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You still have time to contemplate a strategy
By TOM PETRUNO, MARKET BEAT
August 5, 2007

What happens in Vegas may stay in Vegas, but what's happening in the housing market -- a financial bust of epic proportions -- clearly isn't just staying there any longer.

That explains why the fear level on Wall Street has become extreme in the last two weeks. There is real panic in the air now.

Veteran investors know that it's usually a bad idea to sell into panics. But after a 4 1/2 -year-long bull run in stocks worldwide, it's also understandable that many people are antsy to protect the paper profits they've accumulated.

The good news, at least for investors who've been in the stock market for the last few years, is that you haven't yet given up much of your gains. The average New York Stock Exchange issue still is positive year to date, up 2.5%.

So you have time to think about what, if anything, you ought to do with your portfolio.

On Friday, some people decided they'd had enough pain. Worries about the growing money crunch, as nervous lenders of all stripes make credit harder to get, drove most stock market indexes to their worst one-day declines since February.

Bond-rating firm Standard & Poor's helped trigger the latest selling wave by warning that it might downgrade the debt rating of brokerage Bear Stearns Cos., long considered one of Wall Street's premier shops.

There's an element of what-goes-around-comes-around in S&P's warning: Bear Stearns, through its EMC Mortgage unit, was one of the major financiers of the boom in sub-prime mortgages that now is imploding, as rising numbers of strapped homeowners default.

Bear Stearns sold a lot of junky loans to investors via mortgage-backed bonds but also kept some for its own hedge funds. Two of those funds blew up in June, a debacle that S&P said had damaged the brokerage's reputation.

Bear Stearns executives held a conference call with investors Friday and asserted that S&P's concerns about the firm's credit standing were "unwarranted."

But in the same call, the brokerage's chief financial officer, Sam Molinaro, also made no effort to sugarcoat the distress ravaging lending markets. "It's as bad as I've seen it in 22 years," he said.

There are plenty of Wall Street pros who think that's an exaggeration, but no matter: Bear Stearns stock Friday plunged $7.28 to $108.35, nearly a two-year low. The Dow Jones industrial average sank 281.42 points, or 2.1%, to 13,181.91, and broader market indexes fared much worse.

What is a credit crunch? It's when lenders and investors turn reluctant to give money to borrowers who have anything less than top-of-the-line credentials.

Just seven months ago Wall Street was awash in money from investors worldwide. Credit was so easy it was absurd; even the borrowers, in their honest moments, said as much.

Once mortgage defaults began to rise, however, lenders and investors began to wonder what they had wrought. In the last two months, they'd had the same thoughts about financing debt-heavy corporate buyouts. The result: Junk bond interest rates have zoomed to four-year highs.

"The credit event has clearly gone beyond just the housing sector," said John Silvia, chief economist at banking giant Wachovia Corp. in Charlotte, N.C.

It's also global. Some Australian hedge funds that feasted on high-risk debt have warned investors of hefty losses. In Germany, major banks stepped in last week to rescue one of their peers that said it was choking on sub-prime mortgage bonds that had plummeted in value.

It isn't as if credit suddenly isn't available, period. Go ahead, use your MasterCard; chances are no one will stop you.

But we've definitely entered the scary zone of the unknown: How many of your neighbors won't be able to make their mortgage payments in the next year? How many more hedge funds worldwide will fail because of losses on dicey debt? As those numbers rise, how great is the potential for a domino effect -- in other words, "My mortgage borrowers can't pay me, so I can't pay you."

Those questions feed into the biggest one of all: Is the U.S. economy at risk of tripping into recession, egged on by credit-market woes?

On Friday, the government said the economy created a net 92,000 jobs last month, below expectations and the weakest pace since February. That worries market optimists because job growth has been a crucial pillar of support for the bullish case for the economy and for stocks.

Federal Reserve officials have been insisting for months that the economy remains on a decent growth path. They'll get another chance to make their case Tuesday, at their regular midsummer meeting.

They might hint that the markets are overreacting. There are technical reasons to support such a view.

Case in point: Many of the hedge funds and other big investors that bought sub-prime mortgage bonds did so with borrowed money, to juice their returns. Now that the bonds have collapsed in value, the brokerages and banks that lent investors the money are calling in their loans.

That, in turn, is forcing some investors to sell their bonds even though they may believe the prices of the securities are ridiculously low because of the panicked environment.

If these investors could hold on to their bonds, they might be OK. But their lenders aren't interested in waiting this out with them.

As bonds are dumped at fire-sale prices, the effect is to depress the value of similar securities across the board. More investors find their lenders calling in their credit lines. It's the most vicious of circles.

The same thing is happening in the stock market. Investors have borrowed record sums against their brokerage accounts over the last year. That "margin debt" at New York Stock Exchange member brokerages hit an all-time high of $378.2 billion in June, up 67% in 12 months, NYSE data show.

As stock prices slide, brokerages demand that margin borrowers put up more collateral to back the loans. The easy way out is to sell securities and pay down the debt. That selling is accounting for some unknown, but no doubt significant, share of what has happened in the stock market the last two weeks.

Still, perspective may help here. The Standard & Poor's 500 stock index is down 7.7% from its record high reached July 19. This feels bad, of course, but the index fell the same percentage from mid-May to mid-June of 2006.

Periodic corrections, or declines, of 10% to 15% have been typical in bull markets before stocks resume their climb. But this bull has rolled along without even a 10% drop in the S&P 500 index in more than four years.

The point being, the S&P 500 index and other market gauges could fall a lot more in the near term without officially ending this bull market. Usually, a drop of 20% in key indexes is considered a bear market.

Whatever this is -- correction, bear market or just a blip -- some investors may no longer have the stomach to handle Wall Street's manic swings. If that describes you, there is one piece of advice that never goes out of style: Sell to the sleeping point -- meaning, reduce your market bet to whatever level will allow you to sleep soundly.

tom.petruno@latimes.com
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