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Monday, November 28, 2005

The housing market

For four years, I have said housing was overpriced, and for four years, I have been proven wrong by the market.

As Bill Parcells says, "You are only as good as your record says you are." Yet, despite the interventions of friends and family members, I am not willing to admit defeat on this one.

Here's why.

There is something called Fundamentals. When the stock bubble was hitting it's highs of 1999 and 2000, Warren Buffet was sticking to Fundamental analysis, and writing articles in Fortune Magazine firmly stating that stocks were overvalued. Just as Alan Greenspan was being hailed as a Maestro and he proudly accepted the Enron Award from Ken Lay, Warren Buffet was being labeled as a washed-up has-been. But who was right in the end? The "you don't need assets" Ken Lay? Well, you don't need assets in prison. That's for sure.

While Fortune Magazine won't accept my articles, at least there is this blog to express my belief that Fundamentals apply to housing, too.

So, while my brother-in-law states that "housing prices could never go down in this neighborhood" and a good friend here in Boston claims "housing supply is too limited for there to be prices declines", I firmly state: "Malarkey!"

In my opinion, housing prices are driven by two main factors: interest rates and incomes.

What has changed significantly in this boom is interest rates, allowing people with the same income to afford larger principle payments and therefore more expensive houses.

However, if interest rates go up, principal payments will fall, as will housing prices. Already, the housing market is slowing, even as long-term rates have barely gone up.

The other part of the equation is incomes. There are several components to income: number of incomes in a society, amount of those incomes, and amount of those incomes being devoted to housing. Since the 1700's, housing expenditures as a percentage of income have not changed. I don't think they have in this boom, and I don't think they will in the future.

Nor have the number of incomes nor the amount of those incomes changed so significantly since 2000, 1995, 1990 or even 1980 to warrant a multi-fold increase in the price of houses. Certainly the incomes in America are not twice what they were in 2000.

So, what, I ask, has so fundamentally changed?

Interest rates. Of course, there is the very real possibility that the housing market will "correct" by simply staying at these prices for 5 to 10 years, while a politicized Fed keeps interest rates low and let's inflation go through the roof. Although Ben Bernanke says he believes in "inflation targeting", I find it hard to believe that he will continue to raise interest rates if the economy slows down and unemployment worsens, even if inflation continues to accelerate.

In either case - whether the Fed raises interest rates and housing prices decline significantly, or the Fed let's inflation go while housing prices stagnate - one thing is clear: there will be a correction in inflation-adjusted housing prices.

"Fine, but that won't affect this neighborhood!"

Tuesday, November 15, 2005

Imbalances at a critical juncture

Across both old and new media, there is a war of words raging about the direction of the market.

On one hand, you have the optimists, who are jetting around the world from party to party, claiming this time is different (see This time Current Account Deficits and Inflation don't matter. There is a new world order that explains why the dismal scientists, the economists, are wrong.

On the other hand, the economists are locked away in their sanctuaries of study, claiming all is not right in the U.S. of A., and that we face a unprecedented set of imbalances, that either threaten to throw us into a surge of inflation or a contraction of deflation - but either way, threaten the fabric within which we have wrapped our wealth.

In my humble opinion, we are at a critical juncture in the market that will test the various hypothesises that are being put forth, and thereby help us to divine the direction in which we may be headed. In short, $55 Oil, $500 Gold, and 1250 S&P are key lines that the market has drawn in the sand. If those lines are crossed, I believe, a clearer trend will emerge.

Going back for a second to the concerns of the economists, the basis of their discomfort stems from the massive imbalances in the economy, the most pronounced of which is the U.S. Current Account Deficit. Today, that deficit is greater than 6% of U.S. annual GDP. That is tremendous. To put it in perspective, it means we have to import more than $2 billion in investment capital per day just to keep the U.S. Dollar valued where it was the day before. To date, foreign investors have been happily lending us these amounts, and then some. The concerning question is: for how long will they do so? According to Alan Greenspan's comments today, the answer is "not indefinately."

The other source of concern for some is somewhat related to the U.S. Current Account Deficit: the level of indebtedness of the U.S. consumer and the U.S. government. In total, the U.S. consumer has over $11 trillion in debt. The federal government has about $4.5 trillion in debt, while state and local governments owe another $1.7 trillion (not to mention all the Social Security and medical liabilities the government has!). The worry is that there are two paths out of this indebtedness: (1) to have the federal government print a lot of money to pay for it, which of course has the unwanted consequence of inflation; (2) to slow consumption and increase savings, which has the unwanted consequence of a slower economy, with less growth, fewer jobs, and possibly deflation.

To the optimists, all this worry is silly. Debt is at a record high, but so are assets. The net worth of individuals (assets minus debt) in fact has never been higher. The counterpoint is that asset prices have been inflated by low interest rates, and once interest rates go up, the true overwhelming nature of the debt will be revealed. Who is correct? It is difficult to say.

With such complex arguments being put forth, how can an individual investor know which extremity will win out - or whether we will just muddle along with moderate growth and moderate inflation. To make matter worse, the level of complexity described above is just the beginning. In this globalized world, to truly understand the trends in an economy, one must also examine competing economies and currencies. How Japan sets its interest rates or how fast China decides to grow its money supply, all will effect the economy in the U.S. For now, let's just stay with the simple case, and we'll explore the other factors in future posts.

While it will take years for the true path to reveal itself, in the short run the three previously mentioned indicators should be helpful. The first and probably most important is Oil. Oil has been on a long run-up. It is hard to believe a barrel of Oil was trading in the low teens in the 1990's. Since reaching that low, it has skyrocketed, exceeding almost all analysts' projections. Several weeks ago, Oil set a multi-decade high of just over $70 a barrel. Since then, it has come down to around $58 a barrel, where it is today.

Because Oil is such a vital and worldwide commodity, some, including me, see it as a possible indicator of larger trends, such as how fast inflation is growing in the U.S., and what effect foreign economic and money supply growth will have on U.S. inflation. In other words, if Oil is in an even longer term run-up, the more dire predictions of massive inflation are more likely to come true.

To determine the long-term trend of Oil, it is important to see over the next two months whether Oil breaks below $55 a barrel, or stays above it. If it breaks below $55 a barrel, then the trend has been broken. This is no guarantee that the trend will not resume, but a fairly strong indicator that at least for the medium term, the price of Oil will remain somewhat contained. If, however, it fails to go below $55 a barrel, then it will likely retest its high of $70, and at that point, we should all watch the $70 mark carefully. If it can break that, then we may be in for real trouble.

Any comments that aren't spam or obscenities are much appreciated!

Sunday, November 13, 2005

Where to Invest

If you're into investing these days, you have to be very careful.

The world is awash with liquidity, which has driven up lots of asset prices, from housing to bonds. While stocks have come down somewhat, they still trade at a slightly elevated historical price-to-earnings ratio.

There are lots of places to make money, you just have to look a little harder these days.

To start with, here are my high-level thoughts on the state of the market, and where I'm focusing my research.

1. Housing. No way. Don't touch it with a 10-foot pole. Housing is way over-extended, and is already starting to come down a little. Housing prices depend a lot on interest rates, and interest rates are still going up. Until it is clear we are at the top of an interest rate cycle, I'd stay away from investment properties, REIT and other housing investments.

2. Bonds. Stay short-term and high quality. While there are some really nice high-yield bonds out there (I'll cover this later), the Fed is still raising rates. It is unclear exactly where long-term rates are going, but in my humble opinion, I think inflation is not only underreported, but underestimated going forward. Europe and Japan are talking about raising rates, so we could be in for a cycle of rising interest rates. Stay in short-term, high quality bonds and wait until it's clear interest rates are topping out. Only then will it be profitable to extend to longer term maturities.

3. Stocks. There are a few good plays out there. Price-to-earnings ratios are still a little high, but even so one can almost always find some real values in any environment. My personal favorites right now are:

UNAM - $9.49 - a small insurance company that trades just above book value and under 9 times P/E. They got into new lines of business in the late 1990's and lost lots of money. They got out of those businesses around 2000 to focus on their well-understood and profitable California P&C business, but the market is still treating them as if they had the bad businesses. A good value.

GLGC - $4.02 - also trading just above book value, this pharma research and services company is finally getting its two core business to be profitable, and getting into a 3rd, very exciting business. They are very undervalued on a metrics-basis, because the market doubts their ability to get profitable. I think the market is wrong, plus, I think the downside is minimum give their quality assets and high levels of cash.

4. Beware the Fed. I think the Fed is going to pump money into the system via the Repo markets, even as they raise interest rates. This should keep everything humming along, and we may see a holiday rally as is typical of this time of year. Looking into 2006, things are a little more scary, as increased liquidity and strong global growth may continue to generate inflation and force the Fed to continue to increase interest rates. A key metric to watch in the coming weeks will be if Oil stays above $55. The long-term trend in Oil is up, but if it breaks below $55, it will have pushed through it's downside support line. This could signal inflation is not as bad as I have been thinking. If Oil does stay above $55, however, and begins to rally, it could spell bad news for inflation and interest rates in 2006.

That's all for now!