Tuesday, September 30, 2008

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.

Sunday, September 28, 2008

What $1 Million Buys In Homes Around The World

From Forbes.com

What $1 Million Buys In Homes Around The World

Francesca Levy 09.18.08, 4:00 PM ET

It has been a dark week for Wall Street and an even gloomier year for U.S. real estate.

But in some areas of the globe, luxury homebuyers are seeing sunny skies.

As housing prices continue to tumble--down a record 4.8% in the second quarter of 2008 from the same time the previous year, according to the Office of Federal Housing Enterprise Oversight--those looking for a new home in the million-dollar range are getting a lot more for their money. The deepening subprime crisis in states like California and Florida, and in wealthy zip codes, means dream homes and investment properties are being added to the foreclosure list. In Los Angeles, for example, homes in the $4 million to $5 million range would have cost buyers an additional $1 million last year.

In Pictures: What $1 Million Buys In Homes Around The World

Those looking in Europe aren't as lucky. The dollar's decline means $1 million buys you much less. In Paris, many buyers pay for location and make do with apartments smaller than 300 square feet.

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World's Best Places To Invest In Real Estate

In recent years, Americans have been investing in developing countries like Costa Rica, where the same amount will buy you 5,000 square feet of marble floors and Roman columns in lush surroundings.

In short--$1 million buys lot in Chicago and Cape Town, but not in London or San Francisco.

Luxury List
For our look at the world's property markets, Forbes.com examined five U.S. cities and 20 spots abroad, focusing on locales where U.S. investors did business or traveled for vacation or retirement. In each city we selected a million-dollar home that was emblematic of the market. In some cities $1 million homes were scarce, with the price point either far above or far below the market average.

Keeping tabs on property markets far from home is becoming increasingly important. As the worldwide housing arena has transformed, international real estate has become a growing trend. U.S. homebuyers have had to get creative, seeking out the places in the world where the dollar can still buy a luxury home. In recent months, the tightening American credit market has restricted even these investments.

The weakening housing market stateside has given British nationals an in. They have been snapping up U.S. properties, seizing on the strength of the pound against the dollar.

"The Brits are among our top buyers in New York," says Royce Pinkwater, senior vice president at Sotheby's International Realty. "There is a lot of wealth there, and it is a natural transition for them because we are English-speaking."

What $1 million buys in:






However, the dollar's growing strength, coupled with the housing market's instability, may change this. Pinkwater says the currency's comeback, among other factors, is causing Brits to cool their U.S. buying frenzy.

"They are sitting back and taking a break to some extent," she says. "They're hoping the real estate market will keep going down."

But in many U.S. cities, inflated real estate prices can hold firm or slide only slightly in the city center even as they collapse in the surrounding areas, says Richard Green, economist and director of the Lusk Center for Real Estate at the University of Southern California.

"In the inland areas of Los Angeles, you can get a 4,000-square-foot house--a huge house," he says. But in popular Santa Monica or Marina Del Rey, "You'll get a shack."

In New York, $1 million offers a bit more flexibility than it did at this time last year.

"Hell's Kitchen is getting really good values. There you can get 600 or 700 square feet with amenities," says Julie Pham, a vice president at the Corcoran Group.

But those hoping to discover an outer-borough gem are probably out of luck, she says. "Unless you're willing to walk a pretty long distance from the subway, it's not going to be a big discount."

A few of the homes we found showcase cities with unusual housing patterns, like Mumbai, where a short housing supply contributes to high prices.

"You're seeing New York prices on apartments," says Green. "It's very hard to build anything there because of zoning laws. And while the average income is very low, there are a small number of very wealthy people all bidding for the same properties."

How is the housing market faring in your area? Weigh in. Post your thoughts in the Reader Comment section.

In London, where even one million pounds isn't likely to get you far, $1 million gets you an unimpressive one-bedroom apartment--one that may not even meet the American definition of a one bedroom.

"A good studio here would probably look like a one-bedroom there," says Pinkwater. "It's really tight."

Pinkwater says the city's real estate market is unhealthy.

"The market is definitely weaker in London, and I think it will become weaker still," she says. "It has become very, very expensive and now people are watching that market flounder."

Still, says Pinkwater, properties priced $10 million and up aren't going anywhere.

"The top end," she says, "will always be the top end."

In Pictures: What $1 Million Buys In Homes Around The World

What goes for a million bucks here in Vancouver? Post your best MLS listings here.

Wednesday, September 24, 2008

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.

Saturday, September 20, 2008

CMHC Data - Vancouver

Click on the charts to make them bigger.

It appears that we've hit the peak in units under construction (dark blue line). As the number of units falls, we should watch for the impact on employment.

It is truly amazing how the construction sector has boomed during these past few years. From the lows of the year 2000 to the lofty heights of 2008. And now here comes the ride back down again.

Wednesday, September 17, 2008

don't PANIC

Well folks we are certainly in the middle of it now.

There is no denying that the fancy financial shenanigans of the past few years have now fully culminated in the fecal matter hitting the overhead rotational device.

Bring it on is all I have to say. Let's get this over with. Me and my clients are positioned decently to weather this storm but not without a concern for the broader societal impacts.

Investment banks - done.
Sketchy lending joints - done.
Poorly capitalized banks and insurance companies - done.
Hedge funds - done.

Fortunately, life will go on without these companies and hopefully it will result in less speculative mentality and behavior. Let's focus on doing productive things like designing and building stuff that works well. Providing valuable services with pride and honesty. Supplying the world with items of real utility and value.

Tuesday, September 16, 2008

Phinance for Physicists #1

Thanks to jesse for putting this together and doing some legwork.

I had a brief email conversation with Dr. Somerville on his recent paper regarding proper valuations of residential houses in different Canadian cities. He and I agreed that the life of an economist involves a bit more than plugging numbers into equations. However economics is a science so, having no significant formal finance/economics training but a bit more physics training, I thought I would bridge the divide with some much touted but rarely practiced cross-disciplinary legwork. Scientist to scientist.

A good friend of mine opined about physics education that the number of lies told during one's schooling slowly decreases. In many ways, in my current view, economics is like this. We use simple formulas, supply-demand curves, etc. in an attempt to understand the world around us.

With my limited understanding of finance, here starteth the lies.

Net Present value

The concept of The Net Present Value (NPV for short) is determining fundamental value for an asset, such a car, a boat, a stock, a pair of droids, a sail barge, or a house. The concept is simple: that the purchasing of this asset ties up one's money that cannot be used for other things, that people generally want to maximize their wealth, and that there is risk in tying up money in an asset.

Rule#1: The Net Present Value (NPV) of an asset is the sum of a series of expected discounted future cash flows.

What it means is that rational investors, given all other available choices with what to do with their money (opportunity cost), the risks involved, the expected revenue, expenses, and a little something for their trouble, will look at an asset and determine what the maximum they would be willing to pay to produce a fair return.

We can derive a rough formula for the net present value of, say, a condominium that is rented out. We assume the condo is rented out forever, which is a reasonable approximation (forever and 30 years produce about the same number). Returns and inflation compound so the series of cash flows increases geometrically but are discounted:


where i is the expected inflation of rent and expenses (say, 2% per year), and r is the so-called discount rate that is a combination of the long term bond rate (that includes expected inflation), a risk premium, and depreciation. The discount rate is a method of combining risk, inflation, and opportunity cost into one number. Rent is gross annual rent, and Expenses are annual maintenance, tax, and insurance costs (et cetera). Financing costs are not included here as the decision to buy is based upon having cash in hand, though more advanced analysis can explicitly include them. (Financing costs are, to a degree, implicit in the above formula) Note depreciation could be abstracted in Expenses or as part of the discount rate r.

Note that some condos will have more problems with tenants than others. How this is handled in the calculation is typically by having a higher risk premium included in "r" though in essence it could also be handled by using the expected value of rent, not nominal rent. The same principle applies for expenses, like the probability and expense of a condo being leaky for example.

This is in fact the formula mohican used to calculate fundamental value. He chose to use r-i (also known as the "cap rate") as the 5 year mortgage rate as a rough approximation. In his words, "The bond market and the banks are particularly efficient at determining the risk premium and adequately price that in to the 5 year mortgage rate. This is why I use it." Mohican also clarified to me that he assumes land appreciation and structure depreciation are roughly equivalent. It's also worth noting that mohican has chosen to use a relatively simple formula to estimate fundamental price and not spend too much time in details. In general there is nothing wrong with this but in certain situations it helps to know what to do if there are significant deviations.

The working paper Dr. Somerville et al published uses a formula similar to this but in a different form. It can be derived from the same basic principle, resulting in:


Where k is the long term mortgage rate, t is tax rate, m is maintenance, d is depreciation, (the last 3 are as % of property value) and E(DP/P) is expected capital appreciation.

Without going into the details, both mohican's and Dr. Somerville et al's chosen formulas can be construed to have been derived from Equation 1 above, from a strict financial, not economic, perspective.


Let us use mohican's chosen formula in a simple example. A condo rents for $1000 per month, just sold for $220,000 and has expenses that are 20% of rent. The mortgage rate is 6%. NPV = 1000*12*0.8/0.06 = $160,000. This means that a rational investor who is looking only at future cash flows will be willing to pay $160,000 for this condo, according to mohican's formula.

Now, let us use Dr. Somerville et al's chosen formula for the same condo. We will assume that this condo will "conservatively" appreciate at E(DP/P) = 3% per year, k is 6%, t is $1200/year, or 0.5%, m is 0.5%, and d is about 1%. According to this formula a rational investor will pay 12000/(0.06+0.005+0.005+0.01-0.03) = $240,000


Why the difference? There are two reasons. The main reason is contained in E(DP/P). It turns out, according to first principle derivations, that E(DP/P) is equal to the expected appreciation of future cash flows. In other words, a value of E(DP/P) increasing faster than cash flows are increasing from the current asset is expecting to either sell the asset to someone in the future for a price inflated by E(DP/P) (selling an asset is a cash flow), or that cash flows can increase more sometime in the future by using the asset more productively. Assuming 3% annual appreciation is more than what was implicitly assumed by mohican.

The second difference is more subtle. Remember in Equation 2 the expense costs were as a percentage of value. If capital appreciation continually outpaces rent inflation, these percentages perpetually drop; in other words the cost of capital perpetually decreases. This works mathematically but one must realize that the capital appreciation inherently includes productivity increases above what the current structure can support. The potential flaw in this is that the expenses must include construction costs for the productivity enhancements and would boost the percentages higher than what was calculated. Furthermore, and more importantly, one must think hard about what value to use in the denominator of the percentages. For this reason it may (must) be preferable to pull m, t, and d and make them nominal, not as a % of an arbitrary pre-calculated value.

Remember Equation 1 assumes an infinite series of geometrically increasing cash flows. If at some point in the future rents increase faster than expected or the land can be further sub-divided and used to produce more rent (say turning a 5 story condo into a 20 story condo 15 years from now), the NPV could be higher than what current cash flows suggest. One can approximate this by adjusting upwards the exponent on the geometric series. Expenses, too, can be nonlinear if there are major renovations or redevelopments in the future. If, however, the cash flows spike up (or down) too far in the future, their present values are diminished so as not to significantly change the expected capital appreciation rate. For example 1000 years from now a giant space tower with 6000 floors is likely to be built in a detached residential neighbourhood. This will have close to no impact on NPV, even if it were a certainty.

We can of course solve for E(DP/P) to figure out, if the condo just sold for $220,000, what the rational investor expects for capital appreciation.

Another measure thrown around local blogs is the 100X-125X monthly rent multiplier for condos. This would put our example condo at $100,000-$125,000. There is historical precedent for this occurring, though just as prices can be above one's calculated NPV, they can drop below as well. It IS reasonably possible to calculate NPV equal to 100X rent in Vancouver; in fact I think there is a good chance of select condo sale prices equaling this someday soon.

Regardless of which formula, mohican's, Dr. Somerville's, or some other fundamental asset formula, you may choose to use, remember that their roots are the same but their assumptions can be different.

The next (lesser) lie to discuss is looking at E(DP/P) -- capital appreciation -- in more detail; naturally, with housing in mind of course.

Sunday, September 14, 2008

US Financials Falling Like Dominoes

Sept. 14 (Bloomberg) -- Lehman Brothers Holdings Inc. prepared to file for bankruptcy after Barclays Plc and Bank of America Corp. abandoned talks to buy the U.S. securities firm and Wall Street prepared for its possible liquidation.

Lehman and its lawyers are getting ready to file the documents for bankruptcy protection tonight, said a person with direct knowledge of the firm's plans. A final decision hasn't been made, though none of the other options being considered appeared likely, the person said, declining to be identified because the discussions haven't been made public.

Sept. 14 (Bloomberg) -- Bank of America Corp. agreed to buy Merrill Lynch & Co. for about $44 billion, a person with knowledge of the deal said, after shares of the third-biggest U.S. securities firm fell by more than 35 percent last week and smaller rival Lehman Brothers Holdings Inc. neared bankruptcy.

Bank of America and Merrill reached a deal in principle, according to the person, who declined to be identified because the deliberations were private. A final merger agreement hasn't been signed yet, the person said. The boards of Merrill and Bank of America approved the transaction this evening, the Wall Street Journal reported, citing unidentified people familiar with the matter.

Sept. 14 (Bloomberg) -- American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

The insurer has turned down a private-equity investment because it would have meant handing over control of the company, the Wall Street Journal said on its Web site, citing unnamed people. AIG may get access to the Fed's borrowing window in an ``extreme liquidity scare,'' Citigroup Inc. analyst Joshua Shanker said in a Sept. 12 research note.

Thursday, September 11, 2008

New Home Prices Falling

From CBC News:

The nippy growth of the national housing market is continuing to slow, data released by Statistics Canada on Thursday suggests.

Inflation-adjusted prices for new homes nationwide were up 2.7 per cent in July from the same month the year before, the federal agency reported — a slight deceleration from the 3.5 per cent year-over-year hike in new housing prices recorded in June.

Statistics Canada said it was the sixth consecutive month of easing in price pressures for new homes, "mainly due to the softening market in Western Canada." Housing prices have been on an overall cooling trend for two years, the agency said.

Still, several Prairie cities posted torrid growth in costs for new homes. Regina booked year-over-year price increases of 29.6 per cent, down from a peak of 34 per cent in April but still the national leader. Saskatoon had the third-hottest market, with new-home prices rising 13.1 per cent from July 2007.

St. John's had the second-hottest market for new houses, recording a 24.3 per cent rise in prices.

It was a much different story for builders in Edmonton, where prices for new housing fell 5.3 per cent in July from the year earlier.

Statistics Canada attributed the upward pressure on prices for new homes to higher costs for fuel, steel and labour.

New home prices will likely be negative, on a nationwide year over year basis, by the end of the year.

Monday, September 08, 2008

The System is Down

Volcker Says Finance System `Broken,' Losses May Rise (Update2)
By Steve Matthews and Doug Alexander

Sept. 5 (Bloomberg) -- Former Federal Reserve Chairman Paul Volcker said the U.S. financial system, dependent upon securitization rather than traditional bank loans, is broken, and may contribute to the weakest expansion since the 1930s.

``This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere, has broken down,'' Volcker said today at a banking conference in Calgary. ``Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.''

The former Fed chief projected ``a lot'' more losses from the collapse in the mortgage-backed debt market, after the more than $500 billion tallied so far, should the U.S., European and Japanese economies fail to pick up. He urged changes in financial regulations, echoing calls among sitting officials and legislators.

``It is the most complicated financial crisis I have ever experienced, and I have experienced a few,'' said Volcker, who has endorsed Democratic presidential candidate Barack Obama. Volcker ran the Fed from 1979 to 1987, and engineered an increase in interest rates to 20 percent to quell inflation that exceeded 10 percent.

U.S. growth has averaged 2.3 percent so far this decade, down from 3.4 percent in the 1990s. The current growth rate is the weakest since at least the 1940s, when the government began compiling figures on quarterly gross domestic product.

Volcker's comments came after a government report today showed the U.S. unemployment rate rose to a five-year high as the economy lost more jobs than forecast in August. The report underscored concerns that U.S. consumer spending will weaken and push the American economy into a recession.

Economists expect annualized rates of growth of 1 percent in the third quarter and 0.4 percent in the fourth quarter, according to the median estimate in a Bloomberg Survey in early August.
Fed Chairman Ben S. Bernanke said on Aug. 22 that financial turmoil has ``not yet subsided,'' and is contributing to weaker growth and higher unemployment. Policy makers will ``continue to review'' the Fed's measures to ensure liquidity to determine ``if they are having their intended effects,'' Bernanke said.

``Changes are going to have to be made'' to the global financial system, Volcker said. Banks three decades ago accounted for about 60 percent of U.S. credit; that later declined to about 30 percent as securitization -- where financial firms package assets into bonds and other instruments and sell them on to investors and other companies -- spread.

Volcker said he agreed with descriptions of the current financial system as ``dysfunctional. That is a polite way of saying it failed.'' The U.S. government, not the Fed, should take the lead in rescuing any financial institutions when ``push comes to shove,'' he said, echoing comments by former Fed Chairman Alan Greenspan.

The Fed rescued Bear Stearns Cos. from bankruptcy in March, facilitating the firm's merger with JPMorgan Chase & Co. by loaning against $29 billion of Bear securities. Bernanke has also made central bank loans available to nonbanks for the first time since the 1930s and lowered the rates at which banks can borrow from the Fed.

Thursday, September 04, 2008

Fraser Valley Real Estate Prices Lower than Last Year

The Fraser Valley Real Estate Board released the August 2008 statistics package and here is what it contained.

Active Listings in the FVREB ended August at 11,770 homes for sale.

There were only 910 sales in the entire FVREB area during the month of August.

This meant that the Months of Inventory rose to 12.9 months which means that the sales to listings ratio in the FVREB was 7.73% during the month.

As the ball is now rolling on negative price changes, the correlation between the supply and demand metrics and the corresponding price changes is 'uncanny' to put it simply!

And yes, prices fell 0.1% from August 2007 according the the Real Estate Board's benchmark House Price Index.

Wednesday, September 03, 2008

REBGV August 2008 Stats and Charts

Well, I'm back from vacation and, other than a little bit of rain, it was wonderful.

Here are the details regarding the market activity during August 2008 in the Real Estate Board of Greater Vancouver area. Click on the images to make them bigger.

Sales were 53% lower than last August.

Active Listings are at unseasonably high levels - 75% higher than last year.

Months of Inventory is ridiculously high at over 12 months. This is an extreme level, which is putting lots of pressure on sellers to cut prices and gives buyers the upper hand in negotiations.

The ratio of sales to active listings is so low right now that it appears as if nothing is selling at all.

The current level of inventory and extremely low sales is leading to some very negative price pressure, with the benchmark price falling 2% during August alone and over 4% during the last 3 months. It looks as if prices will be negative Year over Year at the end of September.

The real estate market is a 'market' after all and markets are subject to the laws of supply and demand. A new equilibrium is being reached right now, which is causing prices to fall, as buyers are negotiating tougher deals and sellers are being forced to be more creative or aggressive.

That's it for now. FVREB report will be out soon and I will provide another update then.