Posted by Don Martin on Mon, Dec 31, 2012 @ 12:43 PM
Investment Forecast for New Year
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In 2013 the economy may be very similar to 2012. The same investments that worked in 2012 may continue to perform in 2013. However, there is the risk that stocks and other “risk assets” such as junk bonds, real estate, commodities, EM debt could crash.
In Morningstar the top 28 of 108 categories for Sharpe ratio for the 12 months ending 11-30-2012 were bond type of investments. The top performing categories (when ignoring risk metrics such as Sharpe ratio) were primarily either consumer defensive industries or big dividend paying industries. The risk is that people may finally wake up and realize that a dividend comes with a risk of loss of capital when a stock’s market price goes down. Also a dividend comes with probably higher taxes in 2013. So in 2013 the best performing equities will take on a fundamentally more risky character. There is no guarantee that the Fed can reinflate stock prices if they crash like they did in 2009.
It is possible that the economy can slowly muddle through the huge amount of excess debt that suppresses demand and economic growth. However, to do that the stock market needs to walk through an economic minefield without the benefit of having a metal detector. In that situation being inside the armored car security of a bond-like investment may be the best choice.
Even though bond prices are high and there is risk they may go down they may still be a good investment. The best estimate for 2013 is that bond prices (which move inversely to interest rates) may go even higher as the Fed tries to buy more long term bonds to force down interest rates. They can’t force down short term rates so they will have no choice but to lower long term rates by buying long term bonds, thus the price may go up.
China will be using less commodities in their next economic cycle. More capital will we leaving China, Japan, Europe and will not be able to fit into tiny havens like Switzerland, so the capital will come into the U.S.
Emerging Market investment grade sovereign debt should continue to be a good asset. Even though high yield “below investment grade” bonds have an equity-like risk of a future crash they are still an interesting investment.
The best asset class for protecting 401k’s from a Fiscal Cliff may be a diversified blend of investment grade and below investment grade fixed income (bonds, bank loan funds, EM debt, high yield bonds, Treasuries, etc.) including both foreign and domestic bonds. These should have a moderate or short term duration to lessen the risk of a sudden increase in long term interest rates which would hurt bonds.
I have written an article “Can you be both bearish and bullish on bonds?”
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Nov 12, 2012 @ 07:51 PM
The “Fiscal Cliff” has no resolution in sight. Investors dream that Congress will simply kick the can down the road and that the economy will remain unchanged. I doubt this; surely some modest down payment against the budget deficit will be legislated and this will drain purchasing power from the private sector, leading to recession. Corporate earnings are at record highs and will probably fall, especially if workers’ wages keep dropping so that they can’t afford to buy what they make. The president and the new Congress are not in a pro-business mood and don’t understand the problems of business.
The consuming public has become addicted to ever-increasing amounts of debt to finance their consumption in excess of income. For the past 14 years real incomes have been stagnant; they have been augmented by delusional borrowings by underemployed consumers. Surely at some point when a rubber band is stretched too far it will break. When will the excessive consumer debt burden break or when will the source of funds for new purchases be cut off?
When will Congress outlaw U.S. multinationals from taking huge foreign tax breaks? This would lower corporate after-tax earnings which would push down stock prices.
Higher personal tax rates on investing start in less than 49 days. When will investors wake up and sell to use today’s lower capital gains rates? Will the selling make prices go down?
These observations are bearish for stocks and bullish for investment grade bonds.
If the economy is getting better, then the Federal Reserve needs to raise interest rates. But if the Fed raised rates that would hurt the housing market and the stock market, making those assets go down.
Investors should become risk aware and reduce risk to manageable levels. They should consider the possibility that the U.S. will go into a 1937 style recession that occurs within the present Soft Depression. Investors should avoid “investments” that lack economic reasons for succeeding such as momentum trading, naked options writing, buying leveraged financial companies that are dependent on artificially low interest rates, etc. Once the truth comes out these speculative ventures could crash hard and not recover.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Dec 20, 2011 @ 03:32 PM
How does Newt Gingrich‘s campaign affect the market?
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Newt Gingrich’s presidential campaign success has threatened the ability of more reliable, well modulated Republican candidates to get the Republican nomination, thus increasing the chances of an Obama victory. This is a negative for the markets.
With some controversial Republican candidates running there is an increased risk of a deadlock and a stalemate in the Republican primary, which helps politicians who are opposed to market based economic solutions. These controversial, mercurial candidates are at risk of breaking away and forming a third party which would siphon off Republican pro-business voters thus handing victory to those who would oppose free enterprise. By contrast the more mainstream Republican candidates would never consider breaking away from the party.
The test for the candidates would be the Iowa caucus and New Hampshire primary. Iowa’s is not an election, rather Iowa’s is a caucus where people are pressed into reaching a consensus to pick a candidate in face to face town hall meetings. New Hampshire is next to Massachusetts where Romney was governor and that may help Romney to reduce Gingrich’s success. The equity markets could react more favorably once the New Hampshire primary has been completed.
Gingrich was correct when he criticized the formation of a Congressional SuperCommittee. I wrote an article “Super committee failure may lead to recession”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Nov 28, 2011 @ 08:39 PM
Stock Market Forecast: Get Out Now Before it Goes Down
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Today the SP500 rallied 2.9%. Last week the market had the worst Thanksgiving week crash since 1932.
My forecast is that the stock market was propped up by the Fed’s massive Quantitative Easing. The market is supported by over-leveraged hedge funds that depend on cheap Put options that are sold by naïve investors. Eventually the Fed will lose credibility, Put option writers will lose confidence and stop selling Puts at reasonable prices, banks will reduce loans to hedge funds, and hedge funds will need to sell stocks to pay down their margin loans.
To add to the risks of the market the Euro problem continues to be unsolved and the Euro depositors continue to quietly withdraw their funds and reduce purchases of bonds from European banks. The risk is significant of another Lehman-style crash in the Eurozone. The only solution is both a breakup of the Euro and a massive write off of bad bank loans which will result in a German taxpayer bailout of European banks.
Is this all that depositors will get when German banks go bust?
More news reports about China’s weakening economy imply that the great commodities boom they caused may end. One reliable source, Michael Pettis suggested that China’s growth rate will slow to 3%. My opinion is that stocks were priced for a China growth rate of 9% and so the coming reduction in growth will reduce Asian stock prices. Remember, the great Japanese boom of the 1980's ended badly.
This is not the time to own risk assets like stocks or below investment grade bonds. It is not yet time for Asian Emerging Market currencies to outperform the dollar and they could go down in value during the next Lehman-style crash. This is time to be grateful for the possible opportunity of a safe haven (not guaranteed) in domestic investment grade bonds even if they only pay two to five percent before inflation and taxes. Based on PE10 the market, with a 20.7 PE10 ratio, needs to go down to 800 for the SP to be fairly valued and when it does it will overshoot the target and go down more.
I wrote an article “Three things you must know about the crash”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Jun 29, 2011 @ 01:23 PM
Real Estate Valuation is Very Different From Stocks
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When a recession occurs several events occur that camouflage or retard bearish market data, and it takes an extra 18-36 months for the truth to come out. Thus the true state of the housing market during a recession is probably worse than the statistics.
- During recession the few people who buy are able to cherry-pick the best homes that have been over-improved. These homes may have the same square feet and bedrooms and bathroom as their competitors, but they have better overall quality which is hard to compile in a data base. These homes should sell for more than homes with the same size, but if only quality homes are being sold then their sales give the appearance values have not dropped. The people trying to sell tacky homes will simply refuse to cut the price and then they give up and take them off the market, thus creating a situation where the only trades occurring are higher than they should be in a recession.
- Some sellers will entice a buyer by offering cash-back rebates which inflate the value. For example a seller could offer $100,000 cash back on a $300,000 value home if it sells for $400,000, thus enabling the buyer to get a loan that is greater than 100% of the value of the home. This would result in a $400,000 sales price being registered in various databases, giving the appearance that all is well in the market. This act would not be legal, because it is required to be disclosed to the bank, which would not accept such a contract.
- A tract developer may report false sales prices in a tract sale in hopes that future buyers would be willing to buy at the old price, instead of a new, lower value. This is illegal and would result in a suit against the seller.
- Real estate salespersons, when seeking a listing for a property, may find the only way to recruit a client is to “list high” (offer it for sale at a high price) and then hope the home will somehow get sold. It may take the seller a long time before he switches to a brutally honest real estate salesperson who tells the seller to ruthlessly cut the price very deeply to sell it. The code of ethics of real estate agents does not allow properties to be listed at artificially high asking prices, but unfortunately a rogue agent might ignore that.
- Data in appraisals is not as good as it should be. For example, appraisers do not evaluate the influence that a good school district has on values, so during a recession perhaps only homes in a good school district will sell thus creating an average price that is higher than the previous year’s average price!
Vast sums of money were wasted in real estate
The only fair way to track real estate would be to have an index that specified the type of homes that could be compared as a result of a sale. For example the home would need to be specified as having 3 bedrooms, 2 baths, 1,500 to 1,700 square feet, a certain age, in a certain school district in a certain city, a single family house, not a condo or Townhome. Even then there would need to be manual adjustments for over-improved or recently remodeled homes versus properties with deferred maintenance. I have seen some housing reports that did not even bother to differentiate between condos versus detached houses.
Stocks are often evaluated using cash flow analysis. By contrast homes are evaluated using three recent “comparable sales”, which is risky because the recent purchases during a bubble could have been based on emotion instead of on cash flow analysis. Appraisals of owners occupied homes are supposed to examine replacement cost and cash flow analysis but if the home is to be owner occupied then cash flow analysis is deemed not applicable and is not used. Yet that would have been the best way to fairly evaluate real estate, since rents are more stable than bubble era asset prices. But published reports about the broad housing market do not use the detail that an appraiser uses to manually adjust for defects or over-improvements or for square feet or age or number of bedrooms, etc. Thus real estate market reports are subject to the potential for drastically skewed data even if the report’s author is very honest.
I wrote a post “Why real estate forecasts are wrong” and “Bearish news items suggest caution”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 28, 2011 @ 09:08 AM
Mortgage approval is the key to real estate prices
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Real estate values for one to four unit residences are a function of the ability to get a loan, which in turn is a function primarily of mortgage underwriting. (Low and declining rates help somewhat to facilitate the ability to buy a property but do not help enough).
Many investment experts are quoted in the news as saying that the ratio of house prices to income is the lowest since either 1975 or even 1965. However this assumes that personal income is:
- Evenly distributed between all consumers (your pay is, on average, the same as Warren Buffet’s).
- Is all a guaranteed, stable, salaried “base pay” instead of irregular overtime pay, or income from self-employment.
- Based on the assumption is that the crash of 2009 somehow did not affect the two year average of income used to underwrite loans for self-employed people.
Examine the details to find the secret
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The qualitative nature of nation’s personal income has changed a lot since the 1970’s. Back then there were a lot fewer self-employed and commissioned people. A lesser amount of the work force were employed as temporary workers in previous decades.
During the last several decades the qualitative nature changed in manner that is analogous to a stock market breadth indicator. During a market top a few prestigious companies continue to make new highs pushing the broad marker average slightly higher while the vast majority of stocks languish and fail to make new highs. The job market in the past decade consisted of the top 10% of the population getting good pay raises while the bottom 90% had stagnant wage growth. People may now hold two jobs or may have their income from a series of temp jobs with big employment gaps, or they may be an independent contractor or a small business owner. This type of income is riskier than an old-fashioned salaried job with a few years of seniority. This change was the price to pay to make America’s labor force globally competitive. But adjusted for the quality of income (a risk adjusted measure of income) the nation’s personal income has declined. Mortgage lenders evaluate loans according to this. It is more important than credit rating or having a large down payment, although that does not excuse bad credit or lack of a reasonable down payment.
Another analogy would be that today’s irregular workers (temp’s, independent contractors, etc.) are like Small Cap companies and their former salaried job was like a Large Cap company. During recessions Small Cap companies may be hurt by competition from Large Cap companies; it is during boom times that Small Caps get their best income because the Large Caps can’t fulfill orders fast enough. Until another boom comes along then the independent contractors will have aharder time buying a home.
Unlock the secret combination
Diagnosis foiled by smokescreen
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This income problem was camouflaged by the use of “Easy Qualifier” no income documentation loans which were offered from 1984 until 2009. It was also camouflaged by the stock speculation of the 1990’s and the real estate speculation of the 1997-2008 bubble. Since Easy Qualifiers are now illegal and people’s incomes are much shakier than that of a generation ago that means that one can’t compare simple metrics of income to house prices over the past several decades. I wrote "80% of loans were not safe" and "Housing not comparable to the past" about this matter.
The best comparison would be that of the post Great Depression mentality of consumers who for 20 or 30 years after the Depression would resist taking on excessive debt. It took 28 years for stocks to return to their 1929 highs in “real” terms. By analogy real estate should take that long also.
This misunderstanding by Wall Street about real estate finance reminds me of Bernanke, when asked during the real estate bubble about high house prices, responded by saying that high prices were symptom of a prosperous society that could afford to pay more for houses. Instead he should have seen through the smokescreen and realized that people were actually speculating in real estate in an attempt to earn more income becuase some of them may not have had enough income and not because they could afford more real estate.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Mar 09, 2011 @ 04:33 PM
Today in the Financial Times is a fascinating article about the Equity Risk Premium (ERP). I had been intending to write an article about this topic before the article in the FT was printed. I shall point out that the author started on some good points but needs to elaborate on them. He said the ERP has been 3.9% a year over the last century according to Credit Suisse annual yearbook. What the ERP implies is that because you take more risk to buy stocks than bonds therefore you deserve a premium or extra benefit of stocks returning more than bonds.
The ERP has floated around in a cyclical pattern over the past century so there are no firm rules about the ERP. (My guess is that a time-lagged study of ERP would show negative correlation with equities, meaning that when stocks go down then the ERP goes up after a 15 to 20 year lag.) The reason the ERP changes is because after a huge crash stocks are cheap for many years and as investors regain their confidence they make a profit by buying when stocks are undervalued. For example after the Great Depression of the 1930’s it took investors until the 1960’s to fully regain their lost confidence and aggressively bid up the market to high PE ratios. So that meant stocks were undervalued during the 1950’s and thus were rising from a low base so the ERP was high in the 1950’s because the rise from the low base produced more return than bonds. Once stocks became overpriced then they needed to come down or stay flat and thus they were doomed to provide a lower return than that of a bond. Since equity bull and bear markets last roughly 17 years then during a 17 year equity bull market bonds would underperform causing stocks to exhibit a high ERP. Conversely during a 17 year bear market stocks need to go down so they underperform bonds causing negative ERP. So while it is true that over a century the ERP is 4%, it varies so much that an investor can’t casually buy stocks and hope to wait until the ERP rewards him. Instead the investor must use Graham & Dodd 10 year PE’s and only buy when the PE is low and sell equities when the PE is too high. This strategy is similar to value investing, but is not necessarily value investing, as it can be done with quality growth stocks that are reasonably priced. When doing value investing it is very important to manually check the health of a company and not merely assume that a low PE stock with a good dividend is a value company. One must check carefully to avoid the value trap of value companies that are cheap because the market expects them to fail. A good example would be the financial companies that some mutual funds bought increasing amounts of as the price declined during the 2008 crash, only to find the company soon went bankrupt.
As a practical matter, I expect that stocks will crash and then when shares are bought at low prices at that time the ERP will return to a normal figure from its current tie with bonds. This means don’t buy stocks until after the crash when the PE ratio is at least 20% below 15, or 12, using a ten year inflation adjusted average.
I have written about this here.
This is an example of independent investment advice.
Posted by Don Martin on Fri, Feb 25, 2011 @ 05:21 PM
In the Wall Street Journal today Fed Vice Chair Yellen said long term bond yields may have risen due to QE2 because the market expected a larger amount of bond purchases. This is startling statement. If the market expected more purchases then the market was saying the economy needed a lot more stimulus in which case rates should be low. So to make rates low the fed will need to buy even more bonds. This implies that the invisible hand of the market is saying that gradually the Fed is losing credibility and that the patient is beginning to fail to respond to the medicine, resulting in a long term soft depression as in Japan. The big risk is that Fed’s actions will increasingly be disregarded by the market and then the government will loose the ability to control monetary policy. It seems that in response to QE which is intended to devalue the dollar that the market raises interest rates to compensate for loss of purchasing power and thus the goal of devaluing the dollar in negated. Thus QE2 or any QE will not work and thus a new recession may occur.
This posting is an example of independent investment advice.
Posted by Don Martin on Wed, Feb 23, 2011 @ 01:27 PM
The housing market will not repeat its previous patterns over the last 45 years. Using underwriting standards and looking at the inflation adjusted cost of money, we are in a new era in which the eras from 1965 to 2008 are not comparable.
From 1965 to 1982 there was a lot of inflation and it kept increasing until 1982 when the Fed tightened the money supply with Prime rate at 22%. During this era the real rate (inflation adjusted rate) of interest was sometimes negative so that borrowers were willing to borrow to buy a house even if the rate was 12%.
Then a new era of low and declining inflation started in July, 1982 when the Fed’s tightening was so radical that it ended inflation and thus made interest rates come down to reasonable levels. In 1984 the first “Easy Qualifier” home loans started becoming available. These allowed borrowers to get a loan without proper income documentation which led to abusive behavior by some borrowers and excessive, unaffordable borrowing which led to a housing bubble. Also at this time the Shadow Banking industry of non-bank lenders began to offer loans using securitized lending. These acts set the stage for a massive housing bubble that lasted until the crash of 2007-2008 at which time a new era in housing has started.
Now Easy Qualifier (no income verification) loans are outlawed and loan securitization by non-bank lenders has been greatly reduced. So the new era has much harder rules that greatly restrict how much consumers can borrow. Since most homes are financed with a mortgage then this reduction in mortgage lending means that consumers will simply have to buy a lower priced home than what they were used to. So this will put downward pressure on home prices. Basically in a normal lending environment (that did not exist during the time of Easy Qualifiers) what drives mortgage approvals is personal income, not interest rates. So housing could only go up in proportion to the average person’s personal income which grows slowly and steadily, so this why before the Great Bubble of 1983-2008, nationwide home prices did not go up faster than inflation, after adjusting for quality.
The era of inflation for 1965-1982 was an era of cheap money on an inflation adjusted basis, which explains appreciation then. It was an era when people tried to protect themselves from inflation by buying real estate. The era from 1982-2008 was a credit bubble era where loans were granted increasingly with less restriction each year so that in the final years of the bubble the loan underwriting rules were a meaningless joke for those willing to pay the fees charged for “Easy Qualifiers”. During 2001-2006 it was possible to buy a $1,000,000 house with no down payment and no verification of income and no lender’s recourse if the borrower decided to go into foreclosure! No wonder prices appreciated excessively. My point is that financing and inflation conditions since 1965 until 2008 were an unusual situation that won’t be repeated and thus one can’t use the data of the past 45 years to look for patterns that would indicate if another housing boom will start. The best forecast should be based on the fact that mortgage lending is tied to income and income will be growing very close to zero on an inflation adjusted basis. Also there is a huge overhang of shadow inventory that will produce a surplus of housing inventory until 2017-2018. Also, baby boomers need to downsize their homes to free up equity. Also personal incomes will be stagnant or slow growing for a long time, and what little growth of incomes occurs will need to be spent on rising medical costs. As a rule of thumb, when a bubble is busted it remains busted and new bubbles form elsewhere. Remember the Tech stock crash of 2000 and how long those stocks stayed down at low prices. The NASDAQ is still about half of its high water mark of 11 years ago. See my post http://tinyurl.com/46n6u4n
This type of blog post is an example of independent investment advice.
Posted by Don Martin on Sun, Jan 02, 2011 @ 09:20 PM
Should investors seek professional independent investment advice for a fee during a bear market or should they try to “save” money by not using an advisor and simply putting all their funds into an insured CD?
When an investor hears that an advisor is bearish the investor maybe tempted to think he can save money by simply parking his assets in an insured CD and thus avoid paying for investment advice. However, the investor risks missing advice about when is the right time to get back into the market. The investor may miss advice on contrarian strategies that may be feasible during a range bound bear market. An investor who shuns the advice of a bear market advisor may end up being fooled by a bubbly bullish demagogue who encourages buying stocks at the top of the market, which would result in losses.
Perhaps the most important rule in investing is to avoid losing money. This is because for example, if you lose 50% then you need to make 100% to get back to even. Also if you suffer big losses you may feel too frustrated to invest and then miss the rally that occurs after a crash. So for this reason it is more important to get professional advice from a bear market advisor than it is to get bullish advice during a boom time.