Dr. Strangedebt - How I Learned to Stop Worrying and Love My HELOC

This post is brought to you by the Joneses.

Yeehaw!! I love my Home Equity Line of Credit - HELOC.

On the path to financial self destruction, I use my HELOC to buy cars, cool gadgets, vacations, consolidate credit card debt, etc. You name it, and I've spent borrowed money on it.

My friends all think I make $150,000 per year but I only make $50,000 but I'm not going to tell them. I'm living the high life, drinking Hennessey, weekends in Vegas, new car every couple years. I'm going to keep doing it too until I collapse under the wieght of all the debt and declare bankruptcy or I'm forced to sell my home and pay off my debts. Every time I go to the bank, they offer me more money and my rates keep going down so it frees me up to do more cool stuff with money I don't have. My house is making me rich because I can just keep getting more money because my house went up in value. I bought my house for $300,000 a few years ago, had a $250,000 mortgage, and now the house is worth $600,000 and I have a $480,000 HELOC. I'm lovin' it. I just keep making those interest only payments of $1500 per month and its all good.

Strange thing happened though, I went into the bank last week to increase my HELOC because my 2007 Lexus RX is getting a little old now and I really want a new one so I need a little bit of money ($25,000) to pay the difference between the trade in and the new car but the mortgage rep at the bank told me that there was no more money and that they wouldn't increase my HELOC - the nerve. I was pissed because I work hard and I deserve that new car. I told her that I was going to take my business elsewhere if she didn't find a way to do it. She laughed at me and wished me luck. I thought to myself 'that was a little strange - that's never happened before' and I went to another bank. I couldn't get an appointment for like a week and today when I went there, they laughed at me too.

I'm starting to get concerned because I can't put up with driving this old clunker around for much longer. Any advice for this poor soul!?

Bull vs. Bear

Various versions of this chart have floated around for some time but I thought I'd post it here for discussion.

I think the conclusion you can draw from this chart is that the duration of bull markets is longer than the duration of bear markets. Additionally, bull markets nearly always rise higher than the previous bear market fell.

Keep in mind that a 50% fall requires a 100% increase to put you back at the same starting point. Additionally the chart is out of date because as of November 20th, 2008 the TSX had fallen 52% since June 18th, 2008.

When will things turnaround? I don't know, trying to time the market is for fools. Stocks are 'quite cheap' right now so I'm comfortable buying stocks because I have a long time horizon and a high risk tolerance. Perhaps the market will go down further but then stocks won't just be 'quite cheap', they'll be ridiculously cheap.

The advice of investing to your risk tolerance still stands.

Value Investing in the Current Environment

From here.

Jeremy Grantham is the Chairman of the Board of Grantham Mayo Van Otterloo, who manages approximately $120-billion in assets, well known among institutional investors but relatively unknown to retail investors. Here are some highlights from both parts of Grantham’s October 2008 newsletter “Reaping the Whirlwind,” and ”Silver Linings and Lessons Learned.”

Part 1, “Reaping the Whirlwind,” published 2 weeks ago:
“At under 1,000 on the S&P 500, US stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10 prices, but even more so. History warns, though, that new lows are more likely than not.
“Fixed income has wide areas of very attractive, aberrant pricing.
“The dollar and the yen look okay for now, but the pound does not.
“Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!
“Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows.
“As for us in asset allocation, we have made our choice: hesitant and careful buying at these prices and lower. Good luck with your decisions.”
You can read ”Reaping the Whirlwind,” in its entirety by clicking here where Grantham has published his views on the fallout from the financial crisis and the investment opportunities he sees.

Part 2, ”Silver Linings and Lessons Learned”, published early this week:
“When asked by Barron’s on October 13 if we would learn anything from this ongoing crisis, I answered, ‘We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term. That would be the historical precedent.’
“That is unfortunately likely to be the case. But over the next several years at least, there are many silver linings and valuable lessons to be learned.
“Chief among the many benefits of this crisis are unprecedented opportunities for investing in some fixed income areas where some spreads are so wide as to reflect severe market dysfunctionality.
“As of October 18, we also have moderately cheap US and global equities for the first time in 20 years. Probably quite soon, global equities too will offer exceptional opportunities after the additional pain that is likely to occur in the next year.
“We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the S&P as a probable low.
“The world faces unavoidable declines in economic activity and profit margins, so this overrun is unlikely to be much less painful than average, although you never know your luck.”
You can read ”Silver Linings and Lessons Learned,” in its entirety by clicking here where Grantham has published his comments on lessons learned from the credit crisis, as well as his proposed strategy.

Source: Jeremy Grantham, GMO, October 2008

Charts

I found this great chart over at Calculated Risk and thought I'd post it here for discussion.

Here is a chart of the TSX as well. As of market close on October 27, the TSX was down 43.3% from its June 18th peak. In terms of speed of the crash, the TSX kicks butt on the S&P500 with a 43% fall in only 20 weeks.

I've Been Busy

With markets around the world declining further by the day, I've been very busy at work and unable to post much recently.

Markets have fallen further and faster than I've expected and I suppose that shouldn't be a surprise but this is clearly presenting a once in a lifetime buying opportunity in equities for those with cash on the sidelines.

Here is a list of the best things you can do right now to position yourself for future investment success:
1) Stay true to your personal risk tolerance. Now is not the time to mess around with your overall risk level unless you can devote more to equities. Be honest with yourself about your risk tolerance. Can you handle a 10,20,30,40+% decline in your investment value?
2) Set up a systematic investment plan and contribute as much as you can afford to a portfolio that matches your risk level.
3) Develop a plan to meet your goals if you don't have one. Be realistic about your return assumptions and your lifestyle needs.

As always you should pay off unsecured high interest debts before you invest a dime.

It's a Random Walk

From Investopedia:

Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic. Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. Originally examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are independent of each other and have the same probability distribution, but that over a period of time, prices maintain an upward trend.

In short, random walk says that stocks take a random and unpredictable path. The chance of a stock's future price going up is the same as it going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk. In his book, Malkiel preaches that both technical analysis and fundamental analysis are largely a waste of time and are still unproven in outperforming the markets.

Malkiel constantly states that a long-term buy-and-hold strategy is the best and that individuals should not attempt to time the markets. Attempts based on technical, fundamental, or any other analysis are futile. He backs this up with statistics showing that most mutual funds fail to beat benchmark averages like the S&P 500.

While many still follow the preaching of Malkiel, others believe that the investing landscape is very different than it was when Malkiel wrote his book nearly 30 years ago. Today, everyone has easy and fast access to relevant news and stock quotes. Investing is no longer a game for the privileged. Random walk has never been a popular concept with those on Wall Street, probably because it condemns the concepts on which it is based such as analysis and stock picking.

It's hard to say how much truth there is to this theory; there is evidence that supports both sides of the debate. Our suggestion is to pick up a copy of Malkiel's book and draw your own conclusions.

Housing Problems Brewing in Canada

From the Financial Post. Read the actual report here (pdf).

Most of Bay Street has argued there is little risk Canada could suffer the same kind of housing-led credit crunch that is now hammering the United States and to a lesser degree the U.K. but one economist argues all the ingredients are there.

David Wolf, Canadian economist at Merrill Lynch, said Canadians are just as personally indebted as their other Anglo Saxon cousins.

"We believe that markets remain overly sanguine with respect to the prospects for the Canadian housing market, the financial sector and the overall economy," Mr. Wolf said in a note.

Mr. Wolf said the underlying source of U.S. troubles stemmed from the simple fact banks lent people too much money to go out and buy houses but there were obvious danger signs in the data.

For example, every year from 1952 to 1999, U.S. households were net savers, but by 2005 household net borrowing had swelled to 7% of disposable income, which the credit curnch is now reversing.

In the U.K. net borrowing reached a peak of 6.1% early this year.

But Canadian numbers are easily comparable. Canadian households moved into sustained deficit in 2002. The deficit grew to an average 6.3% in 2007 and in the first quarter of this year it reached 6.4%.

Judging from the massive outperformance of Canadian bank shares through the global crisis the market view is that that Canadian housing and credit markets are not going to crack, that somehow household overextention is somehow more sustainable in Canada, Mr. Wolf said.

"We fear, however, it may simply be a matter of time," he said.

The tipping point in the United States was the emergence of falling house prices in the summer of 2006, kicking off the "vicious" circles that have brought the financial system to the brink.

Canadian house prices are now beginning to fall, yet mortgage debt continues to grow at a double-digit pace.

"From this perspective, the absence of a Canadian credit crunch to date may be cause for concern, not comfort," Mr. Wolf said.

Yes, it is true. Canadians are in hock up to their eyeballs and we are no different from most of our counterparts in the rest of the western world. We have plenty of problems here in Canada so we need not try to pick out the specks in other people's eyes until we remove the log in our own.

The Dimensions of Stock Returns

Abbreviated from here.
By Truman A. Clark

An ongoing objective of financial research is to explain the behavior of stock returns. Factors are sought that explain both differences among the returns of individual stocks in any given time period and the variation of stock returns through time. If a factor does both, it is said to explain the common variation of returns. In addition, if a factor is related to non-diversifiable risk and possesses explanatory power independent of other factors, the factor is considered a "dimension" of stock returns.

Fama and French (1992) found that two factors related to company size and book-to-market ratio (BtM) together explain much of the common variation of stock returns and that these factors are related to risk. Small cap stocks have higher average returns than large cap stocks, and high BtM (or "value") stocks have higher average returns than low BtM (or "growth") stocks. Based on Fama and French's findings, size and BtM are dimensions of stock returns.

Fama and French also investigated a market factor. A market factor is needed to distinguish stocks from fixed income securities, and it is important in explaining the variation of stock returns through time. But, among stocks in a given time period, differences in their sensitivities to the market factor are unrelated to differences in their average returns, so the market factor is not a dimension of stock returns.

The Fama/French results have important implications for domestic equity portfolio design. Large capitalization growth stocks constitute large portions of traditional "market-like portfolios" based on indexes such as the S&P 500, the Russell 3000 and the Wilshire 5000. Domestic equity portfolios with greater commitments to small cap stocks and value stocks offer higher average returns than conventional market-like portfolios.

Size and BtM also are dimensions of international and emerging markets stock returns. This confirms Fama and French's interpretation of size and BtM effects as rewards for bearing risk that cannot be eliminated by diversification.

Risk and Return
Controlling for differences in BtM by comparing large cap value to small cap value and comparing large cap growth to small cap growth, small cap stocks had higher average returns than large cap stocks. Controlling for differences in size by comparing large cap growth to large cap value and comparing small cap growth to small cap value, value stocks had higher average returns than growth stocks. The higher average returns of small cap and value stocks represent rewards for bearing risk.

If standard deviation were a complete measure of risk, average returns would increase as standard deviations increase. Controlling for differences in BtM, a direct relation between average returns and standard deviations is found when large cap stocks are compared to small cap stocks. But, controlling for differences in size, a discrepancy appears. Small growth stocks had a lower average return and a higher standard deviation than small value stocks. Since greater standard deviations are not consistently associated with higher average returns, standard deviation is not a reliable measure of risk.

Size, Book-to-Market and Earnings
Seeking a risk-based explanation for the relations of size and BtM to average returns, Fama and French (1995) investigated the behavior of the earnings of stocks grouped by size and BtM. Measuring profitability by the ratio of annual earnings to book value of equity, Figure 2 illustrates the evolution of profitability over long periods before and after stocks are classified by size and BtM. BtM is associated with persistent differences in profitability. On average, low BTM stocks are more profitable than high BtM stocks of similar size for at least five years before and after portfolio formation. Low BtM indicates sustained high earnings that are characteristic of firms that are growing and financially robust. High BtM indicates protracted low earnings that are typical of firms experiencing financial distress.

Expected Returns and the Cost of Capital
Financial markets channel funds from suppliers of capital to users of capital. Expected returns are the rewards investors anticipate for supplying capital. Investors require a higher rate of return (or risk premium) for bearing greater risk. Risk is something that investors collectively shun and that cannot be eliminated by diversification.

The cost of capital is the price users of capital must pay to obtain financing. Competition forces users of capital to bid higher prices to obtain funding for more risky ventures.

In equilibrium, the expected rate of return and the cost of capital are determined jointly as the price at which the demand for and supply of capital are equal. In financial markets that function efficiently, investors only receive risk premiums for bearing risk. As risk increases, the expected rate of return and the cost of capital increase.

High BtM and small size often indicate companies that are experiencing some degree of financial distress. On average, they have higher costs of capital because they tend to be riskier than companies with low BtM and large market capitalization. The higher average returns of small stocks and value stocks reflect compensation for exposure to non-diversifiable risk factors.

The Three-Factor Model
The findings of Fama and French suggest that much of the variation in stock returns is explained by three systematic risk factors.

· The market factor measured by the returns of stocks minus the returns of Treasury bills.
· The size factor measured by the returns of small stocks minus the returns of big stocks.
· The value factor measured by the returns of high-BtM stocks minus the returns of low-BtM stocks.

Portfolio Engineering
Many investors commit high proportions of their domestic equity holdings to portfolios resembling the S&P 500, Russell 3000 or other market-like proxies. Large cap growth stocks are the dominant holdings of the S&P 500 and the Russell 3000. As a result, market-like proxies are poor portfolio structures for investors seeking exposure to the size and/or value factors. Investors can get such exposure by increasing their relative holdings of small cap and/or value stocks.

The potential increases in expected returns due to these tilts can be estimated with the three-factor model. For purposes of illustration, it is assumed that the expected risk premiums are six percent per year for the market factor and three percent per year for both the size and value factors.

Words of Caution
Structured portfolios offer the prospect of higher long-term returns than market-like portfolios, but the expected risk premiums are not sure things. Factor premiums vary widely and randomly. For the 1927-2001 period, the standard deviations of the annual premiums were approximately 21% per year for the market factor, 14% for the size factor and 14% for the value factor. Owing to their high variability, it may take decades before rewards for bearing increased size and value risk are realized.

Cumulative premiums for each factor are computed by adding successive monthly premiums for the period January 1927 through December 2001. Although the cumulative premiums tend to rise over long periods of time, each moves erratically with lengthy episodes of downward drift. The market premium declined from December 1967 to July 1982—a period of more than 14 years. The size premium declined from December 1983 to December 2001—a period of 18 years (and still counting). The value premium declined from December 1987 to December 2000—a period of 13 years.

Structured portfolios are not appropriate for all investors. Structured portfolios have higher expected returns because they are riskier than market-like portfolios. Over periods of less than 20 years, structured portfolios often will have lower returns than market-like portfolios. It is only over periods of 20 years or more that it becomes more probable that structured portfolios will outperform market-like portfolios. Investors with short horizons or aversion to risk should stick with market-like portfolios. Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk.

International and Emerging Markets Equities
Size and value effects are not confined to US equity markets. The MSCI EAFE Index represents a portfolio of international stocks from developed countries similar to the S&P 500. EAFE is composed predominantly of large cap growth stocks. During 1975-2001, international small cap stocks had a higher average return than EAFE indicating a size effect, and international large cap value stocks had a higher average return than EAFE indicating a value effect.Based on the limited amount of data available, size and value effects also appear in emerging markets. The IFC Investables Total Return Index represents a portfolio of tradable stocks in emerging markets countries that non-resident investors are permitted to own. During 1989-2001, emerging markets small cap stocks and value stocks had higher average returns than the IFC index.

The international findings are consistent with Fama and French's interpretation of the size and value effects as rewards for bearing non-diversifiable risk. If size and value effects were related to risk factors unique to the US, forming globally diversified portfolios could eliminate them. Instead, the existence of similar size and value effects in both domestic and international stock returns demonstrates that these effects are global phenomena reflecting exposures to ubiquitous sources of risk.

Implications for Global Equity Allocation
EAFE is the international equivalent of the S&P 500. EAFE returns, expressed in US dollars, are determined jointly by stock returns computed in local currencies and foreign-exchange gains or losses against the dollar. Because the two indexes contain stocks with similar size and value characteristics, it is reasonable to assume that the costs of capital of EAFE and the S&P 500 are approximately equal. If it is also assumed that currencies have zero expected returns, EAFE should have about the same expected gross rate of return as the S&P 500.

Concluding Comments
The identification of size and value factors by Fama and French has important implications for equity portfolio design. Relative to traditional market-like portfolios, portfolios with greater exposures to the size and value factors offer higher expected long-term rates of return.
Structured portfolios can be designed that provide targeted sensitivities to the size and value factors. International and emerging markets equity returns also exhibit size and value effects.
Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk. For the right investors, structured portfolios are promising alternatives to old-fashioned market-like portfolios.

Down Payment Dillemna

In response to several of the comments on the previous thread I'm posting some thoughts on what to do with your downpayment if you are patiently waiting for housing prices to have some kind of resemblance to fundamental valuation before you purchase. Here are the essential steps in my humble opinion:

Step 1: Determine your time horizon - this is easier said than done.
Step 2: Determine your risk tolerance - is some level of value fluctuation acceptable and if so, how much? +/-5% in one year? +/-10%? more?

Options:

1) If your time horizon is uncertain and you need stability and flexibility then a money market fund, savings account or short term GIC offers your only real options. Your rate of return will be significantly hindered. The best rate on these short term deposits is approximately 3% right now.

2) If you are confident that you won't see fundamental value for at least one year then you can clearly lock in for a 'good' rate on a GIC for at least one year. This has the advantage of keeping you disciplined but is much less flexible in terms of access to your money. The best rate on a 1 year GIC today was 3.90%. A 2 year GIC was 4.15%.

3) If you don't mind some mild fluctuation in your investments then a low cost bond fund such as the TD eSeries bond index fund could provide you with a decent coupon yield plus some potential upside if you think interest rates are going to fall before you purchase. If you have enough money some higher yielding corporate bonds can be purchased through a brokerage account. A quick search turns up several decent short term bonds with yields over 4%. Bonds have the advantage of being liquid so if you need access to the funds you will likely be able to get your money.

4) Equities - whether we are discussing an exchange traded fund, mutual fund, or an individual stock, be prepared for volatility. Even if you think you are investing in so-called safe securities, don't be fooled, a stock is a stock and the price of that stock is dependent on the perceived value of the corporation's earnings as seen by the buyers on that day. Your values may fluctuate violently and when it comes time to pull your money out, you may have less than you counted on. For a simple lesson on volatility, please look at the standard deviation of an investment before you purchase it. Bond funds have a low standard deviation because they are less volatile than equity funds.

I am not recommending one of these options over any other option but I hope the explanation is helpful. I don't recommend any allocation to equities higher than 30% for any time horizon shorter than 3 years and I don't recommend any allocation to equities higher than 45% for time periods shorter than 5 years.

This One is for the Kids - RESP

From HRSDC:

A Registered Education Savings Plan (RESP) is a special savings account that can help you, your family, or your friends save early for your child’s education after high school.

The Government of Canada allows savings for education to grow tax free until your child named in the RESP enrolls in education after high school. The child named in an RESP is known as a beneficiary. A parent, grandparent, other relative, or friend, can open an RESP for a child. The person who opens an RESP is called a subscriber.

Benefits of Having an RESP

When you have an RESP, you can start saving immediately for your child's education in the future. Many parents wonder how much to save. They also wonder how soon they should start. The answer is simple. Save as much as you can afford. Start today. By starting early, tax-sheltered earnings on your savings can grow surprisingly quickly.

Further, if you are saving for your child’s education, the Government of Canada will help you with special saving incentives that are only available if you have an RESP, including the Canada Education Savings Grant and the Canada Learning Bond.

Your RESP Provider

You can open an RESP through an RESP provider. RESP providers include most financial institutions, such as banks and credit unions, as well as group plan dealers and financial services providers. It is important to choose an RESP provider carefully. Your provider has a role to play throughout the life of your RESP, which can remain open for a maximum of 26 years:

At the start, your RESP provider will help you decide on the type of RESP that best meets your needs. You can choose from three general types of plans: family plans, individual plans, or group plans.

After you decide on the type of plan that meets your needs, your RESP provider will give you advice about making your money grow with wise investments.

When it is time for your beneficiary to start using the RESP, your RESP provider will administer the payments and ensure that they are made according to the terms of your plan. If the beneficiary does not continue education after high school, your RESP provider will ensure that your contributions are returned to you and tell you how much income you made on those contributions. Your provider will also see that any additional money paid into the RESP by the government is returned to the government.

Some RESP providers charge service fees. Some may also limit the amount of money you can put into your plan and tell you how often you can contribute. Before you open an RESP, ask the RESP provider to explain any fees, limits, penalties or requirements to make regular payments that may apply.

Steps to Opening an RESP

Opening an RESP is not difficult. In fact, you just need to take a few simple steps:

• Get a Social Insurance Number (SIN) for anyone you name in your RESP as a person you are saving for. There is no fee to get one, however, certain documents are required.
• Apply to the Canada Revenue Agency for the Canada Child Tax Benefit if your family net income is $75,769 or less. This form is generally provided at the hospital where your child was born.
• Decide on the type of RESP you want to open.
• Decide on the type of investment that will make your money grow.
• Put some money into your RESP.

Making Your Money Grow

Ask your RESP provider about your investment choices. Some RESP providers offer a variety of investment choices while others have a set investment plan.

It is important to take your time. Ask your RESP provider questions about your investment choices, including the advantages and risks of each. Some of your investment choices may have service fees or penalties. It is important to ask for a list of the fees or penalties that may apply.

Type of Plans - Choosing the Right RESP For You

You can choose from three general types of RESPs: family plans, individual plans, or group plans.

Family Plan

In a family plan, you can name one or more children as beneficiaries of the RESP, but they must be related to you. They may be your children, adopted children or grandchildren.
A family plan may be a good choice if:

• You want all, or any one of the children named in the plan, to be able to use the money;
• You want to decide how to invest the money, either on your own or with the help of a financial advisor; and
• You don’t necessarily want to make regular monthly payments.

Individual Plan

An individual plan is for one beneficiary and the person does not have to be related to you.
An individual plan may be a good choice if:

• You want to save for a child who is or is not related to you;
• You want to decide how to invest the money, either on your own or with the help of a financial advisor; and
• You don’t necessarily want to make regular monthly payments.

Group Plan

A group plan is offered and administered by a group plan dealer, and each plan has its own rules. Usually, group plan dealers must invest the money in low-risk securities such as bonds, treasury bills and guaranteed income certificates (GICs). Generally, you have to sign a contract agreeing to make regular payments into the plan over a certain period of time.

In a group plan, your savings are “pooled” with those of other beneficiaries (or children) of the same age. The amount of money each child gets is based on how much money is in the pool, and on the total number of students in the pool who are in school that year.
You can name only one child in a group plan and the child does not have to be related to you. If the child does not continue with education after high school, your group plan dealer will tell you what will happen.

A group plan may be a good choice if:

• You can make regular payments into the RESP;
• You prefer to have someone else decide how to invest the money for you; and
• You are fairly sure that the child you are saving for will continue education after high school.

Since each group plan is different, it is important to ask your group plan dealer for details.

Using Your RESP

As soon as the child named in your plan is enrolled in a qualifying educational program, he or she can start receiving payments from the RESP called Educational Assistance Payments (EAPs).

Qualifying Educational Programs

Usually, a qualifying educational program is a course of study that lasts at least three weeks in a row, with at least 10 hours of instruction or work each week. A program at a foreign educational institution must last at least 13 weeks.

Qualifying educational programs include apprenticeships, and programs offered by a trade school, CEGEP, college or university.

RESP funds can be used for full or part-time study in a qualifying program.

When Your Beneficiary Does Not Continue Education After High School

If your child decides not to continue education after high school, you may be able to:

• Wait for a period of time, he or she may decide to continue studying later;
• Use the money for a brother or sister who does continue education after high school;
• Transfer the money into a Registered Retirement Savings Plan (RRSP) to help you save for your retirement.
• Withdraw your personal savings, tax-free.
  

Fama and French Speak

Watch this interview with Eugene Fama. http://www.dfacanada.com/library/videos/thinkers_fama/

Watch this interview with Kenneth French.
http://www.dfacanada.com/library/videos/thinkers_french/

Enlightening.

It's Starting

Real estate inventory is now ballooning in all major Canadian housing markets. Most notably inventory is skyrocketing in Greater Vancouver, where many so called experts have said that the market won't have a price correction. The not so far away Fraser Valley market is already saturated with over 7 months of inventory and the inventory keeps hemmoraging through the normally strong spring selling season.

The few lonely voices that have been predicting this exact scenario are being vindicated in their own eyes but villified as doomsayers by others. Many real estate industry pundits are touting this new market as a 'balanced' one but this one doomsayer says 'balanced' is just another word for on the way to the real estate apocalypse.

Mohican thinks that it is becoming pretty conclusive that 2008 is the year the real estate market will enter a prolonged buyers market and prices will moderate from this point on for several years. I fully expect that urban condos, where the price to earnings ratio has hit astronomical levels above 30, prices will correct to bring P/E levels to the 10 to 15 range. This means that prices in urban condos will correct by 30%+.

Suburban markets where the price to earnings ratio has not reached such lofty heights will likely see less of a correction but a hefty price reduction nonetheless. Price decreases ranging from 15-25% will be common in markets from Pitt Meadows to Langley to Chilliwack. Wherever rents cannot sustain the purchase price, we will see prices correct to the level that rents can sustain them.

Mohican's advice at this point in time is do the math. Figure out what a property is worth and don't pay any more than that. If you must shop for real estate, make lowball offers that make sense using this formula.

{Fair Price} = [1/{Five Year Fixed Mortgage Rate}] * [{Annual Rent} - {Property Taxes + Maintenance}]

For example:

A townhouse rents for $1500 per month has maintenance of $150 per month and property taxes of $150 per month. The five year fixed mortgage rate is approximately 5.9% right now.

{Fair Price} = [1/0.059] * [{1500 * 12} - {150 * 12 + 150 * 12}]
{Fair Price} = [17] * [18000 - 3600]
{Fair Price} = $244,800

Have fun and don't get robbed.

Bill Miller's Comments

This commentary is from Legg-Mason's fund manager - Bill Miller who has the reputation of being the manager with the longest track record of beating the performance of the S&P 500 with the performance of the Legg-Mason Value Trust fund - sold in Canada through CI Investments as the CI Value Trust Fund.

This commentary will be short and to the point:

We had a bad 2007, which followed a bad 2006. Over this two-year span, we underperformed the S&P 500 by around 2000 basis points, our worst showing since the two-year period 1989 and 1990, where we underperformed by 2500 basis points.

In the 25 years since we started the Value Equity mandate in 1982, we have had six calendar years of underperformance. Despite that 19-6 record against the market, all the losses are painful. They are also unavoidable and unpredictable. It would be great if we could figure out how to never underperform.

- - -

About the only advantage of being old in this business is that you have seen a lot of markets, and sometimes market patterns recur that you believe you have seen before. It is not an accident that our last period of poor performance was 1989 and 1990. The past two years are a lot like 1989 and 1990, and I think there is a reasonable probability the next few years will look like what followed those years.

The late 1980s saw a merger boom similar to what we have experienced the past few years and a housing boom as well. In 1989, though, the merger boom came to a halt with the failure of the buyout of United Airlines to be completed. The buyout boom had been fueled by financial innovation. Then it was so-called junk bonds, which had been purchased by many savings and loans in an attempt to earn higher returns. Now it is subprime loans repackaged into structured financial products.

The Fed had been tightening credit to guard against rising inflation, which began to impact housing. By 1990, housing was in freefall, the savings and loans were going bankrupt (as the mortgage companies did in 2007), financial stocks were collapsing, oil prices were soaring in 1990 due to a war in the Middle East, the economy tipped over into recession, and the government had to create the Resolution Trust Corporation to stop the hemorrhaging in the real estate finance markets.

Eerily similar to today, the situation began to stabilize when Citibank got financing from investors from the Middle East. Although the overall market was down only 3% in 1990, we got trounced, falling almost 17%, the result of our large holdings in financials and other stocks dubbed “early cycle,” and which tend to perform poorly as the economy is slowing or when it sinks into recession.

If it were possible to forecast with any degree of accuracy, one might be able to descry a slowing economy from an examination of economic data and perhaps adjust portfolios accordingly. But unfortunately, as I have often remarked, if it’s in the newspapers, it’s in the price. The process works the other way: stocks are a leading indicator, so first they go down and then the data comes in.

In 2007, financial stocks began to decline in early February, before the market corrected in March. They then rallied into May, began a slow decline that culminated in an intermediate bottom in August when the Fed lowered the discount rate, rallied into early October, and then began the precipitous fall that appears to have made a bottom around the third week of January. The decline in financials reflected the freezing up of credit markets that began in August and which still persists, and was followed by a steep drop in consumer stocks in November that also may have seen their worst days now that the Fed has begun to aggressively cut rates. All of this was accompanied by the decline in the housing stocks, which fell almost continuously throughout 2007, ending with a loss of almost 60% on average.

The financial panic got going in earnest as we entered 2008; with global markets all dropping in the double digits or close to it as of this writing. The so-called decoupling thesis, which maintained that non-US and emerging markets and economies would be unaffected by a US slowdown, while not dead (yet), is severely wounded.

The monetary and fiscal authorities have now begun to move with alacrity, with the Fed cutting the funds rate to 3.0% (with likely more to come), and the administration and Congress coming up with a fiscal stimulus package estimated at around $150 billion dollars. Will it be successful? Yes. More precisely, if these measures aren’t enough to free up credit and stimulate spending sufficient to set the economy on a growth path, then additional measures will be taken until that is accomplished. The important point is that the monetary and fiscal policy makers are focused and engaged, and will do what is necessary to stabilize the markets and restore confidence.

This does not mean that the recovery will be swift, or seamless, or without additional trauma. But there will be a recovery, and I think the market abounds with good value. Those values may get even better if the markets get more gloomy, but they are good enough now for us to be fully invested.

I think the market is in for a period of what the Greeks refer to as enantiodromia, the tendency of things to swing to the other side. This is not a forecast, but rather a reflection on valuation.

All of the poorest performing parts of the market, housing, financials, and the consumer sector—with the exception of consumer staples—are at valuation levels last seen in late 1990 and early 1991, an exceptionally propitious time to have bought them. The rest of the market is not expensive, but valuations cannot compare to those in these depressed sectors.

Bonds, on the other hand, specifically government bonds, which have performed so wonderfully as the traditional safe haven during times of turmoil, are very expensive. (In bond land, the only values are in the so called spread product, and there are some quite good values there.) The 10-year Treasury trades at almost 30x earnings1, compared to about 14 times for the S&P 500. The two-year Treasury yields under 2%, and is thus valued at over 50x earnings!

The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it was in favor of Treasuries 20 years ago. Just prior to the Crash of 1987, stocks yielded about 2% (same as today), but traded at over 20x earnings. The 10-year Treasury yielded over 10%, vs. 3.6% today. The two-year Treasury now has a lower yield than the S&P 500, and that is before share repurchases, meaning you can get a greater yield in an index fund than you can in the two-year, and a free long term call option on growth. Even more compelling are financials, where you can get dividend yields about double that of Treasuries, which only adds to their allure, with them trading at price-to-book value ratios last seen at the last big bottom in financials.

I think enantiodromia has already begun. What took us into this malaise will be what takes us out. Housing stocks peaked in the summer of 2005 and were the first group to start down. Now housing stocks are one of the few areas in the market that are up for the year. They were among the best performing groups in 1991, and could repeat that this year. Financials appear to have bottomed, and the consumer space will get relief from lower interest rates.

Oil prices have come down, and oil and oil service stocks are underperforming in the early going. Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position portfolios for the 95% of the time the economy is growing, not the un-forecastable 5% when it is not. I believe equity valuations in general are attractive now, and I believe they are compelling in those areas of the market that have performed poorly over the past few years. Traders and those with short attention spans may still be fearful, but long-term investors should be well rewarded by taking advantage of the opportunities in today’s stock market.

Can you afford to retire?

It's RRSP season and I'm really busy so I thought I'd post on retirement planning since it is the topic that is so popular this time of year.

How much do you need to save in order to afford the lifestyle you want in retirement?
What rate of return do you need from your investments in order to make your retirement goal?
What is a comfortable retirement for you?

Here are a couple places to start if you don't know the answers to these questions:

http://finance.sympatico.msn.ca/SavingsDebt/savings_calculator.aspx
http://www.fiscalagents.com/Yahoo/calcs/retplan.shtml

BurnRate.ca - Do you spend too much?

From CBC News.

More than half of Canadians under 50 spend their disposable incomes without thinking about their financial futures, suggests a study released Thursday. I encourage you to go to http://www.mackenziefinancial.com/en/burnrate/index.html to check out the resources that Mackenzie has setup. In particular the videos are quite funny and may hit a little close to home for some.

The Burn Rater Test

1. Have you gone shopping and/or bought things to make yourself feel better?
2. Have you spent money in your account near the end of a pay period, because you knew you were about to get paid again?
3. Have you hidden purchases from family or friends, or told someone you paid less for something than you actually did?
4. Have you bought things you wanted, without considering the longer-term impact of the cost on your personal finances?
5. Have you entertained family or friends at home or at a restaurant more than you could afford?
6. Have you used your credit card to buy something when you didn't have enough money in your bank account to pay for it?
7. Have you avoided looking at your bank account or balance because you were concerned about how much money you've spent?
8. Have you regularly bought things on the spur of the moment?
9. Have you gone shopping (not including grocery shopping) two or more times a week?
10. Have you focused on spending today ahead of creating a budget or financial plan for the future?
    

The Burn Rater spending test, commissioned by Mackenzie Investments, found 24 per cent of respondents under age 50 are overspenders and 32 per cent show overspending tendencies.The term burn rate refers to how quickly disposable income is spent. Questions included: "Have you gone shopping and/or bought things to make yourself feel better?" and "Have you spent money in your account near the end of a pay period, because you knew you were about to get paid again?"Dr. Sunghwan Yi, a professor of marketing and consumer studies at the University of Guelph who helped develop the test, said people who overspend have a hard time making ends meet and trouble saving for the future.

Researchers asked 1,169 adult Canadians to complete an online survey of 10 questions on their spending habits that could be answered yes or no. The polling was conducted by Decima Research in December.

A respondent who answered yes to up to three of the questions was considered a controlled spender, while anyone who answered yes to four to six of the questions showed overspending tendencies. Anyone answering yes to seven or more questions was categorized as an overspender.

The study found Canadians are busy shoppers, with 45 per cent hitting the stores, not including for groceries, twice or more weekly. More than half of Canadians admitted to being impulse buyers, while 37 per cent of respondents under 50 and 22 per cent of those over 50 said they have hidden purchases or told someone they paid less for an item than they actually did.
Many Canadians said they rely on retail therapy for a pick-me-up, with 60 per cent of those under 50 and 47 per cent over 50 making purchases to make themselves feel better.
And when they're spending, almost half of Canadians use their credit cards to buy something when they don't have enough money in their bank accounts to pay for it.

Young, middle-aged not planning for future

Thirty-seven per cent of Canadians said they are not planning financially for the future. Forty per cent under 50, and 21 per cent over 50, said they focus on spending today rather than making a budget.

Sunghwan said he was surprised by the findings, especially "the great divide between under 50 versus over 50 people."

On average, Canadians under 50 answered yes to 4.35 of the test questions, compared to 2.88 for those 50 and above. Only five per cent of respondents over 50 were considered overspenders.

The findings suggest younger and middle-aged people "tend to basically spend money without thinking about their financial future," Sunghwan told CBCNews.ca, adding they "don't seem to appreciate the fact that the retirement age is quickly approaching and this realization often comes as they reach the age of 50, but it's way too late.

"We need to really encourage younger Canadians to start saving money and to develop a healthy habit of saving and investing as early as possible."

Curb your spending

Sunghwan said the study showed a concerning pattern of young and middle-aged people focused "on now rather than the future."

He said the most important changes people can make to improve their spending habits and start saving for the future are creating budgets and using cash instead of credit, because "people tend to feel greater pain when they hand over cash than when they are using a credit card."

He also recommended that Canadians arrange for a set amount of pay be automatically transferred to their savings and investing accounts.

"This way you save first and use the remaining money as necessary, instead of the other way around," he said. And for the impulse shoppers, he said, "Try to walk away for at least 24 hours if you're about to buy something on impulse… during this 24 hours, you are likely to realize that the things you are about to purchase on impulse are not really that important."

Vancouver Population and Economic Prospects

Vancouver's population growth, despite having an indestructible economy and real estate market (according to some), has been undergoing a rather mediocre period of population growth for the past few years since 1998.

Vancouver's population growth was fairly robust until 1998 when growth plummeted and has never fully recovered to the above 2% rate witnessed for much of the city's recent history.

In light of accurate statistics to the contrary, why are so many locals convinced that our population growth is high? Could it be because so many new homes are being built? Why are the homes being built if population growth is so low?

This raises the important question dealing with the possibility of an oversupply of new homes. Is there an oversupply? Based on the CMHC numbers in the previous post, I believe that builders are currently overbuilding and the consequences will be severe. Severe, meaning a massive amount of construction industry layoffs and possibly widespread developer bankruptcies.

Just how high could our unemployment rate get if there were massive construction industry layoffs? Quite obviously, very high, as in double digits high. Construction / Real Estate employment as a percentage of Vancouver labour force was 7% in 2001 and it now stands at 11%. If we just lost the increase in percentage the local unemployment rate would increase from around 4.5% to 8.5%.

How prepared are individuals for the prospect of increasing unemployment and job loss? Not very prepared. BC has a negative savings rate, which means the residents of BC spend more than they earn and have done so for many years now and do not even consider sustained job loss as a remote possibility as we have not had double digit unemployment rates for quite some time.

I don't really like being negative on the prospects of our region's economic future but I see very few bright spots and many risks for the future. The construction / real estate business is in a bubble, the manufacturing, film and tourism businesses are being negatively impacted by the currency, the forestry sector is in for a long downturn and now mining companies are walking away from projects for cost reasons.

It is my hope that people would use our current boom time to cushion themselves for the financial impacts that will be coming. Save, don't spend. Plan, don't consume. Pay off debt and build a cushion. Good luck.

Value of Gold and Dow Jones in Canadian Dollars

With the rapid rise in the Canadian dollar I was curious to see how it has affected US demoninated investments.

First up is the Streetracks Gold ETF which is the equivalent to 1/10th an ounce of gold. Gold is quoted in US dollars so it can be difficult for us Canadians to grasp how that affects us when our currency is so volatile against the US dollar. Gold was $443 US in late 2004 and $535 CDN. At the beginning of 2007, gold was $622 US and $725 CDN. Now gold is at $822 US and $754 CDN. Dramatic appreciation in US dollars and very modest appreciation in Canadian dollars.



The Dow Jones Industrial Average (DJIA) was 10572 US in late 2004 and 12765 CDN. It was 12474 US at the beginning of 2007 and 14531 Canadian. Now the DJIA is at 13266 US and 12165 Canadian. Over the 3 year period the DJIA appreciated over 25% in US dollars but is down nearly 5% in Canadian dollar terms since 2004. Since the beginning of 2007 the Dow Jones has gone down nearly 20% in Canadian dollar terms while rising over 6% in US dollar terms. Wildly different results depending on the currency you are measuring in.


Cheers.

Friday - Odds and Ends

A few things for today.

I added a new link under the "Useful Links" section called the "Stingy Investor." It is a great site with some interesting investing ideas and other investing information.

Reader 'wombatos' sent me this link to a CBC article on how many Canadians are not preparing for retirement, are DEEP into debt, and do no saving. Scary stuff but it isn't news to me. Unfortunately I meet people everyday who have failed to prepare and are living the Kraft Dinner retirement.

"The survey commissioned by CGA-Canada found that a quarter of those who answered didn't think an interest rate hike would hurt them financially. The survey also found that about a quarter of Canadians don't save any money at all, even for retirement. So it came as little surprise that about one in five said they wouldn't be able to handle an unforeseen expenditure of $5,000. The accounting group said Canadians are increasingly relying on borrowed money to finance day-to-day living expenses."


On a personal financial planning note, the deadline is November 1st to put in your T1213 form to have less tax witheld at source. This is important if you are a salaried employee and make RRSP contributions, pay spousal/child support, and/or make charitable contributions among other things. My mentality is that we shouldn't give the Federal government an interest free loan by overpaying our taxes on every paycheque so fill out the form and get it in before November 1. The CRA will reply with a letter which you will need to give to your employer. You will get your tax return all year long!

About Mohican

Hi, mohican here.

Well I am feeling a little weary of this current real estate discussion and financial markets appear to be apathetic to the current risk climate so I thought I'd stray a little from the debate and the analysis to do a post about myself.

For starters, I'm married and I have been for a few years now. We have a young son who was born a few months ago and he has been a wonderful addition to the family with grandparents, uncles and aunts all taking time to enjoy his company. I never imagined how wonderful fatherhood could be and I am planning on cherishing every day. More children are planned.

My wife and I are very practical people who grew up in families of very modest means. My wife's father died in a tragic accident when she was young and finances and family life, although adequate, were never comfortable for her, her mother and siblings. This taught her about prudent financial management among other important lessons.

I also grew up in a family who made choices about lifestyle that meant financial and material sacrifice. I am the oldest of four children and the most meaningful sacrifice that my family made was enabling my mother to stay home for most of my and my younger siblings growing up years. This has had obvious benefits and I am appreciative of the sacrifice my parents made. This also taught me some valuable lessons about personal choice and freedom, namely that it is not necessary to conform to the typical pattern of North American life.

My wife and I are both commited Christians and have been for most of our lives, not without much distraction and wandering on my part. My beliefs play a large role in forming my views on family and finances as I believe God has a place for everything and it is our role to discover the ideal way and put what He has given us to the best possible use - this is a way of thinking called stewardship. This includes how I use my time, talents, belongings, and finances. I am not intending to be preachy here and I've never used this blog as an outlet for that but I believe this part of my life is so formative of my views that I must inform you of it.

I wandered a great deal on an interesting and challenging path of discovery as a teenager and young man. I have always been a hard worker and I was an avid saver during my teenage years. As I gained more freedom as a young man I did not control my spending and consumption habits and got myself into a great deal of debt. I realized that my pattern of consumption was going to end me up in self imposed slavery if I didn't do something drastic so I stopped spending money. I gradually, over a period of 5 years paid off all of my debts and actually started saving money and investing it into some very basic mutual funds at my bank.

Having come out of that experience I wanted to help other people realize that they do not need to be slaves to their finances and that they could take control of the situation by implementing 3 simple steps:
1) stop spending so much
2) pay off debt fast
3) start saving as much as possible

Pretty basic procedure I must admit. At this point the attraction of helping others with their finances was so great I decided to leave my very successful career in the telecommunications field and go into financial planning. This meant a meaningful pay cut and a career restart but I had to do what I felt was right. I do not regret my decision.

I have had two different positions with two different companies since making the decision to go into finance and the one I have now is immeasurably better than the first one. The first job I had was a fully commissioned role with a large insurance company. I did pretty well but I could not come to grips with the fact that I had to sell certain products to the exclusion of others in order to make a decent living.

After one year, I switched companies after a friend told me about an opportunity with one of the big five bank's brokerage division. The institution I work for now pays me a base salary and some small bonuses. The focus is on writing financial plans for my clients and ensuring they are on the right track. I enjoy this role immensely more and I appreciate not having the continual pressure to sell certain products or rely on a commission payout. After helping my clients with a financial plan I help them with their investments, which for the type of clients I have, mostly means mutual funds, bonds and GICs. I do not receive commissions based on what I sell.

I hope that wasn't terribly boring but I like knowing where people are coming from and I thought you might too. Cheers.

Dollar Cost Averaging

Here is a financial planning tidbit to think about over the weekend - dollar cost averaging into an investment portfolio. Dollar cost averaging is an ideal method to build portfolios over time.

What is it?

Rather than make a lump sum investment purchase, dollar cost averaging involves the regular purchase of a small amount of an investment on a weekly, monthly, or quarterly basis.

Why does it work?

The theory is that, over time, financial markets fluctuate, and a fixed dollar amount will yield varying units of a security - such as a mutual fund. The result is that more of the security will be purchased when prices are low, while less of the security will be purchased when prices are high.

What are the advantages?

Three important advantages of dollar cost averaging are:

a) minimizing market timing concerns

b) eliminating concerns over investing possibly large lump sum amounts, and
c) disciplined savings.

How can you do it?

The strategy can be implemented easily by setting up a systematic investment plan that transfers funds from your bank account into your investment account on a regular basis.

An example involving an initial investment of $1,000 in the CI Portfolio Series Balanced Portfolio starting in November 1988 and subsequent contributions of $200 per month until August 2007. This modest start and contribution schedule would have resulted in a $104,000 portfolio value today. This method is quite conservative and the returns far outstripped inflation, Canada Savings Bonds, and 5 Year GIC returns.

I like dollar cost averaging because it eliminates a lot of the emotion from investment decisions and is very disciplined. Have a great weekend.