Investing - Modern Portfolio Theory

Investors are all alike; they all want higher returns and lower risk. Much time and research has been devoted to trying to develop ways of lowering risk while increasing returns. The most popular and effective theory for dealing with this dilemma to date is Markowitz’s Modern Portfolio Theory. Modern Portfolio Theory is one of the most significant and central investing theories in the finance field.

Central to Modern Portfolio is the premise of diversification, that is, by investing in more than one security the investor can lower the overall risk of the portfolio. The overall risk in a portfolio is reduced by holding a diverse selection of securities versus a portfolio that is concentrated in one security or sector. Markowitz showed that investment is not just about picking individual securities, but about choosing the right combination.

Modern Portfolio Theory states that the risk for an individual security’s returns has two components:

• Systematic Risk - market risks that cannot be diversified away such as monetary policy (interest rates), fiscal policy (taxes), and other market-wide risks.
• Unsystematic Risk - specific to individual securities and the risk can be reduced as you increase the number of securities in your portfolio. It is representative of the part of a security’s return that is not linked to the market’s moves. For a well-diversified portfolio, the risk of each security contributes very little to portfolio risk. Rather, it is the difference between the securities’ levels of risk that determines overall portfolio risk. Thus, investors benefit from holding diversified portfolios instead of individual stocks.

Moving on from understanding the benefits of diversification, the question of how to identify the best level of diversification arises. The optimal level of diversification is called the efficient frontier. For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. Any portfolio that sits on the curve is said to be efficient as it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line. This determination of an investor’s risk level is of vital importance.

The substance of Modern Portfolio Theory is that the market is hard to beat and that the people who beat the market are those who take above-average risk. It is also implied that these risk takers will get their just deserts during a market downturn. Review my previous posts on the value investing style to see how it may be possible to beat the market without taking extra risk.

Interesting questions to pose would be - How does real estate fit in an investment portfolio? Where would a piece of real estate fit along the risk / return scale?

Real Estate: House Prices Still High

It looks like our 'economist' friend Cam Muir is interested in the Langley real estate market! This article from the January 9th, 2007 Langley Advance newspaper tromps out the usual suspects: BCREA Economist, Head of the FVREB, and even some politicians but not any real analysis or solid journalism.

The price of a home in Langley has almost doubled during the past five years.
by Matthew Claxton
Langley Advance, January 9, 2007

For those buying their dream home in Langley, 2001 was a lot easier on the pocketbook than 2006. The Fraser Valley Real Estate Board released a five-year analysis of home prices to ring in the new year. Prices for a single detached home in Langley have risen by 86.3 per cent over five years, from an average price of $247,000 to $460,137. Townhouses and apartments were affected similarly. Townhouses prices have gone up by 70.8 per cent, from $164,235 to $278,782. Apartment prices have risen by 90.6 per cent, from $102,046 to $194,491. Few people would have predicted this kind of jump in 2001, said Fraser Valley Real Estate Board president David Rishel. "I try to avoid any kind of predictions," Rishel said. Realtors never know what will be next when it comes to housing prices and demand, he said.

In hindsight, he believes much of the jump was due to the globalization of the real estate market. British Columbia is a desirable place to live and was seen as a bargain by many compared to other world urban centres, said Rishel. That led to five years of solid price increases. The most notable fact about 2006 might be the fact that price increases and sales actually cooled off in the second half of the year. The best year for local real estate sales ever was 2005, Rishel said. "The first half of 2006 looked like a replay of 2005," Rishel said. By the end of the year, however, the number of listings in the Lower Mainland was up by 46 per cent and the price hikes had begun to slow down. The year overall was still great for people selling homes, said Rishel. "2006 shaped up to be the second-best year in real estate ever," he said. While he remains reluctant to predict the future, Rishel said other groups are guessing that the Lower Mainland will see lower but still respectable growth in the housing market in 2007.

"When we look at the market overall, we expect to see a little less frenetic activity over the past 18 months or so," said Cameron Muir, chief economist of the B.C. Real Estate Association. All the conditions that drove prices so high in 2005 are still present, said Muir. B.C. has strong job and wage growth, people moving here from other parts of Canada and the world, and relatively low interest rates. Muir, a Langley resident, noted that there are also local incentives to buy, like the retail corridor along 200th Street and strong job growth in Langley, Surrey, and Abbotsford. "The only thing that's not as positive is home prices," Muir said. With the average price of a listed Langley home approaching half a million dollars, it's getting harder for people to afford a first home. Some buyers are being squeezed out, said Muir. That is leading to the slowing pace of both purchases and price hikes. Muir predicts that increases in home prices by percentage, in Langley and around the region, will be confined to single digits rather than double digits in 2007. The slowing pace of growth has not yet been felt at the Township hall, said Mayor Kurt Alberts. If growth does slow substantially, it will be several months before the planners and clerks who deal with construction applications notice the let-up, Alberts said. "What it means is that there's not as many new applications coming in," Alberts said.

Incestuous Amplification

Incestuous Amplification, Groupthink, or Group Polarization is when a group of people begin to think alike after listening to each other for long enough (from wikipedia):

"Study of this effect has shown that after participating in a discussion group, members tend to advocate more extreme positions and call for riskier courses of action than individuals who did not participate in any such discussion. This phenomenon was originally coined risky shift but was found to apply to more than risk, so the replacement term choice shift has been suggested.

In addition, attitudes such as racial and sexual prejudice tend to be reduced (for already low-prejudice individuals) and inflated (for already high-prejudice individuals)
after group discussion. Group polarization has been used to explain the decision-making of a jury, particularly when considering punitive damages in a civil trial. Studies have shown that after deliberating together, mock jury members often decided on punitive damage awards that were larger or smaller than the amount any individual juror had favored prior to deliberation. The studies indicated that when the jurors favored a relatively low award, discussion would lead to an even more lenient result, while if the jury was inclined to impose a stiff penalty, discussion would make it even harsher."

Specifically referring to online groups (from wikipedia):

"Group polarization has also been found to occur with online (computer-mediated) discussions e.g. (Sia et al., 2002). In particular, research has found that group discussions conducted when discussants are in a distributed (cannot see one another) or anonymous (cannot identify one another) environment, can lead to even higher levels of group polarization compared to traditional meetings. This is attributed to the greater numbers of novel arguments generated (due to PAT) and higher incidence of one-upmanship behaviors (due to social comparison)."

So the question today is: Are we, in the bubble following blog community, prone to this? Are we immune? Why? What weaknesses in our thinking should we be aware of because of these social tendencies?

Real Estate Price to Earnings Ratio

I have known for a long time now that the most important number to look at when considering an investment is the Price to Earnings ratio or P/E ratio. Essentially this ratio tells the the potential investor how long (in years) it will take for the current net annual earnings of the investment (assuming they stay the same) to pay for the price of the investment. The P/E ratio doesn't help us project growth in earnings or the prospects of the company but those are speculative affairs anyway.

Many economists and analysts have also used the P/E ratio to evaluate the suitability of a real estate transaction. In essence they are asking the question - how long will it take for me to earn my money back from the net income on this piece of real estate? This is an incredibly fair question and has significant merit as an evaluative technique because after all isn't an investment an investment. Wouldn't we want to compare an apartment to a company to evaluate their merits as an investment relative to each other?

Lets look at an example:
Lets say that a $200,000 apartment rents for $1200 per month or $14,400 per year (gross earnings). The apartment also has annual expenses of $2,400 for strata fees and $1,200 for property taxes. The gross earnings minus the expenses gives us a net earnings of $10,800 per year. What is the P/E ratio? $200,000 divided by $10,800 which equals a P/E of 18.5 and ignoring all leverage or other investment return factors this means that if the rent stays at this current level it will take 18.5 years for the investor to have the return of his or her money from the net income. This also ignores the possibility of an interruption of earnings or an increase in expenses or rents but all things considered this P/E number now allows us to compare this investment to an equity investment.

I have written a few posts on Value Investing and one of the stock picking guidelines is to never pick companies with a P/E greater than 10. The above example from real estate falls well outside of those value guidelines at a P/E of 18.5 and for a value investor would be completely unsuitable as an investment. In comparison, a simple stock screen produces a list of 402 securities in the Canadian market with a P/E of 10 or lower which provides us with a great starting point for selecting companies to invest in. The same stock screen for the US market produces a list of 263 secuities, which again would be a great starting point.

So for investment purposes the current real estate market shows no value and in fact a recent TD Economics study on the Vancouver housisng market found that this market is in record high territory for all ratios including P/E, Rent vs Own, and affordability. There are times when the stock market also behaves the same way and P/E ratios get exceptionally high and I can show with certainty what happens when P/E ratios get exceptionally high - they fall. I expect no different in the real estate market. Do you?

Gong Show # 3 - High MERs on Mutual Funds

One of my pet peeves as a financial planner is high management fees or MER's (Management Expense Ratios) on mutual funds, especially mediocre mutual funds. This hurts my client's portfolios and takes away from achieving their goals. Canada has some of the highest fees on mutual funds in the developed world and for the most part they are unnecessarily high. Most investors do not understand that the management expense ratio directly takes away from their return and that if a fund has a high fee structure then there will always be a headwind on their potential returns.

A cursory analysis finds that out of the 3783 mutual funds in Canada, 424 have a MER of 3.0% or higher, and 1470 have a MER of 2.5% or higher. There is virtually no reason why a MER should be over 3% and a MER over 2.5% should be looked at with some critical eyes. Granted, some funds have a performance fee added in to the MER but this represents very few of these 424 funds over 3%. The major culprits for high fees are "Investors Group", "Stone & Co", and most of the novelty international sector funds of all the other major fund companies, including CI, Trimark, Fidelity, AGF, Dynamic, etc.. A management fee of over 3% is intolerable in my opinion and actually anything over 2% should be rationalized and value should be shown with long term out-performance. The trouble with most of these high fee culprits is long term UNDER-PERFORMANCE.

High Management Fees on Mutual Funds get the big gong from me for keeping Canadian investors poorer than necessary and for unfairly padding the pockets of investment advisors and mutual fund companies.

Value Investing - Part 3 - Passive Strategy

In the last two Wednesday instalments I talked about the long-term success of the value investing style. Last weeks post was about the difference between an active or a passive investor and how an active investor might use a simple framework for choosing stock investments. Before that, the first post was about how over the past 40 years the return differential between a value index and the market index has been nearly 2%. That extra 2% rate of return is very substantial over a long period of time, resulting in double the cumulative return over 35 years.

So now lets examine solutions for the passive investor and how he/she might go about constructing a portfolio. First, the passive investor should determine how involved he would like to be regarding the construction of the portfolio. If he is a "Do-It-Yourselfer" then he will be placing the trades and setting the asset allocation himself. If, on the other hand, he has no interest in placing trades then he would prefer a broker, advisor, financial planner, etc to place his trades and determine his asset allocation.

For the Do-It-Yourselfer:
1) Set asset allocation (the split of equities vs. fixed income; the split within equities between Canada, US, and International). For example, we could choose an aggressive portfolio of 20% Fixed Income, 20% Canadian Equity, 30% US Equity, and 30% International Equity.
2) Choose the mutual funds or Exchange Traded Funds that will make up the portfolio
3) Place the trades
4) Rebalance to original asset allocation once per year

For the really passive:
1) Choose a financial planner, broker, advisor. Anyone who will be assisting you with your finances should have the credentials to back up their position. They should have, at a minimum, their Canadian Securities Course, and Professional Financial Planning Course. Preferrably, they will have a more advanced designation like the Certified Fnancial Planner marks.
2) Tell the financial planner that you are only interested in developing a portfolio that follows a value investing style. If your planner is unwilling or doesn't know what this is then get a new planner.
3) Your planner will assist you in developing an asset allocation based on your personal risk tolerance.
4) Your planner will help you pick 'value' mutual funds. Please do some of your own research at this point to make sure your planner is actually picking funds that truly follow the value style.
5) Your planner will rebalance your portfolio for you at an annual review.

Suitable ETFs for a value style:
Canadian Fixed Income: Barclays iShares - XBB (Canadian Bond Index), XCB (Canadian Corporate Bond Index), and XSB (Canadian Short Term Bond Index)
Canadian Equity: Barclays iShares - XCV (Canadian Equity Value Index)
US Equity: Barclay's iShares IWW (Russell 3000 Value Index) but there are others
International Equity: Barclay's iShares EFV (MSCI EAFE Value Index Fund) but there are others as well

Suitable Mutual Fund Managers:
Altrinsic
Brandes
Brandywine
Chou
Cundill
Sionna

This is by no means an exhaustive list but these are a few of the dominant value investing managers whose products are available in Canada. Any of these managers are suitable as they all follow a disciplined Value Investing strategy.

Homebuyers line up in Pitt Meadows

An article in the local press about a Real Estate development in Pitt Meadows.

By Monisha Martins
Maple Ridge News, Staff Reporter
Jan 20 2007

Steve Devantier pokes his head out of a tent pitched on a sidewalk beside a mud-stained snow bank. Equipped with a chess board and a slew of board games like Taboo and Dirty Minds, he's prepared for the three day wait. On Wednesday, Devantier staked his spot, third in line, for a row home in the new Pitt Meadows development, Osprey. Just 17 of the red-brick colonial-style houses are being released for sale at noon today by Mosaic Homes. "I can sit out in the rain and snow if it means a mortgage that's $20,000 less," Devantier said. He arrived early because he heard people were lining up. "I don't want to be the fifth person in line, I might not get the place I want," he said. Ahead of him, first in line was Pat Lord, braving the cold and rain for her daughter Stephanie who has her eye on a two-bedroom unit. "She has done a lot of looking and this was affordable, a good location and close to shop," Lord said.

The 87 row homes in Coho Chapter II are set in the "village of Osprey", a new development near the Fraser River between Harris and Bonson Road. Up to 450 homes are planned in the community. It's the first time people lined up three days in advance, said Mosaic Homes sales and marketing manager Andrea Camp. "One of the main draws, apart from the location which is a beautiful setting, is I think people recognize the rarity of these homes," Camp added. "This old world, tumbled red brick facade is seen as beautiful and rare." With a starting price of $289,000, the homes are hard to resist for first-time buyers. "That's a very desirable starting rice," Camp said. "But there are not too many homes at that price."

Mosaic expects the homes to be built by September. The subdivision will eventually include a commercial village with small shops, a chapel as well as a pier. Camp said the commercial space will be built by next Christmas. Mosaic Homes bought the property from International Forest Products which ran a sawmill on the site until 1996. A small part of the site, in the south-east corner, required soil remediation because it was used as a location for applying wood preservative.

http://www.mosaichomes.com/osprey/cohotwo/home.html

Here is another example of a reclaimed mill site along the Fraser River, similar to the Bedford Landing development in Langley, being used for residential development. Apparently we don't have those lumber industry jobs anymore so we just build houses on our industrial land. Where do all of these people work? Where are the jobs? Schools? Roads? Is the land safe from flooding, contamination, and erosion?

Inflation - A Murky Picture of a Beast

Inflation a standard definition (dictionary.com): a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency

An alternate definition (itulip.com): 1. to an economist, an increase in the general or "all goods" price level resulting from an oversupply of money; 2. to a government statistician, a political football thrown onto the field as producer and consumer price indexes, continuously reformulated and subject to interpretations invented to suit various constituencies over time, such as the under-reporting of home price inflation via an equivalent rent formula when home prices are rising and rents are falling, in order to hide the fact of a housing bubble that is needed to keep the economy from falling into recession 3. to the person on the street, rapidly rising prices of non-traded goods and services, especially insurance, education, and health care, resulting from an excess of cheap credit and the inappropriate use of credit to purchase depreciating assets.

I snagged this neat graphic over at itulip.com and it illustrates how the CPI (Consumer Price Inflation) can remain low despite massive price increases in real estate, health care, education, and most other 'services.' This 'service' price inflation vs. 'product' price inflation is due to the interesting effects of globalization and governmental monetary arrangements that are beyond the understanding of most of the general public.



On a personal observational level, I have definitely noticed the massive price declines of goods made abroad and the massive price increases of goods and services created here in Canada. Feel free to discuss the effects of these differentials in inflation. How do they impact you and your personal choices? Why?

Real Estate - Months of Inventory and Price Changes

Okay, I just completed this analysis and I really wanted to get it out before the weekend. This is a chart based on Fraser Valley Real Estate Board statistics from January 2005 through December 2006 and it analyzes the link between Months of Inventory and Quarterly Price Changes. I would expect the exact same findings no matter which real estate market you look at.

What I discovered should come as no surprise to those who subscribe to basic supply / demand economic models. There is a strong inverse correlation to the number of Months of Inventory and Quarterly Price Changes (coefficient = -0.7911). Months of inventory is calculated by dividing the number of Active Listings by the number of Completed Sales in a month. Quarterly Price Changes are from the FVREB stats package.



My unoriginal hypothesis based on this observation and analysis is that when Months of Inventory rises above 6 then there will be negative price pressure. Based on what I am seeing in the market right now we are looking at 7+ Months of Inventory for January for the FVREB and the REBGV. This means that with a fair degree of certainty (4 times out of 5) we will see negative quarterly price change numbers.

And by popular demand, a chart tracking months of inventory vs. Monthly Price Changes with an inverse correllation coeffecient of -0.6664.

What will the numbers be for January? Any anecdotal evidence of anxious sellers and massive price drops?

The Gong Show #2 - Liar's Loans

For this weeks Gong Show, I am presenting the 'Stated Income' mortgage or as its also known - the Liar's Loan. What is a 'Stated Income' mortgage you ask?

This is the marketing pitch from a leading Canadian mortgage company:

"You are independent. And so is your income. But what you make on paper isn't always what you can bring to the table. So when it comes to affording the home you want, getting the mortgage you need can be a trying experience. It doesn't have to be that way. There are different ways of measuring worth. After all, shouldn't your business be your business? Now, there's a mortgage that assumes you are as good as your word. The mortgage is a stated income mortgage tailor-made for self-employed Canadians. It offers an easier mortgage approval process that accommodates your income situation. When it comes to getting the home of your dreams, something as simple as a T4 shouldn't get in your way. All it takes to qualify is your word on income, some employment verification and an assurance that your lending ratios, credit and tax liabilities are in good order."

Stated income loans are also called 'liar's loans' because they almost invite the borrower to lie about his or her income. The practice of mortgage brokers selling this product hasn't really been epidemic in Canada (yet), but in the US and other countries the use of stated income mortgages has balooned well outside the intended target user of the product. From well heeled self employed persons to 23 year old wannabe Donald Trumps.

This financial product seems to me like it should get the gong because of its susceptibility to fraud and misuse. What do you think? What do you think of the CMHC (the federal government) insuring these mortgages?

Value Investing - Part 2 - Stock Picking

Last Wednesday, I wrote a piece about the long term outperformance of the value investing style and I wanted to follow it up with some specific ideas for leveraging this investing style. Before I do that, I want to clarify that there are generally two types of investors:

1. Passive - Buy and Hold strategy, buys mutual funds, has others manage investments, does not have time to devote significant time to research and trading.
2. Active - Buy and Monitor strategy, buys individual stocks and bonds, manages own investments, devotes a significant amount of time and resources to research and trading.

Most people fall somewhere between these two types but will tend toward one or the other. This is probably one of the most important distinctions that a person can make when understanding what type of investor he or she is. For example, a passive investor who attempts to pick his own stocks without devoting enough time to research and monitoring will likely fail in his strategy. Also a word of caution to the active investor; an active investor who attempts to build a portfolio without sufficient funds (at least more than $100,000) will likely spend an inordinate amount of money on transaction fees and commissions thus reducing the total rate of return. Ideally, an active investor, in addition to having an aptitude for research and analysis, should have more than $300,000 to build an appropriately diverse portfolio.

Assuming all of the above is taken into account, the following guidelines would apply to an active value investor. I will discuss solutions for a passive investor next week in Part 3. The following guidelines are a synopsis of Benjamin Graham's investing guidelines from his book: The Intelligent Investor. These guidelines are extremely generalized and form a basis for evaluation but not all encompassing. Please augment this knowledge with your own readings.

1. Look at the average current yield on top-quality (triple-A) corporate bonds. Say 4.5%
2. Multiply that by 2. =9%
3. Divide 100 by the number found in (2). =11.11
4. The number in (3) gives you the highest acceptable P/E ratio of the stocks that you can choose from. P/E = 11.11
5. Note: Generally, don't go for stocks with P/E ratios greater than 10. P/E ratios of 7 or lower should preferrably be chosen.
6. The ratio of stockholders’ equity to total assets should be at least 50%. For example, if a company has stockholders’ equity of $30 million and total assets of $50 million, the ratio is 60%. Since that is over 50%, the company passes the test.
7. Form a portfolio of at least 30 stocks: this is the ideal minimum.
8. Hold onto the stocks until you make a 50% profit. As soon as the stock goes up that much, sell it.
9. If a stock has not met your objective profit of 50% by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 2002, you would sell it no later than the end of 2004.
10. When times are bad for the stock market, i.e., when stocks are selling at low P/E levels, take advantage of the situation and put 75% of your investment capital into common stocks. In good times, when the market is overpriced, when you have trouble finding stocks with low P/E ratios, you should have no more than 25% of your funds in stocks and the rest in other less risky assets.

I would also say that an active investor should devote a significant amount of time to developing his or her analysis skills and into researching potential investments and monitoring his or her current investments. 15 to 20 hours per week for a portfolio over $300,000.

I'll have some more to say about value investing next week for the passive investor or investors who have less than the funds required to build an adequately diverse portfolio.

What do you think? Is Value Investing the way to go? Are you a passive or active investor?

Surrey is 2006 Home Construction Capital

I thought this article in the Surrey Leader was interesting as it highlights the fact that the suburbs are where a lot of the action is in this housing boom. I live and work in the Fraser Valley so I can attest to the frenetic pace of growth and the continual traffic nightmares. We have very little transit and a lot of new residents putting a lot of strain on the roads and other public facilities.

The average price of a detached home in Surrey.
12/2001: $251,224
12/2003: $301,078
12/2005: $389,682
12/2006: $469,029
12/2007: $???,??? (my guess - $431,000)
12/2008: $???,??? (my guess - $385,000)

By Jeff Nagel
Black Press
Jan 12 2007

Surrey became the new home construction capital of the Lower Mainland in 2006. Overall housing starts across the Greater Vancouver Regional District dropped two per cent last year, but Surrey recorded a 20 per cent increase to nearly 4,600 units, according to the Canada Mortgage and Housing Corporation.

That put it ahead of the construction pace in Vancouver, where the number of new starts fell 18 per cent to 3,426. Richmond moved into third place with 2,094 new units started, an 18 per cent gain paced by strong growth in multi-family units. Burnaby, where new construction was cut nearly in half to 1,606 mostly multi-family units, dropped to fourth.

Condo and other multi-family construction surged in places like Coquitlam, Maple Ridge and Pitt Meadows. “Densification is going to be an issue and people better get used to it,” said Greater Vancouver Home Builders Association CEO Peter Simpson. “We have to put more people in a more constrained space.” He predicts builders will increasingly offer developments that let residents live, work and play without travelling far. Coquitlam saw 976 multi-family units started last year, up from 260 in 2005, while Maple Ridge started 528 units, up from 111 the previous year.

Surrey continued to lead the GVRD in single-family house construction, with 2,247 starts accounting for nearly half the region’s total. Simpson expects past political opposition to growth from some city councils, notably in Delta, will moderate this year. “Mayor Lois Jackson has to start walking the talk,” he said, noting plans to build several hundred new units in Delsom Estates there may mark a turning point. The industry ended the year with construction starts down a sharp 26 per cent in December. But Simpson called that a blip due to extreme weather late in the year. “We had horrendous weather conditions,” he said. “We went through winds and floods and rain and snow. I think the only thing missing were locusts.” He predicted more balanced market in 2007 will give builders a chance to catch up on some work.

The number of workers employed in the Lower Mainland’s construction industry hit a new all-time high of 108,500 in December. Construction employment climbed 21.8 per cent in the Abbotsford area and 6.9 per cent in Greater Vancouver, according to the Vancouver Regional Construction Association. The sector marked its third straight annual increase in 2006.

The Monthly Payment Consumer

From iTulip.com. Check out the full article here.

First, a definition from the iTulip Glossary. "monthly payment consumer : n. a new kind of consumer last seen in the late 1920s when installment credit was invented to allow the middle class to afford new products which resulted from the wave of government financed WWI military technology working its way into consumer products, such as radio and refrigeration.

Sustained low interest rates starting in the mid 1990s, and accelerating in the early 2000s created the Monthly Payment Consumer. This consumer's behavior accounts for the cost of purchases not in terms of the total price but as a monthly payment in portion of monthly income. After several years of “No Money Down!” and “Zero Interest for Six Months!” financing, not to mention interest-only and negative amortization mortgages, consumers changed their behavior, stopped saving, and became used to the idea that credit is almost free and in nearly infinite supply.

The monthly cost of a home that went for $1 million in 2005 purchased with a $3.3% ARM carried the same monthly cost as a $500,000 home in 1995 purchased with a 6.6% fixed rate mortgage. The two homes are equally affordable, but the two prices apply to the same house with the 100% increase in price separated by only five to ten years' time and representing no equivalent 100% increase in value (utility). The price inflation was the result of low interest rates provided by central banks. Capital gains income earned by speculators who made money flipping houses during the period of rapid price inflation contributed significantly to consumption during the period.

The Monthly Payment Consumer, through his and her grim determination to eek the last ounce of material enjoyment from the last dollar he or she may so easily earn or borrow as he or she can today, famously accounts for 70% of US GDP. Jane Burns (the article's author) is no help, though, as she explains at the outset. The Burnsian consumer gets more joy and gratification from not buying each and every dispensable product she doesn't purchase than the folkloric consumer of economists' models gets from, in the words of George Carlin, "spending money he doesn't have on crap he doesn't need." The question is how many consumers will go Burnsian on us next year.

How prevalent is the monthly payment mentality here in British Columbia? How many people do you know who are:

1) the Monthly Payment Consumer?

2) The Burnsian Consumer - one who gets more pleasure from not purchasing?

Inflation Adjusted Rate of Price Change

Over the last 30 years, the Vancouver real estate market has been through some ups and downs and I wanted to look at historical price changes in several Canadian cities, including Vancouver, to see if history could teach us something about the current real estate market. Here is a chart graphing inflation adjusted real estate price changes since 1978.



By far the most noticeable event in local real estate prices was 1981. There was a period of extreme price appreciation from 1979 to 1981, followed by a drastic correction that ran its course until 1986. 10 quarters of price increases and 15 quarters of price declines.

1986 through 1989 witnessed big price increases which fizzled through late 1990 and 1991 causing prices to fall 25%. 18 quarters of price increases and 3 quarters of price declines.

1992 through 1995 witnessed another price run up, although more subdued than the previous two run ups, and that culminated in a long period of prices declining through 2001. 15 quarters of price increases and 26 quarters of price declines.

The current cycle started in 2002 and YOY price increases will be evident through at least the first half of 2007 for a total of a 22 quarters of positive price changes. How long will the declines last this time after the longest run up in prices in recent history?

What does the data from the other cities tell us?

The Gong Show #1 - 40 Year Mortgage

If you aren't familiar, the Gong Show was a television variety show spoof that was broadcast from 1976 until 1980. Each show presented a contest between amateur performers of often dubious talent, with a panel of 3 celebrity judges. If the judges considered an act to be particularly bad, they hit a gong to end it immediately.

I am introducing what I hope to be a regular Thursday post called "The Gong Show" in which I will feature a dubious financial product that I think deserves to be gonged. There are many financially suicidal products out there so I have a feeling that I won't run out of material any time soon.

For this weeks gong show I am featuring the 40 year amortization mortgage. Available at most Canadian financial institutions and mortgage companies now, the 40 year mortgage is certain to get the gong from prudent financial managers who think that enslaving yourself to a mortgage is not a good use of the freedom we enjoy in Canada.

Lets see, if you purchase your first home at age 30 and because real estate prices are so nuts the only way you can afford the monthly payment is by going with a 40 year mortgage, you will be paying off your home until age 70. Hmmmm . . . . well, gosh, golly, I never knew it could be so good, sign me up!

What do you think? Should the 40 year mortgage get the gong? Why?

Invest in Value - Long Term Outperformance

Since starting my career in Financial Planning I have heard many investment analysts proclaiming that this asset class or that asset class will be the next winner. "Technology - its the future." "Resources - demand is inexhaustible." Gold, Euros, and on and on.

Until I read the book "The Intelligent Investor" by Benjamin Graham I often put a lot of weight on what these analysts were saying. What I realized is that the analysts don't have a clue a lot of the time and very few investment managers, securities analysts or fortune tellers actually beat the market consistently. Only one investment style has consistently beat the market and made people like Warren Buffett among the richest people in the world.

What am I talking about? Value Investing.

Value investing has beat the broader market consistently over the past 75 years with lower volitility than the broader market. This chart shows the past 12 years and the comparison between the broader index, growth stocks, and value stock. Clearly value wins. Over 10 years the broader index returned 8.42% (not bad), the growth stock index returned 5.2%, and value returned 10.8% for a wide margin of outperformance. Even over longer periods of time (40 years +) value outperforms growth by approximately 4% and the broader index by approximately 2%.



A Value investor follows a few simple guidelines for picking investments and then has the convictions to follow through on his or her analysis.

Real estate and other investments can flow through this same decision making process to assist the investor in making rational decisions about his or her investments. For example, good questions to ask are: What is the P/E ratio? P/B ratio? Stability? Realistic growth prospects? I'll post more about this investment style next week and I'm thinking of having a regular Wednesday posting generally about investing. What do you think?

Like a Slow Moving Train Wreck?

Real Estate market corrections have been likened to slow moving train wrecks and I couldn't resist the analogy to the new home development in Fort Langley called Bedford Landing. I have been quite interested in the $400,000,000, 378 home, 78 acre Bedford Landing development in Fort Langley for two reasons:
1) I like Fort Langley, its charm and historic significance, wouldn't even mind owning a home there someday and
2) I think it is a barometer for sentiment in Fraser Valley Real Estate.

Check it out here: www.bedfordlanding.com
I had the opportunity to tour the discovery centre, sales centre, and showhomes recently and I have followed the press on the development for a couple years now.

Here are some of my observations about what most people see:

1) Lots of local press dedicated to how 'fantastic' the development is and what a 'great impact' it will have on the area.
2) Plenty of press about the 'pent up demand' for the homes
3) Enthusiastic public officials, developer staff, and newspaper articles
4) The obligatory overnight line up for the 'opportunity' to put a deposit on a home
5) Insane stories about people travelling from far away places to live there
6) Townhomes are $375,000 to $400,000 and Single Family Homes are $475,000 to $600,000 with the next release having homes up to $1,200,000.

Here are a few other observations that don't get the press:

1) The development is right beside the main CN Rail line which has 16 freight trains per day traveling past at 80-100 km/h. Two trains went past while I was touring the show homes and the homes shake as the train goes past.
2) The development was built hastily on top of 5 - 8 metres of sand infill dredged from the Bedford Channel.
3) Its on an old mill site - who knows what's underneath the ground?
4) Only half of the homes available for sale have actually sold now - where did the line up go? What about all that pent up demand?
5) Where will all of these people (1000+) shop, drive, go to school, etc? There are no plans for increased amenities in the area and Fort Langley has significant development restrictions.

My take on these observations is that the potential buyers are not so enthusiastic about the homes at current prices and thus that ‘pent-up’ demand has dried up, the demand was false and fabricated, or the people causing the demand are unable to afford the homes at the asking prices. We will see how long it takes before the developer lowers prices to meet potential buyers.
So, is our Real Estate market a slow moving train wreck?

Prices are Sticky on the Way Down

No Data Analysis today, although I am working on a couple of interesting things which I hope to post this week.

I thought this article was interesting from the Boston Herald featuring an interview with Karl Case. He is a founding partner in the real estate research firm of Fiserv Case Shiller Weiss, Inc. (Note: He is a colleague of Robert Shiller, whose name is more recognizable) He is a Director of the American Real Estate and Urban Economics Association and Associate Editor of the Journal of Economic Perspectives. Mr. Case knows a thing or two about the real estate market and its dynamics.

Here is the article:

Buyers vs. home sellers: Standoff could lead to recession
By Scott Van Voorhis Boston Herald Business Reporter
Friday, January 5, 2007 - Updated: 11:57 AM EST

How bad is the real estate market?
At a national conference today, Wellesley College housing guru Karl Case will release the results of a five-month groundbreaking survey of the housing market in Boston’s suburbs. And it’s not happy reading. After tracking 628 homes on the market from July through November, Case found that fewer than a third actually sold. It paints a picture of a market nearing a standstill, in which would-be sellers are opting to take their homes off the market rather than accept big markdowns. Over such a lengthy period, even in a slow market, one could expect 70 percent of these homes to have sold, Case estimates.

But Case’s study found only 30 percent moved. The Massachusetts Association of Realtors has put the average time on the market at four months now. The pain appears to be spread pretty evenly, from the Merrimack Valley town of Andover, which saw just nine of 30 homes sold or put under agreement, to Weymouth on the South Shore, which saw just seven sales of the 30 homes tracked by the study.

Despite the big drop in sales activity, there was no price implosion. Instead, average selling prices fell just 6.3 percent. After seeing the value of their homes soar during days of the real estate bubble, home owners are reluctant to give ground on price. Or, as Case puts it, it’s a case of “sticky” prices common to past market downturns. That could help minimize the feared drop in the “wealth affect,” where a decline in home values puts a big dent in consumer spending. But the standoff between would-be home sellers holding out for top dollar and buyers seeking a bargain is far from ideal. Instead, the drop in home sales activity could be a more serious economic threat, Case believes. Combined with an already-large drop in housing starts, it could put a measurable dent in the nation’s economy. The housing cool down, in turn, could lead to the loss of 1.4 million jobs by the end of 2008, pushing up the national unemployment rate to 5.8 percent, Case’s report estimates. All of which is in marked contrast to the predictions of real estate industry organizations, which have been forecasting a big market rebound in the spring.

Still, the Wellesley College professor and nationally respected housing expert was shying away from grand predictions on where home sales and prices are headed over the next few months. Instead, he is letting his research do the talking. Such as this selling fact: real estate downturns have contributed to three prior recessions. That about says it all

Dr. Case's analysis would seem to indicate that we shouldn't expect drastic price changes from month to month or even year to year but rather a long and drawn out decline in sell/list ratio and prices.

Rental Vacancy Rates and their relation to Price Growth

Rental accomadations can be hard to come by these days. Fortunately, my wife and I own a place we call home and we like it quite a bit, but I have heard that it can be difficult to find a suitable place to live these days. I was thinking about this and the crazy real estate market of the Greater Vancouver area over the past few years and I wanted to do some analysis on this.

What did I find?

Well, first off, I don't want anyone to draw a cause and effect relationship between these two variables (real estate price growth and vacancy rates) but there is, quite obviously an inverse correlation between price changes and rental vacancy rates. We can speculate about the cause and effect relationship.

Here is the chart (based on data from UBC's Sauder School http://cuer.sauder.ubc.ca).

What this data tells me is that when year over year price growth in real estate is high, vacancy rates tend to be low and when price growth is negative or low, vacancy rates are high. For the math fans out there the correlation coefficient is -0.69.

What do you think? Why does this happen? Is it because of the diminishing returns for investors? Transactional overhang? People not buying so it drives demand for rentals? How could we draw a cause and effect relationship?

Fraser Valley Real Estate Board Statistics

I have decided that the truth needs to be told regarding the Fraser Valley Real Estate Market. Its overpriced, overbought, low quality, and generally insane. I don't understand why people pay $500,000 for a house that would have sold for $300,000 three years ago. Why do they enslave themselves with a mortgage that is burdensome and unsustainable? Why do they pay so much so a developer can get rich?

I'll be using the offiicial stats from the Fraser Valley Real Estate Board and drawing on other examples of overprices assets, including other real estate markets and the stock market. Find the data here at the FVREB's website: www.fvreb.bc.ca

I'll be commenting on other financial topics as time goes on but right now I need to get this off my chest.

To start, I have found that there is an inverse correlation between the supply of housing stock and the percentage by which prices move. Here is a chart tracking the inverse correlation of months of inventory and percentage price changes for the Fraser Valley from July 2006 to December 2006. I have added a trendline for illustrative purposes.

If you have saved any other months of the data releases please send them to me and I will update the graph.

Cheers.