by Archie M. Richards, Jr., CFP^®
October 7, 2002

Avoid mortgage-backed securities. They look vulnerable.

A mortgage-backed security is a bond (an IOU) that was sold to the public by Fannie Mae or other mortgage banker. Each bond represents a pool of mortgage loans that are roughly similar. Some are guaranteed by the federal government.

As the mortgage holders make their monthly payments, the interest and principal flow through to the bondholders. When a mortgage holder refinances and pays off a mortgage with a new one, part of the bond is also paid off.

Lower interest rates have induced homeowners to refinance in huge numbers lately. Mortgage-backed bonds have been repaid early in great numbers. The bondholders are forced to buy new bonds paying lower interest.

The current yield on the Lehman Brothers index of mortgage-backed securities is just under 5 percent. Let's say you hold a mutual fund that invests in mortgage-back securities with annual expenses of 0.5 percent. Your net income return would be 4.5 percent. Early redemptions could knock this down to 3.5 percent.

In 1994, the last year of sharply rising interest rates, the average mutual fund of mortgage-backed securities lost 2.4 percent. Such losses could happen again.

The entire world of real estate, in fact, has become an investment rage. Housing prices have risen considerably faster than income. Some of the demand for homes stems from speculators and investors who pulled money out of the stock market. They've helped to push prices to unsustainable levels. Unless the property is where you want to live, don't climb on board.

Investors who chase after the latest investment rage generally suffer unintended consequences. Better to buy investments that others don't want. Domestic and foreign stocks, for instance.

A recent article in Barron's revealed that many technology stocks were selling at ridiculously low prices. According to the article, the total market value of Sun Microsystems, for example, is $8.8 billion (the $2.70 price times the number of shares outstanding).

The cash held by the company, net of debt, is $4.2 billion. The net cash comprises almost half of the company's market value.

$8.8 billion value for a business whose latest 12-month revenues were $12 billion. Normally, businesses are valued many times higher than their revenues. Sun Microsystems is selling for only a pittance in relation to the company's business potential.

Here are other names you may know:

• Apple Computer: Its cash per share, net of debt, is 75 percent of the company's price per share.

• Earthlink: Net cash per share is 65 percent of the share price.

• JDS Uniphase: Net cash per share is 52 percent of the share price.

• Tellabs: Net cash per share is 51 percent of the share price.

These are just the biggies. The Barron's list includes numerous smaller companies whose net cash per share is greater that the stock price.

The Barron's article appeared two weeks ago. The prices of these stocks are now lower. But don't assume that the article was wrong. Assume that investors are stupid for selling such bargains.

Okay, maybe a concentration in technology stocks is too much of a roller coaster ride for you. At least, take these ridiculously low prices as a signal to acquire a broad array of domestic and foreign stocks.

The Vanguard Total Stock Market Index Fund and the Vanguard Total International Stock Market Index Fund, for example.

On Sunday, October 5, Yahoo! Finance commented, "Investors are likely to become even better acquainted with the term 'new multiyear low' this week. The lows from the 1990s are expected to be the starting point for further declines."

Really?

When investors take lower prices for granted, watch out on the upside. What if investors begin to suspect, for example, that liberals could lose control of both houses of Congress? You don't think this would put the market down, do you?

By the way, the most bullish months of the year, November and December, are right around the corner.