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March, 2008


As I write, at 11 AM on 3/19/08, despite yesterday the greatest surge in the Dow Jones Industrial Average in over five years, it is still down 6.7% in just the past 11 weeks, while the Nasdaq (in which, unfortunately, Val and I have most of our equity investments) is down 14.6% in the same short period, and the S&P 500 Stock Index has retreated 9.1% since 12/31/07.

Meanwhile, we are also hearing all sorts of scary stories about housing prices falling more than at any time since the Great Depression, the value of the dollar plummeting as well, oil prices soaring to record levels, other measures of inflation rising, employment declining, huge levels of corporate, government, and individual indebtedness, extremely low savings rates, uncertain values for trillions in derivatives (whatever they are), potential runs on investment banks if not for unprecedented bailouts arranged and partly insured by the Feds, talk of crises and meltdowns, etc.

A little over eleven years ago, then Fed Chairman Alan Greenspan coined the term "irrational exuberance" to describe the state of equity investing euphoria in this country. Price to value ratios were at record high levels and still would rise quite a bit further before that bubble burst, markets inevitably collapsed (in 2000), and we then had our worst bear market since the 1970s.

Now it would seem we are in a bit of an irrationally negative market tailspin and maybe should just "get over it" and return to the quite profitable market surges we have again gotten used to more recently. In the last half of 2007, for instance, stocks were largely momentum driven just as they had been in the late 1990s. Real values for companies and their common stocks were not seen as particularly relevant. Why cannot we just resume that kind of powerful, greed and emotion led advance?

Our situation up till around the end of 2006 was not nearly so severe or dramatic but otherwise looked surprisingly similar to that in Japan about 20 years earlier. In the mid-1980s, that country's economy was briefly even larger than that of the U.S. It's stock market was soaring. Its real estate had never been so high. A square foot of some Tokyo properties was going for more than a small house in this country. Indeed, the sum of the city of Tokyo's real estate held a market value greater than that of all CA real estate. Japanese investment and economic "gurus" were talking of how it was "different this time," so normal market curbs no longer would prevail and the skies were their only limits. Their billionaires were buying up vast "cheap" properties in our country. Our own experts were bemoaning our loss of face as Japan appeared to be surpassing us in many ways. But there were questionable, risky Japanese banking practices and some indications of corruption both in government and in their corporations. These factors were coupled with the equity and real estate bubbles. Their circumstances really were quite vulnerable and simply could not persist much longer. When the end inevitably came, it was like an emperor has no clothes scenario. What people had been blind to before was now obvious to all. The debacle that began later in 1986 brought everything crashing down. Suddenly nobody could understand why their house of cards had risen to such lofty levels with so few realizing things were unsustainable. The resulting collapse affected stocks, real estate, and the Japanese financial system as a whole for an extended period. Their weakened economic state lasted a grindingly long and painful 13 years. Only recently have things been getting fully back to normal. In fact, it was not until still later, in 2004, that house property values again turned slightly positive for the first time in 17 years. Many in Japan during the interim had seen their property values drop 80% or more.

What has been happening here? In the US, average annual increases in real estate prices have historically been about 4%, but through 2006 for many years our real property has been going up at an average rate of 8% a year. In parts of the country, CA for example, the rate of real estate increase had till last year been for quite some time even higher. Ben Franklin, I understand, once used an 8% rate of growth to demonstrate how unlikely it was to be upheld. In a not too great period of time, unless reduced by overhead, such a rate would result in all the world's property being controlled by just one vastly wealthy individual, partnership, or corporation. To quote Herbert Stein, an economist whom I suspect also had a dry sense of humor, "If something cannot go on forever, it will stop."

Even today, after the declines of much of 2007, our real estate is too highly priced if one looks at historical ratios of mortgage costs vs. household income. By some estimates, it still has to fall, on average another 20-30% just to match those prior norms. But financial cycles seldom just stop at the mean either on the upside or when headed back down. So, before this depressing spiral is over, incomes likely need to rise significantly, house prices fall substantially more, or some combination of the two. The last time things were as out of balance in the US was just before the Depression. From 1929, prior to the year's fall crash, till the boom following World War II restored more reasonable prices and incomes was about 17-18 years. This is consistent with the long complete real estate cycle which, including up to down and then back to the mean, tends to run for about 35 years.

As with the stock market, while things are going swimmingly up in real estate, many feel wonderful and that the down part of the cycle will not return. When mortgage and rating companies, banks, new fangled investment enterprises, developers, construction businesses, etc. all get on the bandwagon, the regulatory folks just kind of wink and ask for voluntary controls, and individuals or couples are enticed by offers of cheap adjustable loans and not even having to pay down the principle for awhile, all on the assumption things will simply keep going up and up, we are asking for trouble. Well, now we have it, and it will be with us for awhile.

Are our stock markets in better shape? Let's see. The average historical price to earnings ratio of the S&P 500 Index (roughly 75% of the US stock market by capitalization) has been about 15. At the height of the "irrational exuberance" phase of the late 1990s, it got up to about 37. At that level, investors were willing to get just a 2.7% "earnings yield" return on their investments. Today, even after the drops in stock market prices since the beginning of the year, it is about 18, as yet roughly 20% above average. And markets tend over time to return to the mean, so that 20% is probably itself unsustainable for the long-term.

But we are also in a downward earnings cycle. As people see the value of their homes' equity (most folks' biggest investment) declining, they are likely to reign in spending, particularly as there are stresses too on the economy from high energy and health care costs, food price inflation, and layoffs or company closures as the housing recession settles in. With lower earnings, the P/E ratio will be higher, everything else being equal, unless or until there is a more major drop in stock prices.

Or we can review the price to book value ratio. Historically, it has been around 2.0. But today it is around 2.6 for the S&P 500 Index, roughly 30% above the norm.

If we take into account the substantial amount of debt and credit risk currently floating around corporations, hedge funds, and other financial entities, the values prevalent in the markets are even more suspect. Who could have believed that a major financial player like Bear Stearns, a $167 stock only a few months ago, would be worth but $2 a share early this week?

In short, both for common stocks and real estate, prices still appear to be at least 20-30% high, based on historical levels. Since the greed vs. fear fluctuations tend to go too far both on the upside and downside, and to date neither the excesses in stocks nor those in real estate have been fully wrung out, arguably it is not currently irrational to be negative on these two basic types of financial markets.

If, as seems likely, worse times are ahead, it is more than ordinarily important to batten down one's personal finance hatches, lest a "perfect storm" of contracting prices and credit overwhelm her or his nest egg.

For instance, one might keep debts to a minimum, live on less than the available income, and increase the savings rate. Now is the time to risk in new investments only what one can afford to see fall substantially in price and perhaps stay lower for an unlimited period. While I do not advocate selling at a net loss, it may be helpful to use market surges (such as we saw on 3/18), as opportunities to unload, by the amount of the portfolio's increase, stocks of companies with too much debt or with higher P/Es and price to book values, or to exchange mutual funds into short-term bond funds, money market funds, or certificates of deposit. One may wish to adjust the portfolio allocation, lowering the percentages of assets held in equities or to primarily invest through a dollar-cost-average approach. Yet I would not go overboard in such a reordering of risk. Ironically, once it is generally apparent that the markets are heading down and we are in recession, the values become compelling enough that market turnarounds may be only several months or a year or two away.

And I am certainly not absolutely convinced we should "look out below!" My analysis is as subject to error as anyone's. In any case, there may be many short-term fluctuations before a long-term trend becomes fully apparent. I am, however, sure that we have a greater than normal amount of risk today in real estate, stocks, and the economy as a whole.

Because, whether in favorable or unfavorable conditions, stock prices have a tendency to move unpredictably, pioneer value investor Ben Graham advised never being fully out of the markets but instead keeping at least 25% of one's liquid holdings in stocks or stock mutual funds, though never more than 50% so invested if one perceived that equities in general were overvalued, as seems now the case. The balance of liquid investments he would just put in short-term government bond holdings, as a way to keep one's investment powder dry. Once a desired allocation has been achieved, it is often advantageous to rebalance after the markets' upward or downward flows have caused some categories of assets to get significantly above intended levels or others significantly below. In this way, one may assure selling assets when high and buying when low.

As for real estate, it may be profitable to include well managed, low debt real estate mutual funds or high yielding investment trusts as part of the portfolio. One can dollar-cost-average to acquire the desired percentage (of the nest egg) over a year or two, taking advantage of the markets' gyrations thereby to get a better overall price. For one's own home, the rule of thumb has been to have a conventional mortgage requiring no more than 25-33% of one's monthly income.

If one adheres to such stock, reserves, and real estate guidelines as above, it should help with weathering most eventualities.

After a real watershed has occurred, when in the financial sphere most people have thrown in the proverbial towel and have sworn off investments forever, wondering how much farther down the markets and this awful time have to go (as occurred in late 1974 and 2002, following terrific two- or three-year debacles, respectively), then will likely be a good point to increase one's riskier asset allocations and load up on a new array of bargains such as may only appear once each generation or two.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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