Reforming Property Ownership

With 25% of all mortgage holders in the US owing more on their notes than their homes are worth, and distressed transactions account for 66% of sales in CA, it is important to step back and ponder the significant role that emotion plays in the largest segment of most people’s net worth. Do we have a healthy relationship with property ownership in this country?

If you look at the property boom that spawned from the “dotcom bust,” we see the collective heard shunning fantasy business plans and instead opting for “hard assets.” But there are a few inherent issues with investment in real estate that make it a potentially dangerous asset class:

• As mentioned before, Americans have more of their wealth in Real Estate than any other asset 
• Property and debt go hand in hand—and the banks that secure that debt set aside less money for those loans because of the property as a hard asset as collateral for the loans. 
• As property values increase, homeowners have the opportunity to re-leverage debt by accessing equity (There was a doubling of mortgage debt in the US from 2001 to 2007). 
• Property is not only an inefficient market, but also an inefficient asset class—meaning that you cannot offload pieces of it like you could with an equity portfolio (e.g., you cannot sell off your kitchen, but you could dump an underperforming large cap stock); illiquidity can strand owners in their properties even when it is not a negative equity situation; and the market for the same four walls will be different in different locations (arbitrage?)

Given all of the danger, let’s not get the idea that owning a home is a bad idea, however creating government subsidies and programs to promote “irresponsible” home ownership may not be a good one. The systemic issue seems to be the amount of debt that home buyers are allowed to take on. The Swedish government set a maximum loan to value of 85% last year for mortgage ratio; and that is a step in the right direction.

Whether ending the 30-year mortgage device, or phasing out income tax deductions for mortgage interest, or setting more stringent standards for first-time buyers & family businesses (where all household income is reliant on one business) makes the most sense is hard to say.

Baby Boom soon to be Retirement Tsunami

The first of the 78 million Americans of the baby boom generation (individuals born between 1846 & 1964) start turning age 65 in 2011…an age which has been considered “normal” retirement age. As this increases over the coming years, so will the retirement finance burden.

A couple of interesting statistics about entitlement programs:

1. The number people enrolled in Medicare will grow from 47M to 80M in a mere 2 decades.

2. Enrollment in SS will grow from 44M to 73M during same time frame.

At the same time the American workforce will grow more slowly, therefore the taxes to finance these benefits will significantly decrease.

Compounding the baby boomer retirement issue is the findings published in a recent article in the Wall Street Journal. The savings amassed in the 401k plans of boomers falls well-short of their retirement funding needs.

“The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement, according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.” –WSJ

This fact could be easily explained away by saying that boomers simply did not save enough for their retirement years, but I would argue that part of the issue can be found in the design of the typical 401k plan which is a great accumulation tool in early savings years, but may not have protection features as participants near retirement age.

The other retirement threat for boomers that has not been bantered about in the media is the risk of incurring a major medical event in retirement—the cost of which could significantly erode retirement savings. What happens once savings is entirely depleted and you still need long term care/skilled nursing? Medicaid may kick in to cover these costs…another entitlement program which is probably under-funded.

So how should boomers prepare for the coming retirement tsunami? The years immediately preceding retirement need a careful strategic approach that differs from previous accumulation years. Managing investments for protection becomes important. Price out the cost of a long term care insurance policy early, as the cost continues to grow as you get older Find an advisor who can help you manage these issues in concert.

Municipal Securities next?, Maybe Not…

With headlines blazing “Arma¬geddon,” the normally sleepy municipal bond market is finding itself center stage in the current “name that crisis” championship.


In seeing the sovereign debt crisis spread across Europe last summer, many of the talking heads in the media have begun to pick on struggling states and municipalities as the potential next proverbial shoe to drop. But how likely is it that they would default on their debt obligations.

In my recent conversations with a portfolio manager, an interesting tidbit came forward which I found interesting with regard to municipal securities:
“It is important to focus on higher-quality issuers that provide services that are essential to their communities. This “recession-proof” revenue stream from projects that are critical to the state’s progress, such as hospitals, education, transportation, and utilities, is where investors need to concentrate in this environment. This means carefully-selected essential service revenue bonds should currently be the foundation of a municipal portfolio and likely provide the most stability. Government obligations (“GO”) bonds still face significant challenges with budget constraints and public employee benefits producing high price volatility and the potential for downgrades. Finding issuers with little to no underfunded pension obligations and strong reserves will be challenging, but this is where stability will lie in the GO space.”
The take-away here is that not all Munis are created equal and the pros who are good at managing these types of portfolios should still be able to separate the wheat from the chaff.

The 5 Biggest Surprises from 2010

#1 No Rise in Interest Rates


With interest rates at record lows to start the year, most investors probably believed we were in for at least a minor increase. It looked like rates would tick up, but with sovereign debt worries in Europe peaking at mid-year in Greece, the Fed probably kept rates low to avoid a potential double-dip recession. Couple that with another round of Treasury purchases, and rates hit a low at 2.4 %. But overall, it was a decent year for bond investors, with modest gains across most high-quality bond categories, and even larger returns to riskier areas, such as corporate high yield and emerging-market debt.iii

#2 European debt crisis could bring us down

The spring of 2010 brought the potential for a sovereign debt crisis across the Euro zone. Issues kicked off in Greece as government bonds spiked above 13%, causing the currency to lose significant value, and thus raising fear and volatility throughout global financial markets. A $1 trillion rescue fund was created by the European Central Bank to address future similar problems, and the volatility was quelled temporarily. Ireland became the next problem a few months later, and even later in the year further discussion about Portugal and Spain began. Despite the fact the euro is the world’s second most-important currency and the Euro-zone’s economy accounts for 15% of global output, the region’s sovereign debt turmoil did not derail the global economic recovery. European sovereign debt uncertainty may well continue in the year ahead, but the good news in 2010 was the showing of the world economy’s ability to shrug off these types of events.

#3 U.S. stocks remained unloved by mutual-fund investors

With the S&P 500 up nearly 90% from the March 2009 lowiv, history suggests that investors would be flocking to jump into the next potential bull market. The statistics show that through October, mutual fund investors pulled a net $64 billion out of U.S. stock funds during 2010, and continued to feed bond funds instead. Are we also seeing the feeding of another bubble…this time in bonds? Perhaps it is the more conservative mindset of investors, or the aging population seeking income-oriented investments, but I expect interest in the bond market to continue into 2011. With stocks having made a serious comeback from crisis lows, I also expect equity funds to garner some more attention than in 2010.

#4 Ironies abound in “2-speed”, imbalanced world

It is widely acknowledged that developing economies, such as India and China, have grown much faster than developed nations and are expected to do so for some time into the future. In a world full of contrasts and imbalances, that was just the beginning. The Euro-zone dichotomy included a periphery where Spain’s unemployment rose above 20%, and Ireland and Greece slumped back into recession, while Germany’s economy

rode blockbuster export growth to a near-two-decade low in unemployment.vi Commodity markets flourished, with agricultural commodities and copper returning to mid-2008 record levels, while core inflation rates in the U.S. hit 50-year lows. Within the U.S. economy, the residential housing market languished as sales slumped and foreclosures bulged, but corporate capital spending was brisk. Unemployment remained stubbornly high near 10%, but consumer spending picked up steam throughout the year.vii Corporations borrowed at record low rates, but more than 150 banks failed in 2010, and getting a residential mortgage without a high credit score was a futile effort.viii

#5 Gloves come off in currency debate

The Fed’s latest round of Treasury buying called quantitative easing or QE2, had set off some worldwide currency tensions. Some countries finance ministers have argued this as an effort by the US to devalue the dollar. Right now, no major country wants their currency to strengthen in an effort to keep exports of their goods attractive. I expect currency to play an ongoing role, and China’s ongoing valuation of the yuan will be central

Boring…but, a solidly average year

After a calamitous 2008, and a huge rebound in 2009, I picked 2010 to be important for getting us back to a “normal” market. A modest double-digit return on financial markets is a nice average year, and it could not come at a better time after the violent volatility of the previous market cycle. 2010 reaffirmed that you can’t predict market behavior by looking at the daily headlines.
 
 
[i] Greece’s 10-year bond yield hit 13.17% on 5/7/10. Source: Financial Times,

Haver Analytics, FMRCo. (MARE) as of 12/13/10.
[ii] On April 5, 2010, the 10-year Treasury yield hit 4.01%, then fell to 2.41% on
10/6/10. On Dec 2, 2010, the 10-year Treasury backed up to 3.01%. Source: Federal
Reserve Board, Haver Analytics, FMRCo. (MARE) as of 12/13/10.
[iii] All references to asset classes in the article and their respective U.S. dollar
returns (%) for 2010 are as follows (unless otherwise noted): Large Caps – S&P
500 Index (13.4%); Small Caps – Russell 2000 Index (24.9%); Developed Country
Stocks – MSCI EAFE Index (7.4%); Emerging Markets – MSCI Emerging Markets
Index (16.2%); High Yield – Bank of America Merrill Lynch U.S. High Yield Master
II Index (14.3%); Investment-Grade Bonds – Barclays Capital U.S. Aggregate Bond
Index (6.2%); Real Estate – NAREIT Equity-Only Index (22.7%); Commodities – S&P
GSCI Commodity Index (5.7%); Gold – London Gold Bullion, PM Fix US$/Troy Oz.
(28.6%). Source: FactSet, Wall Street Journal, FMRCo. (MARE) as of 12/13/10.
[iv] U.S. Stocks represented by the S&P 500 Index, which appreciated 90.3% from
3/9/09 to 12/13/10. Source: FactSet, FMRCo. (MARE) as of 12/13/10.
[v] Year-to-date net fl ows for U.S. equity and bond funds were -$64 billion and
$223 billion, respectively, through October 2010. Weekly net bond fund fl ows
turned negative the last two weeks of November 2010. Source: Investment Company
Institute, Haver Analytics, FMRCo. (MARE) as of 12/13/10.
[vi] Spain’s unemployment rate was 20.7% in Oct. 2010, while Germany’s was
7.5% in Nov. 2010. Source: Statistical Offi ce of the European Communities, Haver
Analytics, FMRCo. (MARE) as of 11/30/10.
[vii] The High-Grade Copper COMEX spot price ($/lb) reached an all-time high
of $4.20 on 12/13/10. The S&P 500 GSCI Agricultural Commodities Index stood
at 486.22 on 12/13/10, very near its high of 499.25 set on 3/12/08. The U.S. core
infl ation rate was 0.59% year-over-year, an all-time low. The S&P/Case-Shiller
Home Price Index of 20 metro areas is down 0.05% from Jan. 2010 to Sep. 2010.
The number of new consumers with new foreclosures was 457,000 in Q3 2010.
Gross private domestic investment grew 22.4% year-over-year in Q3 2010. The
unemployment rate in Nov. 2010 was 9.8%. Personal consumption expenditures
rose from $10.1 trillion in Q4 2009 to $10.4 trillion in Q3 2010. Source: Standard
and Poor’s, Bureau of Labor Statistics, Bureau of Economic Analysis, Haver Analytics,
FMRCo. (MARE) as of 12/13/10.
[viii] As of 12/10/10, the Federal Deposit Insurance Corporation stated that 151
institutions had failed or been assisted. Source: Federal Deposit Insurance Corporation,
Haver Analytics, FMRCo. (MARE) as of 12/10/10.
[ix] The S&P 500 fell 15.6% from 4/23/10 to 7/2/10, while gold appreciated by 6%.
Source: Standard and Poor’s, Wall Street Journal, Haver Analytics, FMRCo. (MARE)
as of 12/13/10.
[x] Corporate profi ts after taxes with inventory valuation and capital consumption
adjustments stood at an all-time high of $1.2 trillion in Q3 2010. Corporate liquid
assets of non-fi nancial corporations stood at $1.93 trillion as of Q3 2010, which
represented 7.4% of total assets. Source: Bureau of Economic Analysis, Federal
Reserve Board, FMRCo. (MARE) as of 9/30/10.
[xi] The S&P 500’s calendar year average from 1926 through Oct. 2010 is 11.8%.
Investment grade bond’s calendar year average from 1926 through Oct. 2010 is
5.7%. Investment-grade bonds represented by Barclay’s Capital Aggregate Bond
Index from 1976-2010; from 1926-1975 bonds are represented by a weighted composite
of the IA Long-term Corporate Bond Index (34%) and the IA Intermediateterm
Government Bond Index (66%). Source: Ibbotson Associates, FMRCo.
(MARE) as of 10/31/10.
[xii] The range of returns for the major asset classes listed in footnote #3 above
(excl. gold) was 19.2 on a year-to-date basis through Dec.13, 2010, compared to a
historical average range of 51.5 dating back to 1988. Source: Ibbotson Associates,
FMRCo. (MARE) as of 12/13/10.
[xiii]The S&P 500’s standard deviation from 1926 through Nov. 2010 is 21.4%, while
year-to-date through Nov. 2010 it stood at 21.3%. Investment-grade bonds historical
standard deviation is 4.7%, while year-to-date through Nov. 2010 it was 2.6%.
Investment-grade bonds represented by Barclay’s Capital Aggregate Bond Index
from 1976-2010; from 1926-1975 bonds are represented by a weighted composite
of the IA Long-term Corporate Bond Index (34%) and the IA Intermediate-term
Government Bond Index (66%). Source: Ibbotson Associates, FMRCo. (MARE) as
of 10/31/10.

Inflation?, What Inflation?

I do not intend this post to be a statement that inflation is here. But I think that challenging our traditional notions of how we measure inflation may be in order. Whether it is Core Inflation or Consumer Price Index (CPI had an increase of 1.2% over the last 12 months through November 17), it is clear that these measures are not reflective what has been going on on the commodities markets over the last several months.

Commodity Price appreciation for the recent 5 months:

Commodities                                        Return*
Aluminum                                               19.20%
Barley                                                     75.10%
Coffee                                                    22.73%
Copper                                                   29.83%
Corn                                                       55.27%
Cotton                                                    58.86%
Gold                                                       11.85%
Lead                                                       28.29%
Lumber                                                   15.42%
Lean hogs                                                1.69%
Live cattle                                                4.30%
Nickel                                                     16.87%
Orange juice                                             1.38%
Palladium                                                 66.25%
Platinum                                                  10.03%
Rice                                                        52.44%
Silver                                                      52.86%
Soybeans                                                18.70%
Sugar                                                      47.49%
Tin                                                          40.95%
Wheat                                                     50.08%
Zinc                                                        19.62%
Rare earths                                             60.53%

With interest rates at historic lows, it remains to be seen how investors could keep up with a significant loss of purchasing power.

Investment Discipline

I am sure many of us have heard that trying to “time the market” is not a good idea. Statistics have shown that missing the five best trading days of the year can significantly affect investment returns.

Well, a different statistic this year shows again why timing is not a good idea. According to a study last week by the analysts at Bespoke1 , year-to-date returns for the S&P 500 Index would have dropped from 8.3 percent to -3.8 percent if you were out of the market the first trading day of each month!

The concept of buying near the low end and selling near the high end of a trading range in an attempt to extract incre¬mental return out of a relatively flat market may be appealing. However, when large returns are spread among a few widely dispersed days, asset allocation suddenly looks more attractive than attempting to aggressively trade a range-bound market.

The message? Traditional investment markets continue to be a great place for a longer-term strategy, but jumping in and out of the market for incremental returns is playing with fire.


Source (1): “If Only There Were 20 Months a Year”, December 1, 2010, Bespoke Investment Group, www.bespokeinvest.com

Elections, Taxes, & QE2

With the loss of Democratic control of the House of Representatives, the pendulum of American politics continued its back and forth swing. Divided government has shown much promise in the last 30 years; with the administrations under President’s Reagan and Clinton serving “the middle” very well.

The biggest challenge ahead will be how to tackle the coming tax hike on January 1. With President Obama reaching out to the Republicans, it seems clear that some compromise will pass before the new year ticks over. This, in effect, creates a new round of stimulus for the economy. My biggest concern is that there continues to be no long term plan to tackle the deficit from either side of the aisle. At some point, those in Washington DC will need to make some difficult decisions for the long term financial well-being of the country. The proposed tax deal merely pushes that date out another two years.

What the current tax rate extension will do is take some pressure off at the Federal Reserve. Their second round of Quantitative Easing (or, their current action of buying $600 billion in Treasury bonds—a way of increasing the money supply) has been under-way and is expected to continue through next June, but the tax deal probably puts an end to any more than that.

The hope is that lower tax rates for all will translate into boosted spending and encourage hiring, to battle an unemployment rate at 9.8%. Perhaps it is not a bad short-term plan, but with the deficit growing by the second, and government entitlement programs bursting at the seems, at some point, someone will need to tackle the long term.