Sunday, December 20, 2009
I listened to an economic debate last night on NPR between Jeremy Siegel and John Mauldin. Jeremy Siegel is a professor of economics at the Wharton school of business at UPenn and has in the past been a perma bull. John Mauldin writes one of the most widely read economic newsletters on the internet and is more of a perma bear. Here is the link if you want to listen: http://www.onpointradio.org/2009/12/an-economic-warning
Each economist gave his prediction of the strength in the economy over the next few years.
Jeremy Siegel predicted that the economy will rebound at a 6% to 7% pace over the next few years. His only premise is that the the current recovery will mirror recoveries of the past after similar deep recessions.
John Mauldin predicted that the economy will rebound at a 2% to 3% pace over the next year with a chance at a double dip recession in 2011. John's premise is that this situation is not like other recessions. In the next few years we as a country will deleverage and will have to start paying off our debt. We will even have to start saving. He also stated that there will be tax increases in 2011 as the Bush tax cuts phase out. His last observation is that it could take a decade or more for unemployment to trend below the 8% range. We are in a new "muddle through" economy.
Who do I think is correct?
It will be directly related to how much we borrow as a nation.
For Jeremy Siegel to be correct the government will have to borrow $2 trillion a year.
For John Mauldin to be correct we will only have to borrow $1 trillion a year.
Either scenario can be correct depending on how much debt our government creates. We could even create other scenarios by borrowing more money. $3 trillion, $4 trillion ... how much GDP growth do you want?
Both scenarios of Jeremy and John use debt, inflation, smoke and mirrors to solve our financial problems. Both of the scenarios will create bloated government and each will create huge distortions in the capital markets.
Why are both outcomes equally distasteful? Because our country's financial problems are already systemic and as a nation we just don't care. We have more debt financed at lower interest rates than anytime in our nation's history. The Federal Reserve has made a huge bet that it can create inflation to get our country out of this monstrous debt. The bet is premised on creating enough additional debt to force inflation so we will be able to pay off the monstrous debt that we already hold.
How monstrous is this debt?
The most recent Flow of Funds information from the Federal Reserve shows that the net holding value of homes with a mortgage is zero. Yes zero. $10 trillion of mortgages netted against a housing value of $10 trillion is zero for homes with a mortgage.
It is very odd to think that if you take out the subset of people that own their home outright then our housing stock is worthless. Of course as an accountant I might tend to value it at less than zero due to the $600 billion in sales commissions to exit this worthless $10 trillion investment.
Presently our banks are allowing hundreds of thousands of speculators to live in houses without paying mortgage payments. These squatters have been living in the homes for as long as two years before the bank will start to foreclose. The banks are doing this because if they foreclosed on everyone right now then their balance sheets would be insolvent. Presently The Federal Reserve is funneling trillions of dollars of taxpayer money(future debt) to the insolvent banks so the banks can allow the speculators to occupy the bank owned homes. This government debt also allows the banks to give out record bonuses this year.
Presently the banks are not lending enough money to keep real estate prices in a bubble. Wall Street and housing speculators don't want to give back the false profits of the real estate bubble. Therefore the government is creating more debt through Fannie Mae and Freddie Mac to keep the bubble prices propped up. This will cost hundreds of billions in the next few years as Fannie and Freddie make bad loans to the next wave of speculators in this insolvent market.
So the group of people that have mortgages on their homes are insolvent. The banks are insolvent and our government is insolvent. The only thing that is keeping this game going is debt.
Wall Street economists have already made the policy decisions for our nation. Negative GDP is not an option. Affordable homes are not an option. Lower prices are not an option. Losses for speculators are not an option. Sound government is not an option.
Whatever GDP number we get for the forth quarter will be smoke and mirrors. A large amount of debt by the government to create a small amount of growth for our economy. It really does not make sense. Unless or course you are a Wall Street economist.
Monday, December 7, 2009
Perfection, of a kind, was what he was after,
I am in Love with The Great Depression
I started gaining my affection for The Great Depression as The Tech Bubble was ending. My stock account was going to astronomical amounts. I bought my dream house. My financial life was fantastic in every way but in the back of my mind I knew something was very wrong. I soothed myself at night with investment books like The Intelligent Investor by Benjamin Graham and books of the Great Depression such as The Great Crash by John Kenneth Galbraith. I didn't read these books for knowledge or insight because I was very clear on the inevitable path of our country. I read them for purification and to calm my worried soul. Thoughts of The Great Depression have become my economic "Waldon's Pond" during this period of government mandated excess and speculation in our nation's financial markets.
As the 1990's were winding down I would compare the 90's to the 1920's. They are very favorably compared. The roaring 20's saw the advent of the radio, the auto and the airplane. The roaring 90's brought about home computers and the Internet. Both period's had massive speculation stoked with easy money by The Federal Reserve. The 20's of course ended in The Great Depression.
I had hope that the 1990's would end in the same way and that our nation would come to it's senses and stop living so far beyond it's means. I realized that our government and The Financial Elite would make the same mistakes as The Great Depression and turn a deep recession into a depression. But I also knew that the people of this country were resourceful and could come out of the ten year depression in 2009 with the same independent, hard working attitude that created my grandparents' generation.
My grandparents' and their contemporaries are considered our nation's greatest generation. I had equally high hopes for my own generation. I wanted to feel the same pride that my grandfather felt as he passed the economic torch to my dad.
But something odd happened after The Tech Bubble. There was just a very, very mild recession. There was practically no real unemployment. A pipeline was created between the government and the moneylenders. A pipeline full of gold that from the outside smelled of filth. No one noticed. No one cared. I can't compare it to anything that has occurred in our country before. One would have to go back to the times of Rome under Nero to find a similar totally self serving act. Our Empire is ablaze and our leaders are responsible!
A recession is a natural event. An economic Winter that follows an overabundant Summer. A cleansing that removes speculation and greed from the system and passes along fairly priced assets and a sound government to the next generation.
Business cycles have been recorded since the beginning of the industrial revolution and probably occurred even in primitive societies. Economies move from overproduction, excess and speculation to underproduction, prudence and saving. This cycle can't be regulated because it is tied to the avarice of being human. Recessions will occur even in a tightly controlled society, as we are seeing today. The only difference is that in a free society everyone is aware of what is happening and can react accordingly. In the tightly controlled society The Financial Elite are able to mask the business cycle. This allows the Financial Elite more power and with this power the ability to choose the winners and losers in our economy.
Our Financial Elite have pilloried The Great Depression and made it a priority to protect us from recessions at all costs. The costs that we are presently incurring are massive debt to future generations and the destruction of sound government. This is the antithesis of the business cycle. It is not sustainable in the long run.
The reason that I love The Great Depression is that in spite of massive government intervention the people of this nation were able to survive and then prosper. The Great Depression forged a generation of fiercely independent, highly productive, family and community oriented households. This was the most productive body of citizens any nation has ever known. This was the Middle Class. My grandparents' generation.
The antithesis of my grandfather's generation is my generation. We robbed trillions of dollars of our children's inheritance to prop up stock values after the Tech Bubble which sent our housing market into a bubble. We are presently borrowing tens of trillions of dollars from foreign nations to prop up inflated housing prices that occurred during the housing bubble. We have created the biggest government in our country's history with borrowed money.
So we have spent the savings of our grandparents' generation and borrowed more. We have used this money to inflate asset values and create bigger government. We are passing the debt, the inflated asset values and the government boondoggle to our children. My generation will go down in history as this nation's most selfish generation. It is a very helpless feeling being carried by this ravel of avarice.
I don't blame our people, I blame the tyrants, The Financial Elite. They are far to cunning for our pampered populous. My lament is that we are appeased by bread and circuses as our country is being looted and then burdened with stifling debt.
I am very sure that my grandfather's generation would never have allowed this to happen. A generation that formed massive strikes against unfair employment, rallied against unjust government and to a man gladly sacrificed their lives to keep this country free.
My hope looks to the future as my mind dwells in the past. I await the glory that my children and grandchildren will feel as they slay this dragon of debt. Like my grandparents did before me. I bide time in between two great generations. "They also serve who only stand and wait".
A recession is a natural event. An economic Winter that follows an overabundant Summer. A cleansing that removes speculation and greed from the system and passes along fairly priced assets and a sound government to the next generation.
I am in Love with The Great Depression
Sunday, November 15, 2009
One of my investment barometers is The Herd. The Herd is the group of momentum investors that speculate in the financial markets during times of economic volatility. The Herd does not use valuation or economic variables to make investment decisions. Fear and greed push The Herd in and out of financial investments.
In 2007 The Herd was my biggest consideration when I sold my home and decided to rent for a while. This started when I asked a question to which I already knew the answer:
What if housing is overpriced compared to rents and household income?
The response seemed delusional. Everyone said it was impossible for homes to be overpriced. At the time I thought it seemed mathematically impossible for homes not to be vastly overpriced.
I have noticed a few periods of mass delusion in the past 20 years but 2007 seemed like the worst... well the worst until now.
I pose 4 questions that the stock market, the bond market and The Herd have already responded with: "That's impossible".
What if interest rates move sharply upward in the future?
Presently the bond market is betting that interest rates will remain low for an extended period of time.
In reality the Federal Reserve is spending trillions of dollars to keep interest rates at historic lows creating a bubble in long term treasuries. This is devaluing the dollar and creating a super-bubble in carry-trade as risky assets are purchased in dollar denominated debt by other countries. Also the federal reserve is financing new debt in short term vehicles. Eventually all of this debt will have to be re-financed into longer term treasury bonds. So there is a bubble on top of a bubble while the federal reserve is asleep at the wheel holding short term debt vehicles for our country's long term debt. I can't see a scenario where this is not a problem. The worst case would be a snap back of carry-trade investments cascading into a bursting of the treasury bubble with worldwide debt markets rushing to refinance short term debt into long term debt as interest rates spike. It would make the skyrocketing interest rates of the 1980's look like a cakewalk.
If interest rates rise in this manner it will be due to risk aversion of the bond market and not from inflation. There are many people that are predicting inflation in our future. I am not investing with an eye toward inflation because we are presently in a deflationary environment. Increased interest rates plus deflation will equal stagflation. Very similar to the 1980's.
The Federal Reserve is presently "betting the farm" with the hope that they can create inflation in the future. Since the bet is already on the table, for our country's sake let's hope that they are right and I am wrong. But either the fire of inflation or the ice of risk aversion will have the same shocking effect on the bond market. Neither scenario is priced into present long term yields.
What if the unemployment rate rose to 13%?
Presently the stock market has priced in a recovery in the economy early next year. The Herd expects the unemployment rate to quickly trend downward back to normal in 2011 or 2012. Nine months after the "end of the world" selling of March, 2009 the stock market and The Herd have priced in a 100% recovery in the economy.
In reality the unemployment rate is still trending upward and could easily hit 13% in 2011. It is a distinct possibility that it will take decades to come back down to the 5% to 6% range of 2007 and that is only with the most optimistic economic assumptions. If we remain in the same trend as the past 10 years we will never get back to 5%. Since 1999 there has been a net loss of 300,000 jobs in the private sector. We have drunkenly gone through the biggest private debt binge in our country's history, created the most fiscal stimulus that any country has ever attempted, with the loosest monetary policy in history and still we have negative private sector job growth. We have also stimulated the economy by starting two wars in the past 10 years. Even after all this stimulation, we still have fewer private sector jobs today than a decade ago.
Although there has been no increase in private sector jobs there has been a huge increase in government jobs, government pay and government benefits over the past ten years. Taxes to pay for this government largess will be a massive drag on the private sector for generations to come.
What if the present monetary and fiscal policy does not help the economy?:
Presently the Financial Elite of our country are using massive spending programs to jump start the economy. They are 100% focused on increasing debt as opposed to the historical norm of using debt destruction to heal the economy.
In reality there is no point in history that one can pinpoint to prove that the Keynesian "prime the pump" theory has ever worked. Our Financial Elite use The Great Depression as their only example. But they can't explain why The Great Depression lasted over ten years as Hoover and then Roosevelt poured government money into the economy and devalued the dollar by 50%. This policy is exactly what our government is doing today except Roosevelt's stimulus was directed at jobs and markets. Today money is directed toward gimmicks or given directly to Wall Street.
Roosevelt never insulted the public with gimmicks such as "cash for clunkers" or moral hazards like bailouts for bankers. Roosevelt directly gave people jobs. He also took the high road and enlisted the Pechora Commission to dig to the root of the banking problems. The Glass-Steagall Act that came out of the Pechora Commission helped the economy for 50 years until lobbyists were able to coerce enough people in Congress to repeal it. Now Goldman Sacks is able to game the system by using depositor and taxpayer money to gamble in the financial markets. Most of Goldman's revenue from the last quarter is from these "trading profits".
Debt destruction would solve our economic problems a lot more quickly than what we are doing now. Definitely there would be a lot of pain for speculators and rightfully so. A quick deep recession would cleanse the system of the greed and speculation that has developed over the last 25 years of easy money from the Fed. It would reprice assets to fair value and could probably be over in a year or two. It might even get rid of our delusion that allows the Federal Reserve to exist at all.
But since we have decided to use debt to prolong the downturn I agree with Roosevelt and would like to help the down and out instead of the rich. Our present government's "rob from the poor and give to the rich" mentality seems like the antithesis of Roosevelt to me. I will be very surprised if there is any banking regulation that comes out of all of this economic pain. I have a feeling that our country's delusion will just turn to apathy. We are going down the wrong road and it is definitely not the high road.
What if the debt created by the government becomes a drag on the economy?
Presently our government says that easing the pain of this downturn in the economy is more important than the consequences of the debt in the future.
In reality our country as a whole is much more in debt than anytime in our history. We are piling on more debt to this record number every day. A small part of the debt is being used to fight a war, one could argue that it is necessary. A small part of the debt is being used to help the unemployed, which seems like a prudent thing to do. But the lion's share of the debt is being used to reward speculators, to bail out Wall Street and to make government bigger.
How can anyone think that loading our children with massive debt to fund bigger government and to bail out Wall Street is appropriate? Roosevelt's debt was funded by liberty bonds. The interest on these bonds were paid to Americans. A large part of our present debt is funded by China, Japan and The Middle East. If the trends that I have talked about continue, then in 30 years our biggest government expense will be interest payments to foreign nations. Our country's out of control dependence on debt is one of the biggest economic threats that our nation has ever faced. Looking back in history, most countries are not toppled by war but by debt. I hope we come to our senses soon. Our children's future is at stake.
Our present economic paradigm is built on assumptions that don't seem to be founded on reality:
- We learned during the housing bubble that we could not use the home ATM to create lasting wealth. But now we feel that the taxpayer ATM can create future prosperity.
- We are assuming that interest rates will stay low for a long time even though they are being kept artificially low through trillions of dollars of borrowing from foreign nations.
- We assume that the unemployment rate will go down to 5% even though it is almost mathematically impossible for that to happen and there is no period in history where our country has created enough jobs to fill this large of void.
- We are sure that Keynesian fiscal stimulus will "prime the pump" even though our water table of savings is historically low and Keynesian stimulus has never been proven to work in the past.
The financial markets could have a temporary "V" shaped recovery but long term recovery for our nation back to the prosperity of the last decade is mass delusion on a grander scale than the housing bubble. It is mathematically impossible to accomplish a repeat of this false prosperity without very high inflation. Presently we are experiencing deflation.
I purchased some SPY(Exchange Traded Fund that tracks the S & P index) during the recent stock market dip so my retirement account has increased 1% with the last 7% increase in the S and P. I am slowly selling SPY as the market rises. I have an overall gain of about 11% compared to the 2007 high point for the S and P. Now I feel it is prudent to protect my capital in a market neutral position. I will try to eke out some profits using tactical and generic hedges against the large stock portfolio that I presently hold.
The stock market is priced about 13% above fair value so it is not richly valued. My hesitation about being market positive now is due to The Herd. As I said above, The Herd seems to have some unrealistic expectations about the economy and could bolt from the stock market at any time. The only substantive change in our economy between the "end of the world" market low in March of 2009 and today is that the government is wildly running around throwing away large chunks of borrowed money. Most of this money is being funneled into our insolvent banking system. The same insolvent banking system that will shell out the largest amount of bonuses in the history of Wall Street this year. The same insolvent banking system that should have been liquidated in 2008.
The frenetic and manic policy by our government does not seem like the catalyst to a "V" shaped recovery in the economy. I am betting it will cause market volatility of historic proportions in the next few years. A once in a lifetime opportunity for traders. Hedge funds and Goldman Sacks could make monster returns. I would suggest to invest in them but unfortunately the executives always take most of the gains.
The two previous dips in the stock market in March and in November of last year came sharp and quick. It seems like the market has already forgotten these earth shaking downturns. The S & P index could rise to 1500 and it would not surprise me. But if it did I would be tempted to buy a large short on the market like I did in 2007. For now, I am content with just protecting my capital, making a little gain on the market volatility and sitting back to enjoy the show.My investment advice:
My advice to the reader:
- Spend less than you make (save),
- Invest what you save in investments that are priced at below average historical value(avoid The Herd)
- Slowly move into and out of investment positions (dollar cost average)
- Diversify into a varied group of investments (diversify)
- Use debt and leverage sparingly and only if the investment and the market warrant the speculation (don't speculate with more than you can afford to lose)
I have not lost an hour of sleep in my investments since Enron collapsed in 2001. At $5 a share they had a fantastic looking balance sheet. I lost 4% of my retirement account and learned a lot. The Financial Accounting Standards Board came out with rule FAS-157(mark to market) after the Enron collapse. This rule states that companies must report their assets at market value. It was a great rule. Of course that great accounting rule has just been repealed and now our banks have become little Enrons. It's odd that the CEO of Enron went to jail but the banks that collapsed our financial system are being bailed out with trillions of dollars and will receive record bonuses this year. This is all a part of our country's present economic delusion.
I would like to suggest that one should never invest in anything that causes a lost hour of sleep. We are entering a period that could have more market volatility than anytime in our nation's history. Don't depend on the government or speculation to fund your retirement. Your savings will serve you in retirement and it could also help save our nation.
May you sleep soundly in a diversified mix of very safe investments with absolutely no debt.
That's what I do.
Tuesday, November 3, 2009
The graph above is a history of the 10 year treasury yield compared to federal funds rate. When the economy goes into a downturn especially during an election year the Federal Reserve always gooses the liquidity in the financial system by lowering the Federal Funds rate. There have been a few times in the past where Federal Reserve Governors have "spiked the punch" way beyond what is prudent and necessary. Alan Greenspan was the poster child for this action. He is almost single handedly responsible for the Tech Bubble and the Housing Bubble with his 250% and then 360% spikes in liquidity to prop up Wall Street. The wave of liquidity in 2003 that created the housing bubble was the biggest in history, at that time. It might be hard to see given that 6 years later the Federal Reserve is creating a wave of liquidity that is 10 times bigger than Greenspan's record setting wave.
The graph shows events very clearly. Every period of rampant speculation is preceded by monetary easing from the Federal Reserve. This creates excess liquidity in the system, followed by speculation and is then followed by an economic downturn. This cause and effect didn't start with the Federal Reserve, they have just perfected it. Tulip mania in Holland is one of the first recorded liquidity induced manias. The speculation in Tulips was caused by all of the gold that entered Holland via the new world trade. This increased the money supply and created perceived inflation and speculation in Tulips. The Great Depression on the other hand was not caused by excess gold coming into the country. It was fermented with speculation by the easy money minted from the newly created Federal Reserve.
I have always thought it would make much more sense to have the federal funds rate pegged to the 10 year treasury yield. In this way there would never be a temptation for our government to manipulate the nation's money supply for political and financial gain, as is happening now.
Throughout history there have always been business cycles. Periods of overproduction, speculation and debt followed by periods of underproduction, prudence and saving. The Federal Reserve was created to help keep liquidity in the financial system during periods of underproduction and remove liquidity during over productive periods. Seems pretty simple for anyone that has a little bit of common sense but here is my concern.
Our present Federal Reserve Chairman does not seem to understand basic concepts about business cycles:
- From 2004 through 2006 Bernanke spoke widely about our country's "great moderation" and how the Federal Reserve has eliminated the business cycle. (At the time my charts were showing the biggest bubble I had ever seen happening in our housing market.)
- In 2006 Bernanke denied the existence of the housing bubble. (At the time I was working desperately to fix my house so I could get it on the market. I was really worried about the bubble.)
- In 2007 he finally admitted that the bubble existed but said it would not have a significant impact on the economy. (At the time I took out a very large short position in the stock market to protect my retirement account.)
- In 2008 he started by far and away the biggest flood of liquidity into the financial system in the history of our country. Presently our Federal Funds Rate is 2,725% below the yield on the 10 year treasury yield and destined to go much lower as long term yields rise. This is only part of the story. There are also trillions upon trillions of dollars that are physically being thrown at the financial system willy-nilley as if thrown from a helicopter. (This is a Jekyll and Hyde manic moment, a complete 180 degree turnaround from ignorance, to apathy, to thinking that it is the end of the world. The "end of the world" policy response brings him all the way back to ignorance in my opinion.)
- Back in 2002 he gave a speech saying it would be good policy to drop money from helicopters to solve deflation problems in the economy. (I remember when Bernanke gave the helicopter speech. That was when Bush and Greenspan started creating the housing bubble with easy money, massive tax breaks and a war. I talked to my kids at the time and they understood my concerns. They were only 10 and 12 years old.)
Today my quandary as an investor is that I know that I can get a 12 year old child to understand the business cycle but Chairman Bernanke's actions make it seem that he is clueless and at least one step behind the curve. Therefore, in my mind, I have a Federal Reserve Chairman that I feel understands the business cycle on a lower level than a 12 year old child. Bernanke's research on the Great Depression is worthless in my opinion. His elegant 20 variable econometric models of a million variable world are not indicative of the real economy. He has consistently ignored behavioral economics even though this school of economics is the most useful in measuring economies in crisis and is the most accurate in predicting economic downturns. But his most damaging oversight in this current crisis is focusing on our nation's income statement when the balance sheet is the problem with our present economy. How does borrowing more money solve the problem of rampant speculation and a record setting debt burden?
Maybe Bernanke is eloquent, brilliant and focused but he lacks common sense. We need people with common sense guiding us through these turbulent times. Paul Volker, Elizabeth Warren and Shiela Bair have the brains and the common sense but are being underutilized in this crisis. Paul Volker is not a genius but he is loaded with common sense. Our nation owes him a debt of gratitude for his handling of our inflationary economy of the 1980's. Alas, but he is not Federal Reserve Chairman now. We have the brilliantly manic math whiz. What is an investor to do?
How do I invest in this market?:
I can not find a period in history that matches what we are going through now. Never before has the government spent so much of our future resources(debt) to try to keep the economy functioning normally. Never before has the economy been in such disarray. Our government is expending a vast amount of our future's national wealth to prevent current business cycles. This is the same mania as during the housing bubble when speculators were using their homes as ATM's. What our government is doing is not sustainable just like the homeowner ATM's. Bernanke and other policy makers do not understand that this short term manic behaviour is distorting the capital markets and is in no way sustainable in the long run. As a prudent investor I am resigned to an extended period of dysfunctional markets with government officials that have no common sense choosing the winners and the losers in our economy. Cash for Clunkers, Wall Street Bailouts, Tidal Waves of Cash to the banking system, Bailouts of home speculators, Health Care Reform, Higher Taxes fueled by massive government debt. None of it makes sense other than that the government feels that it must choose winners and losers. Presently, savers, prudent investors, seniors and future generations are being penalized. Speculators and Wall Street are the chosen winners. The message is very clear.
For prudent investors this is a brand new game. Not only do we have to worry about the basic investment variables of risk and reward. There are two new variables that for an extended period of time will usurp prudent investing. These new variables are the government and The Herd. The government is choosing the winners and the losers. The Herd is the group of speculators that is constantly trying to figure out where the rewards of the government are being placed. The capital market has been put on hold for a while. Buy and hold will not work anymore because of the massive volatility and dysfunction of the next few years.
I shorted the market in 2007 when it was overvalued and the recession was pending. I dived in at extreme value in March. The market is above fair value now so I am market neutral. My retirement account is presently 10% above the value of the 2007 stock market high which means I averted the recession. Now is the time to avert the government distortion in the capital markets. I am setting up trading bands and will move my positions incrementally toward market positive or negative as The Herd charges in and out of the market. My goal is to loosely trend with and against the S & P Index based on market valuation and volatility until just before the recession of 2011. Timing the recession of 2008 was easy to avoid because all of the indicators were pointing to a downturn. There will be no indicators pointing to the sharp downturn in 2011. It will be the "Minsky Moment" when The Herd realizes that Keynesianism can prime the pump but can't replace the water table, that our population can't use speculation as a retirement vehicle and that the period of easy money is over. This will be the Waterloo for speculators and the defining moment for the prudent investor.
Saturday, October 31, 2009
There is something very Orwellian about how over the last 20 years the government has created policy toward an "ownership society". People are being strong armed by the government to buy houses so they can become "owners". Today, a more accurate definition would be the "inverse ownership society" where about a quarter of home owners are underwater in their mortgages. Home equity for our country's housing stock is at 40%, by far and away an all time low. Before the 1980's it was always the goal to pay off one's mortgage. This changed during the Reagan years when a house became "a payment". It's all part of the "trickle down" economic theory: give wealth to the rich elite and maybe some will trickle down to the masses. Presently, the goal of the government appears to be to get people to buy houses and become debt slaves to Wall Street even when they can rent and save a substantial amount of money.
The government's ownership policy propaganda worked well until our country's housing values were driven up in price beyond what people could afford to pay. This house of cards ended in 2007 but the government is still pushing ownership. I can think of no reason why a citizen owning an overvalued home does anything to help our economy. It just enriches Wall Street, impoverishes the financially uneducated and brings more speculation and volatility into the market. In a normal world I would hope that a benign government would reward saving and prudent living. Our present government's "ministry of saving"(Orwellian Reference) is creating a mountain of debt to reward people for getting into more debt. I agree with Bill Gross of Pimco. He says that asset values in our country are $15 trillion overvalued. I believe that a big part of this problem is bad government policy.
Presently our government is poring trillions of dollars into subsidies for housing:
- Reduced mortgage rates: The Federal Funds Rate is at zero and the GSE's are guaranteeing most of the mortgage market. The Fed is buying mortgage backed securities and also buying treasuries thus pumping trillion of dollars into the banking system. The mortgage market is on life support from the government. It has ceased to function normally. It is a two step program back to normal. First, the government must stop injecting liquidity into the banking system. Second, the government must back out of the financial markets. I believe that someday it might be possible for the government to complete step one and to stop pouring trillions of dollars into Wall Street and the banking system. Maybe in 5 or 10 years. But it will never be possible for the government to complete step two. The housing market is addicted to government money through the GSEs. For taxpayers to extricate themselves from this largess would take a revolution. This will always be a hidden tax on taxpayers to prop up home values.
- Embedded tax breaks: This is mainly the deductions for home ownership at tax time. Our country must gift homeowners a portion of the interest and real estate tax that is paid for a primary residence. The second gift that is given is the untaxed profit that a homeowner gains with the $500,000 tax exemption. Another gift is one given to investors in the fantasy depreciation of the property. An example would be the $36,000 expense for depreciation that the owner of a $1,000,000 property gets to claim every year. In the real world there is no loss on the $1,000,000 property. That is why I call it fantasy depreciation. In theory it is required to be paid back when the rental property is sold. But if you have a good tax person this fantasy depreciation will never be paid back to our country.
- Fun new tax breaks: This would be the homeowner tax credit. The government is giving $8,000 to new home buyers. It has immediately increased the value of all lower end homes sold and therefore it will probably become embedded into the tax code. I will be very surprised if it is eliminated in April, 2010.
Tax breaks are a big driver of overpriced housing. There are also many other factors that created this inverse ownership society. The Interest Rate Mega Bubble, The peak of the baby boomers, women joining the workforce, The Greenspan Put and the weak dollar are just a few other examples. All of these events raised the price of housing to where it is today. None of these events will occur again and some will reverse to create a drag on housing prices. There is nothing in the future that can artificially drive housing values higher except the speculative nature of The Herd. I sold my home in 2007 with the intent of buying again in 2010 but I am starting to rethink my thesis. I am happily renting and saving a substantial amount of money(against the government's wishes) and see a lot of market volatility in the future due to massive temporary government intervention. I am tempted to use my "house down payment" money to hedge the markets instead of becoming a part of the "ownership society". This may seem crazy but in this totally dysfunctional market betting against The Herd could be more prudent than betting that the government can create prosperity with more debt. My major concern is that The Herd is totally clueless to the "New Normal" that the government has imposed on our future. Our generation has forgotten how to save. We are propping up asset values above fair value with temporary strong armed government intervention. In my opinion it is impossible for these asset values to hold up in the long run. We have been through a period of prosperity unequaled in history and all we have to show for it is debt. We are trying to hang on to this prosperity by using more debt. This will only create volatility and dysfunctional markets in the short run. It will not change the final result in the long run. This will be the "New Normal".
During the stock bubble of the late 90's I remember many people telling me that they were going to retire early and live off the gains from their stocks. During the housing bubble not only were people going to retire early from selling their home for "millions" but also people were using their homes as ATM's to supplement their household income. It was mass hysteria. The new hysteria is the present thinking that if our country creates enough debt we will spur ourselves out of the doldrums that has been created by the record leverage and debt that we already incurred. Today we have much more debt than anytime in our nation's history. The government is trying to keep this Ponzi finance scheme going but it will just create more bubbles and dysfunction.
The present bubble is in long term US treasuries. When this bubble pops it could drive interest rates up and home prices down. Unfortunately long term savers could be directly brutalized by the spike in interest rates and indirectly by inflation. Therefore a prudent saver must hedge against bad government policy. The direct hedge would be shorting long term treasuries. Indirect hedges could be short plays on the dollar, interest rate ladders or just trying to time the markets. Market timing has been my strategy for the most recent stock and housing bubbles. This is not a perfect strategy but it has worked up till now. I think this zero sum game pitting winners against losers will become more complicated in the future. At this point I have no idea what the "New Normal" will look like. It depends on the government, The Financial Elite and The Herd. I will definitely purchase a home in the future but I believe there is no hurry to do so. The Japanese "lost decade" has been continuing for a generation with asset values still trending downward. The Great Depression lasted over a decade and had pretty high interest rates in a contracting economy. Our government seems dead set on implementing the same policy as these two monetary and fiscal fiascos. Yes we can have interest rate inflation but asset inflation seems very far off on the horizon. Maybe I will opt out of the "ownership society" for a little while longer.
Tuesday, October 27, 2009
The real estate market is always fun to follow. Presently I am tracking the action in Antioch. Investors are coming into the market with conviction. In my opinion maybe a little to much conviction but there is profit in the short run for the investors and that's whats driving this mini bubble. At these prices I also see profit in the long run but I think there is a lot of unrealistic expectations by some of the less savvy investors. The frenzy is letting the banks unload a lot of inventory. This is very good for the short run. Eventually the market will come to some sort of equilibrium between home prices and market rents. Rents will be an important driver of prices in the future because this boom is predicated on a large influx of investors renting their homes out at cash flow positive and flipping in 5 years for a profit. Many economists are saying that first time home buyers are fueling this rally. I see the main focus of this frenzy in Antioch being provided by investors.
The Antioch housing market has not made an appreciable increase in pricing since it slammed into a bottom last year. Homes are still selling at $125 a square foot for normal sales, $100 a square foot for Distressed Sales(REO and short sales) and $90 a square foot for foreclosures. The only thing that has changed is that investors are pouring into the market. One investor will buy a home at a foreclosure sale($90 sqft.) or an REO($100$ sqft.), fix up the home and sell to another investor for $125 a square foot. The original investor seems to make about $20,000 to $40,000 for their effort after all the costs. It appears that the second investor is looking to rent the home for 5 years and sell for a significant profit, at least this is what I have heard second hand. Of course some of the second sales are to first time home buyers but it really appears that this market is being driven by investors.
Here are some observations:
Purchased in 1997 for $41,500
Purchased in 1998 for $102,000
Purchased in 2006 for $405,000, lost to bank in 2009
Trustee's sale 2009 to investor for $77,200
Sale to second buyer 3 months later(10/16/09) for $155,000
Purchased in 2004 for $527,000
Purchased in 2006 for $680,000, lost to bank in 2009
Trustee's sale 2009 to investor for $177,100
Sale to second buyer 3 months later(10/16/09) for $283,000
Purchased in 1994 for $157,000
Purchased in 2004 for $441,000, lost to bank in 2009
Trustee's sale 2009 to investor for $149,900
Sale to second buyer 3 months later(10/20/09) for $220,000
Home purchased in 2005 for $650,000, lost to bank in 2009
REO purchase in 2009 for $206,000
Sale to second buyer 2 months later(10/16/09( for $260,000)
There are hundreds and hundreds of examples. Eventually the profit from the spread from the Distressed purchases of the First Investor to the Second Investor will diminish to the point where it is not worth the risk. Once that happens this will take away about 30% of the sales in Antioch. Because of the herd mentality of the Second Investors I am guessing that they will not make the 5 year gains that they are expecting. Once the investors make this realization the sales will be reduced even more. These same Second Investors instead of just reducing purchases could bolt from the market with the double dip in the economy in 2011. Either way this dynamic is extremely interesting and I will keep tracking the Antioch market for the next few years.
Friday, October 23, 2009
Since the start of this rally in March I have only taken 55% of the 60% gain of the S and P. I have prudently forgone the last gasps of this uptrend and I am happily backing away from the table with my gains. I have gone market neutral in my retirement account. This means that my 50 stock positions are hedged equally against generic short positions in the market. I have accumulated quite a bit of cash so if the market goes up some more I could be tempted to go "net short" in a few sectors, such as finance and real estate. In my "house equity account" I have taken some of my cash and I am tactically shorting individual stocks. Presently all stocks appear to be rising evenly. In my opinion the rise in some sectors is premature. One solid example would be hotels which have rising vacancy rates. I have shorted Mariott and Starwood hotels and will sell quickly if I can get a little profit. I will dollar cost average down if the hotel sector rises more. I also have a short on oil. I just sold my short on long term treasuries but that is not to say that I believe that yields will go down in the future. I am just picking some low hanging fruit in this dysfunctional market. Trading on volatility seems to be the only prudent way to invest now that the stock market is above fair value and the government and The Herd are dead set on creating another bubble and thereafter another economic downturn.
Lafayette Housing Market:
The Lafayette housing market has started to trend down from the high in late 2008. Like most high end markets Lafayette peaked much later than lower end markets such as Pittsburg and Antioch. Where Pittsburg and Antioch are pretty close to reaching a bottom, Lafayette is still a few years away. Adding to the problem of a late start is the raw stubbornness of high end markets. Presently Lafayette has a median listing price of $1.4 million and a median pending sale price of $820,000. This is why the Days on Market numbers are going through the roof, from around 10 days for sales during the bubble to 80 days presently. The median final sales figures for October and November should easily finish under $800,000. People trying to sell at $1.4 million and finally selling 80 days later at $800,000. It is frustrating to watch a home that comes on the market at $300,000 over market price stay on the market for 9 months and sell for $1 million under list. In this kind of market a house has to be priced perfectly. I have watched hundreds of homes in the Sacramento market that were priced just a little over market value in 2006 ride the wave for years and sell hundreds of thousands of dollars less. A very bad tactical move but that is just the downward stubborness of the housing market. Unlike the stock market that can move down like a greased roller coaster.
Lower End Housing Markets:
There are some incredible things going on in the Antioch and Pittsburg housing markets. The less expensive fixer uppers are selling like hotcakes. Many of them are being fixed and sold again for a profit in a just a few months. This is a very interesting game, but it does make me question the market participant's motives. If this is just another rendition of musical chairs for home speculators, what is going to happen when we go into the 2011 economic slowdown? The good news is that most of the purchases by investors are for cash, so the government will not have to bail them out after this round.
Thursday, September 10, 2009
Nobel prize winning economist Paul Krugman published a much ballyhooed article last weekend in the New York Times Magazine. The article is called, "How did economists get it so wrong? He steps on a lot of toes and thrashes many of the major Chicago School economists including John Cochrane and Robert Lucas. The article questions the current mathmatical models in modern economics and suggests that the only solution to our present economic crisis is direct government stimulus via the Keynesian model. The article indirectly speaks volumes about our current political system. Krugman is an individual cog of the Financial Elite and is definitely a barometer of future economic policy. This is my take:
- The Financial Elite are laser focused on our country's Income Statement as they continually ignore our Balance Sheet. Policy will always trend toward increasing the country's GDP at all costs. Even if we incur crippling debt in the long run. The thinking is that any debt will be paid with future gains in GDP. This policy was started during the Reagan Era when interest rates on 10 year treasuries were at 15%. The policy has worked for 25 years because of the tailwinds from the Interest Rate Mega Bubble but presently is incurring diminishing returns. According to Ned Davis Research it took $1.50 of debt to generate $1 of GDP in the 1960s, $1.70 to generate $1 of GDP in the ’70s, $2.90 in the ’80s, $3.20 in the ’90s, and an unbelievable $5.40 of debt to generate $1 of GDP in the latest decade. The trend of using debt to replace growth and savings is unsustainable.
- The Financial Elite always look to the past to solve our present problems. There is almost never any discussion of the future. Even though Krugman admits that past economic policy is not working in this economic environment he is adamant that Keynesian Policy is the only solution. I guess when all you have is a hammer, you treat everything like it is a nail.
- Going one step further, The Financial Elite rarely reconcile past events with current policy. Our current situation is much like Japan of 20 years ago when Japan started their "lost decade". Our present policy is almost exactly the same but we expect a different outcome? It just does not reconcile. Keynesian economics has never been proven as a solution. The Financial Elite say that the Great Depression is the example. I suggest that the Great Depression lasted 10 years. The depression after WWI was massive and received no fiscal or monetary stimulus. It only lasted one year and the economy came out of it on a dead run. This fact is never mentioned by Krugman or any of the Financial Elite. Also, the Austrian School of economics and behavioral economics are ignored in Krugman's article and by the Financial Elite even though both were about the only schools of economics that predicted our current crisis.
- Policy is always focused on what is less painful to the "winners" chosen by our policymakers. The "Greenspan put" of the last 20 years has rewarded speculation in Wall Street with a guarantee of easy money and bailouts if investments go bad. I am very surprised that Paul Krugman, the self professed "conscience of a liberal" has not raised questions about rewarding corporate and financial executives with windfall profits in stock options driven by the bailouts from our government. He has also never suggested that the government claw back the obscene amount of money the financial sector made as they brought our financial system to it's knees. He has stated repeatedly that we need a bigger stimulus even though most of the stimulus is rewarding bad behavior and creating winners and losers.
I have no real problem with Paul Krugman's views or his article in the New York Times. He is a small cog in a very large problem that will correct in the future, either slowly or quickly. The speed will depend on the amount of debt created by our government and The Financial Elite. My only lament is that we can't use this period to fix all of the problems with our society. In our country's past, recessions were a financial Winter that purged speculators from the system, eliminated debt, repriced assets to fair value and sent forth a functional system for our children to enjoy. Presently we are rewarding speculators, increasing overall debt in the system, artificially propping up asset values and passing these problems to our children. I would suggest that we are one of the most selfish generations that this country has ever known.
Presently I have gone to stock market neutral in my investments. I am up 54% with this run of the S and P and could definitely lose ground against my target index if people perceive that the economy is improving. But the easy money has been made and if The Herd wants to speculate, more power to them. I see no green shoots. Of course I am keeping all of my stock holdings but I am hedging with leveraged ETF's. Part of my stock hedge is a growing position in the US dollar and a short on oil. Two of the reasons for the stock run up are the weak dollar and the price of oil hence my contrarian position. I am equally long in natural gas as a hedge against my short oil position. I am short on the 10 year treasury as a hedge on my US dollar position. It's a traders market now, the gains are going to be in the volatility of the markets.
Saturday, September 5, 2009
I have been slowly moving my stock position to "market neutral". The events in the economy today reinforced my "market neutral" decision as the dismal jobs report sent the S & P index up 1.3%. The Herd is feasting off the greed created by the 50% rally in the stock market. I will take this opportunity to hedge my position and move away from the The Herd once again. Today I only took 40% of the 1.3% move upward in the S & P index. Friday I purchased more inverse EFTs and will probably only take 15% of any S and P profits on Tuesday if the market heads North.
I still am not able to see any green shoots in the economy. The unemployment numbers on Friday were dismal. It would have been much worse except that many of the unemployed are starting their own businesses. This helps the unemployment numbers but I would suggest that most of these businesses will not be profitable for at least a few years and many will fail. Also, the part time work force is increasing and except for minimum wage jobs, hourly salaries are going down. Many private employers are still planning layoffs in the near future. The only sector where salaries are increasing is the government sector. Presently 20% of household income is generated by our government.
Because of the trillions of dollars of stimulus by our government we will come out of the recession in the next few months. This will be only temporary. I can not see any situation where we will not go into recession again in a year or two. We have endured 2 years of financial pain and have not made headway on the cause of the financial crisis. Our society is deeply, deeply in debt. We presently have more debt in relation to GDP than any time in our country's history, this includes the time during the Great Depression. In 2008 our country's households were in horrible debt and I suggested that because our society has such a repugnance to saving that a recession would be the only cure for our debt obsession. Well I never would have guessed but after the biggest recession since the Great Depression our households are in more debt than in 2008 in relation to net worth. What's worse is that our government is pushing households to increase their debt even more. For the last 20 years our country has become a debt junky and our government has become our dealer and our enabler. The debt is not the desease. The debt is a symptom. The cancer that has infected our economy is speculation. I use the term speculation as the antithesis of saving. The tragedy is that our financial elite are absolutely clueless as to the symptom or the desease. No one saw any problem with the system in 2007 during the biggest asset and credit bubble in history. I was so upset by this denile, "by everyone", that I decided to become a renter for the first time in my adult life and took out a large short in the stock market to protect my two biggest assets.
I had hope in 2007 that in a couple of years, after a clensing recession that things would look better. Unfortunately they are worse. Until someone in the financial elite suggests that our country stop borrowing, stop bailing out speculators and start saving we are in for a bumpy road.