2008 – A year most will never forget

December 24, 2008

Would you like to read my comments and forecast five nights a week for only $1 a day? At the end of each year it is instructive for anyone in the forecasting business to go back and analyze the good and bad results with a special focus on those predictions that were not realized. In bad years this exercise can take days as you wonder if the crystal ball needs to be repaired. Good years remind me of the old Casey Kasem motto of “keep your feet on the ground while reaching for the stars.” This was also a magical year for the Early Warning Wire as the three best bets offered in January became huge winners for readers that were brave enough to come to the plate and take a big swing.Early in the year I saw the world financial markets from a completely different perspective than the majority of “experts.” The Fed was hoping the housing problem was limited to sub-prime and real estate agents were singing the same old tune “it’s always a good time to buy a home” and that set the stage for the beginning of the worst crises in modern real estate history. My theme for the year was that we only see the future from our own experiences and unfortunately many followed those with limited experiences. Real estate experts were certain this year was nothing more than a down cycle where buyers would see the opportunity of a lifetime because history would repeat itself and investors always made $$ by buying when prices dipped slightly for a few months. I reminded everyone that history does repeat but NOT when you expect it. The Fed was caught looking one way and the train came from the other direction. They were forced to ease and quickly producing record low short-term interest rates. My 1st best bet was a play on an increase in the spread between short and long-term U.S. interest rates. The yield curve widened dramatically from 108 basis points in January to over 250 bp in October creating massive profits for those that leveraged their positions. There will be another opportunity in 2009 for those that missed the biggest bull market in 2008. I will discuss that and many other opportunities in my 2009 forecast issue (week of January 5th).World investors began the year in denial about market conditions and the risk they were taking with current positions and because bear markets don’t usually give notice most of these investors remain in these positions with big losses. 2008 was also the year when everyone learned a painful lesson on why it is so important to always have stop losses on ALL positions. It doesn’t matter how confidant you are about a forecast you must set a stop loss point BEFORE you enter the transaction. Frequently a position will be entered for a quick trade but the profit never occurs and a loss begins to build and becomes a long-term hold. Money and mutual fund managers built long profitable track records in the past 10-15 years through a “reversion to the mean” theory whereby you hold stocks, etc. through bear markets and the prices always come back to their “true value.” That strategy works in most market cycles but not in true bear markets which last much longer than expected and don’t end until all the players have left the financial arena promising to never enter again. Buying the stocks of Fannie Mae, Freddie Mac, WAMU, AIG, Bear Stearns and others based on the assumption they would never be allowed to fail caused billions in losses that will take decades to earn back. Amazingly these managers were paid for their portfolio skills and in many cases have moved on to start new funds from scratch while their old investors wish they had the capital to begin again. One famous manager broke the #1 cardinal rule of investing: NEVER add to a losing position. When the above mentioned stocks began to decline these “experts” added to their positions under the premise that it was the buying opportunity of a lifetime. Investors money was wiped out and these managers explained that they had made the right decision but the market had mispriced the securities or it wasn’t their fault because the economy was to blame or the best one of all “everyone else lost so we didn’t do any worse than anyone else.” This year was a perfect example of my theory that the masses would rather lose in company than win alone. Using the excuse that the S&P was down 40% but your portfolio was down only 30% is a poor substitute for disciplined investing. But why would any money manager advise a client to take a loss knowing that they will lose the client but have a 0.0001% chance of keeping the client if they hold the position forever “hoping” the price will come back to their original purchase price. 2009 will begin with investors money under their mattress or in Treasury bills earning 0.00% or less. Trust is not something easily earned and it will be many years before the average investor risks any of their hard earned savings.

Across the Pond

My 2nd best bet for the year was another home run as the British Pound succumbed to the pressure of a sagging world economy, lower oil prices and a runaway real estate market. One of the problems with making long-term bets is that one constantly wonders why investors are taking the other side of the intended transaction. The pound was trading just under $2.00 in January and did rally to $2.05 before breaking hard in the summer and fell 25% in the 2nd half of the year. Confidence in one’s forecast is tricky and is open to much self doubt even as the trend picks up steam in your direction. The Bank of England held interest rates high most of the year as it fought an invisible inflation monster that disappeared when the Fed led other world central banks in massive easing of monetary policy. Although the pound is clearly oversold and due for a bounce in early 2009 the British economy is far from hitting bottom and much like a patient coming out of the ER will need a very long recovery and rehabilitation period.

The ticking bomb

My third best bet was that we would see a dramatic deterioration in the value of commercial real estate values due to a lack of credit and a pull back in consumer demand. This forecast may have been a little early but will certainly be worthy of home run status in 2009 as vacancy rates in office and shopping centers are increasing and mortgage delinquencies begin to climb. Because the CMBS (securitized market) is all but shut down the due dates for fixed financing of many projects will be the equivalent of bombs exploding as lenders go from denial to a state of shock over what to do with property they never thought they would own. Apartment owners in C buildings will be the beneficiary of the DEFLATIONARY wave that has hit the U.S. economy and hurts anyone in debt. Decreasing asset and consumer prices benefits those on a fixed minimum wage as long as they hold no assets. Gasoline prices under $1.50 and declining food prices increases savings and the ability of these low income workers that live in C buildings. With financing available for multi-family properties from Fannie and Freddie these properties are the only ones that have a chance to see price appreciation in the next few years. For those that have consistently seen their property values increase each year 2008 was a shock and will be repeated in 2009 and beyond. Just because you made your fortune in commercial real estate does not mean the market owes you a repeat and only those willing to change and adapt to the new Deflation will profit in 2009.

The more things change the more they remain the same

The one constant for 2008 was the unwillingness of investors, money managers and “experts” to change as the economy and markets deteriorated almost daily. I watch all of the business channels (bubblevision), read 27 newspapers, 50 blogs, magazines, tape Fed speeches and make sure I have a good pulse for what the majority is doing on a daily basis. Almost every day we were bombarded with quotes about how to pick the bottom, whether we were in a recession, when would the economy turnaround, etc. When 99% of stocks decline why do experts try to find stocks to buy from the 1% rising instead of finding stocks to short from the 99% declining. Real estate agents are always telling us it’s a great time to buy but rarely inform when it’s a bad time to buy. Are these people we rely on for our information really being objective or telling us what they think we want to hear for fear if they don’t we won’t use their services? Isn’t it about time you asked WHY the next time some one gives you their opinion? You might find they are just repeating something they heard or are one of the majority that would rather lose in company than win alone. Hopefully the carnage produced in 2008 will give more investors the courage to change and stand alone in their pursuit of financial wealth.

As we begin a new year please ask yourself what changes you will make to make 2009 a profitable year.

Best wishes for a happy, healthy and safe new year.

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Why would anyone want to borrow when prices are going down?

December 15, 2008

If you would like my thoughts on a daily basis I write a comment every evening (Sunday-Thursday) around 10pm that discusses specific forecasts for short-term traders and long term investors.Tuesday’s CPI number will show retail inflation fell at a 1.5% rate in October confirming that a dangerous bout of DEFLATION has entered the U.S. economy. This disease is a rare occurrence as inflation has been the best friend of investors for the past 70+ years. Debt has been used to increase spending and leverage asset purchases that have created billions in profits for real estate investors but created unrealistic expectations about the future based on our own past history. When inflation has increased price levels far above the growth rate of wages the Fed has stepped in and increased short-term interest rates making the “real” cost of borrowing high enough to temporarily change investor expectations about the future. If inflation is 10% the Fed can easily raise the overnight cost of funds to 15% but in a deflationary environment where prices and asset levels are declining it is impossible to lower interest rates to negative levels. The past couple of weeks have seen short-term T-bills trade at minus yields of a few basis points because today the return of capital is more important than the return on capital.

The business news each day covers recent government capital injections to banks and a hope these institutions will lend to businesses and consumers who will spend and invest in projects that will create jobs for the unemployed and raise income levels for those struggling to survive. But it takes two parties to complete a loan and borrowers must have expectations of profit or a fear of future inflation before they will entertain more risk on their balance sheet. When price and asset levels are increasing our view of the future is created by extending today’s trend forward and this is exactly why so many made billions in real estate. Values rise each year at a faster rate than the interest one is paying and with a deduction for depreciation and a small increase in rents it becomes a perfect recipe for leverage to the max with little perceived risk because prices never decline. If there is an expectation of increased inflation borrowers will also rush to their local bank because of a fear that if they don’t buy at today’s prices they will not have the funds to purchase at tomorrow’s higher prices. Unlimited credit and an expectation of higher home prices fueled this real estate debacle and now expectations are beginning to seep in consumers’ and investors’ minds that prices are declining every month and it is better to wait for lower prices.

This is a very dangerous phenomenon because once the “negative feed back loop” begins it is hard to break because the Fed can’t use the same tools it does when it is trying to curtail inflationary expectations. Tuesday the FOMC will announce another cut in the overnight Funds rate by 50 basis points to 0.50%. This move will have very little impact on financial markets as expectations have already been reduced to near zero for inflation over the next 10 years. The inflation component derived from subtracting the TIPS yield from the on the run 10-year is now at 13 basis points and the 5-year inflation component is at negative 42 basis points. Markets clearly are expecting DEFLATION over the next five years and little or none over the next 10 years. Unless the Fed can find a way to reduce interest rates BELOW the rate of inflation there will be no incentive for anyone to borrow for the purchase of an asset declining in value. If prices decline for the next 5-10 years why would anyone borrow money at positive interest rates? That is the key question the Fed, Treasury and new President must deal with and the sooner the better.

Confidence

Every day I am faced with a challenge in dealing with the homeless that my non-profit serves in Hollywood. They face the same obstacle that investors, consumers and financial markets must overcome this year: lack of confidence. The hundreds we see each week lack the confidence needed to hold a job, housing and manage a life as a productive member of society. The difference between having the confidence to know you can do it or walking the streets aimlessly is very thin and once the confidence is obtained it feeds on itself if nourished and supported which is what we do at Food on Foot. The U.S. economy is just as fragile today with deflation the equivalent of a lack of confidence. The negative feed back loop is the same as the homeless congregating on a street corner reassuring each other that losing in company is far safer than winning alone. Giving jobs or housing to the homeless is not an effective solution if they don’t have the desire to sustain or the confidence to know they can achieve. Government jobs will initially create employment but do nothing for borrowing as deflation continues to tear away at asset values. This country was built by risk takers that were willing to see past today and take a chance at big future profits tomorrow. One of my favorite expressions is to be careful what you wish for because you may get it and today’s lower interest rates were seen as the answer to all of our economic ills just a few years ago. Lower long-term interest rates are at all time lows due to the realization DEFLATION has arrived but very few will profit from it in the next few years. Soon the press will be filled with stories about how to bring back inflation but not before the wealth of many successful investors is destroyed because of high levels of debt.

Are you prepared to change?

History does repeat but not when we expect and this recession/depression is being compared to an era in the 1930’s that few remember or were alive to see. It was named the Great Depression and didn’t really end until the war began in the early 40’s. Very little is mentioned of what is now called the Long Depression that occurred from 1873-1879 and is the record for the longest contraction in U.S. history although there really aren’t very many other comparisons. We have a need in this country to always believe things will get better and then search for a part of history we can hold on to while we wait for things to turn around. The good part of this is that we never give up and are always seeking ways to improve but the bad news is that we often miss obvious signs that conditions are deteriorating as we have witnessed in the past two years in the financial and real estate markets. The lack of stop losses by investors and following the theory that stock prices always come back has put a serious dent in portfolios that won’t recover for many, many years. The inability of real estate professionals to be objective about price levels and always seeing higher values made it impossible for home buyers to resist the calls for immediate action. The real problem is the fear of change and unwillingness to stand apart from the crowd. Whether it be “this is all I know” or “I can’t make this much money doing anything else” or “everyone said to do this” we are a nation of followers and that has led to massive destruction of wealth this year and next year will be no exception. How much more financial pain do you need to suffer before saying enough??? A business that loses $$$ is forced to change or go out of business. Isn’t it time you begin to run your assets like a business? You can’t go back a make a brand new start to your finances but you can start now and make a brand new ending for your hard earned savings.

Has economic reality finally caught up with financial markets?

December 5, 2008

Today’s employment report showing a loss of 533,000 jobs in November was the worst since December 1974 (-602,000), October was revised down 80,000 and September was revised down 119,000. The U.S. economy has now officially been recognized as a recession (began 12/07) but the important question is when will it end and how much worse will it become in 2009? When we dig into the jobs report the key indicators we follow show no signs of an impending turnaround. The number of people working at a part-time job because they can’t find a full-time job rose 621 thousand in November and has increased 1.6 million in the past three months.  Temporary help always turns first before permanent job increases but is now plunging and has much more room to decline before hitting the lows seen in 1991. The number of people employed last month but unemployed this month is soaring to new highs and those unemployed for a second consecutive month is also hitting new highs and has a very strong correlation to the monthly unemployment rate. Jobs data is a lagging indicator but shows no signs of any life for the foreseeable future.Unfortunately the theme for this economic period has been a universal expectation that the future would be a repeat of the past. The U.S. stock market’s decline of 40%+ has been met all the way down by now bloodied optimists that were always looking for a bottom based on recent history that declines only last for a certain number of months or bear markets only decline by a certain percentage. Financial television shows (bubble vision) constantly interview “experts” with the first and last question always centering on what to buy for the next rally. I have forecast this bear market for over two years (see archives) and they don’t die easily and not before the vast majority of participants have left the arena vowing never to return. With 99% of stocks declining this year I am amazed by the constant search for the 1% of stocks that are rising instead of taking the easy road of going to cash (long-term investors) or shorting (traders) one of the 99% that have declined this year. The lack of discipline and stop losses has allowed most retirement accounts to be decimated with the only excuse from managers that over time everything will come back or reach new highs. That might be true for someone in their 20’s but how do you explain this theory to the hard working person within 10 years of retirement? Frozen is something that occurs from spending time in an icebox and should not be the investment policy from managers when their recommended portfolios lose half of their value. One of the guests on a financial show gave a great answer when asked what to buy on the way down: “If I had any money left, I would…” These experts will be long gone when the economy hits bottom in January 2013. (Yes, four more years…With a few bounces in between that make everyone feel as if the worst is over.)

The Tortoise (economy) and the Hare (markets)

The good news for investors is that today’s jobs report may be the first sign that reality is catching up to what the markets have been saying for months. Today’s unemployment rate rose to 6.7% and is a sure bet to reach my predicted 8.0% in 2009. Many states (including California) are on their way to 10%+ as they struggle with bankruptcy but the U.S. doesn’t have the same restriction to balance its yearly budget. For those that remain employed the new deflation is the equivalent of receiving a raise as today’s minimum wage salary now buys more gasoline, food, rent, etc. and retail prices begin to show accelerating declines in the consumer marketplace. Today’s news did NOT bring about another waterfall decline in stocks or decline in long-term rates because so many have jumped on board the train to recession/depression land where the rewards for travelling have become reduced to minor levels. 98% of traders are betting on lower rates and those lonely 2% going the other way have not yet profited but when the train slows down they will be collecting huge rewards from the majority who celebrated and never departed from the train at their original destination. Making money isn’t as much about being right but more about being correct when the majority is wrong. If everyone is a winner they can only collect from a few losers (investing is a zero sum game) and that is usually not enough to cover the losing trades that every one has each year. A good investor will have more losers than winners but with stop losses keeping the losers small a few winners will more than make up for the many small losses.

The important point for everyone in the next few months is to watch the reaction of financial markets to the ever growing bad economic news. A market that shrugs off bad news is sure to rise at the first sign of good news. For the past 11 months the stock market has rallied sharply at any sign the worst may be over but then plummeted when reality hit that the economy was NOT repeating what everyone had experienced in their lifetime rather was repeating the 1930’s which I wrote about over and over and over in the past two years. The key question you must ask yourself is do you need everyone to agree before you make a decision? I have spoken with hundreds of investors who say they didn’t exit their positions because their advisors and friends all assured them the worst would soon be over and taking a loss would make them miss out on the next rally. Losing in company is much easier than winning alone as the losers can comfort each other in knowing that their friends, family and associates all lost their savings. Winning alone takes courage and might lose you a few friends who will blame you for not urging them to exit positions.

Interest Rates 

The 30-year Treasury bond has been rising like a rocket ship and has seen its average daily price rise for a record 15 consecutive trading days. Yields have plummeted and combined with the government’s plan to buy mortgages a 30-year fixed rate conforming loan is now UNDER 5.00%. The problem is that a small percentage of homeowners are able to qualify as the old stated income loans have disappeared. For those lucky or smart enough to refi the monthly payment savings will go to pay down high cost debt or increased consumption. The seeds of the next recovery are in the early stages of planting and will take years but lower gasoline and food prices will have a very beneficial effect on the average wage earner.

The 10-year Treasury note has fallen to under 2.60% a decline of 140 basis points in the last month as it correctly saw a rapid deterioration in the economy and a huge flight to quality. The key inflation component hit 0.01% before rebounding to 0.59% and has been going in the opposite direction from nominal rates in the past two weeks. This is an early sign that rates have fallen too far and too fast and must correct. You must use the next couple of weeks to lock all loans as Treasury rates have a historical pattern of rising 75% of the time in the first half of the year and falling in the 2nd half of the year.

The U.S. stock market is in a bottoming pattern before entering a significant intermediate term rally as part of a long bear market. Watch closely the reaction to upcoming economic news (CPI, Fed mtg., retail sales, etc.) and when it begins to rally on bad news that will be the sign it is ok to enter on the long side for a trade. The Aussie dollar appears to be holding the best for a play against the U.S. dollar but is very volatile and should only be traded by the most experienced and tight stop losses should be used. The U.S. yield curve  has pulled back to the 175 basis point level and is a good buy around 150bp. The “back up the truck” play continues to be the Japanese yield curve (81bp) where the risk is limited and has upside potential of at least 200bp.

The next few months will be dominated by headlines of gloom and repeated references to the 1930’s. The time to take advantage of that was earlier this year and now the smart money is preparing for a counter trend rally in most assets. Home prices will stabilize in 2009 before their next move downward in 2010 and won’t see any significant upside price movement for another 5+ years. Declining home prices usually create increased demand but with record unemployment and plunging asset values causing decreased incomes it will be difficult if not impossible for sustained increases in home prices. Be very careful as the overwhelming desire for higher prices will have most people projecting their desires into market predictions. Only those that are focused on the long-term trend (Deflation) will survive the next few years with their hard earned wealth intact as dreams of higher prices will be replaced by the hard reality that this bear market in asset prices will not end for many years (2013). The end will occur when the eternal optimists throw in the towel and realize that history does repeat but not when we expect.

If you would like my thoughts on a daily basis I write a comment every evening (Sunday-Thursday) around 10pm that discusses specific forecasts for short term traders and long term investors.