Four ways to dodge the credit crisis

I've seen this movie before - and I know how it ends. In fact, I've lived it.

During the dot com boom, my wife and I lived in San Francisco. The Bay Area was the heart of the Internet. Venture capitalists were lining up everywhere, clamouring to pump millions of dollars into companies with big dreams and big hype, but precious little else.

On both an institutional and individual basis, the spending was unbelievable. Everyone was invested in the stock market. We attended parties, featuring private concerts with James Brown (yes, that James Brown), where the talk always turned to which Internet stock would take off next. How stocks were the only way to make money. Doctors and lawyers were quitting their jobs to day-trade stocks like Ariba and Commerce One.

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There were millionaires everywhere. Paper millionaires, that is. Guys who planned to retire at 35. It was an amazing time and place to live. But when the party ended in spectacular fashion, portfolios plummeted and the dot com era died, taking jobs and fortunes with it. And today, another speculative bubble is about to pop...

This time it's worse

These days, my family and I live in South Florida. But instead of talking about stocks being the way to wealth, the conversation turned to real estate as 'the only way to make money.'

Not surprising, considering Florida is one of the country's fastest-growing states in terms of population growth and is, of course, a prime destination for millions of America's baby boomers.

But the trend is nationwide. Ordinary people with ordinary jobs built or renovated three or four houses at a time, figuring they can flip them for an easy five or six-figure profit by the time the project is completed.

And just like during the dot com boom, while a few people enjoyed some profits at the beginning, there are now many more stories of people who own four houses, but can't sell them.

But there's a big difference between being stuck in the dot com vortex and the increasingly serious real estate wreck - and this one is worse. Here's why...

Central banks react as foreclosures jump and borrowers feel the squeeze

Investors who got suckered into the dot com debacle ended up with some shredded portfolios. An ugly outcome, for sure. But it's a lot worse to be paying four mortgages and eventually being forced into foreclosure.

Over the first half of the year, foreclosure filings rocketed up 58% to 925,986, compared with the same period in 2006. When measured against the last six months of 2006, filings shot up 30%, according to RealtyTrac, an online foreclosure marketplace. And as the real estate market continues to sag and borrowers remain overstretched, the full-year number could well hit two million.

Unlike in the stock market, where market makers or other investors will buy your unwanted stock (albeit at a less favourable price), these houses are being dumped on the market - but there are no buyers.

This is why we're now starting to see the credit markets crack and the stock markets reel. As interest rates rise and house price values drop, borrowers are feeling the financial squeeze - particularly in the sub-prime mortgage sector.

Hedge funds and institutions have packaged up these businesses into funds, available to buy and sell like any other. But there is no liquidity for these instruments and, in some cases, no accurate way of pricing them.

We've already seen the demise of two of Bear Stearns' sub-prime mortgage funds, as well as trouble in three held by French bank BNP Paribas. And as hedge funds are buckling under the weight of these credits, the sector has crumbled and both the European Central Bank and U.S. Federal Reserve have recently flooded the market with cash to offset the fallout. Even so, some of the major financial institutions will not be able to escape this crisis.

What it means for your porftolio - and how to prepare

The Fed and ECB did the right thing by injecting liquidity into the markets and trying to calm fears. But this credit contagion is serious and I expect that we'll feel the consequences over the coming months. Here are four things you can do today to protect yourself...

Dump The Sub-Prime Slobs: If you own a financial stock that has exposure to sub-prime mortgages, get rid of it - even if you have to take a loss. We're already seeing the fallout and I suspect these stocks will be hit particularly hard in the near future.

Set Stop-Losses: The real estate slowdown and sub-prime collapse is making the stock market very volatile right now. Make sure you employ stop-losses on the other stocks in your portfolio. That way, if a broad and serious decline occurs, you'll escape much of the pain.

Let Your Long-Term Holdings Lie: If you own mutual funds with a time horizon of five years or longer, don't touch them. There's a reason you're in them and over the long haul they should be fine.

Whip Your Stock Watch List Into Shape: To find out more about creating a 'watch list of stocks', see: How to profit during market volatility

By Marc Lichtenfield, Senior Analyst, Mt. Vernon Research for the Smart Profits e-Report, www.smartprofitsreport.com