NEWSLETTER: 3RD QUARTER 2010

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

Greetings!

The purpose of my quarterly news letters is to provide my tax, real estate and home mortgage clients with a unique “outside the media” perspective on current market issues and developments. It is not to be considered a substitute for retaining personalized planning from investment and legal professionals.

In my last newsletter I advised you to sell in May to avoid the expected volatility surrounding the European “Greek Tragedy.” Since then the Wilshire 5000, the broadest measure of the market, has taken a $4 trillion round trip.

As mentioned below – there’s still lots to worry about…

The Euro-PIGS debt crisis is still simmering on the back burner and once again threatens to boil over and require additional “clean-up;” The US Federal Reserve, now sitting on $2 trillion of mortgage backed securities and still facing an economy on the verge of deflation announced it may have to resume purchases to prevent the economy from contracting into a double dip; The US dollar as a result of the announcement has once again begun to tumble lower on foreign exchange markets; Political parties in Washington D.C. are deadlocked over what to do about a host of tax increases scheduled to begin Jan. 1st 2011 that would suck even more from tax payer pockets; Joblessness, after over a year of recovery, is only slightly off its peak of 9.7% in the U.S., and 8.5% throughout the developed world; August existing home sales rebounded 7.6% from the July slump and were up another 10% in September but they are still 19% below a year ago! Now we hear that foreclosures are stalled over faulty paperwork. I could easily go on, but only to repeat what you are reading elsewhere or getting on the evening news. Suffice it to say everyday more bad news, (some of it politically motivated,) flies through the airwaves like a host of locus plaguing the entrepreneur spirits of our economy. However, my take on all this differs in this respect: it appears to me that we’ve reached another inflection point in our markets similar to March 2009 where the risk of further downside, (although very real and possible,) appears limited. Yet unlike that prior inflection point that many missed due to its sharp upward spike – this time may be different. Yes, contrary to popular opinion, it appears that it’s time once again to start buying equities, and this time, in the words of Mick Jagger, “time is on ‘our’ side” whereby a convergence of the positive trends, (outlined below,) should continue to slowly counteract the above negative news and create further upward, (albeit jagged,) sloped markets.

What positive trends? These trends are not easy to see which is why they may lead to a buying opportunity.

Employment trends are down, with private sector growth more than offset by public sector layoffs. Economists world wide agree on this single point: economies need to move jobs from the public to the private sectors. Think of it this way: the economy has recovered from the financial crisis heart attack only to discover the cancer of too much government debt at all levels. Local and State governments in Europe and in every state in the U.S. are cutting employees. The short-term affect is negative, but the long term trend of less government employment is positive. Will the market look beyond the short-term? History says it will.

U.S. Consumer purchases, which stimulate 70% of U.S. gross domestic product, are down and have remained down for several years and due to massive unemployment and other factors they are growing at a slow rate. Yet massive amounts of consumer debt has been paid or written off leaving the U.S. consumer more likely to step-up spending as the employment environment improves. According to Federal Reserve statistics, household debt service payments and financial obligations as a percentage of disposable personal income has, over the past three years, dropped a full two percentage points to a level last breached in 1989! Sales of basic household items including consumer electronics as well as business spending on basic business tools are improving and are extremely unlikely to turn down again. We’ve reached a point where come hell or high water a lot of essential items must be replaced and household and business balance sheets are slowly reaching a point where these items can be comfortably financed or paid for with cash.

The productivity of U.S. companies has in recent quarters reversed its multi-year upward trend and is now falling. More production to meet growing world-wide demand can simply not be met by the current overworked labor force. An ineluctable slow rise in U.S. private sector employment is now inevitable and should begin to accelerate by mid November as soon as the current election cycle produces greater political and economic certainty.

Equities have become a “contrarian investment.” Historically speaking, there have been very few 10-year periods of negative equity returns, but we have been in one of those rare periods for nearly two years now! After a 1.5 trillion drop in household net worth during the second quarter, investors have been moving in droves out of stocks. Stock trading volume which had been rising for years was down a remarkably unprecedented 23% in the third quarter from the year prior. I have argued in these columns for 18 months that free markets and worldwide demand preclude a depression and more likely than not the much talked about double dip recession. Nor, (due to starkly different politics and demographics,) are we likely to be caught in a “lost decade” of Ala Japanese style deflation. More likely, our markets are on the cusp of a gradual long term rise that will take us to unexpected and unexplored heights. This rise should be sustained by billions of new consumers and growing worldwide trade, but its stimulus is likely to be billions of dollars fleeing the bond markets with no better place to go. More on this inevitability below.

Question: What does the so called “bond bubble” and investment real estate have in common?
Answer: Historically low interest rates. What’s next?

Over the last 18 months outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows. In tough times like these with the economy in shambles and interest rates falling and folks burned in past years by plunging stock prices they look more for return of capital than return on capital. The interest rate on non-inflation adjusted 4 year treasury bonds recently broke below 1%. Though understandable given the deep losses investors suffered over the past decade, to me this looks more like an over-reaction to the current investment environment than a good investment.

Not only is it mathematically unlikely that rates will trend still lower, even a small rise in rates will cause these bond funds to lose principal value should investors in these funds sell. It’s one thing to buy a bond and hold it to maturity and retrieve its principal. It’s quite another to own shares in a fund that must sell when share holders liquidate. For example, during the two month period June to July 2003, ten year treasury prices fell 8.2% reflecting sentiment that a healthier economy and rising inflation would prompt Fed chief Alan Greenspan to raise interest rates.

The Fed has set the Federal funds rate at less than 1%, but the market price for capital is set by investors, and interest rates are bid up by these investors as demand for capital increases with the recovery. What do these historically low interest rates and the investment real estate market have in common? Mortgage rates which track the rise in 10 year treasury bonds are destined to rise as the economy improves and inflation (think rent) increases. Borrowing and investing in rental property now, at historically low interest rates virtually guarantees a better return than waiting because an investor won’t know prices have reached bottom until they start to rise, and by that time the dam will have broke, money will be flowing out of bonds into the economy and rates will already have risen. As my finance professor warned us years ago: “Trying to time any financial market is a fool’s game.”

Here is the bottom line on how long it will take for real estate prices to rise: The current U.S. economy (functioning normally) must provide roughly two million homes per year to absorb new households. We are currently building around .5 million homes per year. There are about 2 million homes in some stage of foreclosure with about one million projected for 2010.

According to Census Bureau data new household formation is down dramatically from a high of 3.5 million in 2001 to 772,000 in 2008 to 398,000 in 2009. In other words, the recession itself has caused excessive pent-up demand do to folks doubling up due to a lack of credit, household income and financial reserves. When the economy does start to improve the foreclosures still out there are likely to be bought up relatively quickly and even rented back to the folks who once owned them. The Sheriff of Cook County currently has about a thousand foreclosure evictions on his list. Nearly all of these properties offer the investor positive cash flow.

It’s just a matter of time.

If you are curious about available investment properties, or what foreclosures are selling for in your area click on the Century 21 Galaxy logo above and check out the cutting edge tools available on my web site.

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