Chuck Ponzi July 2nd, 2008

If you were reading the previous post, you know that I was helping out a reader with some advice about his home in Arizona and what to do. Tonight I’ll take on the opportunity of what to do with the funds he has available. My next article will tackle when to buy.

Keep in mind that this advice is free, and you get what you pay for. If I were in the same situation, my actions might be different from what I am currently doing simply because each person and situation (as well as timing) is different.

When we left our friend Boomer yesterday, I had advised him to sell his home in Arizona even though that wasn’t the question. There was no question that the house was overvalued based on normal valuation methods. In addition, rates have remained stubbornly high despite a strong easing campaign by the Federal Reserve Bank. To that point, just over 2 years ago, I wrote about interest rates and what that portended:

1. Why are rates going down over time?
2. Is there a savings glut?
3. Why are risk premiums (spread) so small?
4. Are we about the enter a recession like the other small spreads indicated?

To the last point, if we enter a recession, is there any chance that housing can be saved through inflation? Does this mean 70’s style stagflation, or even worse, Japanese style deflation with ZIRP?

If anyone can provide a coherent way that housing can survive in the next 2 years, please tell us now!

At this point, I think we are out of options from a monetary perspective.

1. We already have inflation. Dropping rates will make it much, much worse.
2. Economic growth is slowing despite the mad dash of construction.
3. The credit market is precariously spread and rates could make a mad dash upward if international investors get spooked and run for the exits. The only way to keep the Dollar from meltdown at this point will be to raise rates even more.
4. Housing speculators will be crushed by negative amortization and high interest rates in this event(which arguably should have already happened by now).
5. The sitting inventory will cause personal financial distress and combined with the mad dash of rates could generate a general credit system event.

Either way, we will be seeing a much more favorable buying environment for housing in 3 or more years due to the general stress and turning of investor sentiment.

The backdrop of investor sentiment is the worst that I can remember, insomuch that you have everyone talking about a financial armageddon:

Buffet Struggles

Todd Harrison is 100% Cash

and, don’t forget the fear du jour:

Oil climbs peak, economies plumb depressions and the future will not imitate the past

While I agree that the next 10 years will not look like the last, I do think that there are plenty of opportunities that can be entered into in the next 6 months.

First, I have a couple of predictions:

1. The DOW should hold somewhere between 10,000 and 10,500. If it breaks that support level, even I’ll admit I haven’t a clue where we’re headed there.

2. I do think we are headed for a U-shaped recession, but that we have entered that recession 6 months ago and that we should emerge sometime in the next 18 months.

3. Oil is a bubble, but like the housing bubble, it is unpredictable. But, whatever you do, do not listen to the experts. They are called the experts because it’s up. If it were down, they’d be called idiots like bubble bloggers were circa 2005.

So, what should Boomer do with his new tax-free windfall?

I am also not quite 50% cash now with some recent purchases, but I do have a major cash position. I won’t recommend specific stocks, but there are some areas that I will generally avoid:

1. Oil-centric energy stocks. This is really dangerous because we learned from previous energy shocks, the seeds of conservation are being planted now and will grow into the future. Oil could very easily crash.

2. Look for investments that provide a cheaper way of performing necessities, or some game-changing technology that reinvents its space in a necessity. (wouldn’t we all like to find them) while avoiding consumer-centric stocks (many of which have already been trounced)

3. Small caps that rely heavily on borrowing for operating expenses. Many of these are already having difficulty obtaining financing, or even maintaining revolving lines.

Personally, I have invested most heavily in individual biotechnology stocks that have previously crashed by have a strong pipeline. Pharmas and biotech are littered with the remains and half-eaten carcasses from failed drugs, but entering after a crash for a company with strong fundamentals can provide some cover for potential falls. Personally, I stay away from pharmas with “lifestyle” drugs such as ED treatments in favor of those with candidates for life extending treatments for cancer, heart disease, and alzheimer’s. With an aging boomer population, I believe that we can still see strong growth in these areas in an attempt to “fix” the medicare problem. The companies I look for are those that don’t just extend life, but prevent deterioration of mental and physical faculties as these will be.

Any way you look at it, even investing in CDs is going to provide a better return for the next 5 years than real estate.

Boomer, sell and find a good place to park that money. Find a few funds that you believe in, or do the research yourself. All of the easy money was made and now it’s down to the nitty gritty of investing… yield, growth, and preservation. Good luck

• Boomers , predictions , Investing
• Comments(2)

Chuck Ponzi June 30th, 2008

I recently had a reader pose a question to me via email and I’d like to take some time from our normal programming to see what is on his mind

Our friend, let’s call him Boomer for short, had this to ask of me:

Moved my family to La Costa area (renting) and own a house in AZ which I owe $159k at 6.5% (it adjusted and will again in 8 months) The home was at peak worth $750k now $550k I had it rented last yr for $2200 and just signed a 3 yr lease w/ new tennant for $2,400 . I have $600k in cash..Should I pay this house off?? or should I just refi it and hold on to my cash to buy here in S cal in a yr or two?

First off, I have a couple of thoughts:

1. Whoever Boomer is, he’s in a pretty good position, relatively speaking

2. Without knowing his age, I’d say Boomer is likely Early Xer or Late Boomer.

3. The most important point of all (where he wants or needs to live) is missing from the question. Don’t feel bad, many people forget this little factoid. We’ll assume that he wants to stay in SoCal.

I’ll deal with some important points:

1. What is that house in Arizona really worth long-term?

2. What should Boomer do with the cash?

3. What kind of financing makes the most sense?

What is that house in AZ really worth?

This is the question that wasn’t really asked, but needs to be answered, what is the house in Arizona worth, so we can understand what to do with the money.

Well, Arizona is a big place. It has a varied geography with beautiful vistas, scorching deserts, and some bone chilling mountains. You may not like what I have to say, but I’ll say it anyway. Your perception of the world and finances is the boiled frog syndrome. Not that I blame you. You’ve been raised in a world of ever decreasing interest rates and increasing asset values. The world has been kind to you.

You see, the success of many of the past 30 years (primarily the boomer cohort) is a demographic abnormality. Asset values have increased simply because of the organic demand of the Baby Boomer generation and ever increasing ability to finance that demand. In addition to this, an extremely relaxed monetary policy has increased the value of assets consistently since inflation was trounced back in the late 70s.

Unfortunately for many, that time is over.

In the short run, houses are worth what someone else is willing to pay for it, but in the long run, they are subject to the value of the next best alternative, or substitute pricing. The best substitute for owning a house is renting one. In some cases (such as short-term living), renting is almost always the clear alternative.

There are many formulas for determining the value, but one of the simplest mechanisms is the GRM (Gross Rental Multiplier). Basically, this number is used to multiply the monthly rent to arrive at a fair estimate of rental value. However, this is only a rule of thumb and is not to be taken as gospel; lower interest rates (like I expect we will see for the forseeable future) will increase the GRM, while substitutes (buildable land, locus to employment centers) will decrease it. In certain premium places like Orange County, the upper stretch might be 220 or so, while in places like Las Vegas or Arizona, a more reasonable 120 to 160 is more in line with reality. If we err on the side of optimism (150 GRM), this places the current value based on long-term fundamentals at about $360,000, leaving Boomer with a $190,000 premium over its fair value. If I were evaluating a stock, I’d say SELL! SELL! SELL! Doubly more so if Boomer had lived in the house for more than 2 of the last 5 years since he can walk away with pretty much all of the money tax free. It doesn’t matter what the market is selling at, if there is really that much of a disparity, sell that house and get your money! (of course, it doesn’t help that it was just rented, but there are always ways to let a renter go, if the price is right). At a 229 GRM, his house is badly overpriced. When it was $750K, I haven’t a clue how someone could justify that, since it would have been a GRM of 340. Holy smokes!

The future good in some ways, but bleak in other. The Southwest is largely overbuilt in nearly every city with a real dearth of extensive employment opportunities (unless WalMart is your target), and if energy prices remain elevated (not a given in my mind), the ability to pay will deteriorate along with the economy. Boomer may end up with late (or no) payments from his rental. Rentals are generally difficult to manage from a long distance and I would only advise it if you were planning on returning back to the home at some date. However, that would be hard after living in LaCosta for a few years.

In addition, a house can be valued at the cost of money to purchase it. This is a bit more detailed, but an easy rule of thumb is to take the rental equivalent, figure in future increases in rent, and discount the cash flows based on current borrowing rates. It accomplishes about the same thing as GRM, but removes the variability of borrowing rates (especially if it is held as a long-term investment). Using the inverse calculation, you could figure what the “money rent” on the current place would be given a few variables such as the “current value” and current interest rates. Given a current value of $550,000, the money rent valuation using 7% says that Boomer should be collecting about $3,700 in rent on that money. This leaves out taxes, repairs, rental expenses, vacancy, and many other options, so it is by far the most optimistic. By this reckoning, the house would have an imputed value of $357K, pretty darn close to our above $360K value. Sounds like time to sell this puppy no matter how you look at it.

As another way of thinking of it, as interest rates go down, this increases the ability to pay, but that can only increase so much since the risk of buying on low interest rates and being unable to sell into a similar situation will weigh heavily on others’ minds and prices will need to adjust to handle this uncertainty. Since demand for housing is waning as the boomer generation ages in place or downsizes (or simply dies), it is unlikely that houses will be able to continue their rich valuation long into the future without a substantial demographic to replace them with the ability to purchase.

Any way you look at it, the house is currently valued at more than it is “worth”. I can show houses in Orange County that currently have better GRMs than what this house is showing, and Orange County is one of the most overpriced locales in the US.

Tomorrow, I’ll deal with the question of what Boomer should do with his cash. Any thoughts before then?

• Bubble , Boomers , Denial , Deflation , Investing
• Comments(3)

Chuck Ponzi June 20th, 2008

I’ve had opportunities to show how much I trounce the market before.  And, frankly, some wondered why I wasn’t spending as much time on the blog lately.  Well, here’s why:

If I had followed conventional wisdom and sold in may, I’d be a bit behind where I am now.  It’s not bad that I’m outpacing the S&P500 by 30% this year.  I’m happy with the results so far.

Investing takes a lot of time to get it right, and frankly, I’m just now reaping the rewards of investments made more than 1 year ago.

Thanks for all of you sticking around, and most of all listening to my jack-assed comments about how great I am at market timing.

There’s still room for a fund in the future!

• Housing Crash , Investing
• Comments(1)