Tuesday, July 29, 2008

Titans or Titanics

Whenever you turn on a financial advice program or read the commentary of some of the more measured and wise prognosticators, “buy good quality stocks,” is often one of the sage bits of advice offered. That sounds a lot like the Will Rogers quote, “the way to make in the stock market is to buy a stock. Then when it goes up, sell it. If it isn’t going to go up, don’t buy it.” Actually, I may have to go with Will on this one. He gives clearer advice.

It is human psychology to latch onto an idea and let go only very reluctantly. I still have remnants of self image when I wrestled at 153lbs. Remnant? My wife would say, delusion. She, on the other hand, insisted we buy an 8mm film camera when video was already advancing rapidly because she had grown up with one and we actually looked for a Renault LeCar when first moving to the United States. The first is somewhere in a closet and the latter became a home for a raccoon. Yet these were perfectly reasonable purchases once.

There is a tendency to find security in familiarity and tuck it away in safe deposit boxes, both real and emotional. Ten years ago a portfolio of good quality stocks could well have held a handful of blue chips with names like, Pfizer, Citicorp, Microsoft, General Electric, AT&T and General Motors. Those were some names you could sleep soundly with. Perhaps not. Below are prices after ten years from July 29, 1998 to July 29, 2008 and average annual change.

Pfizer $28.97 $18.44 -3.63%
Citicorp $23.67 $17.73 -2.50%
Microsoft $23.40 $26.08 +1.15%
General Electric $23.73 $28.17 +1.87%
AT & T $28.45 $30.68 +0.78%
General Motors $41.01 $11.67 -7.15%
Disney $32.29 $31.01 -0.48%

Times change faster than we do often and the brilliant idea of years gone by can be sunk by events unseen on the surface.

There is a natural inclination to relish the emotional ownership of a household name whether you drive it, fly it or take it before meals. Ironically, it is that very security of the familiar that can move us from dispassionate investors to financial has beens. If you have a drawer full of last generation’s titans and are unable to part with them for reasons of tax perceptions, emotional connection or simply benign neglect take a dispassionate eye and make sure your reality is correctly aligned with your ambitions. Balancing tax losses against tax gains can help. Tyco, Enron, USAir and Bethlehem Steel portfolio performance doesn’t just happen. It’s allowed to happen.

The relatively recent advent of exchange traded funds can provide sector exposure and diversification without the need to guess which specific company will avoid the pitfalls of event risk, poor management, competitor success. Very little investment success is the result of company specific choice, so avoiding the emotion of a “name” is a strategy well worth considering.

John Barnyak

Friday, July 25, 2008

Houses Houses Everywhere and Still a While to Sink

Whereas two years ago real estate was cocktail party talk, now it is a walk away subject. As the pain felt by builders, banks, and municipalities as well as owners surpasses that of the dot com bubble it now reaches into the very heart of American values and wealth. It was not so long ago that federal gadabouts were touting the blessed event of home ownership and doing all in their power to put any and all into a mortgage obligation. Now they seem more inclined to talk about personal responsibility than the policies put in place to encourage moral hazard and high risk behaviour.

How long does the housing and real estate market have to slide before reaching its end. When will it be safe to go back in the water and consider real estate again a viable place to put money or buy a home? Unfortunately, while our positive attitudes tell us it has to be nearly over, the facts speak truth to power. Real estate becomes just another product when we strip away the emotional aspect of hearth and home.

Currently there are approximately two million too many houses for sale or rent. That does not include what is referred to as "shadow supply," those units simply sitting vacant and not offered in the market.

There are approximately 129 million housing units in the nation. That figure includes single family dwellings, duplexes, apartments etc. On any given night about 14% of those units are empty. This is far beyond any previous vacancy levels nationally. Understanding the make up of those empty units will give us a clue to how close we are to the end of the housing crisis.

Of the 129 million units therefore, 18.5 million are vacant. The approximate figures by catagory are 7M second homes, 2.2M vacant homes for sale, 1.4M vacant houses for rent and the remaining 7.9 are duplexes, condominiums and apartments.

Clearing this market overhang will 0ccur either be by sale or by bulldozer. It is expected 300 to 400,000 will become teardowns in areas that become blighted by vacancy. A large number of the other inventory however, is relatively new construction and will not likely be taken from the roles in such dramatic fashion. In the last national housing decline of 1980's, housing prices and activity began to recover meaningfully after unsold inventory had been decreasing for two years. Currently the inventory is still increasing so we have not even yet hit that tipping point.

Apart from housing inventory we look at mortgage defaults. There are approximately 55 million mortgages in the country. Currently about 5 million are in trouble and nationally 2.5% are in default compared to a norm of 1%. In other words additional forclosures are coming.

Over the past decade, the U.S. has seen home ownership increase from 64% of households to 69%. It seems likely we will return closer to the historical level prior to the "mis"incentives provided during recent years. The reasonable conclusion is that only demographics will pull us from the clutches of this speculative housing glut.

We are only now beginning to see significant increases in bank foreclosure sales. Those will naturally remain a significant downward pressure on pricing. To clear the market based on the affordability index at current mortgage rates of about 7%, prices need to fall nationally another 10% to begin clearing inventory. The affordability index is based on price, mortgage rate and income and is a dynamic equilibrium. If unemployment rates rise as predicted, either prices or mortgage rates would have to fall as well to approach clearing levels.

One aspect of the housing crisis not often discussed is the price of land. We are beginning to see significant collapses in land prices in various markets. In the weakest, land prices have already fallen 60% to 70%. If considering that the cost of housing is made up of land, labor, capital and material you can see where the pressures will focus. Capital costs are relatively transparent, at historically lower levels and market driven so probably not a focus of cost cutting.

Labor is already under severe pressure and subject to prevailing wages. Expect to see additional pressure here.

Materials costs are in new territory because of the globalization of commoditiy prices and the building boom in Asia in particular. Lumber, cement, metals and plastics are now subject to global pricing pressure more than ever before. In previous building slow downs, domestic materials costs reacted quickly. Now there are other markets ready to provide demand for the physical components of building.

The final factor of production is land. Particularly in those relatively unregulated building markets such as Florida and Las Vegas that have experienced vast building booms, expect land to also begin bank sale foreclosures.

I don't expect to see a flattening of the housing market until 2009/2010 on a national level, and even then it will be longer before consumer balance sheets are repaired sufficiently to provide sustainable upward pressure on housing. The real estate bubble fed on the expectation of higher prices to come. Conversely this deflation will continue to feed on the expectation of lower future prices. As all products in mature markets, prices will migrate to the marginal cost of production and then overshoot to the downside. Keeping capital intact will provide excellent opportunities a few years hence.

On a personal level there will certainly be opportunities to buy in particularly distressed circumstances, but the cost of patience will be very low in the next couple years.

There will continue to be significant market specific aspects of real estate, but in most markets there will be better opportunities to those who wait in the weeds.

John Barnyak

Thursday, July 10, 2008

The Only Stock You Need

One of the persistent myths in the world of investing is that there is single answer to the question of how to make money in the market. Today as we witness the U.S. government agency, Fannie Mae, continue its free fall I am reminded of the cover story of a popular investment magazine a few years ago. The headline was, "the only stock you need to own."
The accompanying story about Fannie Mae was no doubt compelling and logical, the kind of easy idea that lodges in one's brain forever. Fast forward to today and the assertions that Fannie Mae is insolvent and in need of a government (taypayer) bailout. Those who took this sage advice and let their magazine subscription lapse before learning of the next sure thing have watched FNM and their investment fall 87% this decade.

Earlier this year a relative told me in no uncertain terms that the only investment he needed was Berkshire Hathaway. I try to avoid such discussions with friends and family so at that point we went out to a movie. Berkshire is now about 20% lower in the meantime. The first rule of investment is preserve capital. Berkshire's 25% loss since September means it needs a 33% gain to get back where it started. That kind of return is no mean feat, even for the Oracle of Omaha.

I cringe to overhear denial and revisionist history from investors. In the locker room of the health club I belong to I overheard a discussion of why a member's investment in Citicorp was still ok. He was still, "above my cost basis." This somehow seemed more important than the 73% loss of value this decade. Ouch. If that performance came during retirement it could be devastating.

Even the mutual fund universe is littered with flotsom of the last good idea. How many bought Amerindo Fund when the manager could do no wrong in the dot com boom? Perhaps a gold fund or real estate fund would have made more sense in the ensuing few years. Investors who bought those steel, coal, oil might consider as well if now those prescient purchases aren't also ready for review or rebalancing to strategic levels.

Pigs get fat, hogs get slaughtered.

John Barnyak

Monday, July 7, 2008

Secular Bear

This time it's always different. Mark Twain has been credited with the oft used quote, "History does not repeat itself, but it rhymes," and I find the rhymes are often elegantly penned in technical charts of market behavior.

Each market has its own traits and causes. Each bear market has its unique seeds whether external forces such as soaring energy prices, irrational exuberance or misguided monetary policy. What rhymes however, are the human behavioral responses to stress and uncertainty.

The relatively new academic pursuit of behavioral economics has focused on the individual's reaction to economic and financial stimulus, why we make the decisions, and often mistakes, that we do. The collective decisions made by the many create the results of the whole. The stock market is no different and is a macro version of the actions of the millions of individuals.


The current trend is as of yet very short lived. Markets act much like Newtonian physics and the law of inertia. The tendency of a body in motion to remain in motion applies to market behavior as well. Until we see a more prolonged bottoming process there is little prospect of a V shaped recovery. The stresses that have created the rush out of the market need to be absorbed and repriced.

The remarkable bear market of 2000 to 2002 was the result of excess capital investment and speculative equity valuations. In July of 2002 corporate earnings were flat on their back, price/earnings ratios were infinite and valuations to balance sheets reached very attractive levels. I recall many companies that summer valued at less than their cash because there was fear of collapsing business models. It took two years to squeeze out the greed and hope of the 1990's. Today we are barely one year into the current correction of excesses.


The consumer sector is by far the largest driving force in the U.S. economy and clearly back on its heels. Consumer sentiment is falling steadily, unemployment rising slowly but steadily, wealth perception has taken a hit with falling home and investment values and the cost of necessities is inflating at a rate unseen in a generation. Until housing values stabilize and credit conditions loosen once again the investment markets will remain discomforting. I expect that will not occur until 2009.

In a period of change the dangers become evident long before the opportunities. For now, it remains a market of obvious danger and less apparent opportunity.

John F. Barnyak

To say the second quarter entered like a lion and left like a lamb would be half right. April saw broad market gains of 5.33% in a single month after a particularly weak first quarter. However the fundamental problems I've spoken about previously reasserted themselves and June registered a loss or 8.43% as measuredby the S&P 500. It was the worst June performance since 1930, less than a year after the infamous October 1929 crash.

We continue to focus on capital preservation and our goal of equity like returns with lower risk. Given the depth of the economic problems focused on the financial sector a more opportunistic approach is likely needed not only to expand our outperformance but quickly regain positive year over year results. While clients are doing significantly better than their appropriate benchmarks many are now in negative return territory for the trailing twelve months. Relative performance is the measurement that investors use and all clients are outperforming the broad market although all too often in slightly negative territory. I expect the remainder of the year to be challenging as well as markets react to perceived crisis followed by perceived solution.

We are always looking for underappreciated assets to add to portfolios and although the market is technically oversold and likely to find a bounce, the bearish fundamentals are still in control. Visibility in financial industry assets remains murky, commodities are now extended, corporate earnings under pressure and interest rates are thrashing around in the midst of an inflation vs deflation debate. The market is officially in bear territory as it has fallen from October highs by more than 20% which is generally accepted as the defining trait of a bear market. The money center banks and investment banks have created their own demise by retaining highly leveraged, illiquid low quality assets from the subprime mortgage market boom. Even worse, these investments are often off balance sheet and provide shareholders very little in the way of visibility regarding their value. As far as I am concerned these assets are marked to myth. In other words the banks are still unwilling write off the assets to the full extent necessary to reflect an accurate market valuation. This head in the sand approach is understandable. It is likely that if the valuations were accurate, a number of large and important banks could fail.

There are various signs that the stock market is entering a bottoming phase, but how long it will take is anyone's guess. I believe that a 50% retracement of the past five year bull market will be a technical support level worth considering. We are seeing even shares of companies in leading sectors such as steel, coal and materials being sold agressively. Bear markets begin to find their bottoms when, "they start shooting the generals." The erosion of leading sectors is indicative of market capitulation when nothing is immune to sale. Unfortunately, the fundamental seeds of the next bull market such as seen in July 2002 are not yet apparent.

I note clients are also not emotionally immune to the constant barrage of negative news about the economy. I have had more than one call expressing fear that the latest headline in the media directly translates to despairing losses in their portfolios. This is simply not the case. While the market went into "official bear" territory this week, defensive and diversified portfolios have performed as intended in difficult conditions. Taking moderate sized aggressive trades has been a successful tactic when technically oversold conditions warrant. In general however, we maintain a patient posture. The average bear market typically ends with a significant strong upward response. The 20% loss can very quickly become a 30% gain so we are watching closely for countercyclical trading opportunities.

The fundamental reasons to look for the next long, extended bull market are not in place and as such investors should use the time to harvest tax losses. In those assets which are integral to our long term models but have taxable losses, we are selling and replacing with similar holdings to remain invested while avoiding wash sale regulations. Portfolios held elsewhere should be reviewed by clients and viewed with a dispassionate eye. The opportunities of the past can often become the albatrosses of the future and a reason why performance suffers. It is unlikely investors are going to miss anything important in the next few months and should use this time for housekeeping. For the second quarter while the S&P Total Return was a negative 2.74%. Our clients were evenly divided between modest postive quarterly returns and losses ranging to 1.60%. In no case have clients had long term prospects for wealth accumulation and preservation disrupted.

John F. Barnyak AIFA® 7/6/08
PresidentStonehouse Asset Management