~ newsletter sample
May 17th, 2006 by 
independence
Financial Reality Newsletter
Separating fact from fiction in finance and economics
Retirement Investment Management Newsletter
Issue #1 Published Monthly Since 2006 May 9, 2006
In this issue
- Introduction to the Newsletter
- Getting Started
- Essay: Real Estate Prices
- Don’t believe everything you read: ARM’d and Dangerous
- Performance Tracking
- Monthly Summary
Welcome. This is a promotional sample of the Financial Reality Newsletter. It showcases the research, analysis and general tone of the newsletters that our subscribers will receive monthly.The monthly Newsletter is an adjunct to the information in the public and subscriber areas of the Financial Reality at alamedalearning.com/reality. The Newsletter summarizes the activity for the previous month and highlights the areas of interest for the coming month. Additional news and commentary are provided as a background to future directions – those under our control as well as current events and trends that with impact financial reality.
The focus of our service is retirement. Never before has there been the situation where a large cohort of retirees (the Baby Boomers) head off into retirement without pensions, but with lump-sum savings – 401(k)s, IRAs, and so forth – which they must manage themselves. We, too, are in this situation, and are producing this newsletter to share our experiences, good and bad, and hopefully help others who are in the same situation. We’re not in the business of providing investment advice, just sharing an example.
Retirement portfolios are different from normal savings portfolios because they are subject to regular withdrawals, rather than periodic contributions. This is important because these withdrawals can cause a loss of investment capital when they are taken out if the portfolio happens to be in a down cycle. After the withdrawals, the portfolio will have a much harder time recovering in a subsequent rally. Buy-and-hold and dollar cost averaging work well for a savings portfolio. But those same concepts can be lethal to a retirement portfolio.
Our investment strategy is to dynamically allocate our assets in various assets classes and strategies. We use market timing and modern portfolio theory to manage risk and maximize our returns consistent with our risk level. The monthly Newsletter will address each asset class portfolio. Performance, background, analysis, expert opinion, news and commentary are provided to help readers make informed decisions regarding their own portfolios.
We are assuming that readers are individual investors who manage their own assets and have sufficient resources and time to spend reading our monthly Newsletter and following the more-or-less daily web postings. Although the Newsletter is comprehensive, it is limited by the publication frequency. To address more immediate issues and changes in the dynamic global and local economy, we rely on the web site to convey more timely information and immediate notification of actions we are taking as the need arises. Subscribers can request email notification to keep abreast of changes as we update the web site information.
We are a husband and wife team of Boomers with experience in banking, executive-level management, corporate and personal finance, strategic planning, business development and education. As needed, we call on financial professionals, recognized authorities and academics for inspiration and validation of ideas and activities presented.
Getting Started
Do you know where your money is and what it is doing for you? Our research suggests that many Boomers with substantial financial assets really do not have a “big picture†of their assets – just a bunch of monthly statements that get a quick look before being filed (or discarded). There is no time like the present to start formally managing your retirement resources.
We encourage subscribers to actively manage their assets through regular review, research and discussion. Financial Reality subscribers are invited to participate in online discussions with the editors and other subscribers on matters of mutual interest. Strategic planning and tactical examples for persevering and growing retirement assets are key components to all research, analysis and communications here at Financial Reality Newsletter.
We ask tough questions. However, the test is your financial well-being so we think it is worth the time and effort. Nobody cares about you and your money that way you do. We are here to help make retirement investment management interesting and rewarding.
Throughout this issue and those that follow, we will be addressing a broad range of topics associated with retirement investment management, asset classes, analysis of news and events that can impact investments now and in the future.
Essay : Real Estate Prices
When people are asked to justify their belief that real estate prices can only increase monotonically, they generally intone something to the effect of “Well, they aren’t making any more of it†along with “People want to live here†or “People are moving here all the time†and so forth. The implication is that demand is always increasing and the supply is fixed, therefore price will increase to match demand to supply or something similar. They then change the subject, satisfied that the matter has been adequately discussed.
Let’s try to think about real estate prices, specifically SFR (Single Family Residential) prices, a little more coherently. First of all, let us take as a given that some areas are more desirable places to live than others. Accordingly, a beachfront home in Newport Beach, for example, is likely to command a higher price than a recently-vacated crack house in gang territory. However, at any given price level in either case we need a supply of people willing and able to pay that price, sufficient to buy the houses coming on the market. If that supply of purchasers fall short, either price levels will decline until equilibrium between buyers and sellers is reached once more, or houses will remain unsold. Sellers often choose to let their properties remain unsold rather than lower their asking prices and so the inventory of houses for sale climbs. Some sell, of course, but others do not as the general price level is too high for the market at that time. The result can look like the following (From the Naples Sun-Times, 3/14/2006):
“In February 2006 there were 5,417 single family homes listed for sale in the Sunshine Multiple Listing Service (MLS) of the Naples Area Board of Realtors, of which 204 sold. There were 5, 289 condos/coops for sale, of which 179 sold.
Let’s do the math: 5,417 plus 5,289 equals 10,706. Divide that by 383, which is the number of homes that sold (204 plus 179). What do you get? 27.95? That means that in February there was a 28-month supply of homes for sale. In other words, if no other homes came on the market, it would take 28 months for all homes listed for sale to be sold. “
Even in the most desirable areas, there are always people who need to sell their properties. Changes in their financial circumstances, marriages, divorces, births, deaths, job changes, etc. all provide a steady stream of sellers. Some, but not all, will be buyers elsewhere. The converse applies equally if there are more willing and able buyers than there are houses for sale. Then prices rise, either raised by the sellers asking higher prices, or by the buyers themselves outbidding one another.
Looked at from this point of view, the price of property is established by the balance between buyers and sellers. More buyers than sellers means shrinking or very small inventories and often multiple bids over the asking price, driving up prices; more sellers than buyers means growing or large inventories of unsold properties and, eventually, reduced prices as sellers cave in to reality.
So to assess local markets, we need to understand the factors driving the numbers of buyers and properties available for sale.
Properties available for sale
There are four main sources of properties for sale.
The first is the normal turnover discussed above as people who own houses go through various life changes and need to sell their houses. While there are obviously local variations, generally speaking the law of large numbers operates here to provide a steady stream of re-sales.
The second source is negative economic adjustments that force property owners to sell because they can no longer afford the expense of owning the property. These can take the form of economic issues affecting a significant part of an area’s population – for example, the defense cutbacks in California on the 1980s or the present woes of the auto industry in Michigan. But they can also take the form of expense pressures that affect groups of property owners – upwards adjustments in payments on Adjustable Rate Mortgage (ARM) debt, insurance premiums (Florida, Louisiana) and taxes (lots of places). A rising trend in foreclosures and pre-foreclosures is often a symptom of these adjustments.
The third is speculation – people who own houses that they are not living in. Either they moved and kept the old house, bought a second house or are in the “flipping†business. In some areas, such as Miami and Phoenix, it is estimated that the majority of new properties in the last few years have been bought by speculators. Since they don’t live in them, these houses can be quickly available for sale.
The fourth is new construction. Some areas are fully built out – there is no vacant land for new construction – but many are not and developers provide a large percentage of the houses available for sale. These properties are generally sold directly by the builder and therefore do not appear in MLS inventories, making it more difficult to measure inventory levels. Builders typically commit to construction projects long in advance and have a tendency to overbuild when the cycle turns down. Then they can be a major pressure on prices because, as professionals, they are much quicker to adjust prices than the amateurs who dominate the resale market..
Buyers
In order for a sale to occur, a buyer must be both willing and able. Willing buyers come from two main sources:
- Need-based buyers. Folks who are simply looking for a place to live. Either first-time buyers or moving from one house to another, this is the long-term reliable source of buying.
- Greed-based buyers. Speculators. Folks who are looking to buy a house with the expectation of reselling it for a profit. These buyers fall away when prices are declining – they are momentum buyers who buy because they see prices rising and they believe that market conditions are such that they will continue to do so. They are not investors, not in the SFR market, because that is almost never a profitable proposition without relying on price inflation.
Able buyers are those with sufficient financial resources to fund the transaction. This means cash or credit, usually a combination of the two. Credit is assessed using the time-honored three C’s of credit - Character, Capacity and Collateral. These days character means one thing - FICO score. Capacity, the ability to service the debt, means income in relation to payments, often referred to as DTI (Debt To Income). Collateral means the value of the house relative to the amount of credit extended, often referred to as LTV (Loan To Value).
Traditionally, the yardstick of capacity (or the converse, affordability) has been the purchase of a house using a conventional, fixed-rate, 30-year mortgage with a 33% DTI and an 80% LTV (20% down payment). In the press, it is usual to publish an affordability index which shows the percentage of houses that a family with the median income could afford to buy, given this traditional yardstick. These affordability numbers, which for example currently show San Diego at 2% affordability, are today misleading because the mortgage industry has aggressively sought to expand their customer base to potential buyers who could not qualify with the traditional yardstick.
The recent rapid rise in house prices has resulted from a substantial expansion in the number of able and willing buyers. The Federal Reserve drastically reduced short-term interest rates, down to 1% in 2003. This allowed lower mortgage payments for a given principal amount, especially for ARMs users whose payments are tied to short term rates, expanding the number of buyers at all price levels. The efforts of mortgage lenders increased the number of able buyers at virtually all price levels by means of “creative†credit terms, easing their requirements along all dimensions of credit criteria:
- Accepting more sub-prime borrowers (those with poorer credit histories and therefore lower FICO scores).
- Reducing payments – ARMs, interest-only mortgages, option-ARMS and other negative amortization loans.
- Encouraging income overstatement – allowing buyers to state their income without subsequent verification by the lender, so called “stated-incomeâ€, “low-doc†and no-doc†loans.
- Allowing higher payments in relation to income – accepting borrowers who are committing 55% or even more of their income to mortgage payments, in comparison to the traditional 33%.
- Overestimating LTV – inflating appraisals by pressuring appraisers to “hit the numberâ€.
- Eliminating the requirement for down-payments by financing 100% of value or, even worse, using so-called “piggyback†loans where the 20% down-payment is financed by a HELOC (Home Equity Line Of Credit), thereby avoiding the need for PMI (Private Mortgage Insurance)
Lenders have accepted a much higher level of credit risk as a result of these easy credit terms. In a rising market, where the value of their collateral increases on a daily basis, this probably represents a modest financial impact. In a falling market, this level of credit risk is an unprecedented situation with potentially huge risks to the liquidity and even solvency of lenders.
Able buyers also, if they are need-based, have to sell the house in which they are presently living. In rising markets, buyers will not worry too much about this – they’ll sometimes even become speculators and hold on to their previous house. In falling markets, this becomes a big concern and can prevent transactions from closing because buyers are not willing to become speculators with their old house.
Outlook
Using these sources of buying and selling, we can do at least a qualitative analysis of any real estate market area. Overall, it seems that the buyer pool can be expected to shrink and the number of units for sale can be expected to increase. Some of the factors at work on the property for sale side include:
- A recent study by First American Real Estate Solutions, a unit of title insurer First American Corp., projected that about one in eight households with adjustable-rate mortgages that originated in 2004 and 2005 will default on those loans.
- Large numbers of units owned by speculators in markets such as Phoenix, where a recent analysis showed that nearly 50% of the units listed for sale on the MLS were vacant, implying speculation.
- Overbuilding by developers. Nationwide, the number of houses being constructed substantially exceeds the rate of net new household formation.
On the buying side, similarly we see negative factors operating to reduce the size of the prospective buyer pool:
- Lenders are being forced by regulators to tighten credit terms in order to reduce financial risk. This especially affects marginal buyers, such as those using the exotic “option-ARM†mortgages.
- The Federal Reserve continues to raise short-term interest rates, increasing ARM mortgage payments at any given price level.
- Price momentum is slowing or even turning negative, causing speculative demand to dry up.
Looking at these factors, we can see that markets where developers and speculators have been most active are likely to be most vulnerable. Miami, Phoenix, San Diego, Las Vegas and Sacramento would be examples of this situation.
However, even “built-out†markets such as the San Francisco Bay Area are vulnerable to the effects of interest rate increases and tightened credit terms. The big question, of course, is how much prices will move in response to these changes. All one can say with confidence at this point is that the likelihood of significant further appreciation is very low, since it is hard to see how the pool of able buyers will be further expanded without significant increases in family income, which so far have not been forthcoming.
Federal Reserve Board Governor Donald Kohn recently said, in a speech: “All else being equal, interest rates are higher now than they would be were real estate valuations less lofty; and if real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions.â€
Retirement and Real Estate Prices
Over the past several years there has been a significant run-up in the price of houses in many areas. Easy credit, creative financing, fear of being priced out of the housing market due to rising prices and massive housing building have created an opportunity for buying and speculating.
But what does this mean for someone who is a home owner, an investor and worried about financial planning for upcoming retirement? Especially for someone who is looking to equity that they may have accumulated as a potential source for funds in retirement?
What could happen?
As prices rise higher, there are fewer buyers. Interest rates are going up which will mean higher monthly payments for those with adjustable financing based on current interest rates. Many creative low- and no- interest loans come due in the next year, which will lead to a rise in monthly payments that many borrowers will no longer be able to afford. This in turn will lead to more houses on the market as many of these home owners will be forced to sell or face foreclosure.
What to do?
We have sold our house and now rent. We felt that the risk to our equity as a key asset was too high. Others might consider downsizing into something smaller with a fixed rate mortgage, perhaps in a less expensive location, as an alternative if they don’t consider renting viable. Rents, however, are generally very attractive relative to the cost of ownership. We may buy back into the housing market when prices come down to earth - we expect that they will come down a lot. Really.
Real estate speculation may be over for the time being. In some areas, prices are already coming down. In others, prices are still high but there aren’t many sales. In a few months, it may not be possible to sell at any price - there just won’t be any buyers. That is what happens at the end of a real estate bubble like we are seeing - sellers can’t/won’t sell for prices that buyers can pay so there are virtually no sales at all at any price.
Then what happens?
People who want to sell find that their house is worth less than the balance that they owe on the financing and they are not in a position to bring a check to the closing to make up the deficiency. So if the borrower can’t sell the house, the lender will foreclose. Lenders don’t want to own real estate, so foreclosures tend to drive prices even lower.
Real estate investing will return. Those who have some cash can wait for the terrific buying opportunities that will be coming in the next few years. Eventually, prices will plummet and there will be plenty of foreclosed properties that the lenders must sell very cheaply, perhaps for as little as 10-30% of their highest valuation. It has happened before and it can happen again. Stay tuned…
Don’t believe everything you read… ARM’d and Dangerous
“Money” magazine’s March 2006 issue included a section of advice to a variety of families profiled. The advice was courtesy of various “financial plannersâ€. In my opinion, the advice showed a stunning lack of knowledge of the basics of finance and a complete disdain for risk and risk analysis.
For example, a family whose principal asset was a house in a bubble area, that at least theoretically had appreciated fourfold, was advised to take a huge ($500K) new ARM on the property and invest the proceeds in the stock market, because of anticipated softness in the real estate market. Just a couple of points - well, OK, three;
Firstly, what makes them think that the return on the stock market, purchased at these overvalued levels, will exceed the interest paid on the loan? Remember that only the first $100K is wholly tax deductible (assuming they haven’t used that up already), the rest only to the extent of investment income which will likely be small given current dividend yields. Dr. Hussman (operator of the Hussman funds, with the best risk-adjusted performance in the mutual fund universe) observes: “Presently, the likely range of S&P 500 annual total returns for the coming decade is in the 2-3% range based on average and median scenarios, with outside possibilities as low as -3% in the very bearish case and still less than 8% in the very bullish case.†The Likely Range of Market Returns in the Coming Decade
Secondly, what about the issue of portfolio risk? While the relationship between house price changes and stock market price changes is inconsistent - the correlation changes over time - it seems risky to leverage housing to fund what may be a correlated investment in stocks, all you are doing is increasing leverage (and risk). Haven’t these folks heard of MPT (Modern Portfolio Theory)? As an example, a commodity fund investment would be a much lower risk choice because commodities have been consistently uncorrelated and would lower overall portfolio volatility - risk.
Thirdly, how are they going to service the additional debt? They already have outstanding credit card and HELOC debt, indicating that they are unable to meet their expenses from current income. The additional $250K in debt will cost them some $12,000 a year which it appears they don’t have.
It seems to me that any kind of adverse move in the markets will put these poor folks in BK if they take this advice. My advice? Sell and rent. Even in today’s slow market surely they can price aggressively to sell and even then take out the $500K tax free after paying off all the debt. Put the proceeds in TIPS and wait for a better opportunity to move into equities.
The other pieces showed equivalent lack of concern for risk. Of course, we will never hear about these families again in the pages of Money magazine. So I guess it doesn’t matter.
Performance Tracking
We track and account for portfolio changes, reallocations, withdrawals and so forth. We’ll use the mutual fund world’s technique for tracking this by using arbitrary units. Each unit represents a certain asset value for our portfolio and a different one for yours, of course. We will start with 1,000,000 units as the nominal value, in aggregate, of investable funds. If you have, say, $2,500,000 to invest, to emulate our strategy just consider each “unit†as worth $2.50 and go from there. Our starting point is as of close of business on 4/30/2006. And yes, we will include the effects of periodic withdrawals as they occur.
Asset Classes
On the web site, there is a page that describes each asset class along with an index or price which we consider the benchmark for that portfolio. Over time, there will be changes to the composition of the holdings within a given asset class. These changes are reported at the time the changes are made as subscriber-accessible blog entries and updates to the affected asset class pages.
Currently, the asset classes that we’re using include three commodity groups, which we look at as a store of value. We may hold both shares and the commodities themselves, such as gold and oil, especially as these can now be held without resorting to futures contracts or expensive physical storage:
- Energy
- Precious Metals and Mining
- Food & Agriculture
We also include a personal interest: Technology. We will look for both long and short opportunities in technology stocks.
Real Estate is tradable through house price futures (on the CME) and REITs.
A Market Timing portfolio will be used both to make profit and to hedge equity market risk in the other portfolios. This portfolio will be long and short broad stock market indexes, both domestic and foreign.
And of course there is Fixed Income - bonds and similar securities, which can be highly profitable (have you read Michael O’Higgins’ book “Beating The Dow With Bonds”?) as well as a safe haven.
And sometimes you just want to be in Cash, both the US dollar and foreign currency.
Portfolio Changes - May 2006
Along with the specific changes in holdings within an asset class, we provide background, research, analysis and commentary.
For example, it was time to make some changes.
The price of gold and precious metals continue to rise but some holding are now over represented. Selling off some of these, such as .. and taking a profit was indicated to realign the portfolio holdings.
- Technology
Bought put options: Sandisk Sep 45 (SWFVO) , Lam Research Sep 60 (LMQUL). - Real Estate
Bought put options: Homebuilder ETF Sep 45 (XHBUS) - Market Timing
Bought calls: Nikkei 225 Index ETF Sep 15 (EWJIO), S&P 500 Index Jun 1275 (SZPFO)
Sold mutual fund: Rydex Venture Fund (RYVNX) (partial)
Sold puts: Nasdaq 100 Jun 1750 (NDYRO) (partial)
Bought ETF: Brazil (EWZ) - Metals & Mining
Sold ETF: Gold ETF (GLD) (Partial)
SUMMARY
This month has been interesting in that there are signs that the housing bubble is finally starting to stall – even areas where speculation is minimal, housing inventories are dramatically higher than they have been for many years.
Our initial asset allocation, as of April 30 2006, is:
| Portfolio Asset Class | Beta Equivalent | Actual Assets |
| Energy | 38.29% | 38.29% |
| Precious Metals and Mining | 21.37% | 21.37% |
| Food & Agriculture | 0.33% | 0.33% |
| Real Estate | 0.00% | 0.00% |
| Fixed Income | -0.13% | 1.28% |
| Market Timing | -32.55% | 18.84% |
| Technology | 0.00% | 0.00% |
| Cash | 0.00% | 19.89% |
That’s it for this month.
Financial Reality Newsletter
reality@alamedalearning.com
Disclaimer: Information presented in this newsletter was obtained from sources believed to be reliable but accuracy and completeness, and opinions based on this information is not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editors may have an interest in the companies mentioned. All data and information and opinions expressed, as subject to change without notice.
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