by Jeffrey Dow Jones
Thursday June 24th 2010, 8:13 am
| Printer Friendly
Today, on our one year anniversary, we begin with an apology.
I know, I’ve been kind of negative on the markets in the last couple of weeks. Sorry about that. I’m actually a really positive guy! This newsletter goes out to somewhere around 1,000 people now between the website and the email list. You all have become my thousand closest friends so I have to be mindful of my attitude as we build a relationship together. I want it to be fulfilling one.
In life, I prefer to hang out with people who are friendly and have a unilaterally positive oulook, so long as it’s grounded in some sort of reality and not pie-in-the-sky idealism. I take that principle with me everywhere and our mission at The Draconian is to be direct and tell the truth. Our firm has historically fostered a culture of open-mindedness and a willingness to look at things in a way that other people aren’t. We are not dogmatic and are driven instead by fact and data. This gives us the freedom to talk about all sorts of things, the way they truly are the myriad ways they could be.
With that kind of foundation — an eye for positivity and opportunity, with both feet planted in reality — I think the two of us should be able to go to some interesting places and learn some interesting things. That approach has led to some rich relationships in both my personal life and professional life. I am convinced that a mindset of “balanced optimism” will take you anywhere you want to go. We enter our second year here at The Draconian with that kind of attitude.
This week we’re going to briefly talk a little bit about psychology. But then we’re going to take a look at a specific investment — another asset class, really — that I’ll bet most of you have never considered adding to your portfolios before. Over the long run, I think the prospects for it could be rather bright.
The Glass is Half Full
I’ve written extensively that what looms in front of us is what I believe will be a decade of hardship.
Don’t be too afraid. This is all a natural part of macro cycles of culture and economics. It’s the phase where the things that need to die pass on, and it’s the phase where new seeds will get sown. We have survived these cycles before — collectively and as individuals — and we’ll survive the one that we’re facing right now. Be prudent, protect your savings, work hard at your job, and you’ll be just fine.
These environments of uncertainty and volatility make investing a very difficult job, especially for the average family on Main Street. But there are tons of benefits to these wintry cycles, benefits that we all can reap if we keep our minds open.
Consider:
- Cycles of hardship can be enormously helpful from a psychological perspective. We release the unrealistic expectations that we developed in the latter days of the boom. Getting our expectations back in line helps us reduce the suffering we’ll feel in the future when reality doesn’t conform to the ridiculous expectations we used to have.
- During these tough times we get back in touch with our family. The multi-generational household has made a huge comeback. Family is what it’s all about, yes? There are many economic and emotional benefits to having more family around more of the time.
- Just about every single respected source on the matter will tell you that happiness is driven much more by establishing quality relationships with other people than amassing material wealth. I know there’s a correlation between income & happiness at low levels of income, but it starts to flatline at a rather modest level and that continues all the way out the wealth curve. Check out this delightful TED talk from one of my intellectual heroes, Daniel Kahneman, on the subject of happiness and memory:
- We learn the lessons we need to learn to set ourselves up for a new cycle of growth and success. I am a firm believer in the importance of linking cause and effect when it comes to learning. Some of these effects of the last several years have been painful, but that pain has started to shift our focus towards identifying the root causes.
I’m as big a cynic of politics as you’ll find, but even I believe that eventually that mindset will trickle up into Washington D.C. Those senators and congressmen are nothing more than a reflection of our current national interests, and at some point, when people have felt enough pain and are fixated enough on identifying the root causes so as to avoid future pain, we’ll have representatives that actually address them.
Cleaning out all those lobbyists may help too.
Ready for our second year
When we launched The Draconian last June, I set forth our threefold goal of being informative, useful, and entertaining. We’ve been in the industry for a long time, long enough to see that the “Business Elite” are advantaged in many ways. Most of their advantages boil down to simple education, and we thought we could be of value to you by sharing some of this insight while having a little fun along the way. Upon reflection, I think we’ve done an OK job of that so far with some work still left to do.
If you agree or disagree, or wish to share some thoughts on either the year behind us or the one in front, please send me an e-mail. Feedback@TheDraconian.com is the way to do it.
I really do look forward to hearing from you. Unlike a lot of the investment newsletters out there, that e-mail address goes straight to my desk, free from any administrative filters.
Now: instead of talking about all the things I don’t like, this week we’ll talk about an investment I do like.
I think you might find it exciting too.
Wood you believe…
Raise your hand out there if you’ve ever considered trees as an investment. Anybody?
I see a few of you Jeremy Grantham disciples with your hands up. We talked a little about his latest predictions back here. Timber has long been a favorite asset class of GMO’s legendary value-hound. Grantham is fond of pointing out that timber was the only asset class that didn’t lose its value in the Great Depression or the 1970′s. He currently forecasts a 7.5% annual rate of return for the next seven years.
Perhaps the rest of us should grab a little wood?
Don’t laugh! Wood is an awesome resource. It’s naturally occurring and extremely strong relative to its weight. Would you believe that Balsa has a higher strength-to-weight ratio than steel or titanium? There’s a reason it’s used in model airplanes and full-scale light aircraft. Since wood is so strong, light, and inexpensive, we use it to build all sorts of things from pencils to desks to houses.
General construction accounts for half of all timber consumption. Most of the rest gets turned into pulp and paper products and about 10% is used in various wood composites and as fuelwood. Timber has been an important resource for pretty much all of civilized history and that’s not going to change in any of our lifetimes.
It’s sustainable too. Major timber companies don’t just chop down trees and move along to the next site, leaving Mother Nature to sort out the wreckage. Having grown up on and around Lake Tahoe, I can speak from personal experience about respecting the natural beauty of our mountains. Before Nevada was admitted to the nation, the Tahoe basin was nothing more than a source for cheap lumber to ship over the mountain to the mines in Virginia City. We’re still recovering from the clear-cutting and mass de-forestation that occurred over 150 years ago. If you can find a copy of E.B. Scott’s The Saga of Lake Tahoe pay whatever it costs to pick it up, especially if you’re a local. It’s a beautiful pictorial history of the region that we Nevadans are so proud to be a part of. I wonder if the loggers in those early photographs had any idea about the eden of wealth and majesty that Tahoe would eventually become.
So these major timber producers adhere to some sort of sustainable forestry guidelines that are set forth and audited by third-party organizations. Basically, these guidelines boil down to a) planting more trees than they harvest each year and b) being sensitive about specific tracts of land that certain groups and communities deem valuable for non-economic reasons. Check out the Sustainable Forestry Initiative or Forest Stewardship Council if you’re interested in that sort of thing.
For companies that are engaged in the business of chopping down trees, timber producers don’t have as bad a track record with environmental groups as you might think. These guys are experts at growing trees in efficient ways and since the growing cycle is long-term, it’s certainly not in their interest to destroy the environment that powers their inventory. Oil companies or miners don’t have their interests aligned with the environment the way timber farmers do.
The investor’s perspective
There are a few big reasons why investors should be interested in timber as an asset class.
The most important is that it doesn’t really correlate with equities. From 1987 to 2009 the correlation coefficient between the NCREIF Timberland Index and the S&P was about 0.3. Statistically speaking, that’s not very meaningful and a wonderful thing for investors. Remember that the ultimate goal of portfolio construction is to combine assets that each make money over the long run and don’t correlate with one another. Around here we get excited about things that don’t correlate with other things. Maybe that makes us big nerds. But we use these things as tools to lower our overall volatility and increase our portfolio’s return per unit of risk. Nothing nerdy about that.
Timber has interesting cash flow properties too, similar to a long-term zero-coupon bond. You plant the trees for a really cheap price, wait a long time for the trees to mature, and then sell them for a lot of money. If you’re smart about rotating your timber stock (or laddering your bond portfolio), you can time these cash flows so they arrive on a steady and predictable basis.
Since wood is a commodity, it also acts as a hedge against inflation. As prices rise over time, so does the value of your timber stock. Inflation is a good thing if you’re in the business of growing trees! Deflation can be a short-term problem, but we live in a world of central bankers who are haunted nightly by the grim visage of deflationary specters. So that kind of thing never lasts for very long. Plus, another advantage of managing inventory with a 15-30 year life cycle is that if there’s a year where lumber prices collapse, it isn’t that big a deal. You just let your trees keep growing and then harvest them next year when prices have recovered. What business out there can afford to let inventory sit idle for years?
On top of all that, timberland is a long-term bet on land prices. Until we figure out efficient interstellar travel the supply of land will remain fixed. There’s only so much of it to go around on Planet Earth and each year more and more people are born who demand this fixed supply. That’s a good thing for the balance sheets of these timber producers; basically the entire asset column consists of something that will always have a large amount of intrinsic value. The same cannot be said for the bank stocks. What is the intrinsic value of a CDS or a bag of dodgy loans? Give me a few acres of forest instead.
Sounds pretty cool, huh?
Here’s how to play it
The big boys do it through private partnerships. Institutional pools of capital will get together and they’ll go out and purchase actual timberland. It requires a lot of money to do it this way, and a lot of knowhow. Grantham’s GMO manages a few forestry partnerships. Some super-wealthy investors do it on their own.
For the average investor, the easiest and most direct way is through a couple of specific stocks or an exchange traded fund.
Plum Creek Timber (PCL) and Rayonier (RYN) are the two biggest, publicly traded timber producers in the U.S. In fact, Plum Creek is the largest private landowner in the nation with over 7 million acres of timberland on its balance sheet. Here’s a chart of PCL since 1989. The S&P 500 is the green line.
Not too shabby. It’s outperformed the market by a long ways.
The last 10 years have been tough for the market and for most investors. Here’s a 10-year chart of Rayonier. The red line is the DJIA.
As you can see, they did pretty well too and are almost back at a new high. It’s been a much better decade for the timber industry than the rest of the economy. But what about the years to come?
Plum Creek currently trades about 5 times gross sales and 4 times book value, which isn’t cheap. It’s structured as a Real Estate Investment Trust (REIT) which means that it doesn’t pay any corporate taxes and has to distribute at least 90% of its income. This structure makes traditional valuation a bit more difficult since net earnings work a little differently. Plum Creek has always traded at a fairly high multiples but that valuation has been justified by outstanding returns on assets and equity as well as historically large profit margins.
The stock also pays a 4.5% dividend and they just finished up a $200 million share repurchase program. I like companies that send a sizable chunk of their earnings back to their investors and use some of the rest of their excess cash to make investments in their own stock. These guys have demonstrated the ability to reallocate capital in productive and shareholder-friendly ways.
Rayonier tells a similar fundamental story and it pays a similar dividend. They don’t own as much land and they’re about half the size, but their business is a little more diversified. They’re a little more engaged in developing their higher-value land as real estate and they also manufacture cellulose fibers for various high tech uses. Rayonier correlates very closely with Plum Creek.
With investments that aren’t fundamentally cheap but have strong and stable long-term prospects, I find the following strategy useful. Scale your way in slowly. Pick up a little bit whenever you feel ready. After that, wait for events during which to acquire more shares. I fully expect a few more deflationary mini-panics in the next year or two, finite windows where investors sell whatever they can get their hands on and commodity prices plummet. When that happens you can increase your position when these stocks are trading at more of a discount.
A few more ways to do it
There are a couple of other options out there. Take a look at Sino-Forest. It trades on the Toronto Stock Exchange under ticker TRE and on the Pink Sheets as SNOFF. At present, they only carry about $1 billion of debt against about $2.7 billion of land. With a market cap of only $4 billion, you’re buying the rest of the $250 million/year business rather inexpensively.
The intriguing thing about Sino-Forest is that they are one of the biggest forest owners in China. They have grown like crazy over the last decade as they’ve struggled to keep up with bottomless Chinese demand for building materials. Sino-Forest is also one of the largest holdings in the Gabelli SRI Green Fund, whose positions must adhere to “a broad base of socially responsible and sustainability criteria.” China isn’t what comes to mind when I think of environmental friendliness, but it goes to show that sustainable forestry isn’t that bad from an environmental perspective.
Claymore also offers a Timber Index ETF with the clever ticker symbol “CUT“. This fund offers globally diversified exposure to the sector, but CUT has underperformed both Plum Creek and Rayonier since the fund’s inception in December 2007 and it’s done it with more volatility than the S&P. That’s a small sample size from a very unique window in time, so I still think it merits watching. iShares offers a timber ETF as well (ticker: WOOD). It has a greater weighting towards domestic producers and contains more pure-play timber names instead diversified re-sellers of wood- and pulp-based products.
Keep in mind that timber is a long-term play. It’s sort of a “buy-and-forget” investment. I think that’s also why I like it. My brain thinks in terms of long-term cycles — I have no idea what to do about the day-to-day fluctuations of the market — so the multi-decade cycle of a timber farm naturally appeals to me.
It’s also an easy business to understand. Plant trees. Wait. Harvest trees. If I learned one thing from listening to Warren Buffett over the years (and also from managing our own hedge funds), it’s that people should invest in things they understand. There’s nothing complicated about the timber business.
I’ll admit, it’s tough to find good investments in this current climate. Our newsletter is dedicated to helping you all get through this tricky decade in one piece. It’s just as hard to make you laugh or make you think, and we won’t stop trying to do either. It’s important to have fun and keep our minds open to new ideas. There’s a lot more to life than investing, and as we’ve written so many times before: it is all connected.
Thanks for riding along through the last year. I’m pretty excited about the year ahead and am glad that you’re with me.
by Jeffrey Dow Jones
Thursday June 17th 2010, 6:48 am
| Printer Friendly
This week we take a look at what might be in store for the real estate market. By this point, you all have probably read Some Straight Talk on Housing, so today’s newsletter will serve as an update to that one. Residential real estate has been a troubled sector, especially from an investment perspective.
But what might be on the horizon? Is the deflationary phase of great housing bubble finally over? What should homeowners and investors expect from this point forward?
We begin with a story that may sound familiar.
Original Sin, Housing Style
When did I know there were problems in the housing market? I’ll tell you when. Most of my friends have heard this story before so you guys can scroll ahead.
The year was 2004 and I was in the process of buying my first house…
If you were living under a rock and missed the inflation of the bubble, all you need to know is that it was a pretty crazy time. I was buying a new house and I distinctly remember that the realtor said that most people make between $15- and $25,000 between the day they contract to buy it and the day house actually gets built. I had just emerged from three years of sorting out the wreckage of the dot-com disaster. That kind of easy money sounded strange to me.
Still, I was pretty excited. Home ownership was the American Dream! My mom was proud.
Eventually I found a floorplan I liked. Then the banks got involved.
My builder suggested I talk to Wells Fargo who said, “Sure, we’ll give you a loan. No problem.” But a day before escrow was supposed to open they called back and said, “Sorry, we can’t give you a loan.” Something about loan-to-value or income ratio. In retrospect, I really had no business getting a home loan in the first place. My income was indeed too low.
Then I called E*Trade Mortgage. We had the following exchange. It’s pretty much verbatim.
E*Trade: Thank you for calling E*Trade Mortgage. How can we help you?
Me: I’d like to get a home loan.
E*Trade: No problem. How much do you need?
I told them. It was $258,500. I was able to put 10% down which was probably way more than they were used to.
E*Trade: OK, that’s no problem. What’s your income?
Me: $50,000. (I had just received my first raise at my new job. It seemed like a ton of money at the time, and perhaps it was for a guy who was living in his buddy’s spare bedroom with only a handful of assets to his name.)
E*Trade: Hmm. That’s not going to work.
Me: What does that mean?
E*Trade: Well, the system won’t let me do it. It says your income is too low to support this loan. But with this type of loan that doesn’t matter. Your income is what you say it is.
Me: That’s interesting. How much does it need to be?
E*Trade: I can’t tell you that, but if you give me a number, I can tell you if it works or not.
Me: OK. How about $60,000?
I heard her typing on her keyboard. A click click followed by a “hmmm” and then a “no.”
Me: OK. How about $70,000?
I heard more typing, another “hmmm” and another “no.”
Me: OK. How about $80,000?
E*Trade: Yes! That works!
She sounded very happy for me. Happy, I guess, because I was getting a loan. But it might have been because she was about to get a commission.
Immediately after hanging up the phone I went back into Mike’s office and told him the story. I was shocked. He was shocked. Right then and there the two of us sat down and tried to think of all the ways that we could short the housing market. Things were clearly heading for disaster. Some day I would actually make enough to honestly support my mortgage payments, but what about the guy who never would or told an even bigger lie about his income? What about the guy who wanted to buy it just to resell it? There were a lot of those in Nevada, you know.
But there were two problems with Mike & I trying to get short the housing market. The first was that it was 2004 and we were about a year and a half too early — house prices were still going up! The second problem was that neither one of us were smart enough to figure out a way to actually execute that trade. Later that year the two of us went to visit one of the hedge funds our firm had invested in. Those guys were trying to get short the housing market too. But they weren’t sure how to do it either. And those guys were really smart. One of them co-founded PayPal and sits on the board of Facebook.
So I guess that’s when I knew there was something wrong with the housing market. Obvious fundamental problems and no obvious way to short it.
Oh. I almost forgot. This story has an epilogue.
The Epilogue
I didn’t make a single payment to E*Trade Mortgage.
In less than two weeks after closing escrow my loan had been sold, packaged up, and shipped downriver to… wait for it… can you guess who it is… is the suspense killing you… Countrywide Financial!
Apparently they had appetite for garbage loans like mine. That appetite got them killed. Or technically, got them eaten by Bank of America. Go ahead and fill in your own joke about Bank of America’s appetite.
The problem with real estate, as a market.
The real estate is market works a little differently than the stock, bond, and commodities markets. For one, it isn’t very liquid and pricing isn’t always clear. This is what happens with assets that don’t trade on a centralized exchange. It’s difficult to convey decisive information about value, especially in real-time.
On top of that there isn’t really a good way to short housing, and this is troublesome for the market. A few weeks ago I was watching a CNBC interview with the legendary short-seller/cult-hero, Bill Ackman. He made this same point, that one of the (many) reasons that home prices got so out of hand and took so long to come back down was that because it’s nearly impossible to sell the housing market short.
Short sellers get a bad name in the press but one legitimate function they perform is keeping market prices honest. When an asset is obviously expensive, short-sellers typically step in to take the other side of the crowded trade, acting as a catalyst to send the asset’s price back towards fair value. Short-selling carries some extra danger and these guys only do it if the potential profits are worth the higher risk. As a result, short-sellers like Bill Ackman are very, very diligent about making sure both their analysis and execution are correct. The costs of being wrong can be catastrophic. Nine times out of ten, it’s the short sellers that first identify fraudulent companies, and it’s the result of very thorough investigation.
But in markets where nobody can go short — markets where it’s only possible to buy the asset or choose not to own it — bubbles can easily develop and remain artificially inflated for a long time. This is an important thing to keep in mind when assessing the worth of real estate as an investment.
A second leg down in housing?
A couple of weeks ago I heard Meredith Whitney on one of my Bloomberg podcasts. She was one of the earliest, loudest critics of the major banks before the crisis. If you’ve never listened to her speak before, she talksreallyfast so transcripts of her interviews aren’t always so elegant. I emphasized the important points.
What has kept home prices stable – and make note that politicians and banks are eating their own cooking because they really believe home prices are stable – they’re stable because there’s been a ton of inventory kept from the market. Soif you control the supply, you can control the price without controlling the demand.
Here’s a statistic that I find fascinating. This is just for the top four banks. If you look at nonperforming assets – that’s loans that haven’t paid over 120 days – the size of that is 1.5 times all of the chargeoffs that banks have incurred since 2005. So you think credit has stabilized, mortgages have stabilized? Non-performs have ballooned so they’ve more than doubled since the beginning of 2009, and that’s just stuff that has to start going on to the market, and interestingly, this quarter you’re starting to see housing supply reach the market. That to me triggers another down leg in housing, so to me, I’m steadfast in my belief that there’s going to be another double-dip in housing
There’s huge growth in non-performing assets. These are numbers, apples-to-apples, on the four big banks. The issue is when does that stuff that’s not paying come to market, and when do banks recognize the chargeoffs? I think you’re going to see more of that in the second quarter and the third quarter. Does the supply move in the second quarter and then you report it in the third quarter? The timing may be weighted more to the third quarter. I just don’t know. I think you see a huge leg down in asset prices when you see the supply reach the market. So no, it’s not factored into valuations. No, it’s not factored into bank guidance. And yes, I think it’s going to be a big problem for the banks.
That statistic about loans that are 120 days past due is staggering. 1.5 times all the charge-offs that banks have incurred since the very start of the housing collapse! If you’re 120 days past due on your loan, you’re either in big financial trouble or you’ve chosen to default, both scenarios which are really bad news for the bank that holds your loan. In normal markets, banks would have foreclosed already on a lot of these homes. But by electing to just do nothing, the banks are in effect able to control the supply of houses, the price of them, and protect their balance sheets in the process.
Thank goodness we did away with mark-to-market accounting! Many savvy folks say that was the proverbial straw that broke the camel’s back, catalyzing the disintegration of all those junky securities. Those rules were re-jiggered on — conspiracy alert! — March 16th, 2009, almost the exact bottom of the financial crisis. Banks no longer have to mark this stuff at what it would fetch in the market right now. They get to mark it at what they think it’s worth, at what their models say it would be worth in a normal market. Actually, Bank of America defines it as “the most advantageous market … in an orderly transaction.”
How far ’till bottom
First let’s take a look at the most widely-used measure of home prices, the Case-Shiller Index:
You can see that the homebuyer’s tax credit gave the market a shot in the arm last summer, but since that’s over, a second dip has clearly begun.
Now let’s have a look at an updated version my favorite housing chart:
I think one of the most helpful things to do when assessing real estate is to relate home prices to income. That’s the red line in the chart above, the median home price divided by the median family income. Today we’re back in a more normal range, but there’s still some room to overshoot on the downside, especially with structural economic headwinds like we’re currently facing.
With these chart as our guide, it’s reasonable to be concerned about another 5-15% drop in price depending on how severe the economic headwinds and how low mortgage rates stay.
In addition to a simple analysis of price behavior, we can look at fundamental factors like supply and demand. Let’s put that Econ 101 knowledge to use!
Here’s a chart of supply, courtesy of our friends at Calculated Risk:
There’s still a ton of supply out there relative to historical norms, by a factor of about two. What’s more concerning is a recent spike in inventory. That could translate into more months’ supply later in the year and could be real hindrance for home prices. That’s exactly what Meredith Whitney was talking about.
Keep in mind that none of this includes the “shadow housing market,” houses that are bank-owned and not on the market, severely delinquent borrowers whose banks are willfully looking the other way, or “sideline sellers” who are just waiting for better times to put their house up for sale. In a normal market, homes like that would already have a “For Sale” sign in the front yard, and as things slowly sort themselves out these properties will trickle back on the market. This side of the market is being tightly controlled right now.
The supply side is better than it was and moving in the right direction. But it’s still pretty grim (if you’re a seller), and there’s still a long way to go before it gets back to normal again. We’ll continue to monitor this carefully.
What about the demand side?
On the demand side, prices are driven primarily by two things:
Income – how much current and future income the buyer has available to allocate to a house.
Interest rates & lending standards – how accommodative the environment is to enabling them to pay more for a house.
I think you guys have a pretty good idea how that’s going to go. Real incomes haven’t gone anywhere in 12 years and it seems unlikely they’ll increase any time soon. Shoddy lending standards are also gone for good — loans like the one I got back in 2004 aren’t being written anymore. Lenders have to, like, actually verify stuff now.
The best bit of news is that interest rates are still ridiculously low. They’ve actually gone down in the last month or so while the global equity markets panicked on an EU-driven wave of economic concerns. I’m now seeing 30yr mortgage quotes at almost 4.5%. A one percent increase in interest rates reduces purchasing power of buyers by about 10% and a corresponding drop in price. The Fed knows how important the housing market is to an economic recovery and they know how important a factor interest rates are in home prices.
You can do the math: rates will stay low for a while a while.
Jobs, Jobs, Jobs
Here’s another interesting chart that relates the level of unemployment to mortgage delinquencies:
No surprise that those two data points correlate strongly. If you lose your job you’re more likely to stop making your mortgage payments. The housing market won’t firm up until the job situation improves substantially.
What is surprising is how bad things are in Nevada. Over 20% U-6 unemployment and nearly one fourth of all mortgages are delinquent!
On top of that, 70% of all the mortgages in Nevada have negative equity. 70%! The national average is about 20%. No wonder that basically every listing in Reno is a short sale or foreclosure. I did a quick survey around town and found that for the most part, the sensible listings are priced around what these houses were worth back around 1999-2002.
The right way to look at housing
We’ve always said that unless you really know what you’re doing, residential real estate is a lousy investment. It always has been and the average person should not think of it as such. You should think of your house simply as a place to live.
Beyond offering basic shelter and comfort, a house has always acted more effectively as a mechanism for forced savings. I know that changed for a brief window when lenders stopped requiring down payments and handed out HELOCs to anyone that asked, but things are now back to the way they always were. Owning a home forces you to send a little bit every month towards reducing the principal of the mortgage and increasing your equity in the home. Theoretically, that equity comes back to you if you ever sell your house.
I know that didn’t happen if you bought in the last decade, especially in hard-hit states like Nevada. A lot of piggie banks got wiped out as prices collapsed. But if you buy a house in the next decade, there’s a much better chance that your savings will be protected.
In a perverse sense, I think this could actually be a good thing if you’re a buyer who still has a healthy balance sheet. If you were prudent enough to protect your cash over the last several years, there could be opportunity out there. I think there are a lot of families who can handle a $1,500 monthly payment but don’t have anywhere close to the $50-75,000 down payment that would be required with that kind mortgage. Not everybody is in a position to benefit from these low mortgage rates and reduced prices, and if you are, you probably won’t be hurt too badly should you choose to take advantage of them.
I suppose that’s a lukewarm endorsement of the market as a whole.
What are the big boys doing?
It’s clear I’m not the only one with a long-term perspective on real estate. Most of the major homebuilders like KB Home and Toll Brothers have been busy scooping up land in the last few months. They’ve been quite public about this, which makes me wonder. Why are they being so noisy about their land acquisitions? They’re probably being noisy about it to reshape their public image, but that’s not the only reason. Toll Brothers’ inventory has declined for three straight years now, from $6.1 billion to $3.2 billion and at some point down the road they will need more land to build more houses. That is their business, after all. May as well buy at distressed prices.
I recently heard about a local developer who just purchased 40 undeveloped lots in one of Reno’s luxury gated communities. They picked these lots up for a song, about 75% less than what existing lots up there are listed at. Their plan is to just sit on these things for at least five years and then see where the market is at. This isn’t the only incident of something like this happening around town, either. My guess is that the large homebuilders are getting similar deals on the land they’re buying.
So it sounds like the big money is thinking long term, like ten years out. It sounds like they might see some upside way out there and that the downside is manageable enough to take action right now.
When I add it all up, I don’t see a lot of positives for the market, but I see much less chance of getting hurt. I still think there’s another 5-15% of downside in home prices. In tough markets like Nevada, I think the probability of seeing further declines is very high. So many people here have lost their savings or their jobs and there are so many houses for sale out there. In healthier markets, I wouldn’t be surprised if the bottom is already behind us. States like North Dakota didn’t really have a collapse in prices because they didn’t really have a bubble in the first place.
I don’t hear the question “will housing get back to where it was?” much anymore. The answer to that one, of course, is “no.” But the fact that people have stopped asking, stopped hoping, and started realigning their expectations is a positive step on the journey towards normalcy.
Another lukewarm endorsement of the market, I suppose.
by Jeffrey Dow Jones
Thursday June 10th 2010, 7:04 am
| Printer Friendly
This week we’ll review the markets and see if we can catch a glimpse of the future. We’ll also talk about another potential booby trap to watch out for. But before we do, we’ll try and get some historical context. As is our custom, we shall look beyond the traditional world of economics and politics to see what we can learn.
30,000 years of barbarism
The First Galactic Empire had endured for tens of thousands of years. It had included all the planets of the Galaxy in a centralized rule, sometimes tyrannical, sometimes benevolent, always orderly. Human beings had forgotten that any other form of existence could be.
-Isaac Asimov, Second Foundation
Let that sink in for a moment.
Remember the days when none of us could fathom a U.S. economy that barely grows or a housing market that never goes down? Remember when we thought 5% unemployment was where we’d always stay and that the stock market would go up every decade? We forgot that things could be different, despite centuries of evidence to the contrary. We have learned our lesson now, yes? Our history is a history of unforeseen change.
If you’re unfamiliar with Isaac Asimov’s Foundation trilogy, you need to know that it’s one of the most important works in the world of science fiction. If you’re a fan of literature, it belongs on your bookshelf. The story centers on Hari Seldon, a genius mathematician who develops a new science that can accurately predict the broad path of the future. He foresees, against all popular opinion, that the mighty Empire, having enjoyed tens of thousands of years of unified peace and prosperity, is actually on the brink of collapse, a collapse that will thrust the entire galaxy into 30,000 years of chaos and barbarism. Averting the collapse is impossible, but Seldon proposes a plan to reduce the coming Dark Age from 30,000 years to a single millennium. Exactly how this happens is told in Foundation and subsequent books.
Like all great science fiction, Asimov’s works are a comment on society. In fact, he drew most of the inspiration for his Foundation series from Edward Gibbon’s The History of the Decline and Fall of the Roman Empire, the definitive chronicle of the dark years that followed one of history’s greatest empires. Asimov wrote the original trilogy in the early 1950′s, a time when the U.S. was finally emerging from it’s own miniature Dark Age. A lot of major stuff was published during that era which today is recognized as the golden age of science fiction. It was a difficult time for the world, a time when a lot needed to be said about society. Sci-fi legends like Asimov, Robert Heinlein, and Arthur C. Clarke did the philosophical heavy lifting and taught us about the world and ourselves in the process.
If you’ve been reading The Draconian for any length of time, you know that it’s our belief that we are at the beginning of an era of hardship. For lack of a more precise estimate, we think it will last for a decade or so. During this period everyone will sacrifice, and the sacrifice will take different forms depending on how much money you make. If you make a lot of money, you’ll have to contribute in the form of higher taxes and tougher policies on top-decile pay. If you don’t make a lot of money, you’ll have to contribute in the form of reduced entitlements and benefits. All of us will have to contribute in the form of a more difficult, more competitive job market and a permanently higher natural rate of unemployment. Business will be slower; incomes will stagnate. The risk of inflation is still quite a ways out, and that will be another way that we all pay. That might be the final way we buy our departure from this debt-fueled gravy train.
This is not a popular view at present.
Unfortunately, we are not geniuses like Hari Seldon and we don’t have a plan to shrink this decade of hardship into just one year. You may have noticed that the leaders of the U.S. Empire think they are geniuses and have been trying with all their might to soften this forthcoming decade of hardship through bailouts, stimulus, and good ol’ fashioned money-printing. Those of you that are paying attention will also notice that these actions are exacerbating many of the problems that brought about the crisis in the first place. We have treated the symptoms but have made little attempt to cure the disease.
Elder wisdom
It’s been a full generational cycle since our last era of major hardship and sacrifice, the one that Asimov wrote about under the guise of distant galaxies, alien spaceships, and sentient robots. There have certainly been no shortage of books on the economy in the last couple years. A few are even pretty good, but sometimes I learn a little more about where we are today by going further back and revisiting some of that classic science fiction. It’s why I read Isaac Asimov.
It’s also why I read Richard Russell.
Richard Russell was part of the GI generation, who grew up during the Depression and fought in WWII. There aren’t many of his kind still around. Even fewer are actively writing about the markets today. Russell certainly has his share of critics, most of whom harp on his never-ending pessimism of fiat currencies and undying love of gold, but he brings a perspective that’s unique. In short, he has seen things that the rest of us haven’t.
Something he wrote over on Dow Theory Letters last week really stuck with me:
I’m aware that many of my subscribers are skeptical of my warnings regarding the years ahead. The generations since the end of World War II have never experienced hard times. I’m aware that it is difficult to envision what you have never experienced. If I have one unusual talent, it’s the ability to envision vast change.
I’ve been reading his newsletter since 2003. I’ve read enough to know that he’s right about as often as he’s wrong (the best any of us can hope for, I suppose). But I don’t read his newsletter for specific recommendations on this or that. I read it to be reminded of all that came before me and the generations that currently populate the country. It’s one of the few places I can go to get that. For the most part, we have lost our tangible, living connection to the last era of national crisis. The folks who have real memories of the Depression and War, whose values were permanently re-shaped by those dark times, have almost died out.
It’s worth mentioning that the dawn of the Great Depression crisis was a time when those people who had actual memories of the Civil War, the previous major national crisis, had mostly died out. Very few people in the late 1920′s had the capacity to imagine life being any other way. And when the Civil War cleaved the nation in two, there weren’t many still around who actually experienced the chaos and barbarism of life in Revolutionary America. Things had been going pretty well for about 70 years; who could have possibly imagined such a traumatic affair was right around the corner?
I’m sure there’s a reason why history writes itself this way. Just as we all forget the lessons we were supposed to have learned, something happens to teach us again, something that will keep us from ever forgetting. But then we die, and the cycle repeats for a new wave of generations.
I guess this is why I cling so tightly to living perspectives from that era, perspectives like Richard Russell’s. My grandfather on my mother’s side came from a wealthy family that lost everything in the crash; as a young adult he was shipped off to Germany to fight on the ground. I know little beyond the facts I’ve been told and little about the kind of person he was, evidence that has now been swallowed by history. He died when I was very young, but what I wouldn’t give to really get to know him today.
He certainly wasn’t the only young man to have an experience like that, to lose everything and risk his entire future in a bloody war. If you’re fortunate enough to know someone in the family — a parent, grandparent, or maybe a great great-uncle — ask them about eras of sweeping change. Ask them what they think of things today and if the rest of us are too narrow with our view of the present and future.
When I was a child, my parents instilled in me a genuine respect for others, particularly my elders. I suppose that is the kind of thing that one can teach, but we really have to learn for ourselves the true value of our elders’ experience. Unfortunately, most of them are gone by the time we mature to an age where we recognize the importance of this. When we are finally ready to drink from that fountain of wisdom, it’s all dried up.
One of the great ironies of life and history, I guess.
Risks that few are talking about
If you follow John Hussman, you’ve noticed that in the year since the crisis he has been talking primarily about two things:
The U.S. policy of defending bondholders who made bad loans.
A second round of credit strains triggered by a second round mortgage rate resets.
As for the defense of bondholders, I continue to believe it’s a policy of madness. People that make risky loans should have to pay the price if the loans go bad, not the taxpayer. With those kinds of consequences, maybe your bank and your pension fund will think twice before making risky moves to pick up another percent or two of yield. I know that sounds common sense, but an idea like that apparently qualifies as too draconian for our pain-sensitive society. Heaven forbid a large financial institution makes a loan and doesn’t get 100 cents back on the dollar!
The bailout reaction of the EU debt crisis is an extension of that mindset. They avoided a panic, yes. But they made the problem worse. Within the sphere of politics, I will be paying close attention to trends toward any reluctance to make bondholders whole when the debts go bad. I’ll let you know if I identify anything on this front. It will be a step in the right direction for our system.
As for the second round of credit strains, all you regular readers should now be familiar with this old chart:
Here’s a revised version:
As you can see, 2009 was a lull for mortgage resets. In retrospect, that was probably the best thing the credit markets and financial system could have asked for. It did a lot to temporarily calm things down on the credit front.
Keep in mind that what first broke the back of the market was the resetting of all those subprime loans. All those subprime borrowers initially got their loans with awesome terms like low teaser rates, 0% down payments, and the option to pay only the interest each month. Those awesome terms only lasted for a couple of years, not that the bankers really talked about what life would be like once their mortgage reset. That didn’t start happening until 2007. The fantasy terms disappeared and those borrowers’ monthly payments went way, way up. They could afford the fantasy terms but real-life terms were way too expensive so they stopped paying their mortgage, a decision made much easier after they’d seen their house lose 20, 30, or 40 percent of its value. ”Screw this!” they said. ”This is the bank’s problem now!”
Then the whole financial system fell apart.
I know you guys have all heard that story before, but get ready to hear it again through this fall and winter of 2011. It won’t play out exactly as it did, nor will the system react in the same way. The Fed & Treasury have made clear through their policy that they will not let systemically important firms implode and will inject them with enough capital to keep them solvent (aka Japanese Zombie Bank Policy). The new, surprisingly-soft financial regulation measures won’t interfere too much with the way of life that large banks have recently enjoyed. So there won’t be an industry meltdown a la Fall 2008.
But there will be some effects. I know everybody is desensitized to Really Big Numbers right now, but if you think a TRILLION DOLLARS of resetting mortgages in the next year or two — mortgages that are resetting from awesome terms to considerably less-awesome terms — won’t have an effect on the system, then I don’t think I can’t help you. Loans that are good right now will go bad, and these new delinquencies will have systemic and economic consequences. The market will react accordingly when one day it wakes up and realizes that this could pose a threat. Recall that Greece didn’t go bad overnight, though the market’s reaction to it would indicate otherwise. One week the market thought it wasn’t a big risk and the next week it did.
We talked about booby traps a couple of weeks ago. This new round of resetting mortgages is a booby trap that the market hasn’t stumbled into yet.
The good news is that things will be looking much better on this front by 2013! A few years after that, we might actually have a normal mortgage market again.
Market recap
In short, volatility continues:
For all you technicians out there, I’ve got my eye on a few key levels:
1220 – We’re still a long way from the high. A close above that level would be positive, indicative of a resumption of the cyclical bull market that began last spring.
The 200 day moving average – Since we violated the 200 day moving average, I would be much less inclined to buy on dips now. If you still haven’t taken profits on any gains on your equities yet, look to do so on the next rally. What’s most disturbing is that the market has rallied twice right up to that 200 day moving average, bumped its head, and sold back down.
1040ish – This is where most of the technical support is, and this is the level at which the market has recently rallied off of. A decisive close below this level would be very, very bad.
976 – This represents a 20% decline for the market from its cyclical bull peak. While 10% is the level that generally describes a “market correction”, 20% is the level that generally describes a “bear market”. If we break 976 on the S&P it will officially be a cyclical bear market (within a secular bear market). As you can imagine, that’s not a good sign. There is little technical support beyond that, so the market will sell off until it finds a new low. The only significant price is 666.79, the bottom of the market last March. The closer we get to that level, the more I’d want to buy higher-flying growth stocks that will most likely be beaten down on fears of a sluggish economy.
In the last couple of weeks I’ve mentioned that I’m starting to see some semi-compelling values in specific stocks. Things aren’t as cheap as they might get over the course of this year and next, but more sensible valuations are a good sign. If you are bored and desperate to invest in something, there are far worse places you can go than strong, stable companies trading at fair multiples, especially if they have prospects for growth. Especially if that growth will be happening in Asia and not Europe. All the better if they pay a dividend.
McDonald’s is a name that fits those criteria. Colgate Palmolive is another one to look at, as well as Du Pont, Verizon, and Becton Dickinson. Same with the integrated oil & gas companies that have been unfairly dragged down with BP.
Are these boring companies? Yes, these are boring companies. Does that make me a boring guy? Yes, it makes me a boring guy. But that doesn’t bother me because I think I’ll make more money over the next decade with boring strategies than the guy who goes all in on the bank stocks or chases other hot, shiny sectors.
In 2020 or 2025 when we’ve worked out real solutions to our economic problems and the dark times have officially passed (don’t worry, they will). When the future is once again filled with hope and optimism, my goal is to have a few bucks at the ready so I can waste no time getting out there and having some fun.
After such sacrifice, we’ll all certainly need it.
by Jeffrey Dow Jones
Thursday June 03rd 2010, 7:51 am
| Printer Friendly
There’s little I can add about what’s going on in the Gulf of Mexico right now.
This video is the single most interesting thing I’ve seen so far about the oil spill. I understand that there is an emotionally-charged human dimension to this story, as there are also highly-contentious political and environmental dimensions. To be honest, little of that interests me; I’m just not sure what do with stories like that and how to process them. The situation sucks. It’s tragic. A ton of people screwed up and some bad luck intervened. Let’s not sensationalize any more than we need to. Does the worst man-made environmental disaster in history require additional dramatization beyond the absolutely staggering facts of the matter?
Probably not.
Not that that will stop us from dramatizing it so. The always-hilarious XKCD offers a pretty accurate look at how that might go:
Back to the real issue…
Part of the reason why all this discussion is lost on me is that I cannot get over the raw complexity of the problem. I’m not an engineer, but I’ve hung out with enough to know that my brain operates in similar fashion. And the engineering dimension to this problem is mind-boggling. I’m surprised that there does actually exist a group of people in the world who do actually have somewhat of an idea of how to solve a problem like this, one that starts mile under the ocean and stretches for several miles beyond that. A problem that cannot be solved without robots. The conditions of this problem are way beyond what 99.9% of us can even comprehend. That doesn’t stop the rest of us from having opinions about it. Nor does it stop us from expressing them.
If you feel the way I do, you’ll understand why engineering discussions like this are so interesting and geeky webcomics like XKCD are so funny.
All right, what on earth does this have to do with investing?
I bring BP up as a specific example that’s illustrative of an important generality. Lately, a bunch of people have asked me whether BP is a good investment right now. The same thing happened with Toyota a couple of months ago.
As you can see, BP’s stock has been shellacked:
That’s about $60 billion of market cap that just evaporated. When it’s all said and done, will the total cost of this – the cleanup, the lost revenue, the ill will, the forthcoming litigation – really exceed $60 billion? The rest of BP’s revenue stream hasn’t really been impacted by this. They continue to pump and refine oil and gas all around the world.
So is BP stock a buy?
It depends on how sturdy your stomach is. Yes, there’s upside. I think that upside is pretty easy to quantify but may take a long time to realize. Until then? It’s up to you whether or not that limited upside is worth totally unknowable risk. A week ago, things seemed to be slowly getting under control. Now? Who knows. Are you cool owning BP stock if this spill drags on ‘till August? What happens when the first major lawsuits start popping up? What if BP loses a rig or two during hurricane season?
Know this: markets are pretty good at pricing things like this. They’re better at it than you or I. Everything the world knows about BP says that it’s worth $37.50 per share. This price is correct today, but it will be wrong tomorrow. When I look at the October put options contracts on BP I see fairly large premiums, an indication that there are a bunch of people who think BP may actually trade at $30 or even $20. That’s another 20-50% of risk that could be lurking on the downside.
Getting a feel for BP’s true value is like nailing down the position an electron. It involves things like “probability spheres”. I guess this is why so many quantum physicists have joined hedge funds in the last decade. These are probably the same people trying to figure out how much banks like Citigroup are truly worth. Do they have those answers? I don’t know. Quantum mechanics has probably given the world more questions than answers. Same with hedge funds.
This analysis doesn’t just apply to BP. This applies to any scenario where you might have an eye on a distressed asset, one that you think has hidden value. Maybe it was Toyota when the recalls were spiraling out of control. Maybe it was some of those GM bonds before they went into bankruptcy. Maybe it’s the foreclosure down the street.
In all of these cases the investor is anchored to where things were. They look at the asset and say, “Hmm… yesterday this thing was worth $1 and today it’s selling for 50 cents.” Who doesn’t want to buy a dollar for 50 cents?? The problem is that yesterday’s valuation no longer has meaning. Using it as a reference point can get you hurt, especially if the knife is still falling, as in the case of BP. Markets look forward and so should you. Past performance and valuation is most definitely not indicative of future results.
How to play it
If you want to take advantage of the uncertainty caused by the oil spill, why not play it more generally? Use this disruption to scale into other energy positions. Because of this latest deflationary scare (from the EU debt crisis) and the oil disaster, a lot of these energy companies have been thrown out with the BP bathwater.
Total (TOT), the French oil giant, is trading at a little over 6 times next year’s earnings. It pays a 6.7% dividend. Royal Dutch Shell (RDS.A) is trading at a little more than 7x next year’s earnings and pays a 6.3% dividend. Exxon (XOM), Chevron (CVX), and ConocoPhillips (COV) are a little bit more pricey but still pay fairly robust dividends. Or you can also get a whole bunch of energy names through an exchange traded fund like the XLE and knock out all the idiosyncratic risk while you’re at it.
There is still a lot of uncertainty with this sector right now and the risk of more deflationary scares. But over the long run, I think it’ll work itself out. Each year the world consumes more additional oil than gets discovered. There may still a bunch of crude out there, but every year it gets more expensive to tap into. Since the price of oil went nuts a couple of summers ago the U.S. has sort of given up on seriously pursuing alternative sources of energy. Hopefully, this oil spill will change that mentality. I know that the folks in Washington D.C. have a hard enough time looking past the next election, but in the century to come, the nations that build an efficient infrastructure of new energy will be the nations that dominate.
My favorite? The Japanese construction company that wants to put solar panels on the moon. If you’re laughing, you haven’t read George Friedman’s The Next Hundred Years.
Market Recap
The crisis in Europe seems to be slowly moving out of the headlines. The markets are still talking about it, though. We’ve been following the Euro/Yen cross for a while, and so you all know by now that it’s a pretty good global gauge of investors’ willingness to take risk. It goes up when investors have an appetite for risky assets and goes down when they want something safe.
Here’s a chart:
As you can see, it totally fell apart in May when everybody around the world got really nervous all at once. But what I find interesting is that it was trending down for a while before that. I think that explains some of the intuitive caution that we’ve felt since last fall. Most people just look at the stock market for a sense of what’s going on, but there are better indicators to turn to. Some of them are a little obscure, but they really aren’t that difficult to understand. We talk about them here at The Draconian because even a basic understanding of these things can give you a gigantic advantage when it comes to your own investing. When you talk to your friends about the market, tell them about the Euro/Yen cross and how that’s a really important thing to watch right now, a proxy for global risk appetite.
The LIBOR-OIS spread is another of our favorite esoteric indicators:
Remember that this one is a general measure of how banks feel about each other. It’s calmed down a little bit in the last week, but it’s still trending upward and hasn’t put together two consecutive days of contraction since early April. Regardless of what the market does, I won’t feel good about the EU debt crisis until LIBOR-OIS starts to come back in.
Banking crises invariably follow sovereign debt crises, and an EU banking crisis may still be a little ways away. That would undoubtedly be a catalyst to send global markets lower, as would a double-dip recession over there, another thing that appears to be a near-inevitability at this point. Keep your eye on LIBOR-OIS, because it’ll go bananas right before any banking crisis starts to metastasize. If you’re in the market right now and want to know when to step to the sidelines, that will be a signal you’ll want to pay attention to.
And for our final chart of the day, we’ll look at the CRB Index. This is an index of commodity prices, stuff like cotton , copper, soybeans, and natural gas.
All you technical analysts out there will notice that it seems to be putting in something of a “rounded top,” a possible reminder that deflation presents a bigger concern right now than inflation. That’s not a chart you want to get long, my friends.
I think there’s still plenty of opportunity in the market, but you have to take a stock-by-stock approach. This is what pretty much all of the equity-oriented hedge funds I know are doing in this environment. It’s hard work.
We spend a lot of time around here on philosophical, introspective stuff like understanding who you really are as a person and investor. Do you want to do a lot of work with your investment portfolio? Many people don’t. It’s OK. If this is you, don’t try to be an active investor. Have someone you trust do it for you or focus more on passive strategies. In the world of passive strategies, I think one of the best ones right now is simply “hold a bunch of cash.” We’ll let you know about all the longer-term opportunities that we see. In the meantime, go back and check out If You Try Sometimes, especially if you missed it back in April. I received more comments on that newsletter than any other to date. That tells me that investors really are interested in this under-appreciated dimension of investment strategy, this journey of internal self-exploration.
And if you are comfortable doing all the legwork or enjoy the work like we do, go at there and get after it. Right now I like boring stuff that’s a good value or pays me a nice dividend. But if you’re the kind of person who isn’t satisfied unless there is action and excitement, make sure you’ve got a little corner of your diversified portfolio that gives you what you need. Go ahead and try and play the Euro or bank stocks.
