Posted on 11/29/2003 10:00:28 AM PST by Starwind
Determining the price of financial assets is far easier than determining their value. However, knowing there is a difference between price and value and having the wisdom to see the difference, is a pre-condition for making the right investment decisions. Over time, it is certainly wise to buy financial assets at a price below their long term value, and to sell them at a price above their long term value.
Examining the price and value of financial assets is critical for the US economy. The current market price of stocks is about $10 Trillion. While this is down from a 2000 peak of $17 Trillion, it is still a considerable number. Credit market borrowings are approaching a pay-off balance of $34 Trillion. With the US Treasury running $500 billion deficits a year and the single family mortgage market still growing at a rate of over $600 billion a year, the total debt owed is continuing to grow quite rapidly. In our economy, the vast majority of financial assets are nothing more than the ownership of someone else's liabilities. The current total market price of financial assets (liabilities) is certainly over $47 Trillion, or four times GDP. (The cash flows from our $11.8 Trillion economy will not support payments on this level of liabilities. Something has to give, and it will most likely be the real value of the assets.)
Credit market financial instruments are the easiest instruments to price and value. The prices of notes and bonds can be mechanically calculated by a simple mathematical formula for Present Value, based on the current interest rate. One clear and profound observation is the longer the maturity of the note or bond, the greater the decrease in market price given an increase in interest rates.
The usual reason to hold on to the shorter maturity credit market instruments is the need for liquidity, or the inability to find another attractive investment. On the other hand, the reasons investors hold on to the longer credit market instruments are to earn a higher yield, to engage in the "carry trade" borrowing at lower short-term interest rates, or to buy the longer term bonds because the owner anticipates interest rates will go even lower, causing the bond to appreciate in price.
Since these financial instruments are priced at an inverse of interest rates and the Federal Reserve has cut rates to a 45-year low, it is logical to assume the market prices of these instruments are about as high as they could ever be. This, of course, raises the question of "value". If you knew interest rates were going to rise, you would know that the future price of these credit market financial instruments would fall. A wise man would not consider that the current price of these financial instruments is their true value.
More importantly, what would you think about the value of financial instruments if you knew that: 1) the US had no savings and was running massive government deficits; 2) the Fed was holding short-term interest rates down below the level of inflation; 3) foreign central banks were manipulating US long-term interest rates down by buying our treasury debt; and, 4) the Fed has to come out every day to promise the speculative community in the carry trade that this interest rate manipulation can go on forever. Given this is the state of affairs, we believe the current price of credit market instruments in the US has been artificially "pumped-up" by the Fed and Asian Central banks to a record unsustainable level.
Pricing stocks is easy while valuing them has a strong element of art and psychology. The current price of marketable stocks is about $10 Trillion as measured by the Wilshire 5000. The Federal Reserve has made holding cash painful by dropping interest rates to 1% or less. This has propelled stock prices to inflate to extraordinary levels given all logical means of measuring value.
With interest rates artificially pushed down, stock prices have "no anchor". Current liquidity-driven P/E multiples on stocks are at 1929 levels. While investors may hold short-term financial instruments for liquidity and longer term for carry profits or capital gain, almost all stock holders hold stocks for capital gain.
While the Federal Reserve is working overtime to keep easy money available to push up corporate revenues, and a declining dollar helps corporate profits, there is no question that a rise in interest rates would likely smash current stock prices. Rising interest rates would return stock P/E ratios to more normal levels, just as they would return the price of credit market instruments to normal levels. On a current price and normal term value basis, it looks like current stock prices give an investor a wonderful opportunity to sell stocks.
From a value perspective, financial assets are riskier than the average investor can imagine. Our government operates on the assumption that most Americans rarely go overseas. Therefore, the only currency they are familiar with or relevant to them is the dollar. US financial assets are dollar denominated. They are sold and traded for the dollars that the average person will need to buy real goods and services. Now that the average American buys more goods produced outside of the US, it is time to think of other options besides the dollar.
In the foreign countries that make the goods we buy, only the Central Banks take dollars. The private foreign sector knows all about currencies and devaluations and is aware the US is running trade and budget deficits without any savings. They realize the only reason the dollar hasn't crashed is because the Foreign Central banks are allowing speculators to take massive dollar short positions, while the dollar is "eased down" in value. Even if interest rates in the US can be held down keeping the price of US financial instruments artificially inflated in dollars, the average American holding these dollar assets will lose another 30% in addition to the 20% they already lost from a falling dollar.
The average investor has also forgotten how much at risk financial assets are to inflation. Our Central Bank under Greenspan is dedicated to getting significant inflation underway. His propaganda campaign on fighting deflation and disinflation ignores the rapid rise in commodity prices and services, the fall in the dollar, and, the way the CPI is biased against inflation. Beef prices are at a 24-year high and insurance, education, health care, property taxes, and many other day to day expenses make the CPI a joke. The CPI assumes everyone rents even though 65% of households actually own their homes. Rising home prices are not in the CPI but the declining cost of renting a home is. (Rents are weak and many people are opting to buy, rather than rent.) Housing is 22% of the CPI. Another 8% is the cost of buying new and used cars which are temporarily subsidized.
The Federal Reserve wants inflation because only the rising prices of goods will help companies service their massive debt loads, and only rapidly rising wages and salaries will allow individuals to service their record debt loads as interest rates rise and inflation kicks in. For instance, Ford Motor is only one of a long list of companies that requires higher prices of their products to remain solvent. Ford has a debt of $180 billion that is just above junk and a massively under-funded pension fund. Inflation is needed to melt down our country's massive mountain of corporate, government, mortgage and consumer debt. Needless to say, what inflation does to the value of financial assets is like taking a pile of paper and dumping it into a bonfire!
In summary, the outlook for the price and value of US financial assets does not look very good. A rise in interest rates to normal levels would give us Fed Funds of 3% to 4% (or 1% more than the CPI) instead of current Fed policy of 1% less than the CPI. This would put the 10-year Treasury at 6% and the 30-year mortgage rate at 7.5%. A normal level of interest rates would knock down financial asset prices by an easy 20%. The drop in the value of the dollar will certainly wipe out 30% of the value of US financial assets. While the average investor in the US is not familiar with this risk, the average investor overseas is. The smart investors will sell their US financial assets as long as Foreign Central Banks are buying. Foreign Central Bank buying, to slow the dollar decline, is a gift at the expense of foreign taxpayers. This gift should be taken by private citizens from every country. World Central banks are printing money out of thin air to finance the US deficit. Indeed, so much new money is being created that it is only a matter of time before real inflation shows up in America.
Inflation eats up the value of financial assets and helps push up interest rates. A falling dollar eats up the value of financial assets and helps push up inflation. This is not a virtuous cycle!
The average investor has not grasped the concept that most assets are financial assets. However, one man's financial assets are another man's financial liabilities. In the US economy, the mountain of financial liability is so big it can stand in the way of economic growth. The only way to melt down the mountain of debt into a hill that can be climbed is to devalue and depreciate it, effectively inflating it away. For the holders of financial assets, the outlook is clear: Sell before Foreign Central Banks stop buying! Then, if you have to own financial assets, buy financial assets of those countries that will do well as the dollar devalues. If you don't have to buy financial assets, favor real assets (they aren't someone else's liability). Great candidates are marketable commodities and precious metals.
We believe that as long as the Federal Reserve is dedicated to "trashing the dollar" and eroding the value of financial liabilities (which destroys the value of financial assets), the average investor will discover gold and other real assets as more viable alternatives for the preservation of capital.
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| Opinions expressed are not necessarily those of David W. Tice & Associates, LLC. The opinions are subject to change, are not guaranteed and should not be considered recommendations to buy or sell any security. |
Some background:
Chapter 17. The Consumer Price Index
Owners' equivalent rent
The concept of owners' equivalent rent used to measure homeowner shelter costs was introduced in the CPI-U in January 1983 and in the CPI-W in January 1985. The owners equivalent rent index measures the change in the cost of renting housing services equivalent to those services provided by owner-occupied housing.Prior to the introduction of owners' equivalent rent, homeowners' shelter costs in the CPI were represented by five elements: (1) House prices, (2) mortgage interest costs, (3) property taxes, (4) homeowner insurance charges, and (5) maintenance and repair costs. These constitute the major costs associated with purchasing and maintaining the physical asset of a house.
This "asset price" approach to homeowner costs failed to distinguish the investment aspect of owning a home from the consumption aspect. The basic concept of the CPI is as a measure of the average change in the prices paid by consumers for consumption goods and services. Investment purchases, such as stocks and bonds, are conceptually out of the scope of the index and are excluded. A house is not consumed at the time of purchase. It is a long-lived asset (investment), but it also provides the owner with a flow of shelter services over time. Thus, it is the cost of this shelter service provided by the asset that is the conceptually appropriate element of the CPI.
To implement the new concept, the old homeownership component was replaced with two items: (1) Owners' equivalent rent; and (2) household insurance, which contains those parts of homeowners' insurance that do not insure the structure.
In addition, the previous maintenance and repairs component was made a new component covering both renters' expenses and owners' expenses—exclusive of those estimated to be part of owners' equivalent rent. Also, the weight for household appliances was reduced to remove those expenses in homeowners' costs for appliances included with the house.
Consumer Price Indexes for Rent and Rental Equivalence
Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence) are the two main shelter components of the Consumer Price Index (CPI). The Shelter index includes the items shown below with the relative importance of each index. The relative importance is the weight of the specific index relative to the All items index. These data are for the U.S. city average CPI for All Urban Consumers (CPI-U) as of December 2001: :
Item
Relative Importance
Shelter 31.522 Rent of primary residence 6.421 Lodging away from home 2.702 Housing at school, excluding board (2) .241 Other lodging away from home including hotels and motels (3) 2.461 Owners' equivalent rent of primary residence 22.046 Tenants' and household insurance .353 The index for an aggregate, such as the Shelter index, is the weighted average of the component indexes. As a matter of fact, the Lodging away from home index is also an aggregate index, the weighted average of its two indented components (see above). Expenditures for each of these 5 components of the Shelter index are estimated directly from data reported by sampled households in the Consumer Expenditure (CE) Interview Survey. Both renters and homeowners are included in the CE sample. In fact, homeowners constitute roughly 63% of the CE sample in urban areas.
Rental Equivalence--Background
Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing. It was implemented for the CPI-U in January 1983 and for the CPI for Urban Wage Earners and Clerical Workers (CPI-W) in January 1985.
Rental equivalence. This approach measures the change in the price of the shelter services provided by owner-occupied housing. Rental equivalence measures the change in the implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market. Clearly, the rental value of owned homes is not an easily determined dollar amount, and Housing survey analysts must spend considerable time and effort in estimating this value.
When initially introduced, the rental equivalence index's monthly movement was calculated by reweighting the rent sample to represent owner-occupied units. Starting with the CPI for January 1987, the rental equivalence index movement was based on changes in the implicit rents of a sample of owner-occupied units. As part of the 1987 revision, BLS drew a new housing sample to replace the old rent sample. The new sample had both owner- and renter-occupied housing units. To estimate the change in the implicit rents of the owners, the CPI:
- Estimated initial implicit rents by asking the CPI data collectors to work with the owners themselves to estimate the units' potential rent.
- Measured the change in implicit rents over time by matching owner units to renter units with similar characteristics. The characteristics included location, structure type, and other general traits such as age, number of rooms, and type of air conditioning.
- Derived the change in the implicit rent for each owner unit in the sample from the change in the actual rents of its matched set of renters. Because owners pay for utilities separately, the CPI calculated the pure rent of the matched renters by removing the value of any landlord-provide utilities and furniture. The implicit rents of the owner units were moved by the changes in the pure rents of the matched renters.
- Moved the rental equivalence index by the average changes in the implicit rents of the owner units.
In 1997, BLS started the process of developing a new housing sample to replace the one that had been in use since 1987, and began using it starting with the index for January 1999. BLS dropped the owner sample and returned to the method that was used for the rental equivalence index when it was first introduced, that is, reweighting the renter sample to represent owner-occupied units.
This decision was made for several reasons:
- Moving implicit rents by matching renter and owner observations is inherently a reweighting of the rent sample.
- A large portion of the 1987 sample was devoted to owners, to support the estimation of initial implicit rent. By dropping the owner sample, the field staff would not have to initiate, price, and maintain an owner sample.
- Because owner-renter matching is not needed for rental equivalence, the calculation of the index would be greatly simplified.
To reiterate Benson's point (confirmed by BLS CPI background):
Rising home prices are not in the CPI but the declining cost of renting a home is.
Sat Nov 29, 8:34 AM ET
By DAVID LEONHARDT The New York Times
MEMPHIS, Nov. 25 Renting an apartment in much of the country these days can feel a little like waking up on your birthday.
Waiting for the tenants in some building lobbies around Memphis every morning are free cups of Starbucks coffee. In the Atlanta suburbs, people who move into one garden-style apartment building receive $500 gift certificates to Best Buy, the electronics chain. In Cleveland, Denver and many other cities, landlords have been giving new tenants gifts worth $1,000 or more: one, two or even three months of rent-free living.
While rents have continued to rise in many big cities on the coasts, including New York and Los Angeles, they are falling in more than 80 percent of metropolitan areas across the country. Low interest rates in recent years have persuaded many families to move out of rented apartments and buy their first homes at the same time that developers have been putting up thousands of new rental buildings, leaving many landlords desperate to fill apartments.
The portion of apartments sitting vacant this summer rose to 9.9 percent, the highest level since the Census Bureau (news - web sites) began keeping statistics in 1956.
"I've been doing this for 30 years, and this is the worst rental climate I've ever seen," said Leonard Richman, president of the Sunshine Corporation, which manages almost 4,000 apartments in Memphis. "Rents have gone down to where they were about three or four years ago."
The rent decreases and the enticements, which have proliferated in the last year, are helping many younger adults, who are more likely to rent than other groups and who have suffered in the hiring slump of the last three years. Between late 2001 and this summer, the average rent per square foot fell 4.8 percent across the country, according to the National Real Estate Index, which is published by Global Real Analytics, a research company.
But the declines are also a worrisome sign that the nation's housing market has begun to suffer from some of the same problems of oversupply that have already hurt manufacturers, economists say. If mortgage rates continue increasing, as is widely expected, people who might have bought houses will instead rent. That could shift the burden of the excess supply from landlords onto homeowners, hastening the end of a decade of rapidly rising house prices.
"You're going to take the one bright light in the economy, and it will dim," said Mark Zandi, chief economist of Economy.com, a research company. "It's just a question of how much."
The biggest rent declines have occurred mostly in cities, like Memphis, where land is abundant but building regulations are not and where housing costs were already among the least expensive of the country's urban areas.
"In any city in the Southeast or Midwest, you'll drive around and see banners `One month off,' `Two months off,' `$2,000 off,' " said Mark Fogelman, president of Fogelman Management, which manages 16,000 apartments from Kansas to Florida.
Last month, Andrew H. Underwood, a 24-year-old employee of a local bank, moved into a high-ceilinged one-bedroom apartment in downtown Memphis with a view from the balcony of center field at the new minor-league ballpark across the street. He signed a 13-month lease, and though the apartment was listed at almost $1,000 a month, he will pay only 10 months of rent.
"It seems like everyone I talk to in the building got in on a special," Mr. Underwood said.
Buildings in less trendy neighborhoods here are resorting to frills as well as discounts. In some of Fogelman Management's buildings, employees now walk the dogs of residents who are on vacation, pick up and drop off dry cleaning, maintain free fax and Internet service and set out newspapers and Starbucks coffee each morning. The company also takes $25 to $50 off the monthly rent of residents who carry baskets of muffins, Fogelman coffee mugs and advertising fliers to their workplaces.
"The options are pretty much endless here," said Jenny Dail, 28, who next month will move into a brick-and-wood duplex with her husband and 10-month-old daughter. At $725 a month, the duplex is larger and less expensive than their current apartment in Memphis, and they did not even have to sign a lease, leaving them free to buy a house at any point if they choose.
In many cities on the coasts, where new construction is more difficult and where an influx of highly educated people over the last two decades has driven up home prices, rents have held up better. The average rent in both Los Angeles and New York has risen about 4 percent since last year, according to Torto Wheaton Research. Rents in Boston and Washington have declined only slightly.
That has widened the growing gap between the cost of living in the Northeast or parts of California and the cost of living almost anywhere else. Three years ago, for example, a typical 800-square-foot one-bedroom apartment in Los Angeles cost the same as a 1,480-square-foot two-bedroom in Charlotte, N.C.; today, the Los Angeles apartment costs almost as much as 1,900 square feet in Charlotte, according to Economy.com.
The one exception is the San Francisco Bay Area, where rents have fallen more than 20 percent over the last three years, more than anywhere else. Although homes remain expensive there, the collapse of the technology sector since 2000 has greatly reduced the number of Northern Californians in their 20's and 30's who are looking to rent expensive apartments, economists say.
Landlords around the country blame three main forces for the drop in rents. The long economic slowdown has left many people out of work or with less income, forcing some to move in with relatives or find roommates.
The supply of apartments has also spiked, as the coming bulge in college graduates the children of baby boomers has persuaded many developers that new buildings will soon find tenants. Meanwhile, cities across the country have spruced up their downtowns and converted abandoned office buildings, like Memphis's old cotton warehouses, into loft-style apartments.
But the biggest drag on rents, developers say, is the sharp increase in the number of Americans who own their homes. Low interest rates have played a big role in that increase, but so has the willingness of many banks and the giant mortgage lenders, Fannie Mae and Freddie Mac, to accept little or no down payment from families who once would have been renters.
"Our rents have really had to come down to meet the competition," said Bruce W. Duncan, chief executive of Equity Residential, a real estate investment trust that owns buildings across the country.
Bowden Homes, a Memphis home-building company, recently mailed a flier to some renters that included a cartoon of a monster wearing a hat with "Landlord" printed on it. "Stop Feeding the Rent Monster!" the flier read. "For Only $726 a Month You Can Own Your Own Home!"
On the east side of Memphis, former cornfields are now filled with subdivisions where homes cost less than $150,000. Many of them advertise monthly mortgage payments of about $750, and some require no down payment. Housing analysts say that offers like these have caused a spike in home foreclosures, because some new owners have lacked the financial cushion to withstand a job loss, illness or divorce and still make their mortgage payments.
Despite the declines in rent, the prices of apartment buildings have actually increased in the last few years, as many investors have decided that real estate investments are a better bet than the stock market. "That's the only reason a lot of folks are surviving," Mr. Richman said of building owners.
Rents in some cities could stop their decline soon, especially if the economy continues to gain strength, apartment owners and economists say. But few analysts say they expect rents to start rising, or the free coffee to stop flowing, anytime soon.
"We don't see recovery until 2005," said Gleb Nechayev, an economist at Torto Wheaton, which is owned by C. B. Richard Ellis, the big real estate company. "There is just too much construction. There are too many units coming onto the market."
Would the government lie to keep down cost of living increases?
It could be worse (I think?).
Be grateful that civil engineers earned their degrees in different schools than did government statisticians. Can you imagine them 'estimating' the strength requirements in a bridge?
But it's this value, $1.1 trillion, that should be compared to our $11.8 trillion economy, not the entire value of our debt. One should also note that the federal deficit has already been adjusted downward, and GDP growth has been adjusted upward.
Is it just me, or does it appear that Mr. Bear is counting the market value of stocks as a liability?
Yes. Classic allegory.
Does our economy not owe the entire debt? Who will pay on our behalf whatever portion you wish to exclude?
If you extrapolate future GDP, does not consistency demand that one also extrapolate future debt? And if future debt commitments have been made, should not the extrapolations of both GDP and debt growth be estimated out to the same timeframes?
I have some other thoughts, but no time a present to respond at length, perhaps later tonight.
I bet they were saying the same thing in 1929, and 1935, and 1945, ....
Yes, but the terms should compare. Yearly debts should be compared to yearly revenues, and the terms of the entire debt should be considered when paying it off. That's the only consistent way to look at it.
It is certainly a good thing for many of the owner-occupiers. OTOH, this is being achieved by reducing down payments to nearly zero.
For some families, just starting out, this can be wonderful. But, there is a trap in this policy. One of the things a down payment does is to provide some assurance that a purchaser has the ability to financially plan ahead. Even if a large part of the down payment is borrowed from parents, presumably the parents have taught the children some measure of planning ahead.
There is a substantial fraction of the population (~30%) who just do not seem to have this ability to plan ahead. As a long-time landlord, I have seen and dealt with this segment of the population for decades.
By not requiring some type of proof that a family can financially plan ahead, programs which greatly reduce down payments are going to lead to high foreclosure or default rates. This is a bad thing.
Do not for even a second believe the propaganda that low-down-payment plans are designed to help low-income people. It is just not possible to grow up in the US without being inundated with information about choices in life and high income vs. low-income choices which are made early in life. Low income is a sign of a lack of ability to plan ahead.
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