Stocks feel the pain of a buyers strike

But the real problem is that few potential buyers trust those prices. They note the rapidity with which two recently liquidated Bear Stearns (BSC, news, msgs) hedge funds went from a 2% monthly profit to a 19% monthly loss to a 28% monthly loss (same month, different accounting) to the loss of almost all of a $14-$20 billion portfolio.

It's not just that current prices are of questionable utility. The day when prices may be meaningful again keeps getting pushed back. Remember when 2008 was going to mark the bottom of the housing market? And then 2009. Well, the day before the Dow Jones Industrial Average fell 311 points, the chief economist of the National Association of Home Builders put a rebound off into 2010 or 2011.

Prices for existing homes, down 3% between last fall and the end of June, are projected to fall an additional 5% by the end of 2007, according to the home-builders association. It said prices will continue to fall in 2008.

Buyers seeking bottoms

That means big trouble for the holders of mortgage paper in the months ahead. Home prices are falling just as a huge hunk of adjustable-rate mortgages are due to reset at higher interest rates and higher monthly payments. About $1 trillion in mortgages are due for a reset by the end of 2007. So fewer of the most financially stressed homeowners will be able to refinance, fewer will have an incentive to hold on to a home that is falling in value even as mortgage payments are climbing, and more mortgages will go delinquent or into default.

Just look at the current numbers from Countrywide Financial (CFC, news, msgs). For the second quarter of 2007, the company wrote down the value of its mortgage portfolio by $388 million as delinquencies continued to climb. Delinquencies on its best prime mortgages soared in the quarter to 4.6%, up from 1.8% in the second quarter of 2006 and delinquencies for subprime mortgages soared to 23.7% in the quarter, up from 15.3% in the second quarter of 2006.

Here's what potential buyers of mortgage-backed assets want to know: What if that's not the bottom? With the slump in home prices set to continue, it almost certainly isn't the worst. Who wants to buy today when prices are likely to be lower tomorrow?

Buyers strikes end when buyers become satisfied that today's prices accurately reflect the risks in the market. Prices get marked down. More trading volume at those prices reassures investors that those prices will stick. And with trust in prices restored, buyers return to the market.

Back to work?

Investors will be able to tell whether the current buyers strike is spreading to other asset classes or whether the strike is drawing to a close by watching the market for debt used to finance buyouts of public companies by private-equity funds. Right now, potential buyers of this debt are balking at deals, but instead of going on strike, they're returning to the bargaining table to ask for better terms before purchasing.

So for example, the banks who have financed the buyout of British retailer Alliance Boots (ABOYY, news, msgs), a $22 billion Kohlberg Kravis Roberts buyout, have offered potential buyers an extra 0.5 percentage point in yield in order to move $10 billion in loans off the bank's books.

If offers like that succeed in matching buyers and sellers, then the current buyers strike will be contained in the mortgage sector and the market as a whole will start to return to normal. The return to normalcy is likely to be marked with huge volatility because buyers will remain on edge and on the lookout for signs that prices aren't to be trusted. But the re-pricing of assets in the buyout market will have begun, and as investors reveal and then eat their losses, buyers and sellers will resume their normal dance around prices.

But if the renegotiation of prices in the buyout market falters and the market starts to see deals canceled, then the buyers strike will widen to more asset classes.

In that case, prices as a whole will be under pressure even in stock and bond market segments with no connection to the mortgage and buyout woes. Once investors start to question prices in one sector, they tend to get nervous about all prices and go on the lookout for signs that current prices can't be trusted anywhere.

The sell-off in the energy sector sparked by ExxonMobil's (XOM, news, msgs) 13-cent-a-share earnings miss is an example of what can happen against the backdrop of a buyers strike.

There's no need to panic. The economy is solid. Earnings are decent. Interest rates may be climbing, but they're still low by past standards. But a buyers strike can bring months of pain to investors even when the economic fundamentals are favorable.

Editor's note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares in the following equity mentioned in this column: Devon Energy. He did not own short positions in any stock mentioned in this column.

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