defaulted.
This is where the US comes to the UK.
Point 4 - Beyond initial fear when the actual impact hits
Imagine an atomic bomb goes off. You see the mushroom cloud and panic. At that stage, it's all perception of what is going to happen. Only after this stage do you feel the actual effects.
It's the same with this entire share market blip. Nobody yet knows what the full effect is going to be, but one thing is sure, it's got the market talking.
So how does all this really affect you and your portfolio?
Point 5 - Good news for your portfolio -- UK Inflation rate, supply of housing, loan to value and the mortgage market.
The inflation rate target as set by the government at 2.0%, has dropped from 3.2% in March to 1.9% in August. This is great news for interest rates in the UK. It reduces pressure on further rate rises although doesn't rule them out. I listened to the press conference from Mervyn King after the release of the Inflation Report. He basically said that inflation is on target 'with big risks'. 'With big risks' means a whole range of things that the bank cannot quantify.
The supply of housing in the UK is still a major issue and to some degree this and this alone will allow the UK and London property markets to ride through the storm. In truth I still have not seen sufficient evidence that Gordan Brown is actually serious about solving the housing shortage, but I'm happy to give him the benefit of the doubt since even if he put the full force of the government and business behind it, it's still likely to be at least 7-10 years before the shortage is arrested.
One of the greatest features of the UK market is the relatively low loan to value. This simply means that the amount of money owed compared to value is very low. The US is not in the same position as this. Their credit market is a lot more developed than the UK. This gives the UK a massive scope for flexibility for events such as this.
The UK also has a very young mortgage and buy to let market. Many of the products that have been around for years (even decades) in the US are only joining the mainstream UK market now. These products will give us many different ways to access equity, develop profits and provide security. Now I am not saying the picture is all rosy and beautiful. It has, in the words of Mervyn King, big risks, but I'm sufficiently satisfied that the market in the UK is robust enough to see this short term turmoil through.
The important thing about this whole game of property is to understand that it all works in cycles. Work the cycle don't let the cycle work you.
One of my clients, Jim, said to me the other day, 'I am not worried about the property market. I once invested in a dot com and lost my entire investment, but I have never heard of anyone losing their entire investment in property.' It happens in such a statistically small percentage of times (primarily due to total stupidity) that it is not even worth worrying about.
Live with passion,
Brett Wood
PS. Interest rates are quite high at the moment, so if you're having sleepless nights why not give my team a call and they can help you work out a specific plan to see you through these recent interest rate levels.