Financial markets -- who hit the panic button?

The Jakarta Post , Jakarta | Sun, 08/26/2007 1:37 PM | Life

Bear in mind that the only investor who loses money is the one who sells at a loss.

In recent weeks we have seen a partial collapse of the lower end of the U.S. property market, the closure of several hedge funds in both the U.S. and Europe, a sharp fall in global stock markets and now we also have a falling rupiah.

What is happening? Is Doomsday approaching?

Before we head for the hills with our survival kits let's just take a step back and see what has actually happened.

U.S. housing market

For several years, global economies have been growing rapidly. Much of the growth, particularly in the U.S., has been fueled by the strong housing market.

With interest rates at historic lows it has been easy for people to borrow money against the rising value of their homes. Some lenders, still awash with money, found they could reap more profits by lending money to people with poor credit ratings.

The logic of the lenders was that even if the borrower defaulted, property prices were rising so fast their collateral was assured.

Then, rather than waiting in the traditional fashion for repayments to come in, some of the lenders packaged the mortgages together and sold them on to other financial institutions such as hedge funds. These, in turn, could raise even more money for further investment against the security of the mortgages.

But things went badly wrong.

As might have been foreseen, a large number of borrowers were unable to keep up their loan repayments and were forced to abandon their homes. Because there were so many defaults a large number of properties were thrown on the housing market.

Credit was tightened and invariably the value of the properties fell. With a fall in repayments coming in, coupled with the fall in the value of the collateral, several loan companies found themselves in extreme difficulties, as did a number of hedge funds that had bought into this so-called ""sub-prime"" market.

Why should this affect the rest of the world?

As I have said before, we live in a global village. An incident in one part of the village can quickly impact the whole village.

They say markets are driven by greed and fear.

We have seen the greed as people seek higher and higher returns but now we are seeing the fear. There is concern that there may be loan defaults in the broader U.S. market leading to a rapid fall in real estate prices.

This, in turn, will put pressure on consumers who are heavily in debt. Further credit will be harder to obtain.

One of the reasons for the big fall in stock markets is that no one knows how far the credit crunch will go. Global markets have fallen because so many countries depend on exports to the U.S., although there are signs of some Asian countries ""decoupling"" from the U.S. and becoming less dependent on that market.

Why should events affect the rupiah?

First of all, there is often a misconception about the value of the rupiah because it generally takes the U.S. dollar as its reference point.

Over the past year or so it has been perceived as strengthening. This is true in US dollar terms but it has not strengthened against other major currencies such as the euro, British pound and the Australian dollar.

What has been happening is a gradual fall in the value of the US dollar against other currencies. This was reversed a few days ago when the dollar made sudden gains and this was therefore reflected in a lower rupiah.

Very often, what appears to drive the rupiah up or down has nothing to do with domestic issues; it is simply a reflection of what is happening to the greenback.

This said, the rupiah is indeed subject to other forces beyond its borders. When there is uncertainty in global markets there is generally a flight of capital to perceived ""safe"" havens and withdrawal of capital from ""riskier"" assets such as emerging markets.

This affects both emerging market currencies and stock markets. Yet another factor is the so-called ""carry trade"" where traders borrow in a low interest currency such as the Japanese yen and invest in high interest currencies such as the New Zealand dollar and, more speculatively, the rupiah.

This can mean easy profits while currencies are stable but when there is movement such as the recent rise in the value of the yen, the deals have to be quickly ""unwound"" to prevent losses. This ""unwinding"" can cause currencies to fall.

In any event, a slightly lower rupiah can be beneficial to the country's exporters. What is undesirable is large fluctuations.

Impact on the smaller investor

This is likely to leave small investors confused! However, by following sound financial planning principles the average investor should have no concerns about the present scenario.

Three weeks ago I asked whether we were seeing a ""blip"" or ""meltdown"". On Aug. 16 we saw a technical ""correction"" in that the Dow index had fallen 10 percent from its high of only five weeks before.

We could say that a correction lies between a blip and a meltdown!

But whether this is a blip, correction or meltdown, history tells us that the markets will bounce back again. In fact we saw an immediate partial recovery on Aug. 17 when the U.S. Federal Reserve lowered the discount rate on its loans to banks by 50 basis points to ease the credit situation.

Investing, however, is for the long term!

Investing in the stock markets, as with real estate, commodities, private equity or hedge funds, must be seen as a long-term strategy.

Take profits from time to time yes, but do not take losses unless there is a very good reason, such as evidence that a particular asset is virtually certain to fall considerably more or that an eventual recovery is unlikely.

Such cases are rare, although sometimes you have to be very patient! Those who saw paper losses during the long bear market of 2000 to 2003 had to wait three or four years to recoup the losses but at least they did so (with the exception of technology!) and moved back into profit; anyone who panicked out and moved into cash might have to wait decades before recovering losses.

To be able to remain invested in a falling market means maintaining ample cash reserves for the short term. Provided you have such reserves you can afford to wait until value returns to the long-term investments.

Opportunity for shrewd investors

Investor psychology often works against us. People are keen to buy when everyone else is making money and prices are high. Yet they are not keen to buy when people are selling and prices are low.

But those who can take a calculated view of investing are quick to move in when prices fall and invariably do well when the markets recover.

Downturns are also good news for long-term regular savers as the effect of cost averaging means more shares or units are being purchased when prices fall.

The benefits come later on when markets rise. Many people have difficulty with these plans when markets fall because the falls, when coupled with initial charges, often result in valuations well below the amount that has been put into the plan.

This leads to people ""cutting their losses"" and cashing in or making plans ""paid up"" rather than putting more money in. This is a big mistake as money needs to go in when prices are low.

The plans often take a few years to come into profit but the growth is usually significant later on once the effect of charges is reduced and the benefits of volatility start to appear.

Volatility is the friend of the long-term saver!

*****

So there we are. If your financial planning is in good shape you should not be worrying when markets are volatile. Just stay calm and see if there are any new opportunities.

Unless things are really, really bad there's no need to hit the panic button and rush for the exit!

Colin Bloodworth is a senior financial adviser with Financial Partners International. If you have any questions relating to personal finance you may contact him at tel. 5208099 or e-mail: colin.bloodworth @financial-partners.biz

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