The Clearing Point

  

Being in the business of helping people make smart choices about their money is very serious business. The decisions we make now can have long-lasting effects on how we live our lives. Therefore, in the process of taking this very, very seriously occasionally I will change directions on an as needed basis as our environment changes directions. It's all part of the normal process.

Last week I mentioned on my Facebook page that I am somewhat more optimistic than I was six months ago. This is true. But, it is with qualifications.

Surprisingly, it is not because I think the unemployment declines or the increased consumer spending numbers, or any government programs coming out are anything to write home about. They're not. What I am more optimistic about is that the news has been pretty bad for quite a while. What this means is that the ever present, world renowned pricing mechanism has been allowed to do its job for quite a long time. Since it is always truthful… eventually …we now have information to write home about.

Specifically, I am referring to the price of housing. We may begin to see a glimmer of light in our housing spelunking adventure.

According to several sources including the National Association of Realtors, FactSet, and the US Census Bureau; several important things of occurred over the last few years.

• The median price of existing home sales has dropped from a peak in November, 2005 from $227,000 to $165,000 as of November, 2011.  That’s a drop of over 27%.
• Mortgage payments, on average, for new homes as a percentage of average household personal income is down to 10.3% as of November of 2011. To give you some perspective, back in 2006 it was approximately 20%. Back in 1982 it was 37%.
• Household debt as a percentage of disposable income is down to 11%. This is about average historically. At its worst it was up around 14% back in the third quarter 2007.
• We are at the point where the national average mortgage payment for a home of $521 per month is below the national average rent of $708 per month according to JP Morgan.

Tipping Point, Perhaps

Because we have reached a point where key statistics are similar to some key long-term averages, we have to question whether this downturn can go further or not. It is possible that a lot more could go wrong. Or, with housing prices off 27% and the average homeowner paying roughly 10% of their average household income on house payments, we could be close to a price clearing point. That's the point where supply intersects demand and pricing pressure one way or the other is not abnormal.

Healthy Dose of Reality 

• Job growth is still very, very slow. In fact, it may in truth, still be negative. The official number has improved over the last quarter, but there is legitimate concern over how unemployment is calculated. It is important to note that the labor participation rate is a factor in the calculation that has legitimately made the news. This number appears to be uncharacteristically gyrating based on some suspect assumptions. I think this should be the focus of another blog discussion. Suffice it to say unemployment improvement is by no means a slam-dunk.
• Government debt continues to rise. February of 2012 marks one of the highest ever debt months for our treasury. It took on approximately $154.8 billion that month alone. Federal government spending now accounts for approximately 20% of overall spending in our economy (Survey of Current Business). This does not account for state, municipal, and county government spending. It is too high for a flourishing economy. I will refer to a quote from Sir John Templeton when he said "When the government gets in we get out. When the government gets out we get in". Historically, our economy has been far healthier when the government accounted for a smaller part of total spending. What I am watching now is how willing government is to step aside to let the private sector assume more of the spending pie. . No matter who runs the government, this has to happen to spur long-term, high-quality economic growth.
• The federal debt as a percentage of GDP as of 2011 is about 67%. This is historically high, but not the highest ever.

Let's Digress

How much debt is too much debt?  Let's look inward. How much debt is too much debt in our own lives? It is not uncommon for the average American homeowner to earn $75,000 and borrow $200,000 for a home. This is a personal debt to GDP ratio of 260%. It's done daily. If we extrapolate that to our federal deficit, were looking pretty good. But.......More often than not the government backs mortgage loans thereby taking away lender risk. Individuals do not have S&P ratings, but our government does and it matters. So by government fiat our loan becomes AA rated.  It used to be AAA.  Ultimately, the S&P rating of government debt matters and ours has decreased a notch in 2011. So, the comparison to personal debt is not really that valid because the government has tentacles just about everywhere in our system and its perceived ability to pay on time can have marvelous or catastrophic effects depending on how its credit quality is managed. Conversely, if I default on my one mortgage, the only person it affects is me.

Why Are they Still Lending Us Money?

We don't know exactly how much debt is too much debt. BUT, we have a measurement for it. Interest rates reflect the willingness or reticence of investors to trust our safety. Currently, international investors are readily lending to our Treasury even though interest rates are at or near zero in many cases. They are lending their money to us for a song. We must conclude that the U.S. Treasury is still considered the safe haven in the world compared to the rest of the world. This is a very important point.

The treasury is banking on its having plenty of room to continue borrowing. They probably do, based on current interest rates. However, make no mistake about it: interest rates will eventually be increased. When interest rates increase the first time, it will probably be teensy. The press will jump all over it 24/7, the markets will gyrate, they will settle down, and life will go on. Surprisingly, we aren't there yet.

Conclusions 

Overall, I recommend the following: 

• Keeping our eyes on our actual goal.
• Building our portfolios based on our actual goal.
• Not being distracted by the stock market and its wild returns and gyrations. 
• Keeping in step with your investment policy statement unless we see a really good reason to veer from it.
• Maintaining optimism with a healthy dose of realism.

As always, please feel free to call me at 952-230-1340 if you would like to talk.

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

 

Securities offered through LPL Financial. Member FINRA/SIPC.

So, You Want the Money...

In January, I asked what would happen if you had a 30 year US government Treasury bond and you wanted your money before 30 years is up. Here is the answer...

Most things in the world are for sale, and bonds are no different. The wild card is the price. Perhaps surprisingly, the bond market is set up to be pretty orderly when determining price. It is not like selling a home, mostly, but just partly. When you sell a home the first thing a real estate agent does is check the prices of homes sold (if ANY right now) in your neighborhood. He figures that most homes in the 'hood are roughly the same. Then he adjusts for amenities. In the end, he does not move the price too much from the 'hood's average price. It is fairly but not totally subjective. We always think our home is worth more because of some special things we have done to it. It is only human to think so. The bond market is not so subjective.

The value of a bond is based on these items:

1. Cash flow it makes you
2. How long the cash flow lasts
3. How safe the cash flow is
4. What other similar bonds are paying
5. Government regulation
6. Will any of the above change

The Math Thing

The real estate agent can guess. The bond buyer has no such luxury. Your bond is a cash flow maker. That's it. How it is priced is an amalgamation of the points above in as mathematical of a fashion as possible. Before your eyes glaze over, let me explain…
Let’s cover 1 through 4 all in one swoop.

Assume you have a government bond that pays interest for 30 years at 4%. To buy it, you give the dealer $100,000. You begin receiving your $4,000 annual interest (it actually pays $2,000 every 6 months) for the next 30 years. Let's say that in 2 years you want your money out.

In 2 years you have a 28 year bond. The dealer compares your bond to other 28 year bonds for sale and finds that they are paying only about 3%. Since yours pays 4%, it is worth more than the competition.  He will pay you a PREMIUM for your bond since IT pays a premium interest rate. He will pay you enough that when he resells it (net of his service fee for providing a liquid market for your bond) the new buyer will receive net 3% interest based on the price he pays and the annual cash it pays.

He will value it as he should value any cash flow producing mechanism, whether a bond, a rental home, a commercial building, an oil well…whatever. It is worth the value of all the future expected cash flows DISCOUNTED back to today based on how long you have to wait for them and how reliable they are. The longer you have to wait, the bigger the chance of something going wrong. SO, the discount rate reflects this.

Think of the discount rate like this: It is the rate of interest you must earn to compensate you for the use of your money over some time, and also for the chances of something going wrong.

Now, add in 5 and 6 Above…

So, General Motors bondholders, who were essentially thrown under the bus by the federal government in the bailout, in hindsight should have required an enormous discount rate to buy those bonds. If they knew in advance what might happen, they would not have bought them. We don’t know in advance, though, which is why what we do is called “investing”. We can only estimate our chances.

In the Real World

In the real world, cash flow management is not as simple as the example. This is why I generally use professional management. They have the staff and facilities to continually reevaluate the credit quality and relative benefits of our choices. Additionally, in the world, there are many instruments that are associated with bonds, but do not act exactly like I exemplified. They are used when conditions like changing interest rates, credit qualities, currency values, or government regulation change the playing field. Often these instruments are used to help lower risk.

The Take Away

Bond portfolios have values that change daily based on many, many factors. They often contain other instruments that can be highly beneficial in limiting our risk and potentially enhancing our return. Professional management provides a double check on our money that an individual investor could not likely do effectively by himself. Reviewing credit quality and other issues that affect bond prices requires a highly trained, professional staff.

Another very important take away is that bonds have values that very according to many triggers in addition to interest rates. Interest rates play a part, but it is wrong to assume they are the only moving part.

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Securities offered through LPL Financial. Member FINRA/SIPC.

Monopoly and Large, Large Waves…

We are in an official financial crisis. Sometimes I am master of the obvious. Let's explore so that we can relate this back to your bond portfolio in the next entry.

A crisis typically starts as a shock to player and escalates to shocking many players. The really smart people call this contagion and say that this results from systematic interdependence among players. Players do business with each other. One bank loans funds to another.  An insurance company loans funds to a bank. A bank co-ops with an insurance company and to a hedge fund to purchase a building by borrowing from another bank, and the list goes on.  Ultimately, when a shock to one occurs and any sort of intervention to offset the shock doesn't work, we are in crisis.

As we have seen recently, interventions can come in several forms. They can be restrictive or stimulative monetary policy. There can be overwhelming fiscal policy (e.g.TARP), confusing fiscal policy (just watch the nightly news to see how confused even the media is) and no fiscal policy. During this crisis the primary forms of monetary and fiscal policies have been flooding the market with dollars to avoid deflation and a series of pending, potentially severe, regulations on industry.

Along the way a couple of large auto companies were essentially annexed by the US government and many bondholders in the way of those seizures lost their investments. If you ever wonder whether or not there is risk in investing in even blue chip companies, just ask any of your friends who bought General Motors bonds. Most investors could never have imagined that General Motors would default.

As a society we have been erroneously convinced that riskless investments, or even a riskless society can be had for the asking. Society should  may be (???) realizing the hard way that it has made a series of huge mistakes. To its defense, it is understandable to some extent why it has been so easily taken advantage of. Everyone wants to not have to worry over their money. When an authority figure (government) offers to grant an ever more riskless society, it is difficult to say no. Over the years it was easy to rely on past experience (everything has been all right so far, right???) rather than to evaluate objectively where the small steps taken to a point in time will eventually lead. Money management boils down to hopes, fears, and human behavior.

The Wave

The current credit cycle is one measurement of human behavior.

 We are in roughly the bottom of a very large credit wave (cycle). In fact, you could call it a credit depression. Credit expanded dramatically over the last 40 years and more than dramatically over the 10 or so years leading up to 2008. The mechanism that was used to increase credit was primarily the housing market. Congress expanded several programs that targeted home buying as a behavior of choice and blew the doors off through unprecedented credit availability. The mechanisms leading to this were somewhat involved. But know that when Congress wants something it incents the daylights out of the system to get it. It did just that and everybody in the housing credit business had to decide whether to play along or go out of business. As you can guess, most people chose to play along. A few were very good at playing along and made huge profits.

Monopoly… Thank You Parker Brothers!

What we got for our participation was like a seat at a very expensive and costly Monopoly tournament. At the beginning of a Monopoly game everyone starts out flush with cash. Then as fast as they can they purchase properties, followed by homes, followed by hotels. Their hope is that their friends around the table land on their properties, owe them rent, and make them Monopoly money RICH!

Timing is Everything!

Landing on a property with hotels happens precisely at the time when everyone is cash poor. Their money has been spent buying homes and hotels. When one of the cash poor lands on Boardwalk , they must begin liquidating properties to pay the rent. Ring a bell? In the world we call that "price clearing in the marketplace", or being “upside down”. Eventually, enough properties are landed upon and players, one by one, leave the game to watch TV or munch comfort food on the sofa while licking their wounds. Eventually, two players are left. They battle it out until one leaves in disgust heading for the comfort food.

Imagine if this game were played on credit. Prices would blow up even higher and the gains made would be higher and the ultimate crash in prices would be even more dramatic. Welcome to our world. Actually, welcome not exactly to our world. Spice this up with the general feeling that if something goes wrong the government will make it right, so full speed ahead!

Society really wanted to believe that money is risk free. Individuals, in their hearts of hearts, know that human nature makes this impossible. But, they really wanted to believe it. As a result, we are at the bottom of a credit depression.

This scenario should and does impact how we manage money.

Chris

T
he opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investingBonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Securities offered through LPL Financial. Member FINRA/SIPC.