Tag Archives: Real Estate

Decoding Media Speak & What You Can Do About It

Just recently, the Institutional Investor website published a brilliant piece entitled “Asset Manager B.S. Decoded.”

“The investment chief for one institution-sized single-family fortune decided to put pen to paper, translating these overused phrases, sales jargon, and excuses into plain — and satirical — English.”

A Translation Guide to Asset Manager-Speak

  • Now is a good entry point = Sorry, we are in a drawdown
  • We have a high Sharpe ratio = We don’t make much money
  • We have never lost money = We have never made money
  • We have a great backtest = We are going to lose money after we take your money
  • We have a proprietary sourcing approach = We invest in whatever our hedge fund friends do
  • We are not in crowded positions = We missed all the best-performing stocks
  • We are not correlated = We are underperforming while the market keeps going up
  • We invest in unique uncorrelated assets = We have an illiquid portfolio which can’t be valued and will suspend soon
  • We are soft-closing the fund = We want to raise as much money as we can right now
  • We are hard-closing the fund = We are definitely open for you
  • We are not responsible for the bad track record at our prior firm = We lost money but are blaming all our ex-colleagues
  • We have a bottom-up approach = We have no idea what markets are going to do
  • We have a top-down process = We think we know what markets will do but really who does?
  • The markets had a temporary mark-to-market loss = Our fundamental analysis was wrong and we don’t know why we lost money
  • We don’t believe in stop-loss limits = We have no risk management

Wall Street is a business.

The “business” of any business is to make a profit. Wall Street makes profits by building products to sell you, whether it is the latest “fad investment,” an ETF, or bringing a company public. While Wall Street tells you they are “here to help you grow your money,” three decades of Wall Street shenanigans should tell you differently.

I know you probably don’t believe that, but here is a survey that was done of Wall Street analysts. It is worth noting where “you” rank in terms of their concern, and compensation.

Not surprisingly, you are at the bottom of the list.

While the translation is satirical, it is also more than truthful. Investors are often told what they “want” to hear, but actual actions are always quite different, along with the eventual outcomes.

So, what can you do about it?

You can take actions to curb those emotional biases which lead to eventual impairments of capital. The following actions are the most common mistakes investors repeatedly make, mostly by watching the financial media, and what you can do instead.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrongonly in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted the more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens, it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom or top ticks. 

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected, thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position, on the way up.

6) Don’t Fight The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies, it doesn’t take into account market and investor sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company that is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

Conclusion

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money. Focus on managing risk, market cycles and exposure.

The law of change states: Change will occur, and the elements in the environment will adapt or become extinct, and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.” – Tim Hodgson, Thinking Ahead Institute

Investing is not a competition.

It is a game of long-term survival.

Start by turning off the mainstream financial media. You will be a better investor for it.

I hope you found this helpful.

REITs: Slightly Better Than Broad U.S. Market, But Still Not Cheap

When I wrote an article on REITs for the Wall Street Journal in early 2017, I used a research report from Research Affiliates in Newport Beach, CA to argue that the asset class was overpriced and poised to deliver 0%-2% or so real returns for the next decade.

My article sparked a lot of mail and controversy. One reader reply underneath my article on the WSJ website said “Among equity REITs traded on stock exchanges there has literally never been a 10-year period in the history of REIT investing when real total returns averaged 0% per year (or worse) as [John Coumarianos’s] approach predicts.”

Another letter, which the Journal published as a reply to my article, from Brad Case of the National Association of Real Estate Investment Trusts (NAREIT) strangely had the exact same language about REITs never producing such a poor 10-year return as the letter written by someone of another name under the column on the website. Case’s formal, published letter went on to say, “The current REIT stock price discount to net asset value suggests that returns over the next 10 years may exceed inflation by around 8.15 percentage points per year on average.”

The decade isn’t up, but now, two years in, let’s see how things are going for REITs. Also, what’s the forecast today? Have things improved? After we assess recent returns, let’s go through the forecast again to see if things look any better now.

Not A Great Two Years For REITs

In 2017, two major REIT index funds – the Vanguard REIT Index fund and the iShares Cohen & Steers REIT Index ETF — produced a nearly 5% return each.  Considering that the CPI (consumer price index) was up 2.1% in 2017, that’s about a 3% real or inflation-adjusted return.

In 2018, the iShares fund delivered a 5.29% return through October, while the Vanguard fund delivered a 2.03% return through October. So far inflation is running at an estimated 2.2% for the year, according to the Minneapolis Fed. That means REIT real returns for 2018 are in the 0%-3% range, depending on which index you use. For both 2017 and 2018, we are a far cry from Case’s 8.15% real return forecast.

Start With Dividend Yield

The analysis advocated by Research Affiliates was simple. First, start with “net operating income” (NOI) or rent minus basic expenses. NOI a good indication of the cash flow a property or a collection of properties are delivering. Investors take this number and divide by the price of a property to determine what they call a “capitalization rate.” In effect, that resembles an earnings yield (earnings divided by price) of a stock. Mutual fund investors can substitute dividend yield of a REIT-dedicated fund.

For my original article, the dividend yield of most REIT index funds and ETFs was around 4%. Now it’s closer to 3%. The iShares Cohen & Steers REIT ETF yields less than 3.2% right now, while the Vanguard REIT Index fund lists a current effective yield of 3.23% and a yield adjusted for return of capital and capital gain distributions over the past two years at 2.13%.

Upkeep

The second component of a return forecast is a property upkeep component. Real estate requires capital – not only for the initial purchase, but also for maintaining the property. Things are always breaking and obsolescence always threatens landlords who must update kitchens, bathrooms, and other aspects of their properties. It’s true that with some property types, tenants are responsible for some upkeep and improvement, but that isn’t always the case. Research Affiliates figures 2% of the cost of the property per year, is a decent round number to use in a return forecast. Unfortunately, that wipes out most of the 3% dividend yield investors are currently pocketing.

So far, we are running at a 0 or 1% real annualized return for the next decade.

Price Change

The last component of real estate valuation and return forecasting is the most speculative. Where will properties trade in a decade? Nobody knows for sure, but Research Affiliates estimated in early 2017 that commercial property was priced 20% above its long term trend. If prices remained at that level, investors would capture the 4% yield minus the 2% annual upkeep or 2% overall. If prices reverted to trend, investors would have to subtract enough from net operating income adjusted for upkeep to bring future returns down to 1.4%.

Currently on the Research Affiliates website, the firm forecasts REITs to deliver a 2% annualized real return for the next decade. That’s about where the forecast stood at the beginning of 2017. It’s worth noting that although that’s a low return, it’s actually a better forecast than the firm has for U.S. stocks, which it thinks won’t deliver any return over inflation for the next decade.

Gut Check

It’s often useful to take multiple stabs at valuation. So, in the spirit of providing a gut check, I supplemented this dividend-upkeep-price analysis with a simple Price/FFO (funds from operations) analysis. REITs have large, unrealistic depreciation charges, rendering net income a mostly useless metric. FFO, which adjusts net income for property sales and depreciation is a more accurate cash flow metric. FFO isn’t perfect either because it doesn’t account for different debt loads of different companies and because it doesn’t account for maintenance costs, but it’s a uniform metric that almost all REITs publish.

Of the top-20 holdings of the Vanguard Real Estate Index fund VGSIX, Weyerhaeuser and CBRE didn’t publish FFO metrics. The average of the other 18 companies was 20. That’s a pretty high multiple for REITs, which are slow growth stocks.

Rising Rates Are Killing The Housing Market

Earlier this year, I penned an article entitled “The Coming Collision Of Debt & Rates” which discussed the 10-areas that rising interest rates would impact most directly. Number two on that list was housing:

“Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.”

The housing recovery is ultimately a story of the “real” employment situation. With roughly a quarter of the home buying cohort unemployed and living at home with their parents, the option to buy simply is not available.  Another large chunk of that group are employed but at the lower end of the pay scale which pushes them to rent due to budgetary considerations and an inability to qualify for a mortgage.

(For more housing charts click here)

Even after a “decade of recovery,” the full-time employment-to-population ratios remain well below levels normally associated with a strong economy, and wage growth remains stagnant. Both of which makes home affordability an issue.

Despite much of the media rhetoric to the contrary, I have warned repeatedly that rising rates would negatively impact the housing market which was still being supported by low interest rates.

The mistake that mainstream analysts made was in the assumption that the recent increases in real estate prices were largely driven by first time home buyers creating an organic market. The reality, however, has been that market increases were being driven by speculators in the “buy to rent” game. As I noted previously:

“As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.”

“Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices ‘first-time homebuyers’ out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a ‘rush for the exits’ as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.”

You can see that a bulk of the real estate activity has occurred at the price levels of homes that make the best rental properties – between $200,000 and $400,000.

Importantly, you can see activity has dropped sharply over the course of the last couple of months. This is particularly the case at the very high-end and very low-end of the spectrum.

The latest data on existing and new home sales, permits, and completions show that we have likely seen the peak from the bounce in housing activity that started in 2010. It is important to remember, as we have discussed previously, that there are only a certain number of individuals that, at any given time, are actively seeking to ‘buy’ or ‘sell’ a home in the market. Furthermore, individuals buy “payments,” not “houses,” so artificially suppressed interest rates are only half of the payment equation. When home prices increase to levels that begin to price buyers out of the market – activity will slow.

The chart below is our Total Housing Activity Index which simply combines the 4-primary components of the housing market cycle – permits, completions, and sales of new and existing homes.

You will notice the last time the activity index broke is rising trend, the subsequent decline was not healthy. More importantly, both the current, and previous, “housing bubble” preceded the peak in household net worth.

In both cases, the “pin that pricked the bubble” was interest rates. As shown below, when mortgage rates rise housing activity slows as “people buy payments” rather than houses. This is because higher rates have two immediate impacts on the housing market:

  1. The monthly payment rises to a level that buyers can’t afford, or;
  2. Buyers stop their activity to “wait and see” if rates come back down again. 

The monthly mortgage payment required for a loan has risen about 12% over the last three years as mortgage rates rose approximately 1%. The simply put houses out of reach for a vast majority of Americans already living from one paycheck to the next.

As a result, and shown below, the annual growth rate of housing activity is back into negative territory.

However, it is really how many of those “permits” turn into “completions” that matter. Currently, that ratio is sending an important warning which is suggesting more troubles ahead for the housing market as “permits” are being pulled due to lack of demand.

At The Margin

Another “Damocles Sword” hanging over the mortgage industry is that rising interest rates will continue to kill the “refinance market.” Banks and mortgage-related companies have made huge profits over the last couple of decades as homeowners serially refinanced their homes to take out cash and refinance at a lower mortgage rate. That activity has largely ceased as a result of higher rates. We are now seeing default risk rise as adjustable rate credit lines on home equity loans begin to exceed homeowners ability to service the debt.

Furthermore, individuals were previously able to sell their existing home and “upgrade” to a newer or larger home. That upgrade was afforded by extremely low interest rates. Now, as rates rise, the “trade up” activity will greatly diminish as individuals become locked into their existing homes.

Housing is always a function of what happens at the “margins” with the activity contained to those actively searching to buy a house versus those willing, or able, to sell. But in order for MOST individuals to engage in the housing market, they need a mortgage to do so. As rates rise, that activity slows.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery.

Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. We must also remember that record low mortgage rates driven by Fed purchases of Mortgages Backed Securities (MBS) played a large role in the recovery.

Homebuilder sentiment has gone well beyond the actual level of activity. The recent turn lower is bringing that over-confidence back to reality and with that expect to see a decline in new permits and likely rise in the unemployment rate of those involved in the housing sector.

For the housing market, the recent rise in interest rates is extremely important.  There are many hopes pinned on housing activity continuing to foster the domestic economic recovery. If rates do indeed pop the current housing “bubble,” the entire economic recovery thesis will be called into question.

While the Fed has repeatedly noted the strength of the economy as a central underpinning for continuing to hike rates and tighten monetary policy, it is quite likely the damage from rising rates has already been done. Such was noted yesterday when Fed Chair Jerome Powell reversed his position on hiking rates and changed the language to suggest they were close to finished.

But the Fed’s change of tone may just be “too little, too late” as the negative impacts of increased borrowing costs with respect to both auto loans and housing have already become evident. It is only a function of time until the broader economic indicators feel the pinch.

Yes, We Are In Another Tech Bubble

Technology has touched our lives in so many ways, and especially so for investors. Not only has technology provided ever-better tools by which to research and monitor investments, but tech stocks have also provided outsized opportunities to grow portfolios. It’s no wonder that so many investors develop a strong affinity for tech.

Just as glorious as tech can be on the way up, however, it can be absolutely crushing on the way down. Now that tech stocks have become such large positions in major US stock indexes as well as in many individual portfolios, it is especially important to consider what lies ahead. Does tech still have room to run or has it turned down? What should you do with tech?

For starters, recent earnings reports indicate that something has changed that deserves attention. Bellwethers such as Amazon, Alphabet and Apple all beat earnings estimates by a wide margin. All reported strong revenue growth. And yet all three stocks fell in the high single digits after they reported. At minimum, it has become clear that technology stocks no longer provide an uninterrupted ride up.

These are the kinds of earnings reports that can leave investors befuddled as to what is driving the stocks. Michael MacKenzie gave his take in the Financial Times late in October [here]:

“The latest fright came from US technology giants Amazon and Alphabet after their revenue misses last week. Both are highly successful companies but the immediate market reaction to their results suggested how wary investors are of any sign that their growth trajectories might be flattening.”

Flattening growth trajectories may not seem like such a big deal, but they do provide a peak into the often-tenuous association between perception and reality for technology. Indeed, this relationship has puzzled economists as much as investors. A famous example arose out of the environment of slowing productivity growth in the 1970s and 1980s [here] which happened despite the rapid development of information technology at the time. The seeming paradox prompted economist Robert Solow to quip [here],

You can see the computer age everywhere but in the productivity statistics.”

The computer age eventually did show up in the productivity statistics, but it took a protracted and circuitous route there. The technologist and futurist, Roy Amara, captured the essence of that route with a fairly simple statement [here]:

“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Although that assertion seems innocuous enough, it has powerful implications. Science writer Matt Ridley [here] went so far as to call it the “only one really clever thing” that stands out among “a great many foolish things that have been said about the future.”

Gartner elaborated on the concept by describing what they called “the hype cycle” (shown below).

The cycle is “characterized by the ‘peak of inflated expectations’ followed by the ‘trough of disillusionment’.” It shows how the effects of technology get overestimated in the short run because of inflated expectations and underestimated in the long run because of disillusionment.

Amara’s law/ the hype cycle

Source: Wikipedia [here]

Ridley provides a useful depiction of the cycle:

“Along comes an invention or a discovery and soon we are wildly excited about the imminent possibilities that it opens up for flying to the stars or tuning our children’s piano-playing genes. Then, about ten years go by and nothing much seems to happen. Soon the “whatever happened to …” cynics are starting to say the whole thing was hype and we’ve been duped. Which turns out to be just the inflexion point when the technology turns ubiquitous and disruptive.”

Amara’s law describes the dotcom boom and bust of the late 1990s and early 2000s to a tee. It all started with user-friendly web browsers and growing internet access that showed great promise. That promise lent itself to progressively greater expectations which led to progressively greater speculation. When things turned down in early 2000, however, it was a long way down with many companies such as the e-tailer Pets.com and the communications company Worldcom actually going under. When it was all said and done, the internet did prove to be a massively disruptive force, but not without a lot of busted stocks along the way.

How do expectations routinely become so inflated? Part of the answer is that we have a natural tendency to adhere to simple stories rather than do the hard work of analyzing situations. Time constraints often exacerbate this tendency. But part of the answer is also that many management teams are essentially tasked with the effort of inflating expectations. A recent Harvard Business Review article [here] (h/t Grants Interest Rate Observer, November 2, 2018) provides revealing insights from interviews with CFOs and senior investment banking analysts of leading technology companies.

For example, one of the key insights is that “Financial capital is assumed to be virtually unlimited.” While this defies finance and economics theory and probably sounds ludicrous to most any industrial company executive, it passes as conventional wisdom for tech companies. For the last several years anyway, it has also largely proven to be true for both public tech-oriented companies like Netflix and Tesla as well as private companies like Uber and WeWork.

According to the findings, tech executives,

“…believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages.”

An important implication of this capital availability is,

“The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects …”

Another key insight is, “Risk is now considered a feature, not a bug.” Again, this defies academic theory and empirical evidence for most industrial company managers. Tech executives, however, prefer to, “chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside.”

Finally, because technology stocks provide a significant valuation challenge, many tech CFOs view it as an excuse to abdicate responsibility for providing useful financial information. “[C]ompanies see little value in disclosing the details of their current and planned projects in their financial disclosures.” Worse, “accounting is no longer considered a value-added function.” One CFO went so far as to note “that the CPA certification is considered a disqualification for a top finance position [in their company].”

While some of this way of thinking seems to be endemic to the tech industry, there is also evidence that an environment of persistently low rates is a contributing factor. As the FT mentions [here], “When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions.”

John Hussman also describes the impact of low rates [here]:

“The heart of the matter, and the key to navigating this brave new world of extraordinary monetary and fiscal interventions, is to recognize that while 1) valuations still inform us about long-term and full-cycle market prospects, and; 2) market internals still inform us about the inclination of investors toward speculation or risk-aversion, the fact is that; 3) we can no longer rely on well-defined limits to speculation, as we could in previous market cycles across history.”

In other words, low rates unleash natural limits to speculation and pave the way for inflated expectations to become even more so. This means that the hype cycle gets amplified, but it also means that the cycle gets extended. After all, for as long as executives do not care about “judiciously allocating capital”, it takes longer for technology to sustainably find its place in the real economy. This may help explain why the profusion of technology the last several years has also coincided with declining productivity growth.

One important implication of Amara’s law is that there are two distinctly different ways to make money in tech stocks. One is to identify promising technology ideas or stocks or platforms relatively early on and to ride the wave of ever-inflating expectations. This is a high risk but high reward proposition.

Another way is to apply a traditional value approach that seeks to buy securities at a low enough price relative to intrinsic value to ensure a margin of safety. This can be done when disillusionment with the technology or the stock is so great as to overshoot realistic expectations on the downside.

Applying value investing to tech stocks comes with its own hazards, however. For one, several factors can obscure sustainable levels of demand for new technologies. Most technologies are ultimately also affected by cyclical forces, incentives to inflate expectations can promote unsustainable activity such as vendor financing, and debt can be used to boost revenue growth through acquisitions.

Further, once a tech stock turns decidedly down, the corporate culture can change substantially. The company can lose its cachet with its most valuable resource — its employees. Some may become disillusioned and even embarrassed to be associated with the company. When the stock stops going up, the wealth creation machine of employee stock options also turns off. Those who have already made their fortunes no longer have a good reason to hang around and often set off on their own. It can be a long way down to the bottom.

As a result, many investors opt for riding the wave of ever-inflating expectations. The key to succeeding with this approach is to identify, at least approximately, the inflection point between peak inflated expectations and the transition to disillusionment.

Rusty Guinn from Second Foundation Partners provides an excellent case study of this process with the example of Tesla Motors [here]. From late 2016 through May 2017 the narrative surrounding Tesla was all about growth and other issues were perceived as being in service to that goal. Guinn captures the essence of the narrative:

“We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands.” In this narrative, “there were threats, but always on the periphery.”

Guinn also shows how the narrative evolved, however, by describing a phase that he calls “Transitioning Tesla”. Guinn notes how the stories about Tesla started changing in the summer of 2017:

“But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries.”

This meant the narrative shifted to something like, “The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this?” As Guinn describes, “The narrative was still positive, but it was no longer stable.” More importantly, he warns, “This is what it looks like when the narrative breaks.”

The third phase of Tesla’s narrative, “Broken Tesla”, started around August 2017 and has continued through to the present. Guinn describes,

“The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles.”

Finally, Guinn concludes, “Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.” Once this happens, there is very little to inhibit the downward path of disillusionment.

Taken together, these analyses can be used by investors and advisors alike to help make difficult decisions about tech positions. Several parts of the market depend on the fragile foundations of growth narratives including many of the largest tech companies, over one-third of Russell 2000 index constituents that don’t make money, and some of the most over-hyped technologies such as artificial intelligence and cryptocurrencies.

One common mistake that should be avoided is to react to changing conditions by modifying the investment thesis. For example, a stock that has been owned for its growth potential starts slowing down. Rather than recognizing the evidence as potentially indicative of a critical inflection point, investors often react by rationalizing in order to avoid selling. Growth is still good. The technology is disruptive. It’s a great company. All these things may be true, but it won’t matter. Growth is about narrative and not numbers. If the narrative is broken and you don’t sell, you can lose a lot of money. Don’t get distracted.

In addition, it is important to recognize that any company-specific considerations will also be exacerbated by an elemental change in the overall investment landscape. As the FT also noted, “But this month [October] can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals.” This turning point has significant implications for the hype cycle: “Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.”

Yet another important challenge in dealing with tech stocks that have appreciated substantially is dealing with the tax consequences. Huge gains can mean huge tax bills. In the effort to avoid a potentially complicated and painful tax situation, it is all-too-easy to forego the sale of stocks that have run the course of inflated expectations.

As Eric Cinnamond highlights [here], this is just as big of a problem for fiduciaries as for individuals:

“The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill.”

Don’t let tax considerations supersede investment decisions.

So how do the original examples of Amazon, Alphabet and Apple fit into this? What, if anything, should investors infer from their quarterly earnings and the subsequent market reactions?

There are good reasons to be cautious. For one, all the above considerations apply. Further, growth has been an important part of the narrative of each of these companies and any transition to lower growth does fundamentally affect the investment thesis. In addition, successful companies bear the burden of ever-increasing hurdles to growth as John Hussman describes [here]:

“But as companies become dominant players in mature sectors, their growth slows enormously.”

“Specifically,” he elaborates, “growth rates are always a declining function of market penetration.” Finally, he warns,

“Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.”

For the big tech stocks, wobbles from the earnings reports look like important warning signs.

In sum, tech stocks create unique opportunities and risks for investors. Due to the prominent role of inflated expectations in so many technology investments, however, tech also poses special challenges for long term investors. Whether exposure exists in the form of individual stocks or by way of major indexes, it is important to know that many technology stocks are run more like lottery tickets than as a sustainable streams of cash flows. Risk may be perceived as a feature by some tech CFOs, but it is a bug for long term investment portfolios.

Finally, tech presents such an interesting analytical challenge because the hype cycle can cause perceptions to deviate substantially from the reality of development, adoption and diffusion. Ridley describes a useful general approach: “The only sensible course is to be wary of the initial hype but wary too of the later scepticism.” Long term investors won’t mind a winding road but they need to make sure it can get them to where they are going.

Do You Really Need Half Your Money In Stocks?

We’ve all been conditioned to think the balanced portfolio is a touchstone of investing. For many investors, it provides enough exposure to the stock market (60%) to produce a healthy return and enough exposure to the bond market (40%) to provide ballast and a little income to a portfolio. Along the way, advisors like to say that investors have counted on beating inflation by 4 or 5 percentage points. Supposedly.

But, as MarketWatch’s Brett Arends points out, a balanced portfolio hasn’t always performed as advertised, and the upcoming decade might be one of those times. That means investors should consider other allocations (depending on their individual circumstances, of course).

First, from 1938 to 1948, a balanced portfolio trailed inflation. Then, again, from 1968 through 1983, a balanced portfolio trailed inflation, eroding a third of its value in real terms, according to Arends. Basically, a balanced portfolio struggles against inflation. And while it’s obvious why inflation hurts bonds with their fixed dollar payments, it also tends to hurt stocks, despite their assumed ability to benefit from companies passing on higher costs to customers through price increases.

There aren’t easy ways for investors to combat inflation, if it should arise. Gold and commodities helped in the 1970s. Real estate can help too, as inflation can cause property price appreciation and push rents higher. Some foreign stock markets might help. Arends points out that Japanese and Singaporean stocks took off in the 1970s. Corporate bank loans and floating rate corporate debt might also help, though, Arends notes Ben Inker of Grantham, Mayo, van Otterloo (GMO) in Boston says credit protections aren’t what they once were. Finally, Inker notes that cash is a reasonable choice in times of inflation. And cash, as Arends says, doesn’t have to be in U.S. dollars. It can be in Swiss Francs, for example.

The 1970 also saw observers like Harry Browne advocate a different kind of portfolio mix – 25% each in cash, long-term bonds, stocks, and commodities. The cash and commodities would help in inflation, while the long-term bonds would help in times of deflation.

That leads me to the argument that, if you’re going to maintain a static portfolio allocation, something like 30% stock exposure, with the rest in short-term bonds and cash might be reasonable for someone about to retire soon. My reasons are that stocks are too volatile for a portfolio in distribution, and they’re likely too expensive to deliver good future returns in any case.

First, although I cherry-picked the start date so that two severe bear markets are baked into this hypothetical study, this portfolio in distribution phase shows that 30% stock exposure is better for a retiree in a bear market than a more aggressive portfolio. A balanced portfolio worked reasonably well, but only dropping down to 30% stocks allowed the portfolio to remain intact in a nominal sense (though not in an inflation-adjusted sense). Taking money from a portfolio during a volatile stock market is a tricky business. Too much stock exposure – even when using the famous “4% rule” (4% withdrawal the first year and 4% more than the first withdrawal annually thereafter) can destroy someone’s retirement.

Second, it’s not clear that stocks will outperform bonds over the next decade in any case. Even if you’re not in distribution phase, making volatility less of a concern, you may not add return to your portfolio by adding stock exposure. That’s because the Shiller PE (current price of stocks relative to past 10-year inflation-adjusted earnings) is over 30, meaning stocks have to remain more expensive than they have in history barring one other time for the next decade to deliver more than a 4% or 5% return.

And if you do add U.S. stocks to your portfolio, you’ll likely be adding the same old volatility stocks have delivered in the past. Modern academic finance like to use something called the Sharpe Ratio, which is a volatility-adjusted return or indicates how much return an investment achieved per unit of volatility. This view of the world has its problems, because risk might not be volatility, but it can be useful in helping you decide whether you want to add a certain asset to a portfolio or not. Getting, say, 4% or 5% annualized from stocks and assuming their historical volatility is a lot worse than getting the customary 10% from stocks and assuming their customary volatility. Adding U.S. stocks to a portfolio at current prices makes for what modern academic finance would call an inefficient portfolio.

Foreign stocks are cheaper than their U.S. counterparts, but they’re not screamingly cheap. If a balanced portfolio seems reasonable to you, it may not be under today’s circumstances. Consider trimming at least some of that stock exposure and adding a few other asset classes. Those new additions may not shoot the lights out, but, chances are, neither will U.S. stocks for the next decade. Above all, don’t think there’s some rule that says you need half your money in stocks. The idea of the balanced portfolio has become so popular that it feels like heresy to some people to deviate from it. But investing isn’t about faith; it’s about assessing the circumstances and likely returns in as rational a way as possible. Remember also to get some help from an adviser in constructing a portfolio and completing a financial plan. Many asset classes that weren’t available in the past to retail investors are available now. An experienced adviser can help you use them well and manage the risks they contain.

Only 28% Of Americans Are “Financially Healthy” During The Largest Wealth Bubble

MarketWatch published a piece today called “Here is the ‘true state’ of Americans’ financial lives,” which stated that 42% of Americans have no retirement savings at all and that only 28% of Americans are considered “financially healthy”:

The finances of Americans may not be as good as they look from the outside.

Despite optimistic metrics like a nine-year-long bullish, if volatile, stock market, low unemployment levels, and consumer confidence levels nearing record highs, millions of Americans continue to struggle, a study released Thursday from financial consultancy nonprofit the Center for Financial Services Innovation (CFSI) found.

Only 28% of Americans are considered “financially healthy,” according to a CFSI survey of more than 5,000 Americans. “Financial health enables family stability, education, and upward mobility, not just for individuals today but across future generations,” the CFSI says. “Many are dealing with an unhealthy amount of debt, irregular income, and sporadic savings habits.”

Meanwhile, 17% of Americans are “financially vulnerable,” meaning they struggle with nearly all financial aspects of their lives, and 55% are “financially coping,” meaning they struggle with some but not all aspects of their financial lives. The recent volatility in the Dow Jones Industrial and S&P 500 has not helped Americans feel secure, experts say.

What I found jaw-dropping about these depressing financial health statistics is that they are this bad even though America is currently experiencing its largest household wealth bubble in history. As I explained in a recent presentation, U.S. household wealth has surged by approximately $46 trillion or 83% since 2009 to an all-time high of $100.8 trillion. Since 1951, household wealth has averaged 379% of the GDP, while the Dot-com bubble peaked at 429%, the housing bubble topped out at 473%, and the current bubble has inflated household wealth to a record 505% of GDP (see the chart below):

Net Worth As Percent Of GDP

Unfortunately, this wealth boom is not a sustainable, permanent wealth increase, but an artificial, Fed-driven bubble that is going to burst with disastrous effects. If America’s personal financial health is this bad right now, just imagine how much worse it will be when our household wealth bubble bursts! (Yes, I know that the 28% who are considered “financially healthy” possess a disproportionate amount of America’s wealth that is currently inflated, but the bursting of this bubble will make these statistics even worse.)

Please watch my presentation “Why U.S. Wealth Is In A Bubble” to learn more:

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more. 

Give Me An “L” For Liquidity

After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.

It wasn’t that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms,

“Central banks are pitiless executioners of long-lived booms and monetary policy has shifted.”

Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.

Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.

Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don’t even notice it. Because investors have been living in a sea of liquidity, they don’t even notice it. As he notes,

“The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets.”

Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.

One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes,

“But everything for me has never been about earnings. It’s never been about politics. It’s always about liquidity.”

Not earnings or politics, but liquidity. 

While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes,

“we’ll [the Fed will] be shrinking our balance sheet $50 billion a month,” and, “at the same time, the ECB will stop buying bonds.”

Cole describes the same phenomenon in his terms,

“Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.” 

Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]:

“In terms of global liquidity, it’s currently falling at the fastest rate that we’ve seen since 2008 …”

For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out,

“It’s going to be the shrinkage of liquidity that triggers this thing.” He goes on, “And my assumption is one of these hikes- I don’t know which one- is going to trigger this thing. And I am on triple red alert because we’re not only in the time frame, we’re in the part …” He continues, “There’s no more euro ECB money spilling over into the US equity market at the end of the year …”

Or, as Zerohedge reported [here],

“We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air).”

As the Economist notes,

“Shifts in America’s monetary stance echo around global markets,” and there is certainly evidence this is happening. Cole notes, “The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing.” 

Howell also chimes in, 

“You’re also seeing emerging markets central banks being forced to tighten because of the upward shock to the US  dollar.” He concludes, “Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment.”

The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that “Emerging markets face a dollar double whammy” in the Financial Times [here]. He describes, “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts.” He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes,

“The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world.”

As a result, there are a lot of crosscurrents that confound simple analysis.

For example, Zerohedge reports [here],

“When ‘QT’ [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased …” The story continues, “The markets evidently never ‘missed’ the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions.” 

Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights “the huge amounts of money of flight capital that have come into the US over the last four years” and quantifies it as “something like $4 trillion.”

But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, “This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk.” However, by the end of September, “the interbank market’s cross-currency ‘basis swap’ for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp.” Dizard summarizes the likely consequences:

“That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery.”

Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, “China has shown no appetite for buying further US dollar assets over the last 18 months.” He concludes,

“We think they’ve now stopped. And they’re redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending.”

Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes,

“What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector.”

Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: “The banks’ woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market.”

This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.

In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here],

“With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.”

Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, “we’re kind of at that stage of the cycle where bombs are going off,” which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says,

“And until the bombs go off in the developed markets, you would think the tightening will continue.”

Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says,

“Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” He also warns, “[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.

In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war:

“We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a — a defeat for the free world — that was related to the rise of China — and it was a total misreading of a pivotal event — which cost us very dearly.” 

In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.

Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.

A recent story in P&I [here] articulated the challenge well: 

“Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.” More specifically, “The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity” 

This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet:

“You know the drill. In face of market volatility, keep calm and stay the course.”

“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions. 

If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects “a crisis to occur between 2019 and 2021,” a market decline has very different information content.  

Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here],

“Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market.”

Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments,

“You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.” 

Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller’s own actions. As he puts it,

“I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%.”

Based on what he is seeing now, he is ready to pounce:

“I … kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities … and that’s because margins are at an all time record. We’re at the top of the valuation on any measures you look, except against interest rates …”

So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.

Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: 

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents.”

So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily. 

Do You Believe In Magic

Like so many things, magic can have different meanings. Many times, it is regarded as something special that defies easy explanation. Sometimes it also includes elements of nostalgia as in the Lovin’ Spoonful’s “It makes you feel happy like an old-time movie.” Positive, serendipitous experiences are often described as mystical, remarkable, or “magical”.

But magic can also have negative connotations. Common phrases such as “sleight of hand” and “smoke and mirrors” emphasize the misdirection of our attention, often for the purpose of gaining advantage. Increasingly, these types of “magic” infest investment analyses and financial statements and in doing so, belie underlying fundamentals. Just as hope is not a strategy, belief is not an investment plan.

One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.

In the tech bust of 2000, for example, investors learned that some companies inflated revenues through vendor financing. Some backdated options to retain high levels of compensation for key staff. Many used alternative metrics such as growth in “eyeballs” to embellish visions of growth while de-emphasizing real progress and costs.

Similar phenomena existed in the financial crisis of 2008. Exceptionally low interest rates boosted mortgage originations above sustainable levels. “No income, no assets” (NINA) mortgages allowed a large number of people to take out mortgages who were wholly unqualified to do so. Structured credit products boosted growth by creating a perception of manageable risk.

In both cases, there was a period of time during which people thought they were wealthier than they actually were, because they had not yet learned of the deceptions. Renown economist John Kenneth Galbraith thought enough of this phenomenon to develop a theory about it. John Kay describes it [here]: “Embezzlement, Galbraith observed, has the property that ‘weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.’ Galbraith described that increase in wealth as ‘the bezzle’.”

Charlie Munger went on to expand and generalize the theory: “This psychic wealth can be created without illegality: mistake or self-delusion is enough.” Kay notes that “Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.”

As any magician knows, there are lots of ways to create illusions. For better and worse, the current investment landscape is riddled with them. One of the most common is to create a story about a stock or an industry. Investment “stories” are nothing new. In the late 1990s and early 2000s the story was that the internet was going to transform our lives and create enormous growth. In the financial crisis of 2008 the story was that low rates and low inflation created a “goldilocks” environment for global growth. Both stories, shall we say, overlooked some relevant factors.

New stories are popping up almost as reliably as weeds after summer rains. Zerohedge highlighted [here], “Back in December 2017 it was ‘blockchain.’ Now, the shortcut to market cap riches, and a flurry of speculative buying, is simply mentioning one word: ‘cannabis’.” If you are curious what a story stock looks like, take a look at the price action of cannabis company TLRY over the last month. After you do, try formulating an argument that the market prices reflect only fundamental information and no illusion.

Daniel Davies, author of Lying for Money, points out one overlooked, but highly relevant aspect of the cannabis story [here]: “Despite the “bright future of legalized pot”, he says, “The US Securities and Exchange Commission has already prosecuted several companies which appeared to be less interested in selling weed to the public and more interested in selling stock owned by the founders for cash.” As is often the case, the whole story is often more complicated and less alluring.

Stories are conjured about more than just exciting new stocks and industries, however. Sometimes they define a narrative about the economy or the market as a whole. One such story describes the economy as finally getting back on track and resuming its historical growth trajectory of 3 – 4%. It’s a nice, appealing story with significant tones of nostalgia.

It is also a story that is less than entirely realistic, however. The FT cites JPMorgan analysis [here]: “Jacked up on tax cuts, a $1.3tn spending bill, easy monetary policy and a weakening dollar, Wall Street and the US economy have enjoyed their own version of a ‘sugar high’.”

John Hussman describes how the discrepancy between real growth and perceived growth arises [here]: “The reason investors imagine that growth is running so much higher than 2-3% annually is that Wall Street and financial news gurgles about quarterly figures and year-over-year comparisons without placing them into a longer-term perspective.” He explains, “The way to ‘reconcile’ the likely 1.4% structural growth rate of GDP with the 4% second quarter growth rate of real GDP is to observe that one is an expected multi-year average and the other is the annualized figure for a single quarter, where a good portion of that figure was driven by soybean exports in anticipation of tariffs.”

Further, he reveals that fundamental drivers have actually languished during the huge run-up in the market: “[W]hen we measure peak-to-peak across economic cycles, annual S&P 500 earnings growth has averaged less than 3% annually since 2007, while S&P 500 revenue growth has averaged less than 2% annually.”

Tax cuts provide an especially interesting component of the investment landscape. Not only did the cuts in corporate tax rates quickly and substantially increase earnings estimates in financial models, they also provided a powerful signal to many investors that finally there is a business-friendly administration in the White House.

The reality, again, is more complicated and less sanguine, however. For one, the tax cuts came along with higher fiscal deficits, the cost of which will be borne in the future. Secondly, and importantly, the tax cuts did not come as a singular benefit but rather as part of a “package” of public policy.

The FT reported [here]: “At a meeting in Beijing late last year, US business executives tried to explain their concerns about imposing tariffs on Chinese exports to a group of visiting Trump administration officials.” It continued, “The meeting was held after President Donald Trump’s state visit to Beijing and the congressional passage of a large tax cut for corporate America. The executives, who had expected a polite exchange of views, were shocked by the officials’ robust response. One of the attendees reported that they were told, “your companies just got a big tax cut and things are going to get a lot tougher with China — fall in line”.

The attendee summarized, “The message we are getting from DC is ‘you’re just going to have to buck up and deal with it’.” Lest this be perceived as a one-off misunderstanding, it is completely consistent with Steve Bannon’s analysis of the situation reported [here], “Donald Trump may be flexible on so much stuff, but the hill he’s willing to die on is China.”

While “story stocks” and “tax cuts” and record growth” tend to steal headlines, they aren’t the only things that can engender perceptions that differ from reality. Sometimes the most powerful sources of misunderstanding are also the most mundane — because they garner so little attention.

While accounting in general is often overlooked because the subject is dry and technical, it also provides the measures and rules of the game by which financial endeavors are evaluated. But those rules, their enforcement, and the economic landscape have changed considerably over the years.

One big issue is the increasing use of non-GAAP metrics in earnings presentations. As I discussed in a blog post [here], the vast majority of S&P 500 firms present non-GAAP metrics in their earnings releases. Further, as the FT reported, “Most of those non-GAAP numbers make the company look better. Last year a FactSet study found that the average difference between non-GAAP and GAAP profits reported by companies in the Dow Jones Industrial Average was 31 per cent, up from 12 per cent in 2014.” A key takeaway, I noted, is that “non-GAAP financial presentations can play a significant role in cleaving perception from underlying investment reality.”

Another issue is that intellectual capital presents special accounting challenges and is far more important to the economy today than it used to be. The Economist reports [here]: “Total goodwill for all listed firms world-wide is $8tn, according to Bloomberg. That compares to $14tn of physical assets. Dry? Yes. Irrelevant? Far from it.” Further, one-half of the top 500 European and top 500 American firms by market value “have a third or more of their book equity tied up in goodwill.”

The Economist also reports, “Just as the stock of goodwill sitting on balance-sheets has become vast, so have the write-downs. For the top 500 European and top 500 American firms by market value, cumulative goodwill write-offs over the past ten years amount to $690bn. There is a clear pattern of bosses blowing the bank at the top of the business cycle and then admitting their sins later.” Because “the process of impairment is horrendously subjective,” the numbers for reported assets have become less defensible.

In addition, investors need to be on the watch for even more than clever numbers games and accounting obfuscation. The reliability of corporate audits has also been declining for a variety of reasons — which should reduce investors’ confidence in them.

As the FT reports [here], the original purpose of audited numbers was “to assure investors that companies’ capital was not being abused by overoptimistic or fraudulent managers.” However, Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee, assesses, “But the un-anchoring of auditing from verifiable fact has become endemic.”

An important part of the “un-anchoring” process involves the increasing acceptance of fair value accounting, which was implemented (ostensibly) to provide more useful information to investors: “From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.” “The problem with fair value accounting,” according to one audit professional, “is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.” Yet another case of diminished verifiability.

At the same time as the reliability of audited numbers was decreasing, so too was the accountability for the audits. “[A]uditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of ‘tick box’ rules designed to achieve mechanistic ‘neutral’ outcomes.” Professor Karthik Ramanna calls it a process “that is tantamount to a stealthy ‘socialisation or collectivisation of the risks of audit’.” In other words, don’t expect auditing firms to pay when their work fails, expect investors to pay.

To make matters worse, “There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway.” Erik Gordon, a professor at the University of Michigan Ross School of Business, highlights, “They have been able to do better with low quality than with high quality work.”

Jean-Marie Eveillaird, who accumulated an impressive record as an investment professional, summarized the effects of accounting changes in a RealVisionTV interview [here]: “[M]ost accounting numbers are estimates. And indeed, what happened in the ’90s, where there are a number … of chief financial officers decided that- with the help of some shop lawyers- decided that you could observe the letter of the regulations, and at the same time betray the spirit of the regulations, and you wouldn’t go to jail for that.”

In sum, there are a lot of different ways in which illusions about financial performance can be created and many have been getting progressively worse. Notably, they don’t even include the examples of intentional wrongdoing such as the Enron or Madoff frauds. Munger is right, “psychic wealth can be created without illegality: mistake or self-delusion is enough.”

The one thing all these examples have in common is that they are all essentially category errors. As Ben Hunt tells us [here]: “What’s a category error? It’s calling something by the wrong name.” In particular, a Type 1 category error is also called a false positive.

One opportunity for investors is pretty straightforward: Just don’t carelessly and uncritically accept a story as real fundamental information. Don’t call a narrative a fact. Don’t assign 100% value to numbers enshrouded with uncertainty. As Davies highlighted in regard to cannabis investors, “What they are not doing is asking the basic questions of securities analysts.” So ask the basic questions.

Davies also provides some useful clues as to when investors should be on special alert: “The way to identify a story-stock craze — overblown enthusiasm for a sector where there is a good tale to tell about its future — is if the justification for buying into the new hot venture is big on vision and short on detail.” For example, is the earnings presentation dominated by bullet points describing qualitative achievements or by revenue and earnings numbers accompanied by substantive explanations? If you are going to get involved with a story, a useful rule of thumb is: “the time to buy is either when very few people have heard the story, or when everyone has heard it and everyone hates it.”

In addition, the concept of the febezzle presents a fairly useful model for thinking about investment risk. Asset valuations can be thought of as being comprised of two separate components: One is based on fundamentals and reflects intrinsic value while the other is based on the febezzle and reflects illusory, or psychic, wealth. An important consequence of this is that when the illusion is shattered, the febezzle element vanishes and there is virtually nothing to prevent a quick adjustment to intrinsic value. In other words, the febezzle is much more of a binary (either/or) function than a linear one.

This matters for long term investors who are most concerned about creating a very high probability of achieving their long-term investment goals. Not only does the febezzle component subject their portfolios to sudden, substantial, and effectively permanent drawdowns, but it also defies conventional investment analysis. It is exceptionally hard to confirm that a popular illusion is being shattered, especially before everyone else does.

One signal of change, however, is volatility. Using language that closely parallels “destruction of the illusion,” Chris Cole, from Artemis Capital Management, explains [here], “Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth.” In this context, the absurdly low volatility of 2017 was ripe breeding ground for illusions. Investors believed. Higher volatility in 2018, however, suggests that some of those beliefs are becoming increasingly fragile.

Perhaps the greatest illusion of all is the belief that continued market strength confirms strongly improving fundamentals. While recent economic performance has been good, Cole rejects this view and offers an alternative explanation: “When the market is dominated by passive players prices are driven by flows rather than fundamentals.” In other words, strong market performance mainly means that more people are piling into passive funds. By doing so, they have the dangerously intoxicating effect of propagating the illusion of commensurate fundamental strength.

None of this is to suggest that stock fundamentals are strong or weak, per se. Rather, it is to suggest that, for several reasons, stock prices do not comport well with the reality of underlying fundamentals; there is less than meets the eye. As Ben Hunt warns, “It’s the Type 1 [false positive] errors that are most likely to kill you. Both in life and in investing.” If calling something real when it is not can kill you, it is hard to understand why so many people are so tolerant of mistakes and self-delusion when it comes to their investments. The question is simple: Can you handle the truth, or do you believe in magic?

Big Apartment REITs Aren’t Yielding Enough

The seven largest publicly traded apartment REITs are now paying dividend yields of less than 3.5%. The two largest — AvalonBay Communities and Equity Residential — are paying around 3.2%. Essex Property Trust, whose apartment buildings are all in California, is paying barely over 3%, roughly the equivalent of the 10-year U.S. Treasury Note. Historically, REITs have paid one full percentage point more of yield than the 10-year Note, and that means investors in apartments could be in for trouble if the yield on the 10-year Note doesn’t decline and/or the apartment landlords don’t increase their dividends.

Recent History of Apartment REITs

Among the different property types in real estate, apartments (sometimes called the “multifamily” sector) have done particularly well since the financial crisis. That makes some sense since homeownership went from the low 60% range to above 68% during the bubble period of 2003-2007, and the collapsed again to the low 60% range. Families that couldn’t stay in homes after the crisis went back to renting. Also multifamily new development stagnated, and a continued influx of educated people into big cities with limited apartment stock contributed to increasing rents.

At around the beginning of 2011, companies like AvalonBay Communities and Equity Residential, the two largest multifamily REITs, and their competitors began raising rents, and haven’t stopped since. In the early years of the recovery, those rent increases were sometimes more than 6% on a year-over-year basis. After a dip in the rate of increase in 2013-2014 to the high 3% range, rent increases moved up to nearly 6% again in late 2015 and 2016.

 

After declining down to 2%, rent growth has picked up for the past few quarters again. But publicly traded multifamily companies are increasing rent in the 2%-3% range on a year-over-year basis instead of the 6% range. The pattern for Avalon Bay is similar to those of its competitors.

This declining growth would make it difficult for Avalon Bay to increase its dividend despite its current comfortable coverage. Avalon Bay pays around $800 million in dividends annually, and generates around $1.2 billion in funds from operations. That’s  a difference of around $300 million But funds from operations doesn’t take long-term property upkeep and improvements into consideration. One percent of the stated value of the firm’s property — a modest annual upkeep charge — would be around $200 million. Some real estate analysts think 2% is a more reasonable annual charge for upkeep and maintenance. That would be around $400 million or more than Avalon Bay can afford while paying its current dividend.

Perhaps 2% is draconian for annual long-term capital expenditures, but it seems clear that Avalon Bay doesn’t have the ability to pay a dramatically higher dividend if it doesn’t experience more robust rent growth. This is also true for its large publicly traded competitors. Perhaps they could all boost their dividends by an amount that would equate to 4% at current stock prices, putting their yields a full percentage point above that of the 10-year Note, but not much more. And if the large public apartment REITs can’t boost dividends significantly at this point, it makes little sense to own them when their yield advantage over a 10-year U.S Treasury Note is so minimal — unless you think rates are going back down significantly.

REITs Paying 6% Or More — The Good, Bad, And Ugly

Unscrupulous stockbrokers and advisers are always dangling yield in front of unsuspecting clients. “I can get you (fill in the blank with a percentage),” they say to yield-starved investors. But capturing current yield is one thing; buying shares of a firm that can sustain a dividend beyond the next quarter or two is something else.

I ran a screen on REITs using two factors – enterprise value/EBIT of 25 or less and a dividend yield of 6% or higher. I got 12 companies back. And EV/EBIT of 25 is quite high, which tells you something about how REITs are priced right now. Also, the screen was just the beginning of the process. The fun part is examining each company to see if dividends were sustainable and if it had any other warts such as a high debt load, a declining business, competition from Amazon, etc…

Here’s the list of the original screen followed by comments on some of the companies.

The Good

After compiling the names from the screen, I included FFO or Funds from Operations, a REIT cash flow metric, and calculated Price/FFO, a common, though imperfect, REIT valuation metric. Funds from operations or FFO is a measure of REIT cash flow calculated by adjusting net income for property sales and depreciation. A big depreciation charge runs through a REIT income statement, and it usually doesn’t correspond to economic reality. FFO isn’t perfect because some depreciation should be calculated for any property, but FFO is uniform and allows for some comparison between companies.

FFO is also useful for understanding dividend coverage. For every company on our list except for two (Gaming and Leisure Properties and The GEO Group) FFO covers the dividend. When FFO is less than the dividend it can be a sign of a dividend cut coming. Companies not covering the dividend with FFO have to hope for FFO-per-share growth or borrow to pay the dividend. Still, all the Price/FFO metrics were reasonable or downright cheap in some cases. None of the stocks on this list is outrageously expensive in my opinion.

Also, despite some tightness on dividend coverage, the companies on this list are surprisingly healthy in terms of their debt levels. None of them is in financial distress or unable to pay its interest and preferred dividends in my opinion.

The Bad And Ugly

Despite being financially stable and not inordinately expensive, the companies on this list don’t have what anyone would call outstanding, irreplaceable real estate. Buying shares in them arguably violates the old “location, location, location” rule of real estate investing with the exception of a few properties in the hotel portfolios. None of the companies own trophy office buildings in New York or San Francisco, Rodeo Drive retail space (which had some vacancies the last time I was there), or upscale apartments on the coasts where it’s hard to build. Instead the list is filled with strip mall retail space under attack from Amazon (KIMCO, Brixmor, and Tanger) hotel companies that are economically sensitive and always trade with lower valuation multiples than other property types (Hospitality Properties Trust and Sotherly), casinos under pressure from states allowing their proliferation (Gaming and Leisure Properties),  medical facilities including nursing homes (Medical Properties Trust and Sabra), and prisons (The GEO Group and CoreCivic). In other words, these are cheap, high-yielding REITs because they arguably deserve to be based on the quality of their property.

Conclusion

Although these companies don’t own the best property, their stocks are reasonably priced, and in most cases their dividends are sustainable. Investors who understand that REITs are stocks, not bonds, in terms of risk and volatility can own a basket from this list as a small part of an income-generating portfolio. Nobody should bet the ranch on any of these stocks or on a basket of these stocks. Investors should also understand that monitoring that basket is required – not just in terms of how the stocks are performing, but also in terms of how the businesses are performing, including debt levels, occupancy, natural disasters potentially damaging the assets, management decisions, and many other things.

We at Clarity Financial LLC, a registered investment adviser, specialize in preserving and growing investor wealth. If you are concerned about your financial future, click here to ask me a question and find out more.

Disclosure: We are long SKT in some portfolios.

The Most Important Asset Class In The World

Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned.

“As long as the music is playing, you’ve got to get up and dance,” – Chuck Prince, Citigroup

Chuck’s utterance now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke’s proclamation also sounds more like an “oopsie” than a dangerous misjudgment by a top official.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers …” 

One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.

China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF’s Sally Chen and Joong Shik Kang concluded [here],

“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”

The July 27, 2018 edition of Grants Interest Rate Observer assesses,

“Following a decade of credit-fueled stimulus, China’s banking system is the most bloated in the world.”

Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], “So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids.”

One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.

These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes:

“China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that’s 15% of China’s GDP of $12 trillion. Put another way, it’s about $2 trillion. That $2 trillion is 3% of global GDP.”

And so I can’t stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world.”

Chanos is not the only one who sees building for “speculative purposes” as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here],

“The heart of the Chinese model is malinvestment. It’s about building up non-performing loans and figuring out what to do with them.”

The WSJ’s Walter Russell Mead captured the same phenomenon [here],

“Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained. Chinese debt is the foundation of the system.”

Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China’s young consumers have:

“…rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC. Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011.”

Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, “When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1.”

The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, “the bottom line is that very serious adjustments in the economy are required … Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses.”

In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.

Once again, the landscape of Chinese debt is problematic. Russell Napier states,

“The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices.”

Zerohedge adds [here] that the Chinese central government has become “alarmed at its [shadow banking’s] vast scale, and potential for corruption.”

Further, nebulous practices are not confined to the “shadows” in China. The FT reports [here],

“These [small] banks are quite vague and blurry when it comes to investment receivables … There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”

As it happens, “Problems at small banks matter because their role in China’s financial system is growing.” While China surpassed the eurozone last year to become the world’s largest banking system, “small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.”

Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes,

“We’re constantly asked about how good Chinese data are. Is it all bad? It’s all bad, but it’s bad and different variations.” 

Chanos shared his opinion as well:

“As much as the macro stuff has intrigued me … what’s so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don’t seem to be profitable, the accounting is a joke.”

Miller makes clear what the challenge is:

“[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates.”

Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.

Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]:

“[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

That said, the “flavor” of China’s crisis will depend on uniquely Chinese characteristics. Miller identifies an important one:

“I think the problem is that people didn’t understand that this is not a commercial financial system. That’s one of the major takeaways we stress all the time. This [China’s] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other.”

In other words, China has substantial capability to manage liquidity and contagion risks.

As a result, according to Miller,

“We don’t spend a lot of time worrying about an acute crisis. If China falls and China does have the hard landing that a lot of people predicted, it’s not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They’re not going to have the same freeze-up of credit that you did in some of these other Western economies.”

That said, there are still likely to be severe consequences. Miller reports,

“China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China’s economy is, for the most part, headed towards stasis.” More specifically he says, “So I think that we’re heading towards a Chinese economy which is going to slow down quite dramatically when we’re talking about 10, 15 years time.”

Indeed, it appears that process has started. As noted [here],

“Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists.”

Throughout the process, Miller expects China to pursue a policy agenda designed to get the country “on a more sustainable track.” In particular, “that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that.” He is careful to note, however, “But it’s not easy.”

Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here]

“To take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China.”

The FT also notes [here],

“New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks” which will disproportionately affect small and mid-sized banks. Further, as reported [here], “the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market.”

The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and under-appreciated. Perhaps it is because the numbers don’t seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don’t really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.

Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here],

“There is not a snowball’s chance in hell [the Chinese weakness] will not flow through to the US stock market.”

Where does all of this leave Chanos?

“Interestingly, we’re less short China now than we have been in eight years in our global portfolio. Because the rest of the world’s catching up. Although China’s been on a tear recently, Chinese stocks over the eight years are basically flat. And I’ve noticed that some of the other stocks have sort have tripled.”

Fundamentals are important, but so are prices paid.

A major complication of figuring out China will be determining the degree to which it’s domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018:

“China’s credit-saturated economy … is the primary force behind the recent gyrations in FX. The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade.”

In other words, don’t get distracted by the smaller stuff.

Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here],

“In general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation … the current indications are more negative for global growth than positive.”

The FT goes even further [here]:

“The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting.”

Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only “safe” assets are cash and precious metals. When the sparks fly, it’s hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the “most important asset class in the world”.

Right now, that is Chinese residential real estate.

Common Trading Mistakes Investors Must Avoid

The recent stock market correction, and subsequent rally, revealed the many mistakes that investors consistently make when managing their money. Emotionally driven decisions almost always turn out badly and ultimately impair the long-term investment goals individuals are attempting to achieve.

Given that individuals are consistently promised investing in the financial markets is the only way to financial success, it is worthwhile to review the common mistakes most investors make. After all, if investing is “so easy,” why are the majority of American’s so broke?

Let’s dig into the myths, the mistakes and the steps to redemption. 

Financial pundits across the country consistently promote the myth that one simply buys a basket of ETF’s, or individual stocks, and returns will compound at 8, 10 or 12% a year,

Nothing could be further from the truth.

On a nominal basis, it is true that if one bought an index, and held it for 20-years, they would have most likely made money. Unfortunately, making money, and reaching financial goals, are two ENTIRELY different things.

“The chart below shows the difference between two identical accounts. Each started at $100,000, each had $625/month in additions and both were adjusted for inflation and total returns. The purple line shows the amount of money required, inflation-adjusted, to provide a $75,000 per year income to Bob at a 3% yield. The only difference between the two accounts is that one went to “cash” when the S&P 500 broke the 12-month moving average in order to avoid major losses of capital.”

For the majority of Americans, investing has never worked as promised.

The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of ‘short-termism.’

Despite their inherent belief that they are long-term investors, they are consistently swept up in the short-term movements of the market. Of course, with the media and Wall Street pushing the ‘you are missing it’ mantra as the market rises – who can really blame the average investor ‘panic’ buying market tops and selling out at market bottoms.”

Sy Harding summed this point up in his excellent book “Riding The Bear:”

“No such creature as a buy and hold investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10% (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experienced net outflows of investor money. Fear is a stronger emotion than greed.

The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

The only way to avoid the “buy high/sell low” syndrome –  is to avoid owning stocks during bear markets. If you try to ride a bear market out, odds are you’ll fail.

And if you believe that we are in a new era where Central Bankers have eliminated bear market cycles, your next of kin will have my sympathies.

Let’s look at some of the more common trading mistakes to which people are prone. Over the years, I’ve committed every sin on the list at least once and still do on occasion. Why? Because I am human too.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrongonly in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted that they more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

If investors are supposed to “sell high” and “buy low,” such would suggest that as markets become more overbought, overextended, and overvalued, cash levels should rise accordingly. Conversely, as markets decline and become oversold and undervalued, cash levels should decline as equity exposure is increased.

Unfortunately, such has never actually been the case.

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom tick or top tick. 

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position.

6) You Can’t Fight City Hall OR The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies it doesn’t take into account market, and investor, sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company which is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

Steps to Redemption

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money.  Leave the pontificating to the talking heads on television. Focus on managing risk, market cycles and exposure.

STEP 1: Admit there is a problem… The first step in solving any problem is to realize that you have a problem and be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are It doesn’t matter what your portfolio was in March of 2000, March of 2009 or last Friday.  Your portfolio value is exactly what it is rather it is realized or unrealized.  The loss is already lost and understanding that will help you come to grips with needing to make a change.

STEP 3:  You are not a loser… You made an investment mistake. You lost money. It has happened to every person that has ever invested in the stock market and anyone who says otherwise is a liar!

STEP 4:  Accept responsibility… In order to begin the repair process, you must accept responsibility for your situation. Continue to postpone the inevitable only leads to suffering further consequences of inaction.  

STEP 5:  Understand that markets change… Markets change due to a huge variety of factors from interest rates to currency risks, political events to geo-economic challenges. Does it really make sense to buy and hold a static allocation in a dynamic environment?

The law of change states:  that change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

STEP 6:  Ask for help… Don’t be afraid to ask or get help – yes, you may pay a little for the service but you will save a lot more in the future from not making costly investment mistakes.

STEP 7:  Make change gradually… Making changes to a portfolio should be done methodically and patiently. Portfolio management is more about “tweaking” performance rather than doing a complete “overhaul.”

STEP 8:  Develop a strategy… A goal-based investment strategy looks at goals like retirement, college funding, new house, etc. and matches investments and investment vehicles in an orderly and designed portfolio to achieve those goals in quantifiable and identifiable destinations. The duration of your portfolio should match the “time” frame to your goals. Building an allocation on 80-year average returns when you have a 15-year retirement goal will likely leave you in a very poor position. 

STEP 9:  Learn it…Live it…Love it… Every move within your investment strategy must have a reason and purpose, otherwise, why do it? Adjustments to the plan, and the investments made, should match performance, time and value horizons. Most importantly, you must be committed to your strategy so that you will not deviate from it in times of emotional duress. 

STEP 10:  Live your life… The whole point of investing in the first place is to ensure a quality of life at some specific point in the future. Therefore, while you work hard to earn your money today, it is important that your portfolio works just as hard to earn your money for tomorrow.

I hope you found this helpful.

Housing Recovery? Or Another Fed Driven Inflation?

Last week, John Coumarianos penned an interesting piece discussing the surge in home prices over the last few months. To wit:

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.”

He is right.

Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

John makes a very interesting point of the potential for the recent bump in housing numbers to be part of the global asset chase.

While, there has been much hoped placed on the “housing recovery story” over the last few years, the hopes of a stronger housing-driven economic recovery has failed to emerge. But, in just the last few months, there has been, at last, an uptick in some of the data.

Is the improvement the beginning of “the” long-awaited housing recovery? Or, is it just the final inflation of a combined asset bubble driven by excess liquidity, cheap credit and a “yield chase” of epic proportions? 

Let’s look at the data.

At The Margin

The problem with much of the mainstream analysis is that it is based on the transactional side of housing which only represents what is happening at the “margin.”  The economic importance of housing is much more than just the relatively few number of individuals, as compared to the total population, that are actively seeking to buy, rent or sell a home each month.

To understand what is happening in terms of “housing,” we must analyze the “housing market” as a whole rather than what is just happening at the fringes. For this analysis, we can use the data published by the U.S. Census Bureau which can be found here.

Total Housing Units

In an economy that is roughly 70% driven by consumption, it is grossly important that the working age population is, well, working.  More importantly, as discussed in “Yellen, Employment & Policy Errors

“This also explains why the labor force participation rate, of those that SHOULD be working (16-54 years of age), remains at the lowest levels since the early 1980’s. This chart alone should give Ms. Yellen pause in her estimations on the strength of the underlying economy.”

To present some context for the following analysis, we must first have some basis from which to work from. Our baseline for this analysis will be the number of total housing units which, as of Q4-2017, was 136,912,000 units. The chart below shows the historical progression of the seasonally adjusted number of housing units in the United States.

(Note: Importantly, despite data released by the marketing arms of the real estate which suggests that millions of units are being built each year. The reality is that from Q1 of 2009 until Q4 of 2017, there has been a TOTAL increase of just 5,911,000 units. This equates to an average increase of just 657,000 units per year.)

During that same period, the population of the U.S. grew by over 21,125.000 or an average of 2.35 million people per year. More importantly, since in order to own a home, one must have a job, those counted as having a job grew by almost 17-million during the same period.

Rising employment and population growth are strong drivers for the housing sector. After all, people have to live somewhere, right? But when we take a look at what homes are being sold, we see a deterioration in the percentage of homes being sold to those that comprise 80% of income and wage earners and an increase in those that belong to the top 20%. 

Furthermore, there continues to be far more houses in the “process” stage (permits, starts and completions) than actual homes being sold.

This activity at “the margin” is further obfuscated by the seasonal adjustment, and annualization, of the data in the monthly reports. However, by analyzing the Census Bureau data of how many homes are sitting vacant, owner-occupied or being rented, we can obtain a much clearer picture of the real strength of the housing market and the purported recovery.

Vacancy Rate

Out of the total number of housing units, some are vacant for a variety of reasons. They are second homes for some people that are only used occasionally. They are being held off-market for one reason or another (foreclosure, short sell, etc.), or they are for sale or rent. The chart below shows the total number of homes, as a percentage of the total number of housing units which are currently vacant.

If a real housing recovery were underway, the vacancy rate would be falling sharply rather than hovering only 0.5% below its all-time peak levels.

Owner Occupied Housing

Another sign that a “real” housing recovery was underway would be an increase in actual home-ownership. The chart below shows the number of owner-occupied houses as a percentage of the total number of housing units available. See the problem here?

There are two important points here.

The first is the recent uptick in “occupied” housing doesn’t equate with the reported rise in home sales shown above.

Secondly, while owner-occupied housing as finally ticked up, it coincides with the recent jump in interest rates which is likely forcing buyers into the market temporarily. However, since rates have everything to do with “payments,” the bounce is likely ephemeral if rates do indeed rise further.

Home Ownership

The reality is that there has been little recovery in housing. With nine years of economic recovery now in the rearview mirror, it is clear that the average American is not recovering as evidenced by the lowest level of home ownership since the 1980’s. The recent uptick, as stated above, coincides with a sharp acceleration in debt as interest rates have begun to pressure buyers.

However, the recent reports of sales, starts, permits, and completions have all certainly improved in recent months. Those transactions must be showing up somewhere, right? 

Buy To Rent

As John notes, prices are rapidly rising in the “hotbed” areas. As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.

Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices “first-time homebuyers” out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a “rush for the exits” as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery. Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. More importantly, homebuilder sentiment has gone well beyond the actual level of activity.

The point here is that while the housing market has recovered – the media should be asking ‘Is that all the recovery there is?’

The housing recovery is ultimately a story of the “real” unemployment situation that still shows that roughly a quarter of the home buying cohort are unemployed and living at home with their parents. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

While the “official” unemployment rate suggests that the U.S. is at full employment, the roughly 94-million individuals sitting outside the labor force would likely disagree. Furthermore, considering that those individuals make up roughly 50% of the 16-54 aged members of the workforce, it is no wonder that they are being pushed to rent due to budgetary considerations and an inability to qualify for a mortgage.

The risk to the housing recovery story remains in the Fed’s ability to continue to keep interest rates suppressed. As stated above, individuals “buy payments” rather than houses, so each tick higher in mortgage rates reduces someone’s ability to meet the monthly mortgage payment. With wages remain suppressed, and a large number of individuals either not working or on Federal subsidies, the pool of potential buyers remains contained.

The real crisis is NOT a lack of homes for people to buy, just the lack wage growth to be able to afford to. Of course, that probably says more about the “real economy” than just about anything else.

Housing Bubble 2.0? Not Yet, But Prices Are High

House prices continue to rise. Yesterday a Bloomberg article reported that home prices jumped to all-time highs in almost two-thirds of U.S. cities in the fourth quarter in the face of limited new supply and an improving job market. Rising home prices have spurred the question: Are we in another housing bubble?

Our quick answer is probably not, but prices are elevated. We constructed a chart of the relationship between median home prices and median household income going back to 1987. We used national numbers, including the S&P/Case Shiller U.S. National Home Price Index and Median National Income. Since the home price index isn’t adjusted for inflation, we used nominal household income.

We went back as far as we could using data on the St. Louis Fed website – 1987 — and we found that for the period up until 2000 the index stayed around 100. And that’s what  you’d expect because prices shouldn’t get radically divorced from income. But then a sharp rise ensued peaking at a whopping 153 in 2006. That was the bubble. We’re at 120 now, which is where the index was in the 2003-2004 period. The standard deviation of the data set is 16. So, at 120, we are beyond it using the early 1990s flat period average. But we are not at two standard deviations (which some people use as the definition of a bubble) from that early flat period.

home prices median income real estate housing debt mortgageData from St. Louis Fed

Our chart doesn’t capture the differences in regions and cities. Home prices on the coasts, for example, may be extravagant again. Indeed the Bloomberg article reports that the most expensive markets were San Jose, San Francisco, Irvine, Honolulu, and San Diego, with San Jose experiencing a whopping 26% increase in prices. So some cities might be in bubble territory, but the relative simplicity of our approach indicates where the national market stands compared to the bubble, and also gives a somewhat longer term perspective. A crash in San Jose and other California cities probably wouldn’t affect the entire country or banking system the way the previous housing crisis did, though it could lead to a recession.

Anecdotally, mortgages aren’t as easy to get as they were during the run-up to the bubble. We’ve heard stories from well-qualified borrowers whom banks have assessed with considerable rigor. Still, it’s likely that very low interest rates have spurred the new price increases. Mortgages may not as easy to get for most people, but they are still available. And because enough of them are still available and rates are so low, house prices continue to levitate.

It’s important to note, however, that there isn’t always a strictly mechanical relationship between interest rates and asset prices. Economist Robert Shiller, who is a student of asset price bubbles, rarely mentions interest rates as primary causes of bubbles, and he’s quick to point out that there have been periods of low rates and low asset prices such as in the 1940s. There are always psychological factors involved when prices elevate beyond reason. Still, nobody should ignore low rates. It’s likely that low rates have facilitated the new rise in home prices as well as other asset prices.

The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet t seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.

Inverted Curve? Not So Fast, Says Gundlach

While many pundits have been calling for a flat or inverted yield curve – a widely acknowledged recession-predictor – DoubleLine Capital founder, Jeffrey Gundlach, recently argued not so fast. Looking at the difference in yield between the 10-Year and 2-Year U.S Treasuries, Gundlach said in his January 9th, 2018 “Just Markets” webcast, “I’ve noticed that the yield curve has stopped flattening.” Gundlach noted at the time that there are more curve-flattening bets now than at any time since 1995, and said that the crowded trade already wasn’t working.

Normally, creditors demand a higher yield to lend for a longer period of time, making for an upward sloping yield curve. But the curve can flatten or invert if creditors pile into longer term bonds, sending their yields down, if they anticipate a slowing economy and future low rates

Sure enough, after narrowing to 50 basis points on January 4, the difference in yield between the 10-year and the 2-Year has begun to rise again at least for the time being, hitting 62 basis points on February 1.

Gundlach reminded his listeners that the Fed has three rate hikes scheduled for 2018. While that could contribute to flattening or inversion, Gundlach asked listeners to consider the possibility that the long end of the yield curve could steepen. This is in contrast to other asset managers such as Morgan Stanley and T.Rowe Price, who think the Fed’s elevation of short term rates will accompany worldwide central bank balance sheet expansion, buoying demand for long-term debt and leading to a flat yield curve. According to a Bloomberg article, Morgan Stanley strategist, Matthew Hornbach, thinks the U.S. central bank’s plans to shrink its balance sheet is already priced into the market, and that the yield curve will flatten in the third quarter of this year.

Gundlach said leading indictors show no recession for the next six months. From the time of Gundlach’s webcast on January 9th through February 1st, the spread between the 10-Year and 2-year Treasuries has widened from 57 to 62 basis points.

On Friday, Gundlach tweeted about the Federal Reserve Bank of Atlanta’s GDPNow estimate of 5.4% GDP growth for Q1 2018 and average hourly earnings increases. These developments support an inflationary thesis and a steepening curve. Late Saturday, Gundlach also gave an interview to Reuters’ Jennifer Ablan arguing that it was “hard to love bonds at even 3 percent,” given recent GDP growth estimates.

Commenting on the blistering pace of rate increases on parts of the yield curve since September, Gundlach told Reuters that “this is partly caused by the manic mood and partly caused by the falling dollar and related rising commodities.”

While Gundlach doesn’t think bond yields of 3% are attractive given prospective economic growth, PIMCO’s Dan Ivascyn and Mark Kiesel say 3% yield on 10-Year Treasuries might be a signal to buy, according to another Bloomberg article. The article quotes Ivascyn saying “[T]here’ll be buyers of bonds if we back up to 3 percent,”

Not All REITs Are Equal

As an investment concept, I like REITs, and so should small investors. Real estate investment trusts give ordinary investors the ability to own office buildings, apartments, hotels, storage centers, medical facilities, industrial warehouses, malls, movie theaters, gas stations, and even data centers where large computer systems for big online retailers and Internet businesses are stationed. REITs are organized in a way so that there is no tax at the corporate level in exchange for the company distributing 90% or more of its profits as a dividend to shareholders. Dividends from REITs are not qualified, so it helps to hold them in tax-advantaged accounts.

But, as much as they afford small investors the ability to own unique properties, like any investment, REITs can get too expensive. And despite trailing the broader stock market in 2017 and posting losses so far in 2018, most REITs still aren’t priced low enough to deliver big returns in the future. In this article, we’ll show you how to assess REITs, and highlight some possibly cheap ones in an otherwise expensive sector.

Making the assessment

While many investors look at a P/E ratio to appraise a stock, that doesn’t work for REITs. That’s because accounting rules allow real estate investors, including REITs, to take a big depreciation charge every year. So a REITs earnings or “net income” almost always look tepid. Luckily for an investor, that charge doesn’t reflect economic reality well, and the real cash flow the properties inside a REIT are generating is usually significantly higher than stated earnings. That’s why, instead of looking at earnings, knowledgeable REIT investors look at another metric that all REITs publish, but is still poorly reported in the business press, called “funds from operations” or “FFO.”

Basically, FFO takes earnings or net income and adds back the depreciation charge and any profits a company may have made from selling property instead of renting it out or “operating” it, which is its main business. Now, adding back all the depreciation may be too generous because property owners must consistently pour money into properties for upkeep, and, even then, properties get old and obsolete. In other words, FFO isn’t an accurate reflection of reality either. However, FFO is a standardized metric that helps investors compare different companies that own similar or different types of property. And it’s a better starting point than net income, from which investors can subtract their own upkeep estimates.

So instead of a standard Price/Earnings Ratio, we constructed a Price/FFO Ratio for the top-25 REITs in the Vanguard REIT Index ETF (VNQ). The results show that these large REITs are trading at around 18 times FFO. That’s not a cheap price. Investors seeking to by an ETF are buying into an expensive sector. It’s true that REITs have much lower debt burdens than they did before the financial crisis, and the companies are covering their dividends with FFO instead of having to borrow money. But that doesn’t mean future returns will be high.

What looks cheap?

Vornado, a company that owns retail and office property looks like the cheapest stock on our list, with a P/FFO of around 10. But since its one-year FFO number is likely inflated due to one-time rearrangement of its property portfolio, including a spinoff, investors will have to do some digging to arrive at an estimate of “normalized” FFO.

That leaves Host Hotels and Resorts with a P/FFO of around 12. Hotels are, of course, the most economically sensitive property type, with their one-night leases that consumers and businesses slash from their budgets quickly when the economy falters. For that reason, they typically trade at lower multiples than other property types. Still, a multiple of 12 seems compelling, and Host has a good portfolio of 96 hotels with nearly 54,000 rooms encompassing upscale properties including Marriotts, Hyatts, and Westins in major U.S. cities, five Ritz-Carltons, and Le Meridien Piccadilly in London. It also has a few properties of more economy brands, and they are centrally located in cities as well.

Besides a compelling Price/FFO ratio, the next thing investors should want to know is if Host’s 4% dividend yield is safe. The firm pays a quarterly dividend is $0.20 per share, and FFO per share for Q3 2017, the last reported quarter, was $0.33 per share. A dividend soaking up less than two-thirds of FFO shouldn’t be in jeopardy. And while it is of some concern that FFO per share declined in Q3 2017 from $0.37 in Q3 2016, FFO per share held steady for the three quarters before that on a year-over-year basis.

The other stocks that have lower P/FFO ratios are either healthcare companies like Ventas (VTR) or retailers like Simon Property Group (SPG). The companies that own healthcare facilities have not grown dividends in recent years, and the retailers are under pressure from Amazon.

Is A Company You Own Making A Dumb Acquisition

As a shareholder, you do well to place more emphasis on risk than on reward. Corporate management usually does the opposite, and this is why most large acquisitions fail.

In fact, I assume from the start that an acquisition will fail — or at least will turn out not nearly as profitable as the picture management paints.

For starters, a buyer typically pays too much. An old Wall Street adage comes to mind:

“Price is what you pay; value is what you get.”

It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the latest trade. When a company is acquired, though, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.

How much higher? Acquisitions have the elements of a zero-sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince the company’ s board and its shareholders that the sale price is high (unfairly good). The buyer in turn needs to convince his constituents that they are getting a bargain. Remember, both are talking about the same asset.

This is where a magic word — which must have been invented by Wall Street banks’ research labs — comes into play: “synergy.” The only way this acquisitions dance can work is if the buyer convinces his constituents that combining the two companies will create additional revenues otherwise not available, and/or it will eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.

If you examine why General Electric Co., for example, has been a subpar investment over the last two decades, you’ll find that it’s because of poor capital allocation. The company lost a lot of value in making destructive acquisitions — buying businesses at high prices, relying on false or unfulfilled synergies, and selling (divesting) at reasonable (or low) prices.

There are also a lot of “dis-synergies” (a term you’ll never see in an acquisition press release). The two corporate cultures may simply be incompatible. One company may have a strong founder-led culture, while in the other company decisions are made by consensus. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.

A case in point: Silicon Valley pioneer HP Inc. has been substantially gutted by large acquisitions. When the company acquired Compaq in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. The same happened with EDS (acquired in 2008), which had a service culture, and again with Autonomy (in 2011) — a software company that ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.

Acquisitions can also lead to an employee morale problem. The day before the acquisition, people at the acquired company came to work as usual. They were not particularly worried about the future. After the acquisition announcement, though, their job security is perceived as being at risk, and they are now on LinkedIn updating their profiles and networking. Now they worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new, more profitable organization that may be about to let them go.

Finally, integrating businesses is difficult. Aside from the culture problems, companies must realign global supply chains, move or combine headquarters, and merge software systems. In large companies, this task is like merging two complex nervous systems.

So while the acquisition press releases may tout synergies, they don’t talk about the price tags and dis-synergies (risks) that come with the deal, too.

Here’s a good example of the right approach: Gilead Sciences’s management has a terrific, but small, acquisition record. In 2011, it paid $11 billion for Pharmasset, a company that had no revenues and a molecule a few years out of (maybe) being approved: a cure for hepatitis C. Well, cure hepatitis C it did. It was an incredible success, generating $20 billion in revenues in just the first year of sales. It is incredibly difficult to judge this transaction, though, because we don’t really know the role that luck played here.

Wall Street sees Gilead’s October purchase of Kite Pharma as Pharmasset 2.0. Gilead is paying $11.9 billion for a company that has just $20 million in revenues but also has a possibly revolutionary medicine to treat cancer — and potentially reap billions in profits. We own shares of Gilead and would love to believe that this acquisition will be a success, but we don’t know — and neither does Wall Street.

Yet from a risk perspective, even if the Kite acquisition doesn’t work out, it will not weaken Gilead. It will the cost the company one year of earnings. Gilead generates significant, stable cash flow, has a great balance sheet and management that is great at running the business, and is a rational, patient capital allocator. Indeed, our upbeat view on the company has not really changed, except that now we also hold a $12 billion lottery ticket that may cure cancer. Moreover, this acquisition doesn’t have most of the dis-synergy risks we discussed above — Gilead is buying research and scientists. Science and luck will decide whether the deal is successful. If Kite’s drug is as good as Gilead’s management thinks it is, then we’ll have Pharmasset 2.0. If not, we lost a year of earnings.

To be sure, acquisitions can create value. But when a company grows through acquisitions, its management needs to have a highly specialized skill set that is often different from that used in running a company’s day-to-day operations.

Accordingly, it’s important to examine the motivations of management when it makes an acquisition. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” desperation to them — and a corresponding price tag.

Bitcoin – Millennial’s “Fake Gold”

I’ve been asked about Bitcoin a lot lately. I’ haven’t written anything about it because I find myself in an uncomfortable place in agreeing with the mainstream media: It’s a bubble. Bitcoin started out as what I’d call “millennial gold” – the young (digital) generation looked at it as their gold substitute.

Bitcoin is really two things: a blockchain technology and a (perceived) currency. The blockchain element of Bitcoin may have enormous future applications: It may be used for electronic contracts, voting, money transfers – and the list goes on. But there is a very important misconception about Bitcoin: Ownership of Bitcoin doesn’t give you ownership of the technology. I, without owning a single bitcoin, own as much Bitcoin technology as someone who owns a million bitcoins; that is, exactly none. It’s just like when you have $1,000 on a Visa debit card: That $1,000 doesn’t give you part ownership of the Visa network unless you actually own some Visa’ stock.

Owning Bitcoin gives you a right to … what, actually? Digital bits?

I can understand gold bugs and the original Bitcoin aficionados. The global economy is living beyond its means and financing its lifestyle by issuing a lot of debt. Normally this behavior would cause higher interest rates and inflation. But not when you have central banks. Our local central bankers simply bought this newly issued debt and brought global interest rates down to near-zero levels (and in many cases to what would have been previously unthinkable negative levels). If you think investing today is difficult, being a parent is even more difficult. I tried to explain the above to my sixteen-year-old son, Jonah. I saw the same puzzled look in his eyes as when he found out where babies come from. I also felt embarrassed, for my inability to explain how governments can buy the debt they just issued. The concept of negative interest rates goes against every logical fiber in my body and is as confusing to this forty-four-year-old parent as it is to my sixteen-year-old.

The logical inconsistencies and internal sickness of the global economy have manifested themselves into a digital creature: Bitcoin. The core argument for Bitcoin is not much different from the argument for gold: Central banks cannot print it. However, the shininess of gold has less appeal to millennials than Bitcoin does. They are not into jewelry as much as previous generations; they don’t wear watches (unless they track your heartbeat and steps). Unlike with gold, where transporting a million dollars requires an armored track and a few body builders, a nearly weightless thumb drive will store a dollar or a billion dollars of Bitcoin. Gold bugs would of course argue that gold has a tradition that goes back centuries. To which digital millennials would probably say, gold is analog and Bitcoin is digital. And they’d add, in today’s world the past is not a predictor of the future – Sears was around for 125 years and now it is almost dead.

A client jokingly told me that his biggest gripe with me in 2016 and 2017 was that I didn’t buy him any Bitcoin. I told him not so jokingly that if I bought him Bitcoin, he’d be right to fire me. Maybe I’m a dinosaur; but, like gold, Bitcoin is impossible to value. What is it worth? It has no cash flows. Is a coin worth $2, $200, or $20,000? But Wall Street strategists have already figured out how to model and value this creature. Their models sound like this:

“If only X percent of the global population buys Y amount of Bitcoin, then due to its scarcity it will be worth Z”.

On the surface, these types of models bring apparent rationality and an almost businesslike valuation to an asset that has no inherent value. You can let your imagination run wild with X’s and Y’s, but the simple truth is this: Bitcoin is un-valuable.

In 1997, when Coke’s valuation started to rival some dotcoms, bulls used this math:

“The average consumer of Coke in developed markets drinks 296 ounces of Coke a year. These markets represent only 20% of the global population.”

And then the punchline:

“Can you imagine what Coke’s sales would be if only X% of the rest of the world consumed 296 ounces of Coke a year?”

Somehow, the rest of the world still doesn’t consume 296 ounce of Coke. Twenty years later, Coke’s stock price is not far from where it was then – but on the way it declined 60% and stayed there for a decade. Coke, however, was a real company with a real product, real sales, a real brand and real tangible, dividend-producing cash flows.

If you cannot value an asset you cannot be rational. With Bitcoin at $11,000 today, it is crystal clear to me, with the benefit of hindsight, that I should have bought Bitcoin at 28 cents. But you only get hindsight in hindsight. Let’s mentally (only mentally) buy Bitcoin today at $11,000. If it goes up 5% a day like a clock and gets to $110,000 – you don’t need rationality. Just buy and gloat. But what do you do if the price goes down to $8,000? You’ll probably say, “No big deal, I believe in cryptocurrencies.” What if it then goes to $5,500? Half of your hard-earned money is gone. Do you buy more? Trust me, at that point in time the celebratory articles you are reading today will have vanished. The awesome stories of a plumber becoming an overnight millionaire with the help of Bitcoin will not be gracing the social media. The moral support – which is really peer pressure – that drives you to own Bitcoin will be gone, too.

Then you’ll be reading stories about other suckers like you who bought it at what – in hindsight – turned out to be the all-time high and who got sucked into the potential for future riches. And then Bitcoin will tumble to $2,000 and then to $100. Since you have no idea what this crypto thing is worth, there is no center of gravity to guide you or anyone else to make rational decisions. With Coke or another real business that generates actual cash flows, we can at least have an intelligent conversation about what the company is worth. We can’t have one with Bitcoin. The X times Y = Z math will be reapplied by Wall Street as it moves on to something else.

People who are buying Bitcoin today are doing it for one simple reason: FOMO – fear of missing out. Yes, this behavior is so predominant in our society that we even have an acronym for it. Bitcoin is priced today at $11,000 because the fool who bought it for $11,000 is hoping that there is another, greater fool who will pay $12,000 for it tomorrow. This game of greater fools is not new. The Dutch played it with tulips in the 1600s– it did not end well. Americans took the game to a new level with dotcoms in the late 1990s – that round ended in tears, too. And now millennials and millennial-wannabes are playing it with Bitcoin and few hundred other competing cryptocurrencies.

The counterargument to everything I have said so far is that those dollar bills you have in your wallet or that digitally reside in your bank account are as fictional as Bitcoin. True. Currencies, like most things in our lives, are stories that we all have (mostly) unconsciously bought into. (I highly encourage you to read my favorite book of 2015: Sapiens, by Yuval Harari.) Of course, society and, even more importantly, governments have agreed that these fiat currencies are going to be the means of exchange. Also, taxation by the government turns the dollar bill “story” into a very physical reality: If you don’t pay taxes in dollars, you go to jail. (The US government will not accept Bitcoins, gold, chunks of granite, or even British pounds).

And finally, governments tend to look at Bitcoin and other cryptocurrencies as a threat to their existence. First, governments are very particular about their monopolistic right to control and print currencies – this is how they can overpromise and underdeliver. No less important, the anonymity of cryptocurrencies makes them a heaven for tax avoiders – governments don’t like that. The Chinese government outlawed cryptocurrencies in September 2017. Western governments are most likely not far behind. If you think outlawing a competitor can happen only in a dictatorial regime like China’s, think again. This can and did happen in a democracy like the US. With Executive Order 6102 in 1933, US President Franklin D. Roosevelt made it illegal for the US population to “hoard gold coin, gold bullion, or gold certificates.”

However, nothing I have written above will matter until it does. Bitcoin may go up to $110,000 by the end of the 2018 before it comes down to … earth. That is how bubbles work. Just because I called it a bubble doesn’t mean it will automatically pop.

Why You Are Like The Astros

You’re the Astros, not the Dodgers, Yankees or Red Sox

The city of Houston is elated, tired and relieved today with the close of an epic World Series and our team coming out on top. This has been a long time coming, 56 years to be exact and it almost feels surreal. Houston is a tough city, not in the way of these streets are tough-though some are. More in a way that we’re resilient, diverse and have that never say never attitude. Yes, baseball is just a game, but this year it’s provided some much needed reprieve from daily life in a region devastated from Hurricane Harvey.

Look back a couple of years and this is a team that endured 3 consecutive 100 loss seasons. A starting over, if you will from being a once competitive staple in the National League Central Division. This organization has had to pick itself up from bouncing around on rock bottom. They could have easily tried to spend their way out of the hole or they could very strategically and patiently draft and develop talent little by little, year by year. This is a roster that until recently was void of any top earners and really the last bet Jeff Lunhow the Astros general manager made was one of risk/reward in Justin Verlander and boy did that pay off in ways only imaginable for the Astros fans. This team is now set up for years to come, by not taking the easy way out, by sticking to their plan and enduring the process knowing that these days will come. Is this a Dynasty? Only time will tell, but they are set up for the next several years with players under contract and a clubhouse that appears to love each other’s company.

The Dodgers, Yankee’s and Red Sox have the highest payrolls in baseball and have a collective 40 World Series Championships. In retrospect, they are your too big to fail banks. You and I we’re just mere mortals. Championships were bought and paid for long ago for times just like this week. They can afford to swing and miss because they’ll just step back up in the batter’s box with more money to offer and the promise of chasing a ring to superstar free agents. Most people, companies or teams don’t have that luxury.

In a lot of ways, we’re just like this Astros team, our financial wealth generally didn’t appear from thin air. Rather it was worked on, sacrifices and plans were made. There are times life throws us curve balls in the form of sickness, job loss, natural disaster, children, death or just unexpected expenses. This is when one must remember to stay the course, market returns help grow your money, but you and your good saving and spending habits will get you to your destination.  Risk management is now key, especially when you accumulate assets or when you reach your goal. For most, that goal is retirement. Find a Jeff Lunhow or in our case an advisor to help chart your course, you see you don’t have to be the Dodgers, Yankees or Red Sox to get the prize.

The road isn’t straight nor is it easy, but just like these Astros showed a little planning, nurturing, patience, sound defense and a double or home run every now and then can get you a long way.

Should You Pay Off Your House? 7-Things To Consider

“If I have the cash should I pay my mortgage off early?”

That is a regular question we are asked.

While it might seem to be the simple answer of “yes,” such is not always the case. Like anything, when it comes to making decisions for an individual, or family, a plan and some sound advice is always beneficial when facing these tough decisions.

Since we can’t do a plan, here’s some advice.

Everyone’s scenario is different and I do mean everyone. You may be able to pay your mortgage off and still have millions in the bank. Maybe you have enough guaranteed income and additional savings that paying the house off earlier won’t cause you to skip a beat. Or maybe you need all additional liquidity, flexibility and income you can get.

Regardless of your scenario, I believe everyone can take something from these 7 considerations.

Let’s set the record straight. I’m not opposed to paying your home off early when given the right scenario. In fact, there are times that paying your home off early can provide great peace of mind. First, I would go through this exercise:

1) Have a sounding board- No, not your neighbor

This should be your advisor, CPA and/or attorney. If you were my client, I’d prefer it be me. We’d build a team of professionals or work with your existing accountants and attorneys. Your team should be constructed of a group of individuals that have your best interest at heart, a fiduciary is a good start.

The only reason it shouldn’t be your neighbor is they generally have a biased opinion based on what they did. For every one good piece of advice I’ve heard a client gleam from a neighbor there are 9 bad ones.

I’m sure your neighbor is a great guy, extremely smart and successful, but odds are they don’t know your full financial situation. It’s not that your neighbor isn’t smart or even that it’s bad advice, it’s just that it’s not good advice for you.

Gathering information from a number of people may be helpful for you to digest the magnitude of such a decision.  Remember to take that advice with a grain of salt and don’t get paralysis by analysis. Sometimes too many differing opinions can cause us to shut down or put decisions on the back burner.

Unfortunately, there are times we find out clients have paid their home off early after the fact.

For most, paying your home off early is more of an emotional decision than a planning decision. We need to reverse this aspect, just like when investing in markets we need to be as my partner Lance Roberts says “void of emotion.”

This is why it’s important to have someone on the outside looking in. Someone who has seen the triumphs, trials and tribulations of others, experiences that are sometimes priceless and can evaluate your scenario holistically.

2) How long do you plan to live in your home?

The amount of time you plan on living in your home could alter the decision to put your mortgage to bed.

Less than 5 years?

Keep your hard-earned cash on hand. Housing markets, like stock markets move in cycles. I’d hate to have to move and not have the necessary liquidity to put down on a new home or have to sell in a down or slow market.

5-15 years?

Maybe you pay it off? I end that last sentence with a question mark, because this time frame is a bit trickier.

If you find yourself in position to pay your home off early I would hope you could weather any recessionary period even after making that last home payment.

You must have enough in emergency funds and not pull from other assets that are designated to other goals. If you lost your job tomorrow could you still pay your bills and for how long?

This now becomes a best use of capital question. How much interest are you paying and how much can you earn in a relatively safe investment. In today’s environment taking advantage of lower borrowing rates doesn’t seem like such a bad idea.

This is your “forever home.”

Meaning you plan to stay there until you can no longer care for yourself. I really have a hard time with changing your liquid asset (cash) and turning it into a hard asset (your home.) As my partner, Richard Rosso calls it “turning water into ice” I think the analogy fits considering you’re taking your hard-earned cash and putting it into something that’s difficult to “chip” away at. Rule 6 can also play a role in this decision, sometimes when you need senior care you don’t have the luxury of funding it once your home sells.

There is always an exception to the rule, in this instance it’s if the money is going to burn a hole in your pocket. Pay it off, lower your expenses and at least you will have put the cash into something worthwhile, your home.

3) Tax Deductibility

Itemize your taxes? If you itemize many consider the interest tax deduction as the “end all be all” when considering paying off your home. The truth is the majority of people that are paying off their homes typically are in the last years of payments and have little interest to write off.

When considering the deduction of interest one must remember that it’s not 1 for 1. What do I mean by that? The deduction doesn’t reduce your tax burden 1 for 1, it reduces your adjusted gross income by the amount of deductible interest or overall deductions.

For example,

Your Adjusted Gross Income (AGI) is:      $100,000

Itemized Deductions are:    $15,000

Taxable Income:   $85,000

Yes, it does reduce your taxes. No, it’s not the reduction most think.

4) Best use of funds

What are the best use of funds? With current interest rates still near all-time lows, it would suit most to borrow money and use your cash in another way to get more bang for your buck. For most people leverage and credit is not your friend, however when used properly it’s a great tool.

Can you make more on your money investing semi conservatively? For instance, we can currently find investment grade bonds with a coupon of 5% with a 5-7 year duration, buying them at a bit of a premium you may see a 3-4% YTM return on your money.

The other argument is if you do pay your home off early and you’re in retirement the amount needed for expenses will decrease which will in turn decrease the amount you will need to pull from your investment accounts to live.

If you’re in the accumulation (working) mode paying off the home early would increase the amount you could put aside monthly.

Enter, the 5th consideration, liquidity.

5) Liquidity=Flexibility=Options

How much is liquidity worth to you? Having liquidity gives you options.

It’s likely you don’t fall into this category since you’re still reading and considering options. Congrats, you’re in an enviable situation to the majority of your peers. The liquidity you possess is powerful.

According to a Bankrate study 69% of Americans don’t have enough saved to meet 6 months of expenses.

When disaster strikes or opportunity knocks I don’t know about you, but I want cash in hand or liquid assets.

Natural disaster, take Hurricane Harvey and all the Houstonians (roughly 70-80%) without flood insurance.  There are some very tough decisions to be made by many, but in the end cash is certainly king.

Business opportunity or real estate deal you can’t pass up?

Need to move quickly, medical or family emergency or would just like to generate additional cash flow?

Cash flow is an important part of the equation. Can these funds generate some type of income for you and your family and you still retain a degree of flexibility? Go back to #4, best use of funds.

6) Do you have Disability or LTC Insurance?

While in your working years disability insurance is a must. If you use a substantial portion of your liquid assets to pay your home off it could be even more important.

How will you maintain the lifestyle your family is accustomed to if something were to happen such as a car accident or a health scare that kept you or your spouse from working for an extended period of time? A large part of financial planning is the risk management of protecting your family. Make sure you’re protecting your most precious asset.

Long term care insurance, do you, have it? Can you get it? Can you afford it without disrupting your cash flow? Do you need it? I could write a whole article on just these topics, but this should certainly be a consideration when paying off your home.

Remember, in your retirement years getting access to funds can be extremely important and when the funds are tied up in a home, access is limited and can take time.

If you do pay your home off early in retirement, having a home equity line of credit ready and available to use may mitigate some of that risk. I would also recommend having a Power of Attorney who can help in the event you’re incapacitated.

7) But my house has gone up so much in value!

For starters, if you have been in your home for any period of time I’d hope that to be the case. You’ve been socking money away in the form of your monthly payment year after year now add a little inflationary growth and I think you get my point.

But…

Have you ever stopped to calculate how much you’ve actually put into your home in maintenance and improvements? And don’t forget to add those pesky property taxes and HOA fee’s.

Most find that after a similar exercise they come to realize that maybe their home isn’t the investment they thought it was.

The following two charts show prices in real terms and the percentage change.

Price in real terms indicate prices in $’000 at 2015 prices (deflated by CPI) and the percentage change shows the change in inflation adjusted prices between the two selected dates of 1980 to Q2 of 2016

These charts indicate that if you weren’t living in New York, San Francisco, Los Angeles, Miami, Boston or a handful of other offshoots the average American or Houstonian for that matter didn’t see substantial or real growth in their home valuations.

Unless you’re finding a home in foreclosure, at a heck of a discount or buying in one of the above valley’s I suspect that if we were as diligent about funding our other goals we may have a different outlook on what’s really our best investment.

Another consideration if you’re truly treating your home like an investment is you must actually sell it to realize any so called gains, after all you will always need someplace to live.

In conclusion:

Paying off your home early is a very personal decision. It’s a decision that’s best evaluated if you can take a step back and look at the big picture. Personally, I don’t like much debt, but debt can be a powerful tool when used correctly or a disastrous enabler.

There are so many sides to this coin, I feel like I could write for days, analyze every scenario and consideration, but then we’d have a book. This is only meant to be a template or guide for things to consider should you find yourself in this scenario.

Consider your circumstances, plan accordingly and make the right decision.  Find or use your resources to make decisions you feel confident in and don’t look back. Learn from your mistakes, don’t dwell on them.

There is no one size fits all.