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Fasten Your Seat Belts, Investors

Volatility has returned to the stock market, with a vengeance. We take a look at the issues underlying the subprime mortgage crisis.

The Dow Jones industrial average on August 1 surged to a 150-point gain in the final minutes, dramatically reversing earlier losses. And that was the mirror image of the day before, when big early gains were wiped out late in the day, replaced by 146-point slide. Fasten your seat belts, everyone, because it appears you'll see lots of similar volatility in months to come. Explosions in the toxic subprime-mortgage market guarantee much more turbulence ahead.

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Scarcely a day passes without word of another subprime mine blowing up. One day it's the collapse of a leveraged hedge fund stuffed with arcane mortgage-linked derivatives like collateralized debt obligations. The next day it's a mortgage lender vaporizing. Or a jump in subprime borrower defaults and home foreclosures. How long will this Chinese water torture continue? "Unfortunately, no one knows how subprime will play out," says Kevin Murphy, managing director of Putnam Investment Management.

Markets, of course, hate such uncertainty. One certainty is that we'll be stuck in this subprime swamp for many more months. Loan payment problems typically crop up when interest rates are reset (that is, jacked up) on adjustable-rate mortgages. Merrill Lynch estimates that $87 billion of subprime mortgages reset in the second quarter of this year. That's a hefty sum but nothing compared to the pain ahead: $500 billion in subprime-loan resets from now through the third quarter of 2008, according to Merrill. The deflationary picture in housing prices means delinquencies, defaults and foreclosures have nowhere to go but up.

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These loans were securitized, repackaged and sold by Wall Street as part of, for example, collateralized debt obligations. What are these worth? It's often hard to tell. "CDOs are very opaque; their market values and even the contents of their portfolios are unclear," says Jeff Schappe, chief investment officer of BB&T Asset Management.

Schappe sees the subprime fiasco as just the worst symptom of a period of easy money, when the Fed opened the money taps and excess savings from Japan and China poured into the U.S. economy. "Housing is a classic bubble, created by a credit bubble, which was created by lots of liquidity," he explains. "The riskier the bets you made, the more you were rewarded."

That game has come to a screeching halt. Tectonic plates are moving all across the credit markets, and in recent weeks, corporate, high-yield and emerging-market bond yields have all moved to wider -- and more normal -- premiums to yields of U.S. Treasury debt. Stock markets will take their cue from the bond markets. Schappe says credit markets will require at least another three to six months to "settle down and distinguish between good and bad credits."

So what's a stock investor to do? Our advice is along the lines of Schappe's. He has an aversion to market-timing, so he advises against reducing your portfolio's allocation to stocks. And he's not averse to long-term investors putting fresh money into the market. He likes energy stocks such as Exxon Mobil (XOM), health care stalwarts including Medtronic (MDT) and Johnson & Johnson (JNJ), and multinational companies such as Coca-Cola (KO) He also favors tech stocks such as Cisco Systems (CSCO), because he thinks business investment will hold up much better than spending by consumers, who are squeezed by higher food and gas prices and reduced home equity. "The party's over for the American consumer," he says.

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