Fears crawl into minds of investors

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Robert Rodriguez, CEO of First Pacific Advisors, is so worried about risk that he has about 41 percent of the FPA New Income (bond) fund and 35 percent of the FPA Capital (stock and bond) fund invested in cash. In addition, he has only 1 percent of the New Income fund invested in junk bonds, or corporate bonds most likely to default. He said his exposure to junk has never been lower.

He is concerned because of a breakdown in lending practices, he said. Mortgages were given to homeowners that clearly weren't qualified to get them. Between the most-qualified borrowers and the least (subprime) is a category called Alt-A, and defaults are showing up there too.

Borrowers started missing payments within just a few months of receiving the loans, an obvious sign that lenders gave loans to people who couldn't afford them, Rodriguez said.

In addition, he complains that when the securities were rated for safety, examiners did not build into their models the presumption that housing prices would decline, as they now are doing in some areas. In other words, investors invested in bonds without an appreciation of the risks they were being exposed to.

"Alan Greenspan has said there won't be contagion" from the mortgage securities, said Rodriguez, referring to the former Federal Reserve chairman. "I'm not sure that's correct. We are quite concerned."

Nagaswami also is concerned that a long period of relative calm in stock and bond markets worldwide has made investors too complacent about the riskiest of investments.

"Bond investors are acting as if nothing can go wrong," she said.

She contrasts the behavior of bond investors with those in stocks. Investors don't like uncertainty and expect to get paid for it when they invest. But very low yields on bonds throughout the world suggest investors have let down their guard and aren't asking to be paid for risks they are taking.

A stark example is evident in emerging-market bonds, noted Steven Romick, manager of the FPA Crescent Fund.

"The yield on an Iraq bond is just 10 percent. That's crazy given the risk," he said.

While investors have been willing to invest in the riskiest of bonds without being compensated for potential defaults, stock investors have not been as complacent, Nagaswami said.

Overall, the price of stocks compared to earnings remains similar to historical averages, as do other measures. But she said investors are taking extraordinary risks in some parts of the stock market too, especially areas where they'd least expect problems.

So-called value stocks and value stock funds, which investors typically buy because they are cheap and less risky, are anything but that today, she said.

Investors, she says, appear to be making the same mistake about value stocks today as they made about growth stocks seven years ago. Then, investors pushed up the prices of growth stocks to extraordinary levels, and stocks such as technology collapsed in March 2000. Technology stocks as a group fell more than 70 percent, and investors have shunned them while buying value stocks for the last seven years.

But now, Nagaswami said, value stocks are as vulnerable as growth ones once were. "Value is no longer value. ... Cheap is not cheap anymore. They have crossed into the realm of the absurd."

That's because sectors such as materials, commodities, energy and financial services typically are defined as "value stocks" and are what people buy when they invest in value funds.

They have "outperformed to a level never seen," Nagaswami warned, and are vulnerable to any economic slowdown.

Investors now have $426.6 billion invested in large-cap value funds and only $156.9 billion in large-cap growth funds, she said. "Nothing concerns me more."

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