Second Quarter Market Observations

In this day and age, uncertainty can be a precursor for panic.  During the second quarter, the bond money market funds saw outflows while domestic equities saw inflows.  When the fed annouced tapering of QE toward the end of the quarter, bond investors headed for the hills, and equity investors decreased some of their risk appetite.  Sectors such as IT, Materials, and Utilities suffered in the broad market index, while the consumer sectors and healthcare continued their strong performance.  Financials finally saw some light within the domestic market. Growth investments saw some movement versus Value investments due to a more positive viewpoint of the market, and investors more willing to bear risk.

Internationally the same issues still exist, but now China is having growth revised down due to the possibility of a over inflated real estate bubble, and the government is forcing the banks to solve this issue.  Japan has seen good returns since the start of their QE program, but the question remains if wealth will trickle down to consumers in the form of increased of increased wages (wealth effect).

The popular thought is: "Will we see a claw back that has occurred during the past two years?" If economic news continues to be positive, then it should continue within the domestic market.  If not, then  a conservative stance should be taken.  With housing coming back, this has improved personal balance sheets which has been positive toward fueling growth, but it needs to have more first time homeowners participating and not investment firms.  2014 will be a difficult environment with uncertainty of political/policy changes in the EU.  Across the board there will be low growth across the developed region as long as the company and personal balance sheets remain over leveraged.

An alternative thought to personal investing

As an individual we have two sources to create/expand net worth.  This can be accomplished by either financial capital or human capital.  Financial Capital is based off of monetary worth (savings and investments), and it has an inverse relationship with human capital. Human capital is defined as the value of future earnings.  As you get closer to retirement , the number of working years decreases and human capital declines. On the other hand, financial capital should be growing assuming you are consistently saving.  Financial capital compounds at your portfolio's rate of return, while human capital compounds at your salary growth rate.  Coming into the work place a majority of a person's possible net worth will be based on human capital, as their financial capital will be small in most cases. As time goes on and savings amount increases, financial capital capital starts to grow while human capital decreases.  But, what does this has to do with investing? The answer is everything!

One of the pillars of good portfolio management is managing risk.  For example, if a person has a steady job with a known annual growth rate their human capital is considered pretty safe. This characteristic mimics a bond (fixed income investment).  What this allows a person to do is expose themselves to more risk within their portfolios by holding more equities or less liquid investments.  The individual is able to bear more investment risk since their employment status and financial viability is known.  On the other hand, if a person is in a position/industry that is going through a downturn, being unemployed is a higher probability.  With more employment risk the human capital acts similar to a stock (equity investment).  To balance out this risk, it would be prudent for a person to move into more conservative investments to preserve capital.  When considering your situation cash flow is dependent on your employment situation.  This is not a new concept and is tactically used by institutional investors all the time.

When investing(and saving), most people fail to account for the total risk that they are taking by not factoring in their occupation.  In essence, a person could be exposing themselves to more risk, or capable of bearing additional risk.  One point that should be emphasized is that if your future value is derived primarily from your human capital, the two primary ways to increase that amount are by increasing your salary or increasing your savings rate.

Random Market Observations for the first quarter of 2013

Investors that remained in the market over the past four years have been rewarded.  During the first quarter of 2013, the DJIA reached a level that has not been seen since the economic downturn and the S&P500 closed the quarter on a high not see since October 2007. All signs point to a positive environment; but is this irrational exuberance or are companies better positioned, financially?

The answer points to the latter as companies are flush with cash, bonds are reissued at historically low rates, and consumers continue to spend.  As money has flowed into the stock market over the past two quarters, more conservative asset classes have seen better returns.  Consumer Staples and Health Care have lead the way, while Information Technology and Financials have lagged. During this time frame Value has outperformed Growth.  The search for yield has also been a running theme over the past six months as investors have substituted coupon payments for healthier dividends. Over the past couple weeks in April, we have seen a pull back in the market.

What should be interesting to watch is that large cap equities have been highly correlated to the benchmark making this asset class more efficient. This correlation could possibly be a natural causation because of increased analyst coverage within the large cap sector over the past couple of months/years.  Midcap stocks have done well as these companies have less risk than small caps, and more inefficient than large cap stocks.  Small cap has done well, but slightly trails Midcap.  The US market has performed well in comparison to European and Asian economies.  Uncertainty within foreign markets has created more investor-interest and preference in the US economy.

 Within fixed income, the hunt for yield has become a drought.  The historically low rates have depressed spreads within the fixed income market and forced investors to look outside of the US.  The issue with searching outside the United States is that investors have to understand the political, sovereign, and country specific risk that are inherent within foreign bonds.  Not to mention, the possible tax liabilities that can exist from interest payments. 

There seems to be an acceptance that we could possibly see a repeat of 2012 over the next couple months where the best returns were seen in the first quarter and the remainder of the year was flat.  As investors, this is the main reason why correctly timing the market is impossible. The summer time is usually a low volume period for the market. As an investor the best view would is to look at your personal circumstance and determine if you can either bear more risk or be more conservative. 

Fresh Perspective On the Value of Home Ownership

When the topic of real estate comes up,everyone automatically starts to cringe.  It is not meant to be an offensive reaction, but is one that stems from the emotional connection most of us have with our house in conjunction with the thought of the stock market collapse of 2008.  Your house is your biggest investment that usually accounts for 20% to 35% of your monthly budget.  Because of loose regulations and lending standards, for some that percentage went up to almost 50% or 60% of their monthly take home pay.  During the time leading up to 2007 and 2008, housing pricing steadily increased and consumers took out equity within their dwelling to help finance their living standards.  Most people that own a home lost between, 30% to 50% of its value. Historically, housing has an annual appreciation of about 3%.  At that rate it would take 13 years to recover from a 30% loss, 18 years for a 40% loss, and 24 years for a 50% loss.  The effects of 2008 have forced individual consumers toreconsider the real purpose of a house.  

In this monthly blog I will explain why individuals should really think of their residence as a tax shield and a retirement planning tool as opposed to an ATM.  To explain my reasoning, I have included a table below (from the CFA institute) showing the classifications of various types of real estate categories along with their usual investors, sources of returns, and specific investment.

Type	Investors	Investment Traits	Sources of Return	Risks
Vacant Land	Speculators, Developers, investors	Passive, illiquid asset	demand, location, zoning policy	land doesn't increase in value, opportunity cost of capital being locked up
Apartment buildings	HNW individuals	significant debt, greater liquidity, income generating, potential appreciation in value, depreciation tax shield	market demand	active managerial oversight, more competition, high barriers to entry
Office Buildings	HNW individuals and other business entities/organizations	somewhat liquid, income generating, appreciation in value, depreciation tax shield	economic demands and tenants	active managerial oversight, competition, technology
Shopping malls	HNW individuals	low liquidity, location driven, moderate leverage	regional demographics and economic opportunities, active management	managerial oversight with high service, vacant units, malls
Hotels/Motels	HNW individuals and REITS	moderate liquidity, depreciation tax shield	location, tourist events/conferences	active management, competition, staff turnover, high utilization rate needed
Warehouse	Investors demanding cash flow	passive approach, moderate debt/liquidity, income generating, low lease cost, depreciation tax shield	commercial activity/strategic location	competition, outdated technology

What should be taken away from this table is that personal residence is not mentioned as an investment category within Real Estate. Why not? This is because your house is not, unless you have an income suite within your property.  Your personal residence cannot be sold tomorrow or in a week, which makes it an illiquid asset.  Besides rawland, every other category produces a cash payment.  Some of the advantages of real estate are:  tax benefits, the use of debt, control over property, diversification, a potential inflation hedge, and low volatility of returns. On the other hand, the disadvantages are: inability to split the investment, high information cost, commissions, operating/maintenance cost, location risk, and political risk (tax deductions).

So as an individual, how should you view your personal residence?  In my view, it should be a two-part type of investment.  Your residence should be a tax shield in the early years, and as retirement is closer it becomes a source of cash.  

Home ownership provides the household an opportunity to maximize on itemized deductions instead of using the standard deduction. For example, if an individual itemizes, they are able to deduct the following: medical/dental expenses, real estate taxes, mortgage interest, non-reimbursed business expenses, gifts to charity, and other miscellaneous expenses as allowed by the IRS. Using a slightly outdated IRS table (2010), the standard deductions were: $5,700 for single, $11,400 for married filing jointly, $8,400 for head of household, $5,700 married filing separately, and $11,400 for qualifying widow(er). On the other hand, a person owning a house that cost about $200,000 at an interest rate of 5%, the payment would be about $1,073.64 per month.  In the first year the homeowner would have paid $12,883.72 for housing of which $10,000.00 would be deductible interest.  If real estate taxes at 2% were factored in, that would be an additional $4,000 of tax-deductible expenses.  Just off housing along the household would receive more than the standard deduction without factoring in any other expenses.  This is a diminishing tax shield but because of amortization (the process of decreased accounting for, an amount over a period), your home provides a tax shield for almost at minimum the first 10 years. The only way the standard deduction is a viable option is if there are no housing expenses. So, what should be noted is that no other expenses were factored into this scenario.  Some investors have criticized home ownership as a waste of money.  Unless you can live somewhere rent-free or have housing expenses less than the standard deduction, once taxes are factored in, that argument becomes less visible.  Besides your home being a tax shield it does carry some sentimental value, and historically has been the root of a firm family foundation. 

As a family or individual gets closer to retirement a house can be a source of cash as you downsize your lifestyle. The gain (purchase price minus the loan value) on the sale of your housecan be used to purchase an annuity to be a source of additional income during a time in which you are living on a fixed income. For example if $100,000 from your housing gain was used to purchase a single level payment fixed rate annuity of 1.75%, the monthly payout would be about $513 according to the government Thrift Savings Plan website (www.tsp.gov).  In retirement ourearnings potential is minimized, but this extra income monthly could be used to offset medical expenses.  

I know this blog was a bit lengthy, but I wanted to ensure that I explained why your primary residence is not a traditional investment.  The benefit that should come out of homeownership should be in the form of a tax shield, retirement planning vehicle, or an emotional connection.  Multiple factors fueled the real estate bubble.  Ultimately, we saw one of those very prevalent factors—using a house as a proverbial ATM—prove to be a disastrous fad.  When irrational exuberance is rampant, a crash always happens. Such behavior forces all assets to exhibit a mathematical phenomenon called, mean reversion.

13 things to think about in 2013

1. In order to achieve financial health you must think of yourself as a business. This will require you to remove the emotions from your financial decision making process. In a formal business assessment we do a SWOT analysis, which covers your strengths, weaknesses, opportunities, and threats.


2. Continuing with the business theme, you must understand your financial balance sheet. What is your net worth? What is your best asset? Which liabilities are non productive loans? What are the interest rates on your current loans?


3. How will you invest in your personal brand? How does this increase your current or future wealth? Will this action erode from your well being? What are you sacrificing?


4. Should I rent or own? This decision should be based on your income level, future needs, and purpose. Certain studies show there is a strong correlation between stability and homeownership. But as you might have learned from the past five years, a house isn't an ATM. From a personal finance perspective, some might argue that a house should not be considered an investment. Instead, a home should be thought of as an illiquid asset that is either a tax deduction or income generator.


5. Have you created a will? If so, does it truly reflect your wishes? Charitable endeavors are more sophisticated than others; do your financial wishes include these? If so, are others aware of your ultimate intent? One key note: If a physical asset such as a house is involved, is the beneficiary aware of your ultimate intent and able to accommodate this request?


6. Do you have insurance; if so, what type do you have? Do you know how much you will need? Why do you have insurance? The amounts/types depend on your current household needs, debt level, family situation, and purpose of insurance.


7. Am I working to live or living to work? Can I afford a vacation? How much would I need if I were laid off for a year? If I do have a financial disaster, what should I immediately do?

8. During the past couple of years, businesses have been paying off debt or refinancing it at a lower rate. Within corporate finance, this is known as deleverging. As you start 2013, have you thought about ways to get rid of some debt? If you have not thought about this, what are you willing to give up now for higher cash flow in the future (quasi definition of opportunity cost)? When making any change with your debt load, there is an assumed risk. It could be lower monthly savings, lower 401k contribution, etc. Bear in mind that in order for this trade off to work, the risk must be less than the reward.


9. 401-K investing is the biggest trick ever pulled. The reason I say this is because it gives you the power to invest your money, but a majority of overall participants lack the understanding to do it well or efficiently. Your retirement account should not only match and reflect your current view of the market but it should also reflect the current risk level you are comfortable taking. Risk is not based solely on how much pain you can bear, but also should reflect your employment/industry risk.


10. When thinking about portfolio management within the context of marriage, Alpha and Beta have multiple definitions. Within any marriage it is appropriate to plan a lifestyle around the beta earning spouse. This person has the more steady income, while the alpha (unpredictable income) spouse has the ability to earn more in a given year; however, that ability is dependent on factors outside his or her control.


11. Planning for retirement starts the first day you enter the workforce. Once retirement is closer the main focus should be deleveraging your lifestyle. This includes: downsizing your living arrangements, putting extra money aside, tracking your spending habits, and planning your next chapter of life. If you have five years or less to retirement this needs to be done today! Retirement planning is not always about "what you will have to spend" but should be more about "what lifestyle you will have."


12. Being "financially catfished" happens everyday. The only true way to get rich from investing requires an individual to take on more risk to increase the amount of reward. This includes creating a business, funding a business, or buying a business. These ventures share a common denominator -- an individual needs a large amount of capital to participate in these transactions. If you invest in the stock market, don't expect to get rich. Everything in this realm centers around due diligence, if you don't believe me, ask a Madoff victim.


13. The difference between being "Rich" and "Wealthy" is a state of mind. How does it feel to be wealthy? As someone told me, it is like giving your two-week notice to your employer and then coming into work carefree everyday. The only question that remains is, how do you maintain that feeling for life?

Is this you?

2012 has ended and we are in 2013.  Are you struggling to figure out how to make it through the year? Do you know how you would like to live 5, 10, 15 years down the road?  If not, then congratulations you are in the right place!  Please follow this blog as I will be updating this on a monthly basis.