American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Aug. 2007 – The Subprime Distraction


The greatest threat posed by the meteoric rise in mortgage defaults and the resultant collateral damage in the capital markets is that they might cause investors to abandon their long-term strategy. Investors who are aware of their capacity for risk, and who have established an appropriate allocation plan should view recent events as no more than a distraction, albeit a spectacular one.

As evidenced in the enclosed article on mortgage REITs, our recommendations have never included the risky debt instruments currently roiling the markets. Our strategy is rooted in empirical research, consistent with the methodology of our parent organization, AIER. It includes asset classes that when held in combination, have served investors well throughout previous “boom and bust” periods.

In November 2005, when Ben Bernanke was named Chairman of the Federal Reserve Board, AIER observed that “we suspect that, like his recent predecessor, Bernanke will stumble into occasional asset price bubbles linked back to monetary policy failures that are rooted in (a) bad data, (b) bad forecasts, (c) political pressures, or (d) all the foregoing, with all the attendant bank supervisory failures and political demands for industry-specific bailouts.”

Indeed, we have been here before. As AIER has pointed out, every wave of financial innovation (e.g. junk bonds) seems to generate enormous enthusiasm followed by a rush to the exits and an inevitable crash before a sustainable level of activity emerges. (For a thorough discussion of recent events, see AIER’s September 3rd Research Reports.)

Market watchers have been weighing in on the magnitude of the spill-over effect on the broader markets and the overall economy. Investors would be wise to remember that the total sub-prime mortgage pool represents a total of about $500 billion, or roughly 3.5 percent of GDP. By comparison the savings and loan market represented roughly 10 percent of GDP at the time of the 1980s S&L crisis. In relative terms, the current number of non-performing subprime loans appears to be manageable.

The fact is, no one knows for certain whether the current credit crunch will push the larger economy into recession. But historical data suggests that wise investors will not panic by bailing out during stock market routs. Since January 1945 there have been roughly fifty-five ten-year (calendar year) rolling periods. Over that span the S&P 500 did not earn a negative return for any single period. Over the entire period the index produced a nomimal average annual return of 11.91 percent, and a real return of 7.59 percent. To reap the benefits of capitalism, long term investors need not delve into the mysteries of high finance. All that is required is consistent exposure to the capital markets.

Also In This Issue

ETFs: A Look Under The Hood
Mortgage REITs: Why We Have Avoided Them
A Starbucks A Day Pushes Retirement Away
The High-Yield Dow Investment Strategy
The Dow Jones Industrials Ranked By Yield
Recent Market Statistics