Charlie's Thoughts - 3/9/2009
There are two topics that I love to talk about. The first is tax, obviously. The second subject is The Economy which I think of as: the market game of how our choices relate to the choices of others.
I received a call from my Dad a couple of days ago. He asked if I was losing sleep lately because of the stock market. I told him that I had lost a little sleep the night before. My big fear: not having enough money in the stock market at these value levels. So the next day I bought some more Dell, US Steel, Cisco and Target. It helped me sleep better the following night. My biggest fear is that in 5 years I will look back and regret not buying at these present low valuations. Yes stocks can go lower but the valuations are compelling. Just two years ago no amount of bad news could send the stock market downward. Today the situation is reversed. This is the "Paradigm Shift". The change in the market's perception of reality from one absolute to another. When I use this term I envision a reckless herd of animals, of one mind all moving in the same direction. It's not a perfect analogy but the concept helps me remember to avoid "The Herd" for fear of getting trampled.
I have never heard so many dire predictions from “financial experts” about the economy, the stock market and our country. This current media rendition of market timers does not affect my investment decisions today nor did it affect my investment decisions two years ago when they were predicting blue sky forever in the economy. No one has ever successfully timed the stock market in the long run but it is human nature to try. I love to save quotes from people that have tried to time the stock market. My favorite quote is from Bill Miller who in early 2007 was considered the most successful investor of all time. He said in February of 2007, “the economic cycles as our parents knew them are probably a thing of the past” as he compared the coming years to the bull market years of the mid 1990’s. I clipped the article because at the time I was hedging my accounts preparing for a recession. Presently his Leg Mason Value Trust Mutual Fund is down over 75%. His reputation and his client’s portfolios will never recover.
The current investment de jour of “The Herd” are corporate bonds. While present valuations are discounted from par values they don’t seem like a prudent investment now to me. We are at the bottom of the interest rate cycle. This is historically a very bad time to buy bonds or homes. Both of these markets make the majority of their gains during periods of high interest rates cycling down to low rates. The mega trend that started in 1982 with a 10 year treasury yield of 15.32% has just ended. The Federal Reserve is presently hammering the last nail in this cycle's coffin as The Fed tries to artificially keep rates below natural levels. What the investor needs to realize is that about 175% of the gains of bonds and housing over this mega trend were interest rate related. Those gains have been realized and as interest rates increase the dynamic will reverse. In the case of housing this was almost one half of the total gains made during this period. Hopefully the reversal of this mega trend will be gradual or else bonds and housing could be negatively effected. Given The Fed's attemped manipulation of the markets there is definately one thing I will hedge my accounts against, that would be market volatility.
I would like to say as I mentioned in "Herd Theory" that I do have some of my money in "High Yield Bond Closed End Mutual Funds". These bonds are very different than corporate bonds. High Yield Bond Closed End Mutual Funds always get clobbered during recessions and they always are a top performer at the other end. The key is to slowly dollar cost average into them because they can be very volitile.
Another fad that "investment experts" are pushing is the purchase of dividend producing stocks. Since this is a very complicated subject and it would take much time to explain the accounting behind my opinion all I can say is "good luck". I am a balance sheet investor and high dividends weaken a balance sheet. If it's management was good I would be more tempted to purchase a company that lowered it's dividend as opposed to raising it, all other things being equal. I am not saying dividends are good or bad in the same way I am not saying the color of the company's building is good or bad. It is not a focus for me. Although I do like earthtones for a company's building.
The present low interest rates do create an environment that is favorable to corporate profits. Historically stocks outperform during periods of low interest rates. Presently stocks are at extremely low valuations compared to historical book values and smoothed P/E values. Also, households are holding less stock as a percentage of GDP since stock prices bottomed in 1974. All of these are valuation based reasons to start purchasing stocks. On the demand side, there are trillions of dollars, yuan, yen and euros on the sidelines that need to be invested somewhere. The stock market will always have the highest gains of any other investment class because wealth is created through production rather than through inflationary forces. We have a market bubble in short positions that will eventually have to be covered. Nothing raises the price of the stock market more quickly than short covering. One big event that will effect the stock market is that our government is using every tool in our fiscal and monetary arsenal to prop up the economy. This “shock and awe” should have a motivating effect on our consumerist population. In the long run our children will pay for this debt binge but if their parents are buying stocks now that do not pay dividends then these lucky children might be able to spend the future totally tax free inherited gains without the government taking a portion of the profit to pay the interest on the national debt. I would like to note that in a non tax prefered brokerage account the inherited gains from stocks in almost all cases will be 100% tax free but any dividends will be always 100% totally taxable. My last comment is an important investment concept. Just for fun ask your present financial advisor to explain it. If they can't have them give me a call. I will explain to them some of the tax disadvantages of dividends.
Another argument to purchase stock comes from the consolidation and efficiency that is produced by recessions. Bad companies go out of business. The surviving companies become more efficient and gain customers. This is why I invest in individual stocks instead of mutual funds. As an accountant I look deep into the balance sheets of the 50 diversified stocks that I own for signs of stress. I would be very surprised if more that one or two of my companies went bankrupt during this recession. For most people mutual funds are the best way to get a safe and diversified portfolio. Having a portfolio that is not diversified is a form of market timing. It can never pay off in the long run.
The last advantage that the recession will have on the surviving companies is the use of tax losses. Most of the companies that survive will be able to profit from all of the losses that they have incured during the downturn. Some companies like Bank of America will not only be able to use their own losses but also the losses of the companies that they have purchased. B of A will not pay taxes for many years thanks to Countrywide and Merrill Lynch. A 40% boost to their after tax profit for as far as the eye can see.
There is no valuation based reason(S & P index at 680) not to start slowing moving money into the stock market now. Yes the market might go down more, that is why I am dollar cost averaging into the market. Currently I don’t care if the market goes up or down. If the stock market goes up I stop dollar cost averaging, if the stock market goes down I lower my cost basis. I will continue to stick with my plan from 2007.
Presently my retirement account is 70% stocks and 10% high yield bonds. My house account is 20% stock and 80% cash. If the stock market goes significantly lower from these levels I might consider renting for 5 more years and investing a significant portion of my house money in the stock market. As always, it depends on the actions of The Herd.
My advice to the reader: spend less than you make, invest what you save wisely in investments that are priced at below average historical value, slowly move into and out of investment positions, diversify into a varied group of investments, use leverage sparingly and only if the investment and the market warrant the speculation and finally always invest so that you will never lose an hour of sleep. Besides the loss of sleep the other night when my Dad called, I am solidly following my own advice.
My thoughts above are for the entertainment of the reader and meant to provoke discussion and perhaps reflection. As I have tried to express above, I am worried about our country's obsession with the short run. I believe we are ignoring our children's future and the consequences of the long run. We are definately the, "I want it now generation."
I started to quantify my present values 18 years ago during the 1990 Housing Bubble. That was when I started to question the numbers. I am an Accountant and also have a degree in Economics. I perform trend analysis on the economy for fun. Everything above is related to my own situation. I am not a licensed investment advisor so I would never presume to give anyone else investment advice. But, keep in mind that if you need tax advice, I will give you as much as you want for free. Just give me a call.
More Thoughts - 4/9/2009
I just wanted to emphasize my thoughts on the economy. In the past month since I wrote on the stock market the situation has changed. The market has jumped in price faster than just about any time in history. The S and P has made a 24% run. My retirement account has made a 29% run. This extreme movement is not good or bad it is just an effect of The Herd. In order to sleep well at night I am hedging my large stock postion. I definately want to keep my stock but in order to sleep well with The Herd on a rampage I need to limit my losses.
I am hedging with ETF's. I started buying SKF, FAZ, QID and just started buying SH. These are not naked shorts they are generic short positions insuring a percentage of the stock positions that I own.
I do not care if the market goes up or down. If the market goes down quickly I sell my hedges, if the market goes up quickly I might be tempeted to buy more or different hedges. Presently it is prudent to be net long in the stock market. As I said in Herd Theory, the market's volitility requires hedges to smooth out the disfunctional movements of The Herd.
Exhausted Rally - 5/4/2009
I have been hedging into the final days of this market rally. As always I have moved into my hedging position to fast and to early. I have only realized 1.8% of the last 4.4% of the S and P index gains. This is unfortunate but overall I have have a gain of 33.5% during this 32.3% run of the S and P. Since I am investing for long term gains and conservation of capital so I can't complain that my benchmark index has bested me in the short run.
Today the chart of the S and P index shows one the most exhausted rallies that I have ever seen. From this point forward I will only take 40% of the market gains until the end of this run. It is possible that we could have a big move upward in the next couple of days. This movement will be The Herd greedily moving money into the market at the end of an exhausted rally thus setting up the next market correction. Although I am bullish on the market I want less capital at risk at the end of a long rally than at the beginning of one.
One of the benchmarks that I previously utilized was the Calpers pension fund. Now it is just a source of mild entertainment. My plan in 2007 to circumvent the coming recession was to utilize an increasing allocative target with a parity hedge. This just means I wanted to smooth out the volatility of the market by strongly buying in toward the end of market dips and hedging my gains at the end of each market run. I have made huge timing errors but no tactical errors. The tactical errors are the portfolio killers. I made large gains against my target indexes at the beginning of the recession and until this week I have bested the S and P by a couple percentage points every month. I have lost 1.5% against my benchmark this week but I am still 40 individual percentage points(not 40% but 4000 basis points) above the S and P since December 2007. With a pullback of over 7% in the market I could continue my streak of monthly gains but I am not planning on it.
Calper's investment strategy during the recession appears to be to hold pat as the market moves up and down. They have not reallocated once since the recession began and if they have hedged it has been at exactly the wrong time because they are consistently trending away from the S and P index whether the market goes up or down. The fund managers at Calpers have lost 32% of the pension money of California government workers. Over $80 billion dollars so far. A prudent investor must have a plan in place to replace fear as a motivator during an economic downturn.
This market is ripping all the old investment paradigms to shreds because our financial system is built on economic modeling. I use the term economic modeling when it is used as the averaging of past events to predict what will happen in the future. Unfortunately if you put 100 years of information into an econometric equation it just spits out equilibrium. If a statistician runs a monte carlo scenario on that same information it still is weighted substantially toward equilibrium. Economists can predict the future with 100% accuracy in all situations except market turning points. This is as useless as the weather person saying there is a 50% chance of rain today. We need economists to predict the hurricanes in the economy. This is something that no economist has been able to accomplish. All economists missed the Tech Bubble. They all missed the 2006 Housing Bubble and the present Credit Crisis. My simple excel charting using Federal Reserve Z-1 data showed massive Tech and Housing Bubbles while the highly paid Federal Reserve economists were writing papers explaining how asset prices will keep trending upward at the same rate as before.
Presently our economic elite are oblivious to the shift into the next interest rate mega bubble. I don't believe that any economist has noted the significance of the first interest rate mega bubble on our economy even though it was the single biggest economic event of the 20th century. It is interesting that the financial elite that are choosing the winners and losers in our markets today are the same economists that could not see the impending Tech Bubble, Housing Bubble or the Credit Crisis and still can't see the start of the next interest rate mega bubble. Get use to hearing the term "stagflation", it is about to make a comeback.
Housing Hedge - 5/22/2009
Today I moved $100,000 from my house account into long treasury bonds as the 10 year treasury yield is closing in on a yield of 3.5%. I normally try not to move large amounts of money quickly into investments but treasuries were really beat down today and seemed like a good deal in the short term. I sold all of my treasury shorts a month ago as the 10 year yield approached 3% and must invest some cash. The Herd has discovered that long term treasury short positions are up 50% so of course that is where they are throwing their money. I once again am moving my money away from The Herd.
I am buying EFTs specifically: EDV and TLT. If interest rates go higher then I could dollar cost average into more long treasuries. If the Federal Reserve is successful in pushing treasury bond yields lower then I will sell my long treasury EFTs and perhaps I could start to short the treasury market again. If prices stay the same I will take the 4% yield. I do not care which way the market goes.
The only way my house account could be negatively effected in the short run is if interest rates go up quickly. If this happens then both the housing markets, the bond markets and our economy would face very severe headwinds. This could hasten my entry into the purchase of a home here in Lafayette as The Herd moves out of high end real estate with the help of their exploding Option ARM loans. I absolutely don't care which way the market goes. I am positioned to react to The Herd in whichever random way it runs.
Presently half of our country's economists believe we are coming out of this recession. The other half think the recession will get worse. This group of very highly paid economic prognosticators is set to have a 50% success rate in the aggregate on their predictions going forward. While this is not a very good success rate it will be much better than their predictions for the economy three years ago.
My prediction for the coming months is that we will have a lot of volatility in the markets and plenty of unintended consequences from the government policy that is being propagated.
5/27/2009: After a 2% loss on my treasuries I sold off them off this morning. A humbling experience for the short term but a great lesson for the long term. Always move money into and out of investments slowly. The 10 year yield has jumped this afternoon. I am more worried now about China giving up on long term treasuries than my $2,000 realized loss.
6/5/2009: The paradigm of The Herd has shifted to blue sky forever after a 37% gain in the S and P. The unemployment numbers came out today and they are worse than any of the bank stress test senarios by the government. Treasury bond prices are rising faster than anytime in history along with the price of oil. None of this is good news for the future economy but the market is euphoric and keeps trending upward. I am still holding all of my stocks from March but they are hedged. I have taken all of the 37% in gains in the S and P index but will forgo any short term profits until the market appears rational again. I can't have significant money on the table when The Herd is on a stampede.
The Lafayette housing market is moving significant inventory as interest rates are rising. This will lock in another group of losses as mortgage rates rise and homes must be discounted to reflect the higher mortgage interest rate environment. The quick rise in oil, stocks and housing are short term bets setting up another recession in a year or two. This is not a firm foundation for future growth.
Long Term Treasury prices have increased faster in the past month than almost any time in history. I would love to invest in the volitility of this market but I have found no way to do this without a lot of risk. All of the EFT's and mutual funds that I follow are not tracking this price movement properly. Maybe the only way to hedge this distortion is through the futures markets. I will have to look at it further.
7/10/2009: I am slowly selling my hedges in the stock market and using the gains to buy more stock. I am still buying market leaders. I just started buying Verizon to add to my 50 other stocks. I also bought some more Walmart and I am watching Merck, Pfizer, Safeway and Sysco for entry points to buy more stock. My entry points will probably correspond to the negativity of the market even though my choices are totally value driven.
This past downdraft in the market has allowed me to gain a couple hundred more basis points in relation to the performance of the S and P. During this same period the Calpers retirement fund has lost another $4 Billion dollars in capital. My retirement account is up 9% for the year and is up about 1% since October of 2007. The S and P index is down 3% for the year and off 44% since the peak. The Calpers retirement fund is off 5% this year and 30% since the peak. Calpers is consistently outperforming the S and P on the "down trends" and underperforming the index on the market upswings. This is the opposite of how any prudent investor should be performing in this volitile market. I am amazed at how consistent this pattern has been since the market peaked in 2007. Calpers has just now reallocated their equity mix back to 50% equity. They had under 40% in equities for the past 3 months during the biggest gain in market history.
Home Purchase: There has been a real estate mini-bubble occurring for the last couple of months in Contra Costa County. This could be the next step down for home prices in the area. In Walnut Creek and Lafayette two thirds of the sales in the lower end market are "distressed sales" of either bank owned properties or short sales. Distressed sales are selling on average of $300 a square foot compared to "normal sales" selling at an average of $400 a square foot. There is a large impending wave of foreclosures in the pipeline that will come onto the bank's books this winter. This will force the banks to move old inventory off their books. They hold as much REO inventory as possible to protect their balance sheets. Presently the REOs are priced at cost of the foreclosed loans or in some cases higher. Once a property is sold the bank realizes the difference between the holding value and the Fair Market Value, which can create a significant loss. Also by holding the REO properties they are trying to prevent the cascade effect if a wave of properties come on the market and effect the market itself. This could create a negative feedback loop.
I will spend this Winter making "low ball" offers on homes in the $550,000 price range in Walnut Creek and parts of Lafayette. I am mentally pricing in a loss of 20% of my purchase price on the transaction. I plan on selling in 2-3 years and could lose $100,000 on the sale at that time but in the 3 years of owning I could save a net $100,000 in not paying rent. I come up with this number because my house account is mostly in cash and is earning almost nothing and rents are very high. Whatever the outcome, my loss will be the result of dollar cost averaging back into the physical housing market with the goal of moving to the upper end market of Lafayette in the future. Presently the jump to the upper end of Lafayette is out of the question due to the huge leveraged risk involved. At this point the numbers just don't make sense comparing debt to equity, rent to equity or household income to price. The market must correct the pricing imbalance in the long run either through price declines, inflation or a huge demand curve shift.
The upper end of the Lafayette market will not bottom, in real dollar terms, until at least 2013. The higher end of real estate is always very, very sticky on prices trending downward. I track the lower end of Lafayette very closely but spend very little time tracking the upper end. People appear adamant that they will only sell at peak bubble price and keep all of their 300% gains earned since 1996. Presently there are years of inventory on the market in the upper end and years more shadow inventory waiting to come on the market once prices recover. The only viable option that could make bubble prices return in higher end housing would be if the Government is able to jump start the consumer and force an inflationary environment in the economy. The only way the government could accomplish this feat is with the multiplier effect of the private sector. Looking at the balance sheets of the large banks this appears to be an impossible task. Without the multiplier effect of the banking sector all we will get for the tens of trillions of dollars of government debt will be stagflation.
The economy can't function normally until the large bank's balance sheets are cleaned up. Once the economy starts functioning normally then two more events must occur to create a firm foundation for growth. First asset prices need to return to fair value. Secondly, debt ratios need to come down to affordable levels. Unfortunately our elected officials are moving in the opposite direction. The government is using massive debt offerings to bring us a Ponzi Prosperity that will reward speculators in the short term but like all Ponzi schemes is destined to fail in the long run.
I am doing many things that appear to be speculative but in reality I am hedging the dysfunction in the economy brought about by bad government policy. I sold my home in early 2007 and decided to rent, bought a massive short in the stock market in late 2007, bought a large short in the Treasury market in 2008 along with many other smaller hedges. My decisions may seem crazy and extreme but I have not lost a dime in the housing and stock bubbles and will not lose money in the future bubbles that are being created with the present misalignment of capital being forced by our government. Sometimes in an insane world the sane man must act insane to survive.
8/6/2009 - Crap Table
This roll of the dice for stocks has been about the longest continuous run in the history of the market. The S and P is up a straight 50% and my retirement account is up 51%. Today I have been buying hedges for my stock positions and next week I might go to market neutral if The Herd drives the market up significantly. I don't see the "green shoots" that everyone else is seeing in the economy and stock prices have come up to a little over fair value. It is now more of a trader's market than a value driven market and I will be more prudent and thoughtful in my allocation mix.
These huge stock rallies almost always come during a prolonged bear market and more often than not tend to end badly. Whether good or bad this rally has definately brought out the greed in the market. This greed and the volatility that will follow can not be good for the future of our economy.
The government is supporting the insolvent big banks with artificially low interest rates and The Fed has loaned trillions of dollars backed by bad assets to the big banks. The Fed will give any big bank 50 cents on the dollar for second mortgages as long as they are performing loans even though many are underwater. The Fed will give 70 cents on the dollar for primary mortgages even though a significant portion are underwater. The government is also allowing the big banks to falsify their balance sheets by not valuing their bad loans at value. Presently Notice of Defaults are rising rapidly and Foreclosures are decreasing. This is because the big banks are letting millions of speculators live in homes and not pay the mortgage payments just so the bank does not have to foreclose on the property and show the bad loan on their balance sheet. The big banks and the speculators are being enabled with large amounts of money by taxpayers. This is the biggest Ponzi scheme in history. The only way it can succeed is to inflate(debase) our currency so the government can pay off the debt with new money. I must say this type of scheme did work for the Vietnam war debt in the 70's but our country's population has much, much more debt in relation to GDP than we did in 1974. The result of the bad government policy in the 70's was stagflation and skyrocketing interest rates.
My concern is that our country has much, much more debt as a percentage of GDP than it has ever had before. Also I am concerned about why we are creating the debt. The debt is not being created to help our country. It is being created solely and absolutely to bail out speculation. We are bailing out Wall Street and speculators that are favored by our government. Savers are still being punished. Our country's wealth has not grown in real terms for 15 years because there has been no savings. Our country's wealth has just moved from the middle class to the wealthy. The only way to create real wealth is through savings or production, not debt and consumerism. The present course that our government has set is unsustainable. As interest rates rise it will put a drag on the economy that could last a generation. My goal as always is to hedge my investments to counteract the dysfunctional enviroment that is being created by bad government policy.
I sometimes compare the stock market to a crap table. There are 2 items that are uniquely different and important to the investor when comparing the two. First, no matter how long the roll at the crap table the odds of the dice to roll a "7" are around 50%. In the stock market, the longer the rally the more the value facet of the market is stretched. I suggested in March that stock values were under fair value and it was a good time to buy. Now after a 50% run by the market stock values are being stretched and it is becoming very likely that we could have a snap back to fair value. Secondly, gamblers are always ready to make a bet where speculators in the stock market are driven by the momentum of The Herd. During the March stock lows any news about the economy was perceived as negative by the market and investors left the stock market crap table even though stock values were at a 15 year high. Today the stock market appears to be filled with helium. Nothing can drive it down. People are crowding the stock market crap table and throwing money at all bets. Bankrupt companies like AIG, Fannie Mae and Citigroup are making huge gains. I just started buying SPXU a triple inverse play on the S and P. I will slowly buy to the peak of this momentum rally and have a lot of comfort as I sell when The Herd moves away from the table after their drunken orgy of buying. It's a trader's market now. The value is in the volatility. The Fed, with it's totally dysfunctional policy has guaranteed that there will be plenty of market volatility and dysfunction in the future.
8/12/2009 - I am closely watching the 10 year treasury market. I am waiting to see the 10 year yield go over 4%. At that point I would like to buy some 10 year treasuries to hedge the cash in my house account. We will see how it goes. I am a little worried that the government will come up with a "cash for clunkers" type of gimmick in the Real Estate market. That could create more speculation in the housing market and slow my move from a rental to owning a home again. In this market any significant investment has to be hedged against the market distortion created by bad governent policy.