Why do we hate efficient markets?

I am an economist and an accountant and I love thinking about efficient markets. I also hate thinking about politics. I know very little about politics because I purposely avoid talking about politics and I try to avoid reading about the subject. My wife tells me who to vote for most of the time. Normally it is a woman or a minority candidate or a democrat or a green party candidate. I know she would never vote for a white male republican if there was a decent alternative. I don't really care and it makes my wife happy when I vote for the same candidate as she does.

Most people would probably consider me politically incompetent and I would tend to agree with them.

It appears that everyone else in our country is the opposite of me. Most of our citizens hate efficient markets and love politics. People are constantly talking about what elected officials are doing and saying. It is all over the media. The media would never have a story about efficient markets. No one wants to hear about stuff like that.

Everyone wants our politicians to lower taxes and raise government services.

I would actually like to pay higher taxes and receive less government services. I would pay much higher taxes to get the government out of the investment markets. Of course you would not understand. Everyone in our society is attached to the golden government teet either directly or indirectly.

How can everyone benefit at the same time? Because we are robbing resources from future generations. In the past two generations we have created $15 trillion of government debt and the possibility of $100 trillion in unfunded liabilities that will have to be dealt with by our children. This was caused by the federal, state and local governments wildly overspending and then kicking the can down the road. Your life is much easier because of it but there is a cost. The cost is inefficient investment markets and a lower standard of living in the future for our children.

It is strange that in three generations our citizens have gone from a populace of 3 dimensional financial thinkers working toward a "middle class" society, to the present rabble of linear thinking automatons that are only capable of following the advice of highly paid Wall Street salespeople and depending on the government for handouts. I am not talking about transfer payments to the unfortunate. I am talking about the government spending trillions of dollars of direct involvement in manipulating the financial markets. The only benefit of this mammoth spending program is to make our financial sector bigger and less efficient.

Wall Street and the big banks are taking a larger and larger portion of investment profits as they cause more and more problems in our economy. Our grandparents understood that the financial sector is not a productive segment of our society. It is a simple service to hold money and transfer it from one location to another. In theory the financial sector should be a very small part of the GDP of a country. They should produce nothing. If the financial sector of a country gets to large it becomes a drag on the economy. Presently our financial sector is robbing a large portion of productive capacity that could be used for something else, perhaps education or health care.

But of course we are financially incompetent and need to have our hands held as we are being sold very complex, expensive and risky products that will under perform the stock market. We are happy to pay these salespeople five times the salary of a doctor. They make buying a stock or a home much, much more expensive than it would cost in an efficient market. I have stated before that if you use a money manager to buy mutual funds then your profit could be close to half of the earnings a stock investor would receive over the next 10 years.

But salespeople slap us on the back and call us "partner" and "buddy". They explain to us that this is the best time to buy a home or an annuity in the last 30 years. They warn us: "you can't miss out on this deal, someone else will steal it!" They push us into borrowing lots of money. Maybe they deserve to siphon off 30% of our country's national income. Who am I to say. All I know is that it is not efficient.

Anyway our government puts the backslapping salespeople to shame. The financial salespeople are only croupier's in the investment casino. The government is the casino owner.

The government is borrowing ten's of trillions of dollars from hostile foreign nations and funneling most of it into the financial sector. These are the profits from the casino and the taxpayer is paying the bill. Taxpayers are placing a high priced bet that they have no chance of winning. Unless they are a financial salesperson. The financial salespeople have been deemed the only important gamblers in the casino. As the financial sector is sucking 20% more from the economy than in an efficient market the financial sector is being bailed out by the taxpayers. Inefficiency piled on top of inefficiency. And our financially incompetent populace doesn't have a clue because they are listening to the politicians and the salespeople.

The trillions being borrowed by the government is not a redistribution of wealth. I would not have a problem with that. This is a casino game with arbitrary winners and losers chosen by our government.

Presently the winners are: the "too big to fail" banks", Wall Street and speculators.

The losers are: the smaller banks, small businesses, prudent investors, savers and definitely our children.

Large banks are so flush with cash thanks to a tsunami of government bailouts that they have gone on a spending spree. Not only are executives getting large bonuses but all bank employees are getting record pay raises. In a normal world all of this government money that is pouring into the banks would be used to repair their insolvent balance sheets. But our government is allowing the banks to misstate their balance sheets, Enron style. They are the government's best friend and will be rewarded for an "extended period".

Wall Street is raking in massive profits. This makes sense because the Wall Street economists are advising the government on where to spend the money robbed from our children's piggy bank. It's not surprising that the big Wall Street firms that were "to big to fail" are growing much bigger every day. Taking more and more of the resources of our economy. Very inefficient but of course very consistent. Everyone expects the government and Wall Street to magically get us out of the massive debt that our government and Wall Street talked our households into borrowing in the first place.

The government has been able to create another bubble. As stocks and housing go back into overvaluation, incompetent investor's are pouring money back into the overpriced markets thanks to government manipulation and government subsidies. Presently assets are being purchased at above fair value. Speculators are able to sell now and make record profits. But the people that are buying these assets will be holding an overvalued asset. The returns going forward must be lower. The speculators have made a huge windfall as anyone who intends to buy and hold the asset long term will get below average historical gains. It is another inefficiency piled upon our bloated financial system and the fixed government casino.

The fact that our government is choosing arbitrary winners and losers in a casino environment seems unethical to me. Shouldn't it be based more on need than favoritism? But I am politically incompetent so I am a bad person to judge this situation. All I know is that it will create dysfunctional markets in the future. I also know that our nation has never experienced this abject favoritism before. One could argue that this casino environment happened during the Great Depression but I would suggest that government's involvement then was a redistribution of wealth more than a casino game. I am sure that all Wall Street economists would disagree with me. This of course is a big part of the problem today. The Wall Street economists running the country are nothing more than salespeople. They are linear thinkers that are unable to see anything but the casino profits that are driving their salaries.

Presently our economy is contracting so I feel buying overpriced assets now is speculation. It may be hard to tell because the government has created another bubble. As for me, I will wait until our economy stops contracting before considering the purchase of an overpriced asset. For now I choose to back away from the table and let the drunken Herd mortgage their future with hopes of being a winner in the government run casino.

What our country is doing now is very inefficient. Spending trillions of dollars to create bubbles for speculators and then spending trillions to bail out the speculators so they don't lose any money. All of this while a significant number of our citizens are living paycheck to paycheck and are grossly overpaying for housing, financial products, education and medical expenses because of inefficient and in many cases manipulated markets.

It might make sense politically but it sure doesn't make sense from an efficient markets standpoint.

How would I solve the problem. Higher taxes and balanced budgets. This has been the solution for the past 4,000 years of organized government. In the ones that survived that is.

The fact is that our financially illiterate populace is attempting to do something that has never been suggested by any of the financial geniuses of the past is very disturbing to me. Our country has borrowed itself to the point of insolvency and now we are attempting to borrow our way out of insolvency. It makes no sense in any way shape or form except in political economics. Unfortunately this is something that I just don't understand.

The government is running a casino style economy for it's financially incompetent citizens with borrowed money and manipulated markets where the taxpayer can't win and Wall Street can't loose.

Although I know almost nothing about politics, I think Franklin, Jefferson and Hamilton would would agree with me. What do you think?

I'm done, it's official - Market Neutral

Since 2008 I have followed the stock market very closely. My goal has been to buy into a large portfolio of fairly valued large cap stocks with the intention of holding them forever. I am very happy with my choices:

DELL, KFT,MDT, MSFT, SCHW, SWY, SYY, BAC, DIS, CI, CSCO, FDX, GOOG, INTC, JNJ, LOW, MMM, MRK, MT, PFE, RSH, SLB, TGT, UNH, WLP, WMT, X, YHOO.

All of them are large cap market leaders with minimal amounts of debt.

From 2005 until 2008 I was mostly in short term fixed income investments, so the last recession was a wonderful opportunity to buy into good companies at a fair price.

My goal has always been to trend with the S & P index. So now as the market has gone over fair value I have been buying generic hedges on my solid portfolio of stocks. FAZ and SKF protect my large holding in Bank of America and SPXU protects everything else. These are my main hedges which are presently protecting 60% of my stock portfolio. As the market has been going above fair I have been purchasing hedges. I feel that the fair value of the S & P index is around 1000 to 1050.

The last part of my "sleep at night" portfolio are my volatility bets. These also serve as hedges and round out the 100% protection of my portfolio. I am using: UNG, FXP and VXX. I am also planning on moving in and out of treasury bonds with TLT and TBT as interest rates swing wildly over the next few years.

Now that we are solidly into our next economic bubble my goal is to spend less time following the markets. I want to back away from the table and let the drunken Herd of investors move this market to whatever extreme their easy money intoxicated state allows.

As always, I am out of the market far too soon but this is always preferable to the alternative.

I can't start moving to a market long position until we are solidly into our next recession. But I will trade the volatility in the markets over the next year or two. I will try to eek out some gains as The Herd runs wildly back and forth in what could be one of our country's most dysfunctional stock market periods.

The S & P will probably go to 1250 or above as the government pumps trillions into our economy. Mathematically it's not sustainable but psychologically investors see nothing but green shoots and blue sky forever in the future. This is what makes me nervous.

So I will miss out on the last bit of this rally and watch from the sidelines.

This is just part of my financial strategy. I sold my house in 2007 and moved to a comparable rental property to save 50% on house expense. Then in 2009 I made the decision to cut my housing costs another 50% and moved to a very nice townhouse. So we are paying 1/4 of what we would be paying to own a house in Lafayette and giving up very little.

So for the next few years I will be able to save 50% of our household income. I feel this will be more than enough to make up for any loss of bubble profits in the stock market over the next year.

I would also like to say that as I am paying 1/4 the price of owning a home in Lafayette, comparable house prices in Lafayette will be trending downward. As I have stated before I will not buy a home above 2001 prices. How can anyone justify paying bubble prices in Lafayette when many other areas are hitting 2001 prices and below. This is happening while rent prices are trending downward. It may not feel like it because of the bubble but we are in a contracting economy. Paying over fair market value for assets in a contracting economy is a fools game.

My plan is to play it safe during what will be one of the most challenging economic periods in the last 100 years. I have no idea what will happen in the next year of two. But I know that now is the time to play it safe.

In 5 years our country's savings rate will increase, taxes will increase and market volatility will increase. Asset prices will come to equilibrium fair value after falling below fair value in the next recession.

Our country's standard of living must decrease proportionately as we work our way though this bubble and then through the third and hopefully last recession for a while.

We have lived though a magical period where money fell from the trees with the collapsing of the interest rate mega bubble, unprecedented debt creation and massive fiscal and monetary programs from our government.

This magical period is absolutely impossible to recreate no matter how many trillions are borrowed from our children. Our country's standard of living must decrease.

There is only one temporary alternative and I pray that our elected officials aren't allowed go down that road to perdition. Hopefully our children will be old enough by that time to stop the sale of our country to hostile foreign nations.

Snap Trading

Congratulations are in order. Our government has managed to create another economic bubble. The Fed Funds rate has been at zero for close to a year and a half. Our elected officials are pumping over one and a half trillion dollars in to the economy this year with the expectation of continued largess carrying over for many years. Also, we are engaged in at least two wars not counting the war on terror, the war on drugs and the war on fair home prices.

Debt, unsound fiscal policy and war have a very stimulating effect on the economy but they can't last forever. Especially with our government presently insolvent with over $10 trillion in stated debt and an albatross of $60 trillion in unstated Enron style off balance sheet promises.

Mathematically, this false economy must end eventually. But strangely many see a bright future ahead for our nation. Investors have priced many sectors of our housing stock, commodities and our stock market to overvaluation yet again. Hence we are in another bubble. Therefore, I am approaching market neutral in my "sleep at night" portfolio . I refuse to buy overpriced assets.

In my last post I explained how our country has progressed in 2 generations from a society that thinks of investments in 3 dimensions to the baby boomers that are only capable of one dimensional economic thought. We use the advice of salespeople to make our investment decisions as Wall Street is taking a larger and larger portion of our gains.

Speaking of these salespeople, I just read a post by Nobel Laurette Paul Krugman. Dr. Krugman does very well in generating speaking and book fees and presently has found a nitch as the proponent of bigger government. He is a salesperson of the financial elite because his one dimensional thinking is being used by many people to make investment and policy decisions.

His latest post on his blog suggests that we don't need to worry about our country's present account deficit because at current interest rates our nation's debt will only account for 7% of government expenses in a few years. He says that at the current short term borrowing rate of 1.4% this country has nothing to fear borrowing large amounts of money from foreign nations.

This is the way it works. He states his opinion. He gains attention. He makes lots of money giving speeches and writing books. In 5 years no one will note whether his current thinking was right or wrong. Our nation of linear thinkers does not even look side to side, much less at the past. We are destined to repeat history again and again. Bubble after bubble as policy makers rack up monstrous debt to be paid by our children to hostile foreign nations.

I wish Krugman's call could be a wager in Las Vegas as an over or under bet. I would bet the over position. In my mind it would be a totally riskless wager. I also know that Krugman would take the "over" position also. He may make sensational statements to gain notoriety but he is no fool. If he could wager he would bet on the interest on the national debt as a much bigger percentage of government spending than 7% in the next 5-7 years. His assessment that government's 1.4% rate of borrowing will remain in place in the future is infantile at best.

Our government is churning over it's debt in short term vehicles. This short term policy is a huge structural problem and can't possibly continue forever. Our politicians are financing ultra long term debt in short term treasuries that are being purchased by hostile foreign nations. This is definately a problem and Krugman should understand this.

So why does he make the sensational statement then. Because he is a salesman. Just like everyone else that is giving you information.

I would like to take this a step further. Suppose we have a nation of Krugmans. One dimensional thinkers that see events change in a line and not as a trend. They would never be able to predict a bubble because a bubble is a curve. This is why no one in our present society has been able to predict any major turn in the economy.

In my opinion the only predictions that are important are the turns and in the future we are destined to have a lot of turns.

Investors in this country have a fixed focus on a goal that is straight ahead. Kind of like a herd of wildebeests following their leader across the plain. Our country's investors are a herd of mindless animals running in a straight line following the advice from Dr. Krugman, Wall Street, The National Association of Realtors, The Media and just about anyone that can make make a profit off our financially incompetent populace. Everyone is happily moving in a straight line knowing that the taxpayer ATM is the magic that will lead us to prosperity. Just like the homeowner ATM led us to prosperity during the housing bubble.

So what is an investor to do?

I say invest in the snap.

Given the current market metrics there is one thing that is under priced now in relation to the future. That is volatility. There is no value in the market now and The Herd has unrealistic expectations of the future.

I am a value investor so as the S & P index moves higher above fair value I am buying hedges on my stock holdings. Generic hedges on my large cap, market leaders with low debt. Once I get to market neutral at S & P 1200 it's not like I'm going to sit out this market. I'm going to start buying into volatility.

There are many ETF's on the market now that track just about everything. Most are not suitable long term investments but many have tremendous volatility. Presently I am slowly moving into FXP and UNG. These are both at historical lows. FXP is a short on a portion of the Chinese stock market and UNG is long on natural gas futures. I am dollar cost averaging very small amounts of capital into each.

You might say this is gambling. I say if you are significantly long on this market you are gambling a lot more.

I choose an ETF that is at a historical low that is backed by an asset base that is currently trending close to a 52 week low.

Natural gas futures are trending toward multi years lows while UNG is at an all time low.

If UNG trended down for another 6 months maybe I would end up with 5% of my portfolio in the investment. If I get the snap back to fair value my investment could make 30%. A 1.5% portfolio profit. 4 of these profits a year and that will equal the performance of the S & P per year over the next ten years.

Remember this volatility play is only on the table while the market is significantly overpriced. If stocks go under fair value I sell my generic hedges protecting my stock investments and make a profit. If stocks go significantly below fair value I buy more stock. If we stay in a bubble I take a small portion of my portfolio and play the snap. My goal is to stay with The Herd and equal the 6% to 6 1/2% gains in the stock market over the next 7 to 10 years. But I choose to take those gains in a straight line and without risk.

I would like to note that to make my intended goal without risk, I choose to avoid long term bonds like the plague. There is presently just to much distortion in the market. But I will invest in the volatility of long term bonds as interest rates vacillate wildly over the next few years as the government distorts the market. Presently I am slowly buying a small position in TLT, an ETF that is long on long term treasury bonds. I sold off my treasury short last year at a very nice gain thanks to The Herd.

Back and forth, back and forth over the next few years. You will deal with it by taking Rolaids. I will make a little profit while I wait for The Herd to start climbing the next interest rate mega bubble in 5 to 7 years. That is when it will get challenging.

But for now my premise is that if stock prices are forced to overvaluation by investors that have unrealistic expectations of the future then this will cause volatility. My goal is to trend with the S & P index. But as an investor that hates risk I must smooth out the wild gyrations that will occur in the stock market over the next 5 to 7 years. My gain will be in a straight line as I use the two dimensional surface of the investment plain. The Herd's movement will be a frenetic two dimensional zig zag as their linear focus is diverted from the salespeople, to the government to the dysfunctional markets that are being created by bad government policy.

Buy and hold does not seem to be a prudent way to invest in this market.

I remember talking to day traders back in 1997. They were buying and selling stocks and stock options. It didn't make sense to me at the time. The volatile stocks that they were trading were the ones that were likely to go to zero. One stock investment goes to zero and that wipes out a lot of capital.

Now that we have ETF's and massive volatility on the horizon day trading makes sense. If I start to buy into VXX, a direct investment in VIX volatility futures at a 52 year low there is no chance of it going to zero and wiping me out. As it is being sold off, The Herd is running away from the 52 week low as they are tethered to an elastic band tied to historical fair value. As that band stretches it becomes harder and harder for The Herd to pull away. The farther from historical fair value and the further beyond the 52 week low then theoretically the harder the snap back.

The future of stock and stocklike investments will be one of high volatility as the market gyrates wildly over the next 10 years making below average historical gains. Probably on average about 6 to 6 1/2% increases a year. But those gains will not be linear like the advice of the salespeople. Those gains will come after a stock market roller coaster with The Herd running large distances for very little gains.

During periods in which the market is overvalued I plan on making small profits on the long distances that The Herd will be running as they race back and forth across the investment plain.

The Herd is trained to follow the salespeople. Destined to run wildly toward the oasis of golden prosperity that will be created by the massive debt from the Taxpayer ATM. But using ultra long term debt funded by hostile foreign nations to buy votes in the next election does not seem like a solution to me. Call me crazy, but it seems like a bit of an ethical problem in the short term and it is definitely a structural problem over the long term.

Dr. Krugman will cheer, "just another $10 trillion of debt to China will bring us closer."

But like a mirage in the distance, adding more debt to our already over leveraged nation will keep true prosperity just out of reach.

In 7 years when The Herd is exhausted from running they will find themselves at the bottom of a mountain. This will be the beginning of the next interest rate mega bubble.

Dr. Krugman's legacy will be the crushing debt that our children will be destined to carry to the top.

Value Investors, Santa Clause and the Easter Bunny

There are 3 types of investors. The first type would be people that only see one dimension of their investments. They rely on a salesperson to make their decisions for them. The salesperson in turn wants to take the biggest portion of your investment principle without having repercussions coming back upon themselves later. One dimensional investing is the easiest but unfortunately the most costly way to invest.

I can always pick out a one dimensional investor. When I try to explain two dimensional value investing I get the "bovine stare". Their eyes become black vacuous holes as brain neurons immediately stop functioning. Go down to the stockyard and look in the eyes of livestock. The same far off stare. This is the herd behavior of our ancestors. This is the same behavior that is making Wall Street huge profits today.

The salespeople that are advising the one dimensional investor can be real estate agents, financial advisers, the media, Wall Street and our government. But they are also friends, family members and neighbors. If your friend bought a house in 2007 then our course they will try to sway you into thinking that house prices are a good value. You can call it a defense mechanism but in the end it is just a sales pitch to validate their bad decision.

The second dimension of investing would be thinking about the investment yourself instead of letting someone else do it for you. This approach works best using mathematics and historical trends to determine if investments are priced appropriately. Most importantly one would have to ignore the sales pitch and get information directly from a reliable source. An almost insurmountable task.

This two dimensional investing can have complications. There is a group of people that think they are value investors as they use data from tainted sources. So in the end, they are no better off than the one dimensional investor. This creates more useless data and more static for the true two dimensional investor. If there really is such an animal. I have never really seen one.

Suppose that there was a true two dimensional investor. Their performance would have to tie to real events. The larger the event the more credible the performance indicator. The fact is that no one saw the 2004 housing bubble. No one saw the 2007 credit crisis. No one saw the 2008 recession. These were huge events that where basically, "no brainers". Our best and brightest not only ignored all variables to predict these events but they belittled anyone that suggested these almost certain outcomes as even a possibility.

The last type of investor sees in all three dimensions, up, down and to each side. It is impossible to teach or learn. It is breed by circumstance. The only way to be a three dimensional investor is to live through a period of extreme economic hardship.

This is why I tell people that The Great Depression was a wonderful event. It created two generations of fiercely independant, hard working, family oriented individuals. This country had two generations of three dimensional investors. These people understood value, hard work and sound government.

The last 15 years has seen a three tiered collapse. The collapse of the Interest Rate Mega Bubble rewarded a generation of one dimensional investors that have lived far beyond their means. This has collapsed our savings rate and turned our nation from a creditor to a debtor. These one dimensional investors are dismantaling the constitution to maintain this profligate lifestyle. This is the collapse of sound government.

This collapse should have seen an outcry that was heard around the world. Our grandparents would have thrown out the lawyers, economists and politicians that have forced the most powerful nation on earth to mortgage our children's future to hostile foreign nations with the sole intention of creating economic bubbles and making government bigger. It would not have made sense to our grandparents but oddly we are unable to see what is right in front of our eyes.

We have tainted investment DNA. Kind of like the 3 eyed chickens that live next to Chernobyl. Only the Chernobyl chickens aren't sacrificing their chick's future to live decadently in the present.

Our country has changed from a nation of 3 dimensional hard working savers to mindless debt producing consumers. We have become one dimensional thinkers.

For myself I would rather read a memoir about the Great Depression than today's paper. There is so much more honesty in people working together in overcoming a period of extreme hardship than what we are going through today. The excess and avarice of today's pampered populace. Everyone listening as salespeople tell us to create stifling debt for our children so we can create another housing bubble and consume more Chinese junk.

I have wanted to write a post comparing our current plight to the movie Starwars. Paul Volcker would be Obe wan Kenobi. Elizabeth Warren could be Princess Leia. Of course our government would be Jabba the Hut. Darth Vader would be played by Wall Street with Giethner and Bernanke piloting the Death Star. But the story would be incomplete because there are no Luke Skywalker or Han Solo characters yet. You can't put Krugman, Roubini, Shiller or Taleb in these roles. They are profit driven and are just motivated by book and speaking fees. Some day we will have a young Volcker that will save our economy but that is far in the future.

Presently the only way for me to describe our present situation is as an Orwellian drama. Animal Farm but with just pigs. Our population has become pigs at a trough with the most favored pigs being at the opening of where the government pork comes out. The rest of us less favored pigs are in line to pick up the leftovers. Our piglets are in the pen next door as we hear wild squeals. Later the young pigs exit with the same blank stares as the adults. Their future has been chopped off and sold to the Chinese. Scraps come back to the feedlot and are ground up for the soylent pork that the government feeds us.

It seems to fit current events pretty closely.

So you think you are a two dimensional value investor.

Here are some questions:

Do you think the economy is growing?

If you said "yes" then you are being led by salespeople which makes you a one dimensional investor. Our economy is contracting. Presently we do have a positive GDP number but it is only positive as our government uses massive debt to borrow resources from the future to pay for votes in the next election.

Are you investing with an eye toward inflation in the future?

If you said "yes" then you are being led by salespeople which makes you a one dimensional investor. There is no way that our government can create "magic inflation" that will not raise interest rates. As interest rates rise it will collapse long term asset values. We are in a contractionary period and will stay there until we get halfway up the slope of the next interest rate mega bubble that our Federal Reserve is creating. Then and only then can we have real inflation. Yes our government can create a new bubble but hopefully you have learned by now that this in not inflation. Look back in history, there has never been "magic inflation" that brings prosperity to a country after a period of wild excess and stifling debt.

Do you like dividend paying stocks?

If you said "yes" then you are being led by salespeople. There is no long term tie between dividends and long term stock performance. Increased dividends are a sales tool by a company to sway investors to buy their stock. Actually dividends could be a drag on company's performance as they take productive resources from the company to be taxed twice and given out to shareholders. Historically mature slow growth companies have higher dividends. Young high growth companies don't issue dividends because they are able to invest their profits in future growth instead of dividend payments that entice short term thinking investors to buy their stock. If you own high dividend producing stocks you are sacrificing long term gains to replace your lack of long term investment planning. It is ironic that our financial salespeople are selling unwary investors on this scheme after our country has lost 30% of your retirement account.

Do you own any long term bonds?

If you said "yes" then you are being led by salespeople. The only way you should be holding any long term bonds is as a short term hedge. These of course would have to be sold long before interest rates start to rise. Presently long term bonds are a terrible long term investment.

Do you feel that real estate will make more than 1 1/2% real gains in the future?

You have to be honest here. This is part of the DNA change that has festered over the last 15 years. A house has become a speculative high priced rent payment. Contrast this to how our grandparents treated their homes. Back then real estate was something to be paid off as soon as possible. Our grandparents had memories of the Great Depression and how housing debt ruined families in a contracting economy. Our next generation will have these same memories. Presently, you know in your bones that real estate will pay for your retirement, even though it is mathematically impossible. Over the past 100 years real estate gains were 1 1/2% above inflation and stocks 6 1/2%. You will favor real estate as an investment over stocks because it is part of your DNA.

Do you have a vast understanding of the interest rate mega bubble?

This is the deal breaker. The interest rate mega bubble is the biggest single economic event in the last 50 years. 187% of the last 300% profit from real estate was driven by this event. Over half the profits from long term bonds since 1988 have come from this government created bubble. This event that you have never heard about and definitely don't understand changed your investment DNA. You will never be the same.

Our present generation only has memories of the "financial geniuses" that through no ingenuity of their own, rode the collapse of the interest rate mega bubble and the easy money of the Federal Reserve to a once in a hundred year profit. This is an event that is mathematically impossible to recreate and will never happen again. Except in the minds of present day speculators. Our generation is tainted, financially illiterate and totally dependent on salespeople to make our investment decisions.

You are not a value investor because like Santa Clause and The Easter Bunny they presently don't exist. You are a product of your environment. We will not have value investors until the next generation takes over the helm. They will be able to see very clearly what a value investor looks like. The exact opposite of our generation.

Herd Behavior vs Casino Gambling

When I was a kid my parents had a pool with a 10 foot bottom. Sometimes I would play games in the water. One of my favorites was tying an anchor from my Dad's boat around my ankle and throwing it into the deep end of the pool. I would spend 2 minutes trying to untie the knot and then if I couldn't, I would grab the anchor, get in a crouch on the bottom of the pool and push myself up to grab the pool ladder. When my Mom found out about the anchor in the pool she kind of freaked out.

Contrast the pool anchor to the high wire acrobatics that some high end buyers are choosing to perform today. Let me recap.

There are thousands of examples in the areas that I follow of high end buyers that took on far to much risk and are presently underwater. There are many others that bought at fair prices before 2001 but have used their homes as ATM's and are presently underwater. As a behavioral economist I have noticed that this herd-like mentally has become very common in the last 15 years. With the collapsing of the interest rate mega bubble and the easy money policy by our Federal Reserve many people have become "financial geniuses". These "financial geniuses" through no ingenuity of their own have been able to make huge profits in speculation. Other people see this behavior and want to emulate it. This is herd behavior and is very human .

What is happening now seems very foreign to me. Now that the interest rate mega bubble, the housing bubble and the credit bubble are collapsing why are people still choosing to make huge gambles in the high end real estate market? There is no one to emulate. It's not herd behavior. It's just flat out speculation. Purchasing in any high end area of the Bay Area is taking on a huge risk with almost no chance of gain in the end. Unless the thrill of owning a house is worth the cost of overpaying a million dollars or more in rent for 30 years plus the immediate downside risk of over $300,000 when house prices correct to fair value in 5 years.

I go through the actual numbers in my last post called "Immediate Gratification?".

Let me explain one simple fact that is understood by absolutely no one today. Buying a home is renting. It is not like renting. It is in fact renting. You are renting money from the bank. The only difference in renting money from a bank compared to renting a home is that instead of a month to month lease you are tied to renting money for 30 years or until you sell your home.

Some might argue that you can refinance your loan. Let me explain another fact that no one understands. We are at the end of the interest rate mega bubble and are starting a new one. When you are in the upslope of an interest rate mega bubble you can't refinance because your equity is being wiped out as interest rates are increasing. Plus why would you want to refinance at a higher rate anyway. It doesn't make sense.

Some might argue that a house is "inflation protection". Let me explain again. We are in a contracting economy with no inflation on the horizon. It could be 7 years before we stop contracting. If you have any questions about this comment just google "Japanese lost decade". The Wall Street economists that are guiding our policy decisions are the same ones that were used by Japan to create twenty years of economic contraction. I also write about "inflation protection" in my "Immediate Gratification?" post.

Why would one bet on "inflation" when we are presently in "disinflation". Anyone that is buying an overpriced asset as "inflation protection" is betting that the people at our Federal Reserve that didn't notice the biggest housing bubble in history will be able to create Latin American style inflation without interest rates rising. If you are buying an overpriced house in a high end area now, it is a million to one bet, that if you win you are just given your money back. Good luck with that wager. I think that I will sit this one out and watch.

While I'm on a roll let me include one other fact that no one understands. Our housing market according to the latest Federal Reserve figures has a net worth of $6 trillion. We have outstanding mortgages on that $6 trillion dollar investment of $10 trillion. So as a country we have decided to create $10 in debt for every $6 in equity. We are debt slaves to our homes. Before it was a figurative expression that owners are renters through the banks. Looking at the present figures owners have literally become leaseholders that are overpaying the price of rent as they are locked into 30 year leases.

Back to the pool anchor. Would I vote to outlaw anchors in pools? Absolutely. There are just to many people that are willing to take risks far beyond what is prudent. The anchor that I spoke of above was an 8 pound plasticoated dingy anchor. At the time I could have given a pearl diver a run for their money. I could tread water while I held it. I could have repeated the game a million times without a problem. These were the variables then. But changing one variable would make it far to risky. People in general are very poor judges of risk. Plus there are always people that overextend a game and create more risk than is tolerable. An example would be anyone that is choosing to pay bubble prices to buy into a high end market.

In most high end markets people have gone beyond good natured herd behavior. There are less and less suckers to pass the overpriced asset to. There is absolutely no driver to warrant the behavior. No herd behavior, why would you emulate people that are losing money. No profit motive as I have shown in many times in my previous posts. It's just an individual madness to own a home no matter how overpriced it is. It is casino gambling and the "house" almost always wins in the long run.

It was a little painful to watch during the housing bubble as people were overpaying for homes. But it was so human, this herd behavior. The present high end real estate market is driving me nuts. That's one of the reasons that I started this blog, as kind of an outlet for my angst as I watch people make very bad decisions. It is not herd behavior anymore, it is flat out speculation in a negative economic environment. Casino gambling by a nation of "financial geniuses" who don't understand that the last 25 years of easy money was a once in a century aberration and not a birthright. It is mathematically impossible to recreate this madness in the same way that it is impossible for someone that is underwater in their home to borrow another $250,000 from the bank. We are tapped out and Uncle Sam the loan shark is soon to run out of easy money. The game is over. When you buy an asset it has to make financial sense. It has to be affordable and the worse the economic environment the more affordable the asset must be.

It was impossible to document all of the bad decisions of the past 8 years because there were so many. But of course it was a mania so it is better to document the event in the aggregate. But now is different. The group is not driving prices anymore in high end areas as herdmembers are leaving the market. The market is being driven more and more by individuals. Unfortunately some of these individuals are tying a boat anchor very tightly around their necks. It will have a bad effect on the whole high end market as we trend toward affordable prices.

I would like to document some individual sales that are creating some of the Lafayette Lotto(see my Lafayette Lotto post) winners. These casino gamblers that are risking everything for no chance of gain.

Looking at the sales from 1/1/2010 it is comforting to see that prices in Lafayette are trending downward toward fair value. But there are still uninformed individuals that are grossly overpaying for individual homes and slowing the fall in prices to affordability for everyone while they are taking on huge risk to themselves. I would like to use examples gleaned from Property Shark to track the markets trend back to the fair value prices of 2001.

My first example will be a sale in Burton Valley in January. It sold for $1.1 million. It is an average home built in 1962 on a quarter acre lot. The purchase price works to over $503 a square foot. Close to peak bubble price. This home sold for $397,000 in 2001. This will be property "A" from January 2010. In 5 years it could trend to $300 a square foot while each month the owner is overpaying rent by 100%.

I would like to interject that 99% of the people that read this blog will not understand what I am talking about. They are not able to comprehend the idea of fair value because it is a foreign concept. We have lived in a period like none other with money falling from the trees. That is what you are used to just as someone that lived through the Great Depression saved 25% of their income and kept it under the mattress. We are a product of our environment. So if what I just said did not make sense don't worry about it. I will have another chance in two years to explain once the data is in. You will be able to see the trend downward. Of course you can deny it then also. In psychology I guess that is called a self defense mechanism. But be aware that there will be some point in the future where everyone will realize that money does not fall from trees. Where saving and productivity gains are the way to increase our standard of living. Not easy money bubbles, government pork and horrendous amounts of debt. The sooner that you realize this the better off you will be. The sooner that our society realizes this the better for everyone, especially our children.

Speculation with debt is so ingrained in our society it is almost impossible for investors to step back and look at value. Believe me I know. I have spent the last 15 years getting blank stares from people when I explain the principle of fair value.

Would I purchase a home in a lower end area like Anitoch? Absolutely, prices there are affordable compared to rents, household income and historical trends. Would I buy a home in a higher end area? I would much rather tie an anchor to myself and throw it in the pool.

My next post will explain why there is no such thing as a value investor.

Delayed Gratification?

One of the topics that I love to discuss with my kids is saving. The longer one can delay gratification the better. It builds character as one is creating a pool of assets which could directly lead to comfort and security in the future.

Contrast this concept to the fact that our present government is desperately trying to force our insolvent banks to lend as much as possible to our insolvent households. I'm sure this dynamic makes sense to most of the Wall Street economists that are advising our government but on paper the numbers don't work.

Anyway I would like to suggest some other numbers that don't work. Buying a home in a "high end" area of San Francisco instead of renting.

Let us suppose there are two people that want to live in Lafayette for 7 years. Let's call them "you" and "me". You buy a $1.2 million home and I rent an identical home. We both have a 30% down payment.

But we must agree on what the future will be. I say homes will trend downward 30% in 7 years. You say homes should increase slightly. So let's say that prices will stay the same. I don't agree with it but I accept the premise.

I am sure we can both agree on a historical 6.5% return on stocks and we will let you have a 6% loan.

Now let's look at the numbers. At the end of 7 years I will have made $500,256 cash gains and you will have made $85,764 in equity.

No, I didn't misplace a decimal point.

Your mortgage, real estate taxes, extra insurance and maintenance for your home is $6,188 after the $1,158 itemized deduction subsidy from our government.

I will pay $4,000 to rent the same house. I will put the $2,188 that I save each month in the stock market and after 7 years will have $264,457. I will also earn the same 6.5% on my down payment which will be another $235,798. This is a long term capital gain of $500,256 in 7 years.

You will tie up your down payment for 7 years as you make very large interest payments to the bank.

At this point you are saying, "what about your capital gains tax?". I will say, "what about the 6.5% cost of selling your home?" Both charges to exit the investment end up being a little over $75,000. Let's call it a wash.

Is it possible that my rent will go up some? Yes. But it is much more likely that your home will go down in value much, much more. By my calculations about 30%. With a 30% discount the price of your house would still be overpriced compared to 1998 values. Back in 1998 homes were affordable compared to rent and household income. Housing markets almost always trend toward affordability. The last ten years have been a very, very large anomaly.

The example above is what I mean when I talk about affordability. Homes in Lafayette are unaffordable. Look at the numbers!

I would have $860,256 minus capital gain taxes, to put as a down payment on my $1.2 million home if I wanted to buy it. This includes my original down payment with capital gain plus my profit from renting with my long term capital gains.

So if I purchased then my housing costs after the tax deduction would be $1,907. This is $4,280 less per month than you would be paying if you had stayed in you house.

But my original premise for posting was Delayed Gratification and the example above actually gives me a beautiful house with free pool and lawn care.

So what if I decided to delay my gratification for a few years and live in Walnut Creek to save money. Suppose that I decided to rent a smaller place for half the rent. Then I would be able to pay cash for a house next to yours in a little over 8 years.

I will not pay a mortgage payment for 22 years while you are paying $5,036. I will have $2.8 million in the bank and a home in 30 years. You will have just a home.

The numbers are outrageous but they are not the main focus when I choose to rent instead of own a home. I am not renting to save $2.8 million in the next 22 years.

I am renting because of the huge downside risk in high end housing. Real estate has always trended toward affordability. To think that this time is different is lunacy. There are no variables in the future that can possibly drive real estate prices in high end areas to more unaffordable levels short of the government giving upper middle class taxpayers money. Realistically the opposite will be true. Taxes for residents of Lafayette will skyrocket in the future. The top 50% of wage earners pay 96% of the taxes. Almost all of this debt that our government is creating now will be paid by people that live in high end areas. And just in my opinion, rightfully so.

There will be no positive inertia in the future that will push high end real estate to more unaffordable values. But there will be many, many factors in the future that will push prices toward affordability. Affordability is where prices trend most of the time and that's a good thing.

There are great examples of affordability in many lower end real estate markets. In Antioch, Sacramento, Las Vegas and Phoenix homes are below fair value. In these areas and many others it is cheaper to own than rent. By historical standards this is not unusual. Real estate prices trend toward affordability so sometimes they are below fair value and sometimes they are above. As a value investor, if I lived in Antioch I would definitely buy a home.

The Lafayette housing market will absolutely come back to affordable levels at or below 1998-2001 pricing. There is also a chance that they could go below fair value.

As a value investor the chance to lose $360,000 or more by choosing to spend an extra $2.8 million on housing does not make sense.

There is one last idea that the gullible will parrot from the salespeople that are trying to entice them into 30 years of debt servitude. A house is "inflation protection".

Let me explain the chain of events that are in process. Our economy is contracting. This is the opposite of inflation. If our Federal Reserve is lucky enough to debase our currency enough to create inflation then interest rates will spike first. This will cause stagflation exactly like the 1970's and eventually inflation like the 1980's.

So if we are eventually lucky enough to get inflation first we must deal with spiking interest rates. These higher interest rates will collapse housing prices. At that point one could argue that housing would be an insurance against inflation but not now.

Presently housing is not an inflation hedge in fact it's just the opposite. You won't be able to use real estate or long term bonds as an inflation hedge until interest rates are 2/3rds of the way to the peak in the interest rate cycle. That is a long way down the road. We are presently at the bottom of the interest rate cycle. Inflation is not even a variable that I am presently considering.

Inflation might not be a factor for 7 years. Hence my example above comparing renting to purchasing.

During the Great Depression our country incurred economic contraction just like today. But ironically when you read memoirs of investors during that time period their biggest concern was inflation. It's very similar to today. As our economy is contracting most people are worried about inflation. Inflation is the next red herring that Wall Street will use to take your money. We are not even close to stagflation much less inflation.

My recommendation is the same today as it was 10 years ago. Only buy a home when it's affordable. When we are halfway up the next interest rate cycle then we can talk about "inflation protection".

Why Does Our Country Hate Fair House Prices?

I follow the Lafayette real estate market very closely. Today was unusual in that there was a house that sold for close to fair value, which is 2001 pricing - $188 a square foot. One of the first in the past 8 years, so it is kind of exciting to me. It was an REO sale in a pretty nice neighborhood. Mountain View Drive to be exact.

Since I am a value investor. It always gives me a good feeling when I see an asset priced at fair value. You can call it historical trend value, intrinsic value or fair value, it all means the same thing to me. It implies that the asset is affordable and the price is fair. That's a very good thing.

Now here is a question to determine if you are a value investor:

Do you feel that Lafayette will go back to 2001 prices?

Most of the recent sales in Lafayette are at 2006 prices. Therefore homes are still priced at bubble prices. Every once in a while I will even see one sell at 2007 prices. This kind of makes me cringe.

What is strange is that most of the market experts be it Realtors, economists, bankers or brokers would say that this recent Mountain View sale is an aberration. The Lafayette housing market definitely knows it's an anomaly because families are paying on average 2006 prices. So what's the deal.

I reflect back to 1990, 1996, 2007 and today:

• 1990 - Houses were unaffordable and everyone was climbing over themselves to buy a bigger and pricier house. Everyone was telling me I had to buy a bigger house for my growing family. I looked at prices and they didn't make sense to me so I refused to buy and we lived for the next 6 years in a house that was too small, much to the consternation of my wife and my Mother-in-Law. Houses at the time were priced above historical trend.
• 1996 - No one wanted to buy a home. Everyone said houses were overpriced. I bought a house that was a stretch for me. I remember people coming over to my home and not being able to understand how I could afford a house that was so impressive. Well the fact was that I had saved money while others were debt slaves to an overpriced home. Houses at this time were very affordable and way below historical value trend. But no one wanted to buy. Very strange but of course very consistent
• 2007 - This was the peak of the last housing bubble and our whole society had decided that they were going to retire at 50 from the equity in their homes. Since homes were far, far above historical value trend when I sold my home I made a vow to myself not to buy another home until at least 2010.
• 2010 - I am renting and saving a significant amount of money while my down payment is in a brokerage account earning interest. Lafayette housing will have to fall 30% to be in line with historical value trends. The economy will slow and this could shave even more value off that amount as rents and household income decline. For myself, I refuse to buy a home at over fair value.

This post is not meant to give all of the variables that will contribute to the high end real estate market correcting at least 30% in the next 5 years. I have written extensively on that. I would like to make an observation about human nature.

Why is it that most of the time our economic experts miss the big turns in the economy? Why is it that they can't determine the historical value trend of assets? Why on earth would we let the knuckleheads that consistently and continually denied our economic problems in the first place use extreme fiscal and monetary policies that have never been successful before?

So, I would like to say very clearly that this Mountain View property that just sold is the first of a trend back to fair value.

So you say this is impossible. Well, Antioch real estate is presently selling at 1998 prices and Sacramento is selling at 1996 prices.

Las Vegas is the same. Phoenix the same. Florida the same. So is this bad?

Lower end real estate markets always come back to fair value more quickly than higher end areas after a bubble. Presently real estate in lower end markets like Antioch have become affordable for the first time in 9 years.

Now each sale in Antioch wipes out a speculator. Each sale eliminates a subprime loan that was sold by a corrupt mortgage broker. Each sale helps a family get out of stifling debt which could make their rent payment less than half of their old mortgage payment. Each sale will strengthen the balance sheet of the bank that is financing the new home. Each sale could weaken the balance sheet of the bad bank that made the toxic loan in the first place and hopefully make them fire the person responsible. This could create a job for a more capable young person in the future.

But the most important event is that each sale allows a young family to feel the joy of buying a new home that is affordable. Is this bad?

So back to the sticky high end real estate market. There is no reason why Lafayette can't bottom at 2001 prices. It is actually the most likely scenario. Young families that buy now are making a very large leveraged bet buying an overpriced asset in an extremely unsound economy. Is it good that our government is slowing the trend back to affordable values by robbing trillions of dollars from our children?

These young upper middle class families that are buying now in Lafayette could very well be underwater in 5 years as the government is artificially manipulating almost every facet of the real estate market with borrowed money. Will this be a victory for our government?

So I come back to the human nature part of the equation. Why is it so important for asset prices in Lafayette to be wildly overpriced? Why has our government spent tens of trillions of dollars over the last 25 years in subsidies, incentives, gifts, graft and bailouts in an attempt to make prices of homes unaffordable?

Why do we want our government to choose the winners and losers? Why do we love home owners and hate renters? Why do we love speculators and hate savers? Why do we hate our children and expect them to take on the debt that we are creating to distort our asset markets to reward favored members of our society?

Why does our country hate fair house prices?

Going one step further. The net value of our nation's residential housing stock is honestly about $6 trillion on a good day. Our government has spent tens of trillions of dollars over the last 25 years in an attempt to artificially manipulate house prices higher. The choice by our government to pay $10 trillion to distort prices in a $6 trillion market does not make sense. Even paying $1 to distort any market prices does not make sense.

It makes no sense economically. Fair and affordable asset prices cultivate a sound and vibrant economy. Or to state it differently: improperly priced assets will reek havoc with even the strongest economy. So why do we hate fair house prices?

House prices in the upper end of Lafayette are mispriced. I can rent for half the price of buying. Case closed, now let's move along.

People say to me all of the time, "how could you possibly know what house prices will be in the future". "Do you have a crystal ball?".

All I can say is yes, I have a crystal ball. It's a chart of the historical value trends. Assets have always come back in line with affordability. It is an irrefutable fact that all of our economic experts consistently ignore. In the same way that we ignore the fact that our experts have been consistently wrong on every major turn in the housing market and the economy.

Blind faith is a blessing in one's religious life but it is definitely our country's curse when it comes to investing.