The 5-Sigma Report

The market has handed investors some nice, consistent returns over the long run, but in the short term it can often be as unpredictable as an episode of The Real World. In a pair of articles, I explored the market's so-called "fat tail" distribution -- the tendency of stocks to make huge moves that seem extremely statistically improbable. Since then, I've been following "5-sigma moves," or one-day price moves that are five standard deviations or more from a stock's average one-day change.

Keep in mind that we're looking at the price change relative to the stock's historical volatility, and not just the same old jittery "most active" stocks. So although Energy Conversion Devices, Gymboree, and FLIR Systems had some big percentage changes last week, you're not going to see them here because of their higher average volatility.

As I've mentioned before, working with these stocks isn't as easy as selling every stock that makes a big move up or buying every one that does the opposite (or vice versa). Some stocks continue on a major upward march even after a huge one-day move, and some continue to lose ground even after a huge one-day fall. So you need to dig in and figure out whether the move was a result of market overreaction or of some lasting, fundamental change at the company.

Here are a few of the 5-sigmas from the past week:

The subprime blues
Let's focus on New Century Financial, which is seeing the effect of the housing bust pretty painfully. Last week, the subprime mortgage lender announced that not only will it restate its financials for the first three quarters of 2006, but that 2007 loan production would be down about 20% versus 2006. In a similar announcement, HSBC (NYSE:HBC) said that it was bumping its provision for loan losses to $10.6 billion, a 20% markup from the previous estimate. Investors were not amused.

At the start of the millennium, housing prices all over the country were on fire. Low interest rates meant that buyers could afford more house for their money, builders could easily move new homes, and lenders could price in a great margin on their loans. But the excitement went too far. Buyers wanted more and bigger houses, and builders and lenders accommodated them, sometimes even making loans that actually increased the principal over time.

Eventually, of course, reality intruded on the fairy tale, and a massive number of subprime borrowers found themselves realizing that the real estate market isn't a fantastic candy-land world where housing prices rise 10% every year and homes can be easily flipped before the mortgage balloons to an unaffordable level.

And we may only be at the outer reaches of the storm right now. Many questionable loans have a period of three, five, or even seven years of lowered payments before they bump up by a significant amount, meaning fallout from the frothiest years of the bubble may kick in during 2008 and beyond. Compounding the risk is the fact that the subprime lenders aren't going to be able to show the same kind of growth going forward, as they start to buckle down on underwriting discipline.

Analysts believe that more diversified lenders such as Countrywide Financial (NYSE:CFC), which have just dipped a toe into that turbulent subprime pool, will do fine. The same could be said for larger banks like Bear Stearns (NYSE:BSC), which have only recently added subprime exposure. For New Century and competitors like Novastar Financial and Accredited Home Lenders, though, downgrades have already hit the wire, and the full downside for the industry likely still lies ahead.

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Fool contributor Matt Koppenheffer encourages feedback and thinks you should check out the picks of FBR on The Motley Fool's CAPS service for a Wall Streeter who sees trouble ahead for New Century. He does not own shares of any of the companies mentioned. The Fool's disclosure policy is your personal rock of stability in a crazy world of uncertainty.