NEWSLETTER: 2ND QUARTER 2010

May 4, 2010 8:18 pm Published by Leave your thoughts

Greetings!

HAPPY MOTHER’S DAY! Sell your stocks and have a pleasant summer. Yes, I’m starting to peep out from under a pile of tax return documents and as you can see from the article below – I don’t like what I see! The market has actually dropped 10% since I started writing this. (Another good reason to get a personal financial advisor and not to rely on your CPA for investment advice.) I’m trying not to be a Cassandra here. Even as I type my mind’s eye is overcome by the image of my college finance professor’s warning that “market timing never works!” Nevertheless, this debt situation brewing in Europe (of all places) requires your attention. The recent unsettling disclosure that the prior Greek government had been “cooking the books” to hide its insolvency is a game changer. At the very least I feel it is safe to say that you will be more comfortable over the summer being out of the stock market than in it. Not that I think the world-wide economic recovery is necessarily in danger of regression, but it appears there is going to be a very serious world-wide re-evaluation of risk as it relates to public and corporate finance and this market assessment is not likely to be resolved quickly. Worst case scenario – you won’t make any more money in the market. Best case scenario – you won’t lose any more either.

We have had a good run over the past 13 months in the equity markets. Those of you who invested in an S&P index fund should be up about 70%. Those of you who followed me into the financials could be up as much as 140%. As I pointed out in my past four newsletters, the unprecedented monetary and fiscal stimulus both here and abroad is precipitating a world-wide economic rebound that by rights should continue for many years to come. However, in light of recent headline risks, I have temporarily liquidated my long equity positions and taken up the near-term mantra. “Sell in May and go away!” Events unfolding in Greece remind me of the woman a few years ago who told me she took out a second mortgage to help her pay her first. Needless to say, her financial situation did not result in a happy ending. It seems clear the situation in Greece is not going to have a happy ending either. News over the weekend of May 7th is that the European Community will implement “stabilization mechanisms” by Monday that should result in a short-term bottom to the current correction. I would take advantage of an almost certain short-term rebound to exit and head for the beach.

What do I mean by headline risk?

Listening to the financial news of late should remind you of the spring and summer of 2008 when financial institutions were re-evaluating risk as it related to sub-prime mortgages and were rushing to hedge this risk by purchasing credit default swaps to insure their various mortgage related instruments against default, and purchasing these swaps even as their prices rose commensurately with their panic to purchase them. The re-evaluation of risk taking place today is no less consequential to equity prices and in similar fashion I fear many investors will be caught like deer in the headlights of another financial panic and resultant market swoon and yet again sell at the bottom.

We have all had experience with debt traps. That’s when your creditors (for whatever reason) decide you are a greater risk than they thought and they raise your interest rate as a consequence. Greece has been operating beyond its means and its debt ratings have fallen below investment grade. The Greek government has had to pay higher and higher interest every time it has issued government bonds and those financial institutions that purchased them have had to pay increasingly higher costs to insure these bonds against default. Sound familiar?

Normally a country in Greece’s situation would play a dirty little trick on its creditors, devalue its currency, pay its local debt with cheaper paper and pay its foreign debt with foreign currency earned by exporting cheaper products. Greece can’t do this because it is part of the European Union and is not in charge of the common Euro currency. So Greece has no easy way out. They have to do what you or I would do if caught in a debt trap – we’d tighten our belts, withdraw money from our pension plans, cut back all but essential spending and pay down our debt in chunks as quickly as possible. Betting that Greece will seriously take this route (despite the billions of Euros in low interest loans offered by fellow Euro countries and the International Monetary Fund) is a losing bet if I ever saw one. Greece in my opinion is more likely go the other route that you or I could take. We’ve all seen images of Greek government union members rioting in the streets. Greece seems more likely to go bankrupt and default on its obligations. (It will be referred to as “restructuring.”) Default causes money to “disappear.” This leads to deflation and lower asset prices. This chain reaction is what the market fears. The EU and its central bank will continue to address the crisis, but the fear and expectation of default is unlikely to be permanently dispelled. They may be able to defend the Euro, but unfortunately they currently lack the political infrastructure to take the steps necessary to address individual country insolvency. Risk is being re-evaluated world-wide from Spain to Los Angeles. Market volatility has sky-rocketed. Credit markets are in disarray. Nobody is going to lend money at current interest rates to any country, county or City perceived to be in a debt trap. Sell in May go away – preserve capital for another day. That’s a time worn and venerable market adage and one I recommend to the average investor at this particular juncture. We will undoubtedly visit this issue again next quarter.

Here’s a question for you. Which is more important price or interest rate?

I recently met a young couple who’ve just completed the renovation of their two bedroom condo and want to move into a house. They asked me to do a comparative market analysis to find out what they could realistically sell it for. This is what I said…

Unfortunately today it is not realistic to expect to get more out of a renovation than you put into it. If you are handy and do the work yourself you might get your materials cost back and you might sell the home more quickly. If you have to pay a contractor to do the work – forgetaboutit! You’ll end up pouring a lot of your money down the drain. If you are planning on selling your home and buying a new home by far the most important decision you have to make involves timing – not renovation of your existing home, and surprisingly, not what you can sell it for. The most important factor: is this the right time to make your move? The answer to this question depends first and foremost on your ability to pay your mortgage. Do you feel secure with your job or business? Remember, even though you can use the income from two jobs to qualify for a mortgage you double your exposure to a lost job. If you do lose a job do you have the marketable skills to get another? Finally, in case you do get laid off, do you have the financial flexibility to pay your mortgage until you find a new job. Next, what is your credit score? Hands down, repairing your credit score is more important than repairing your home. Today, you need a minimum score of 620 to get a mortgage, but unless you have a 720 score you will have to pay one or two extra points at closing or a half percent higher interest rate. A half percent more in interest on a $200,000 loan adds an extra $125 a month to your payment and a whopping $44,658 in extra interest over the life of a 30 year mortgage.

This gets to a third important component of timing: what is the interest rate environment? Are interest rates gradually dropping or rising? If they are dropping it means the economy is slowing and home prices are falling so what’s your rush? All things being equal, why not wait until the economy bottoms and lock in the lowest possible rate on your purchase. If interest rates are rising that means prices are rising as well – better to move quickly and lock in a low rate before they rise further. So looking at the broad scheme of things does the selling price of the existing home really matter? As long as the seller is not under water, as long as the new home’s “price is right,” and as long as the seller has already secured the down payment necessary for the new mortgage and doesn’t require cash from the home he is selling, in the broad scheme of things if the timing is right, the selling price of the existing home should not be a critical factor.

Let’s say the sellers in our example identify a perfect house to purchase for $200,000 and have been pre-qualified for a 30 year mortgage at 5% and a monthly payment of $1,075. However, because they find they can only sell the condo for $100,000, and will only break even once the real estate commission is paid, they decide to wait. Lets say two years later the real estate market has completely recovered and they are able to sell the condo for $150,000. Were they smart to wait? Let’s run the numbers. A house exactly the same as the one they could have purchased for $200,000 will now cost them $300,000 (same percentage increase as the condo) and because the economy is doing so much better they have to pay 6% interest. Based on these reasonable assumptions they now need a loan of $250,000. ($300,000 price of house less $50,000 from sale of the condo). Get this, their monthly payment is now $1,500 and they will pay an additional $103,000 of interest over the life of their 30 year mortgage. Now consider the $50,000 they “made” on the sale of the condo. They would have “made” $100,000 in appreciation on the house had they bought it two years earlier. If the timing is right it shouldn’t pay to wait.

If you are sick and tired of seeing Wall Street brokers make all the money when the stock market falls, and if you have discretionary funds you might otherwise use to take a weekend vacation to Las Vegas and if you have a brokerage account with an online trading platform and the time (and inclination) to glue your face to a computer monitor from 8:30 a.m. to 3:00 p.m., and if you’ve always liked rock climbing, wild amusement rides or playing with matches here is a list of exchange traded funds that go up twice as fast as the equity index they track goes down. Do not tell your investment advisor where you got this list!

  • DXD – ProShares Ultra Short Dow 30
  • QID – ProShares Ultra Short QQQ (Nasdaq)
  • SDS – ProShares Ultra Short S&P 500
  • SMN – ProShares Ultra Short Materials Stocks
  • SFK – ProShares Ultra Short Financial Stocks
  • DUG – ProShares Ultra Short Oil & Gas
  • GLL – ProShares Ultra Short Gold
  • FXP – ProShares Ultra Short China
  • EUM – ProShares Ultra Short Emerging Markets

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