Saturday, May 4, 2013

Newton's Cradle: Visualizing Asset Prices Through Capital Movement

This conversation is going to delve into more personal parts of my life than I have discussed in the past. I do this to provide a different point of view on the way markets and assets can be viewed around the world.

People like to put labels on people within the financial markets.  Over the past few years I have said that I was “raising cash” and during large sell offs at times I was purchasing gold and silver. This one sentence would put a general label around me that I am something called a "bear." If I was currently interested in purchasing stocks or real estate I would be labeled a "bull." The mainstream financial media hosts segments during their daily telecasts called "Bull vs. Bear" based on someone's belief on where stocks are going tomorrow.


This is the complete opposite way that I look at the world.

I take in a tremendous amount of financial information on a day to day basis. This involves reading articles, books, and tracking markets. I don’t take in this information and then try to decide if “the world is ending” or if “the world is booming” in some black and white fashion. That’s not how it works.

When I close my eyes, I imagine capital moving all around the world. This incredible process has been taking place for centuries. When capital flows, as I have tried to discuss here over the last few years, it does not always move in a perfectly efficient manner as many text books teach (the efficient market theory). These books feel that markets are always efficient, therefore the best thing you can do is create a diversified portfolio that will appreciate over the long term. If you believe the markets are efficient then you can design algorithms that will profit as they revert back to their means or what these professionals tell the computer is a harmonious market.


I believe that due to the combination of human emotion and psychology, which is the fundamental engine that drives the movement of capital flows, every asset on the planet swings from under valuation to over valuation. Is simple terms, I believe that markets are not efficient. This can be described using many terms but I like to think of it as cycles. Long term secular cycles lasting 15 to 20 years, to cyclical cycles within those longer term trends. I could write an entire text book on the topic of cycles so I will save further discussion for another day.




For hundreds of years markets have moved from pessimism to skepticism to optimism to euphoria. This process has creates both large and small “bubbles” that then burst. Based on countless hours studying human psychology and the impact on markets, I do not see this process ever stopping.

Before I begin to describe real capital flows, the best visual I can provide of this process is through Newton's Cradle. As capital travels toward an investment or investment class, it moves from under valuation at one extreme and keeps pushing through until it reaches the maximum point of over valuation. It then reverses and moves back the other direction as there is no more force (capital) available or willing to push it higher. This is the continuous process, both long term and short term, that markets cycle through:



In this overly simplistic example we will describe the current capital flows moving around the world as "yield on" vs. "yield off."

Most of the assets I own today provide no yield. The reason for this is because these assets are currently out of favor. Sentiment is low. I like cash today because no one wants cash. People today want assets that yield something, not assets that yield nothing. Examples of these higher yielding assets are stocks, bonds, and real estate.

I believe that sentiment toward “yielding” assets is currently high, meaning a large amount of capital is flowing toward these sectors. When that happens, prices rise, and become overvalued.


Many of these assets can be purchased with leverage. That means that not only do investors want to buy them, but they are willing to go into debt to bet on prices going higher. In some ways this leverage and euphoria is now even more extreme than what occurred in 2006-2007.

Red line below shows the net margin debt (borrowing to buy stocks) at the NYSE:


In the fall of 2008 the movement of capital changed. Investors did not care about what the yield was on their assets, they cared about the return of their principle. This created a rush to cash. Yielding assets fell in price as capital flows moved away from these sectors, and these assets became under valued. Cash become over valued.

During late 2008 through early 2010 I was interested in selling cash to buy yielding assets. Now I am doing the exact opposite.

To take this a step further, you can begin to find assets within the realm of cash (no yield asset) or currency that move in and out of favor. For example, over the summer the Brazilian Real (currency) fell and I moved some of my cash into that currency. A few weeks ago I was purchasing the Canadian dollar. Today I am purchasing silver (I view precious metals as form of cash) and the South African Rand (currency) because they are both out of favor with investors.

Does this mean that I am bullish or bearish? No, I am thinking about global capital flows and making investment decisions based on fundamental under/overvaluation and sentiment.

At some point, I don’t know if it will be tomorrow, December, or 2017, yielding assets will reach a certain extreme level in price where investors will no longer be willing or able to pay, or more importantly in today's world have the ability to borrow to pay, to purchase more. Investors will begin to move back to the other side of the ship. I certainly do not care when that occurs, I just need to be cognizant that this change is taking place and adjust my capital position accordingly. It is not a complex mathematical science, it is just a common sense understanding of human nature and the ability to act rationally.

The DOW reaching 16,000, 17,000, or 20,000 has no impact on how I view stocks because I am not viewing them with emotion. If real estate prices explode higher, or bond yields fall lower, that does not make them a better investment. With common sense you can see that it makes them a far worse investment.

At some point the current “rush for yield” will reverse. There will be rush for cash. I will sell my cash and move into yielding investments.


I’ll take this a step further and get a little more personal into my own life. My view of global capital flows impacts decision I make beyond just my personal investment portfolio. It impacts how I spend the “business” hours of my day to day life.

Longer term readers of this site know that since this site originated in mid 2008 I felt capital would be moving away from residential real estate (specifically in the United States though it has been more extreme in other areas of the world). As capital moved away, real estate prices fell for close to four years in the residential market. As investors began their rush toward yield some large funds have moved into the residential real estate market and have begun to push prices higher in some areas.

This occurred back in 2010 for the apartment sector as investors looked at that market (and continue to look at that market) as a great location for a strong yield.

When investors move away from yielding assets at some point in the future I think the real estate market will be impacted in a negative way. During the coming transition out of "high yield" investments I want to be purchasing stocks and bonds when they go on sale but real estate has specific traits that makes it even more appealing: the amount of leverage available to purchase it, tax advantages, and the control you have over the asset.

The difference between real estate and paper assets (stocks/bonds) is that it takes a larger skill set in order to participate successfully in the market. You have to know how to finance properties, handle everything that is involved during the acquisition process, and manage the properties once they are acquired (this is far more important if you are interested in the commercial/multifamily sector).

I think the U.S. apartment market is one of the most overvalued sectors in the world right now. Why? Because capital has been, and continues to, rush toward that sector. At some point, and I have no idea when it will occur, this process will reverse. Capital will eventually move on to another asset class somewhere in the world when prices reach a certain extreme.

Knowing this, my goal in the present moment today is to be as ready as possible for when capital moves away from the asset class and it becomes undervalued.


I recently spent two years managing a 500 unit apartment community. I spent my days learning how to efficiently manage the daily operations, cut costs in a budget, and most importantly manage the team that works there. Rather than try to read it in a book, I felt the best way to learn would be to do it myself. I can drive in to a community today and “feel” how it is being run both inside the management office and walking through the property.

My business hours during the week now are spent in large part working at one of the largest commercial real estate finance companies in the country. I spend my days churning through and analyzing the financial statements of apartment communities all over the country that are being bought, sold, or refinanced. I am surrounded on the floor that I work by the most gifted minds in the country on commercial real estate finance, and I am doing everything possible to train myself to become machine at taking in and analyzing data on a property.

I have not spent years working and learning about the multifamily business because I think it has a great short term future.  In fact, it is for the exact opposite reason.

I want to be as ready as humanly possible to purchase as much real estate as possible when capital moves away from the asset class at some point in the years ahead. The apartment market has tremendous long term fundamentals with the key demand demographic, those aged 25 to 34, set to grow steadily over the next two decades.

I don’t “like” cash as an investment. It is a terrible long term investment. I own cash today because capital is moving away from it. Capital is flooding, with full force, toward yield in any and every form.

I look forward to the day when this site can be focused on buying stocks, bonds, and real estate, which is far more exciting conversation. I can’t wait to sell the silver I bought back in 2005, or the Brazilian Reals I bought last summer for something that provides a yield. I have no control over when that day will be, and it really does not matter to me if it is 6 months from now or 6 years from now.
Like the ocean tides, the cycles will change, investors will continue to behave irrationally, and certain investment classes will become under and over-valued.

This process has nothing to do with “doom and gloom” or "positive projections" only understanding that the world changes and capital is moving at every second of every day. It is the ultimate sport, something you can spend your entire life trying to master.  

Why Buy Stocks? "There Is No Other Alternative For Income"

Imagine that you have inherited $1,000,000 from a relative who has unfortunately passed away. You are 65 years old, no longer working, and this money represents your entire retirement. What are you going to do?

You call a financial advisor and he tells you, "before you think about anything, before you pick up the remote to turn on the television, or before you even make your breakfast, you must find a return for that money. You need to get that money working for youToday’s low growth and low interest rate environment has created only one option for you to get that return desired return: high dividend paying stocks. This morning I will safely put your portfolio in large cap, blue chip, safe stocks located in the DOW which has just crossed 15,000 and is rapidly approaching 16,000 and then of course, 20,000. Not only are dividends growing at 10% per year, the stocks themselves are appreciating even faster."



Before he hangs up to put in your order ticket he reminds you why are making this simple choice: “There is no other alternative to provide you a return on your money.”

With the understanding that there is no other alternative you decide to go ahead and get invested. The following morning you begin to collect a healthy 3% annual dividend return on your money. This works out to be $30,000 per year or about $24,000 after taxes giving you $2,000 per month.

Let's see how this outcome would play out in a "hypothetical black swan world" that could obviously never occur under either President Obama or Benjamin Bernanke's watchful eye.

Let’s say that instead of rising quickly to 20,000 over the next 24 months that the DOW moves from 15,000 to 10,000 in May of 2015. Does DOW 10,000 seem impossible? We were very close to it about 19 months ago.


That is a 33% reduction in your total retirement. You now have $667,000 in retirement savings. How long will it take you to recoup that loss with your 3% annual return? 11 years.

11 years to get back to where you started. You are spending all of your dividends to live on, so in real terms, it would take as long as it would take the DOW to get back to 15,000 (if the same companies remain in the DOW during that time).

There’s probably a reason why stocks fell 33%. It is most likely because the economy has slowed significantly, corporate profits are sinking, and companies are looking out at a different horizon than they were during the beautiful spring of 2013.

As humans we are forward looking and tend to believe the future will be a projection of the current trend line we are on (which is why everyone is fooled at major turns), so perhaps management gets a little nervous and feels the company needs to raise more cash. What is an option to bring more cash into the company?

Cut the dividend!

Your 3% dividend is now at 1.5%. So you are bringing in $1,000 per month after taxes, instead of $2,000. 


This would be very difficult for anyone to live on in today’s world, but what if something else changed during the spring of 2015? Another "impossible in today's modern world black swan" occurred.

What if some of the trillions in printed money that the Fed has been pumping into the banking system every year since 2008 began to filter into consumer prices? What if inflation actually rose?

You have most likely heard that it is impossible for inflation to rise during a period of economic weakness. You only need to go back to the 1970’s in the United States to see this is not correct, or look through countless examples around the world over the last century. The term is called stagflation; high inflation and low growth. I assure you that not only is it possible, after what I believe will be a short term period of deflation ahead, you will see just this.

What if you had the opportunity to go back to May 2013 after you inherited that $1,000,000 and make another decision? Let’s say that instead of doing what your financial advisor said was the “only option for your money” you decided to put the money into safe cash. What does safe cash earn?

0.0% at today’s rates. Zippo. Nadda. Nothing.

Fast forward to the spring of 2015. Your sibling, who also collected $1,000,000 and invested it in stocks because it was the only option to receive a return, now has $60,000 collected in dividend payments over those two years.

Your total dividend payment is $0.0. Not only that but you had to eat into the $1,000,000 in order to stay alive over these two years. Let’s see how everyone stacks up at this point:

Sibling:

$667,000 + $0 (used $60,000 in dividend payments for living expenses) = $667,000.

You:

$1,000,000 - $60,000 (used $60,000 for living expenses) = $940,000.

Dividend rates are now cut to 1.5% and you decide to invest the money into the stock market.

You now receive $14,100 in annual income (before taxes). Your sibling still receives $900 more per year. The only difference? You have $237,000 in additional stock. It will take a 50% rise in stocks in order for your sibling to get back to even.

For everyone that tells you that “there is no other option” I hope I just provided an example of one and why that option could be better. If we are at the start of a new bull market and dividends continue to rise over the next decade this option will certainly be the wrong one.

I am in the minority today that a scenario such as the one above is even a possibility. Barron’s Big Money poll recently showed that 94% of money managers are bullish on the stock market over the next five years. 86% are bullish over the next 12 months. These percentages dwarf any bullish reading over the past 20 years, just as stocks are touching new all-time highs.  


Even those that are not bullish on stocks will recommend you put the money into longer dated bonds to try and lock in a return, an investment that may carry just as much danger or more in principle losses in the years ahead  

I am certainly not recommending an investment strategy, only providing a thought experiment against the most common phrase used today to push individuals into stocks: "there is no other alternative."

Friday, May 3, 2013

DOW 15,000 - S&P 16,000: Bring Out The Champagne

Sorry for the lack of writing over the last week. I've been able to keep up with all the reading, but I haven't had the chance to get everything down on the site due to it being a busy week.

Lots to come this weekend on stocks, bonds, real estate, commodities, and economic data.

Stay tuned....

Jim Rickards On Gold