by Archie M. Richards, Jr.
November 5, 2007

Jeff writes, "Is Vanguard's exchange-traded fund for financial stocks (symbol VFH) a good buy?"

Whether it's a good buy or not, Jeff, VFH wouldn't fit into my recommended portfolio (see archierichards.com). I suggest asset classes. Financial companies are not an asset class; they're an industry.

Asset classes include big stocks, small stocks, growth stocks, value stocks, foreign-region stocks, real estate, and bonds. Most of these groups are broader than any single industry. Most of them, in fact, include the stocks of almost every industry.

Over the long pull, I don't know which industries will outstrip the others. Fortunately, I don't have to know; I buy asset classes instead.

As to the short term, financials have fallen prey to sub-prime mortgage problems and gone down more than most stocks.

Have financial stocks hit bottom? It's a chancy guess, but I'd say no, not yet.

As explained in more detail in my column "What Caused the Market to Drop?" dated 8/27/07, the story began with the Clinton Administration's effort to help people of lesser income to own homes. The government encouraged companies to loosen their standards for providing mortgages to low-income people and to make the initial costs low. People who should have continued renting until their incomes rose became homeowners instead.

Mortgage companies sold billions of dollars of sub-prime mortgages. Investment bankers bundled them and sold them as bonds to financial institutions and mutual funds worldwide. Hedge funds borrowed heavily to increase their holdings of these mortgages.

But two years ago, real estate prices started falling. For many sub-prime mortgages, the value of the underlying real estate is now lower than the mortgage balance. For the financial institutions, unsecured debt increases risk.

Mortgage holders are now defaulting, and the institutions are writing off bad loans in big numbers. The values of remaining loans are uncertain. So are the values of the derivatives acquired in an attempt to reduce the risk - they're uncertain, too.

The interest on many sub-prime loans are now resetting at higher rates, and real estate prices will probably continue falling for a while. Both of these factors will make matters worse.

No, the sub-prime loan problems won't go away soon.

Last spring, the American Institute for Economic Research (AIER) predicted that the U.S. would suffer a recession. As discussed in my column "A Recession Now Seems Likely, But Don't Sell Your Stocks" dated 4/30/07 , AIER's record of predictions has been outstanding.

AIER's prediction early in 2007 was made before the sub-prime mortgage problems became serious. Now that mortgage problems are indeed serious, a recession seems all the more likely. As the prospect becomes more of a reality, stocks will probably take additional hits - especially the financials.

But for the market as a whole, prices may not drop for long. By the time a recession is identified for sure, the market may have begun rising.

It's all very well to guess about these possibilities. But stock prices rise especially fast off the bottom. If you buy and sell your portfolio in anticipation of events that are far from assured, you're likely to end up holding cash while prices are rising. This reduces long-term results severely.

Take the bad with the good. Don't trade. And stick to asset classes, not industrial groups.

Howard writes, "With oil prices so high, would you underweight the emerging markets index fund in your portfolio?"

No, Howard. For many years to come, I expect less-developed nations to grow faster than developed nations. Here are reasons why:

• Developing nations have a long way to attain prosperity. But they don't need to create the technologies to get there. Developed nations have already done the job. The less-developed ones just need to buy the technologies.

• Many developing nations are cutting tax rates. Nothing stimulates economic growth more.

• Many developing nations, including Russia, Indonesia, Nigeria, Venezuela, and Middle Eastern nations, produce oil and benefit from its high price. Maybe oil will drop; maybe not. I don't know.