Friday, October 14, 2005

The Federal Reserve has certainly gained the stock, bond, and Real Estate market’s attention. The Real Estate market (as measured by the iShares REIT index) is off sharply, Bonds have had negative returns, and equities have had a rough start to the 4th quarter as well.

The target on the Fed Funds, now at 3.75%, is projected to stand at 4.5% in January by the futures market. My own opinion (at this moment) is that 4.25% is a lock, and 4.5% is 50/50, but, as always, my opinions are subject to change without notice. The Fed is in a tough spot: they helped create the current environment of commodity inflation (this includes land prices, metals, and oil), and now must reign in the U.S. housing and real estate market in what they must hope will be a soft landing. I am not so sanguine about their prospects.

I understand the “explosive” (I believe that Real Estate in Shanghai, Hong Kong… is a bigger bubble than South Florida, and when it goes, so will the certain commodity prices, but more on that in another commentary) growth in Asia, but I am of the belief that, irrespective of China’s demand for commodities, our own contribution in this equation has been substantial and misguided. We have become a nation of homebuilders, condo developers, and land speculators, brought about by extreme policy accommodation on the part of the Fed. Remember economics 101? Savings that can be used for investment for the purpose of production? Just how many widgets will be manufactured in those condos we are building? How much software will be written at that country club development? Our economy has spent far too much of its resources in Real Estate development, and far too little on productive capacities (oh, I can hear the “there is too much capacity as it is” nay sayers as they point to all the cash Corporate America is hoarding – to which I say - “buffalo chips”!).

If it is not the housing market that the Fed has in its bomb-sights, then what is? Core inflation for September was just .1%, hardly the boogey man that the Fed has been seeing under its bed. The moment that the housing market appears to have been humbled the Fed will cease hiking rates. The Bank of England, raised short term rates to 4.5% recently but had to change course and lower by .25% because of a dramatically slowing economy. Are you listening, Alan?

The Federal Budget Deficit is finally getting the press it deserves. Federal spending on the “War on Terror”, pork, Katrina, Rita, Tom (DeLay), Dick (Cheney) and Harry (W) has gotten out of hand. The negative impact of these deficits on long-term interest rates is not an “if” but “when”. I am almost embarrassed to call myself a Republican, considering the profligate spending by our Government and the Federal Reserve’s complicit encouragement of spending by consumers (remember our little 0% savings issue? We now have negative savings); they have created the current bubble to pay for the previous bubble. Did I mention the possibility of an out and out civil war in Iraq? What is it the Chinese say? “May you live in interesting times…” I am no politico - I am a businessman, and I want to make money. Unfortunately, free-market types are not running the show in Congress.

Real Estate:

Opportunity Cost:

“The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.”
“The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6%-2%).” - Investopedia

Investors considering Real Estate as an option would do well to reacquaint themselves with this concept. I always hear “you can’t lose money in Real Estate”. “Donkey Dust”! Investors who bought Real Estate in 1990 lost over 30% in inflation adjusted dollars by 1999, while investors that bought a S&P 500 fund and held it over the same period made over 400% in inflation adjusted dollars. OK, you say that Real Estate has doubled from 2000 to 2005 (I question this analysis but lets just make the assumption for this discussion) while the S&P 500 has declined 20%. For the 15-year period 1990-2005, it is not even close.

It is important to compare apples to apples. I am comparing Real Estate investors with equity investors, not Real Estate developers with private equity funds (these are the wholesalers that investors buy their various holdings from). If I were, the disparity would have been far greater in favor of the private equity guys.

The opportunity cost of Real Estate over the next decade when compared with other asset classes will not be as great as the 1990-1999 period, but it will be substantial, in my opinion. Real Estate enjoys the power of leverage more than other asset classes – you can mortgage it – but leverage is a double-edged sword, and it cuts, hard, both ways. Just look at the history of bankruptcy for the land speculators and developers in past recessions. That’s the problem with debt; lenders have this pesky requirement of being paid back irrespective of market conditions. With the new bankruptcy statuettes taking effect this week investors in this sector would be well advised to understand the effect of the leverage in their holdings on their personal fortune should the wind shift.

As measured by the iShares Dow Jones US Real Estate Trust (IYR – NYSE; it is not a perfect index, but it is certainly indicative of market conditions and valuations), the market has corrected significantly, 14.5%, but not nearly enough to interest me in putting money to work in this asset class. Another 20% down as measured from the top (35% peak to trough) and I might have some interest, 50% peak to trough and I would be a buyer. I doubt that that is how things will work out. Markets are not quite so neat in their corrections. The following is a quote from an analyst for whom I have great respect:

“…the average dividend yield for the stocks in this REIT index has dropped more than two percentage points--from 7.3% in September 2002 to 5% last month. As the Fed raises interest rates, their advantage over CDs or money market funds is rapidly disappearing… Few investors in REITs remember the 40% to 50% losses, which occurred leading up to the last two recessions in 1990 and 2001. We strongly urge subscribers to avoid the lure of these REIT investments and their attractive yields. Those yields won't appear so favorable when a significant portion of your original investment disappears.” (Amen!)
- Catherine Hetrick; InvesTech Research

Remember my ranting diatribes earlier in the year on the housing market? I took a lot of heat from clients and prospective clients because my views diverged from what they read in the local newspaper. Reminds of the Will Rogers line, “All I know is what I read in the papers”. Here is a quote from a recent Merrill Lynch report:

Deflation: "Folks, this is still a deflationary world," said David A. Rosenberg, a Merrill Lynch economist. "The airline industry, which is the closest to the oil price runup, is having problems raising fares." Instead, it's cutting jobs.

The Housing Market: ”The housing market is getting softer. Inventory of existing homes, condos and new homes on the market is up. Unsold new homes have jumped to a five-year high. “

It is interesting to note that Mr. Rosenberg is concerned with Deflation at a time that the Federal Reserve is concerned with Inflation. Could it be that we are in a period of commodity inflation and wage deflation? If so, where will the convergence/divergence take place to correct the imbalance, and give us an opportunity to profit? I don’t give specific strategies in this forum (but I do have an opinion), I merely point out macro trends that your local newspaper usually misses.

For my South Florida readers: The carrier of last resort, Citizens, is considering asking for 100% rate hikes for its wind damage insurance. It is safe to say that flood insurance will be considerably more expensive. Energy costs and interest rates have spiked considerably, yet there are no means to recoup any of this from tenants in many leases (even if you could, just ask the airlines how hard its been to pass these costs along). Demand for second homes is falling at a time when a great deal of supply is coming on line. Corporate relocation to our region has dried up. This is not the stuff positive returns are made of. When the “newbie” Real Estate investors “hit the bid” (hit the market) en masse, my sense is that market will be a place of extreme pain.


If you were long bonds over the past several weeks, you truly know what pain is. The 10-year Treasury closed today to yield 4.49%, up from roughly 4.05 in early September, and as we all know, when bond yields rise - bond prices fall (yes, if you hold them to maturity you will receive all of your interest payments and return of your principal, but remember the concept of “opportunity cost”). I am tempted to reign in my prior cowardice when I said it might not be till the end of Q1’06 that the yield on the 10-year would hit 5%, and move back to year-end ’05, but only tempted. This would imply 30-year mortgage money at 6.5%, and adjustable rates not much lower. I continue to be a bond bear. For those investors needing the security of principal bonds represent I would look to short term CMO’s and equity indexed annuities. These relatively new products from the insurance industry give investors most (but not all) of the upside of the equity markets with none of the downside. It is hard to beat that risk/return ratio, but I am sure Wall Street will give it a shot soon with some new product. In the mean time, “Buy-Write” mutual funds (they own high dividend paying stocks and then sell, or “write” in industry jargon, calls against their positions or some comparable index picking up income in addition to the dividends), usually issued as closed end exchange traded funds, pay dividends in the 9% range and have a fairly low beta (risk profile in relation to the overall market).

Oil & Gas:

Demand is going to grow 2 – 3 % per year worldwide for the foreseeable future. Are worldwide reserves going to keep up? I doubt it. On any pull back in energy equities (like the one we are having now), you know what you need to do.

Domestic supplies will increase, refineries will come back on line, hurricane damage will be repaired, and prices will adjust, but there is no stuffing the genie back in its bottle. China and India are going to be major economic powers – and soon – and major economic powers consume lots of energy and other commodities. But you know this, you just need to act on it.

Equity prices in the energy sector have fallen sharply in recent weeks. Is this the absolute best time to add to these positions? Who knows? I added to my positions last week, and will do so in the near future.


A rough start to what is usually the equity market’s best quarter. The Fed is much closer to the end of its tightening cycle than it is to the beginning, and the equity market traditionally rallies nicely in the months before the final crank of the policy wrench. The markets had been looking, and I might add anticipating a bit too soon, for the end of the current tightening cycle. Core inflation is not a problem, and if Q3 earnings come in during the next several weeks as I expect (another double-digit earnings gain, outpacing analyst expectations) the next 6 months will reward investors in consumer non-cyclicals, healthcare, pharmaceuticals, bio-tech, and energy, to name a few. Remember where we are in the Fed cycle and avoid industries that have historically performed poorly in flat yield curve and rising rate environments.
I keep pounding home the theory of “reversion to mean”. The equity markets, and growth stocks in particular, have been significant under performers for the past 5+ years. And in that time the total earnings of the S&P 500 has doubled. Certain international equities are also in a good position to perform well for dollar denominated investors.

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