Sunday, December 7, 2008

Faith-Based Investing - Defying the Laws of Logic

Investing based on faith and not logic, is never a good idea.

 By faith-based investing, I do not mean investing in religious-related investment funds, although such funds are often the source of fraud and thus related to this topic. (Folks buy into the "Jesus Fund" because it is being touted at their church, and they neglect to notice the fellow running it is a convicted felon - until it is too late)

What I mean by this term is investing based on non-logical criteria - investing based on faith alone, which cannot be logically argued or debunked. Like religious beliefs, faith cannot be attacked using logic, so don't bother trying. When someone gets that glazed, far-away look in their eyes, the best thing you can do is back away slowly.

At the present time (December, 2008) we are seeing the fallout from such faith-based investing. Investors bought houses and condos in a orgy of consumption from 2002 to 2006, without any real basis in logic or sound reasoning. Financial instruments were offered to finance these deals - financial instruments that no sound person, in retrospect would either offer or accept. In the cold hard reality of 2008, suddenly the actions of even a year ago seem bizarre and unfathomable. What the heck were we thinking?

And this is not the first time faith-based investing has struck. As recently as the 1990's, we fell victim to it with the "dot com" boom and the Enron meltdown. Defying logic, people declared that basic financial rules, such as profit and loss, no longer applied to this "new economy." We look back and laugh now, but at the time, those meltdowns harmed a great many people.
Before that, it was the Real Estate meltdown of 1989 (a neat 20 years from this meltdown, but no one seems to recall it). Before that, the "Reaganomics" recession of the mid 1980's, then the "stagflation" recession of the 1970's, and so on and so on.

Going back further, we have the Great Depression, the result of the mother of all faith-based investing - the giddy stock market boom of the 1920's. Before that there were various bank crises, crashes, runs, and the like - probably going back to the dawn of time.

What things should we be looking for to tell us when the next bubble comes? And how can you protect yourself from such meltdowns, if at all possible? And what causes these brief incidents of mass-insanity? The first question, I think I can safely answer. The second question, I have some ideas on, but no concrete solutions. The third question, well, I have some guesses.

What things should we be looking for to tell us when the next bubble comes?

Looking at all these incidents of "faith-based investing" a pretty consistent pattern emerges. Economists traditionally have viewed people's economic choices as being based on rational decisions - that the market economy always finds the "right" price for any commodity and is self-correcting. Yet on more than one occasion, mass-hysteria takes over and shifts the market in one extreme direction. Like stretching a rubber band, these deviations from the market equilibrium last only a short while, but the more the rubber band is stretched, the greater the "bounce back" in terms of economic recession or depression.

How can you tell if you are in the middle of a "bubble" or other non-rational deviation from the market norm? Here are some indicia I have seen over the last few market bubbles:

1. People who ordinarily do not get into the market start investing: We saw this in the Real Estate boom, where amateur investors jumped in, well after the boom had started, driving prices up further. Regular Joe's and Jane's, fueled by easy money, decided to "make a killing" in Real Estate, only to later be killed. The same thing happened in the "dot com" boom, where regular salary slaves would try their hand in investing in that booming market. The problem with this scenario is that amateur investors don't know what they are doing, and often bid up the prices of stocks (or houses) to ridiculous levels. These sudden increases in prices encourage more people to "get in on the deal" as it seems that "everyone is making money" and no one is losing. The same thing happened before 1929, when even your grocery clerk was checking his portfolio between stuffing bags. When amateurs get into a certain market segment, beware of extreme volatility!

2. Idiotic Mantras and Silly Talk is Repeated About the Market: During the Real Estate bubble, I heard many folks - Real Estate Agents, Mortgage Brokers, Buyers, Sellers - everyone, it seems, repeating the same stupid theories. "Real Estate in Florida will NEVER go down!" they cried. "Even if folks here stop investing, buyers from the UK or Brazil will buy all these Condos!" We saw similar silly talk occur back in the 1990's as well. "Profits are a thing of the past!" the dot-com millionaires told us, "All that matters is that you have a good 'burn rate!'" The idea that you never need to make a profit and the success of a company can be indicated by how fast they squander capital, are both ridiculous ideas. But people bought into them.

3. Many Articles Appear Warning of a Meltdown: People like to say they were blindsided by this recession. But if you read even the popular press of the last few years carefully, you would have seen all the warning signs. Articles appeared in every newspaper and magazine - not just financial rags - warning that things that were going on made no sense at all, and that an impending economic meltdown was going to occur. I read those articles with great concern and heeded their advice. Most folks preferred to listen to "silly talk" - the foundation of faith-based investing, as it was more comforting and reassuring.

4. The Math Doesn't Add Up: When P/E ratios go haywire and a stock costs hundreds of times its earnings, something isn't right - and a correction will be coming in short order. Similarly, if the monthly carrying cost on a house or condo is more than the rental income, the market is clearly out of whack and a correction will be due. Granted, there are short-term incidents where the market "gets ahead of itself" and people invest, not based on short-term gains, but on how they perceive the long-term value of a stock or real estate investment. But after two or three years, if the market is still "ahead of itself," and the basic math still doesn't work, you're in a bubble!

5. Investments go up in value by double-digits for several years: Back in 1989, houses in Fairfax County, Virginia were going up in value by as much as 30% a year - for several years in a row. Depressed home prices shot up when lower interest loans became available and the government and the region expanded. Such things would explain a modest increase in prices for a year or two. But the double-digit increases for years in a row were simply not sustainable. Similarly, rapid increases in "dot com" stock values clearly could not be sustainable in the long term. Yet many investors "jumped on the bandwagon" (particularly the amateurs) long after the initial increases took place - and just before the correction.

6. Investments Increase in Value for No Apparent Reason: If a pharmaceutical company develops a new cancer-curing drug, or an electronics company makes a new "must have" micro-chip, it is not uncommon to see a big bump in share prices once sales (and profits) go up. Similarly, if oil is discovered near a small town, and people start moving there to work the fields, you can expect Real Estate values to skyrocket - for a short while. But in the long term, the profits level off for new products, and stock prices, having gone up, will level off at the new level, and perhaps go down if competition develops. Boom-towns might see Real Estate go up, until contractors start building new housing to meet demand. Bubbles are characterized by rapid increases in prices for no apparent reason, or rapid increases caused by an apparent reason that continue to rise long after the triggering event has died down.

7. People Investing Talk Only to Themselves or Like-Minded People: Silly-talk deflates like a balloon when exposed to scrutiny. Thus, you tend to find the rabid faith-based investors only talking to their like-minded peers. During the dot-com boom, the dot-com "faithful" would read only those articles that said that everything was great and getting greater. Anyone trying to sound the warning gong was ignored or discounted as an "old school" crank. Similarly, during the recent Real Estate bubble, the amateur investors listened only to their own kind - and the army of Real Estate Agents, Mortgage Brokers, and Developers who repeated the same tired old Mantras - "Real Estate will always go up, up, up!" Folks who wrote articles pointing out that the boom was going to go bust were again dismissed as unnecessarily pessimistic - a view validated every day that the market continued to rise.
This is by no means an exhaustive list of bubble indicators. And not all be present to indicate a bubble is taking place. But if more than one or two are present in any given market, you can be sure the market is overheated - and overvalued.

How can you protect yourself from such meltdowns, if at all possible?

A realistic investor expects that the market will go up and down. Some stocks might see a double-digit increase for a short while, but a rational investor knows that a "good" rate of return on an investment is all that he should reasonably expect. A realistic investor also realizes that in order for an investment to increase in value, it has to make a profit - whether it is a rental condo, or a "dot com" stock. Investments that lose money will decrease in value, simply because no one will buy an investment that loses money.

But as a rational (we hope) investor, how do you deal with these things? The recent downturn in the economy "took out" the investments of nearly everyone in the country. Even if you carefully invested in a 401(k) mutual fund that was stable and slow growing, and made a careful investment in Real Estate with a large down payment and good cash flow, you've probably found yourself losing ground as your investments have decreased in value.

To some extent, you can't protect yourself fully from the follies of your fellow man. Only a clairvoyant could know exactly when the market has peaked and know when to sell a stock at its absolute peak and to buy it at its absolute nadir. But you can take steps.

First of all, recognize a bubble for what it is, using the indicia outlined above. I bought a lot of Real Estate before the last bubble started. When prices started going up, I was making good money on my equity increases, but also had positive cash flow on all my properties. It was the success of folks like myself that drove others into the market (particularly after the "dot com" crash discouraged these same amateurs away from stocks). In a way, it is like the Ponzi scheme (see my article on scams) where the "success" of the early investors fuels the fire later on.

As a conservative investor, I became alarmed early on. I expected my properties would increase by maybe 2-5% a year and be happy with that. When they started increasing by 20-30% a year, I became alarmed. Since I had a positive cash flow on these properties, I held tight and enjoyed my new found millionaire status (on paper, at least).

After a while, I got used to this new level of Real Estate values. But, I had stopped buying properties at that point. Since I strongly believed that you need to have a positive cash flow on any investment, I took a "pass" at deals where I would be paying, every month, for the privilege of owning a property - on the premise that some even bigger fool would buy later on.

I cashed in before the market crashed. Some properties I sold too early, some too late. One duplex I sold for $280,000 increased to nearly $400,000 the next year. If I had "held on" for another year, I would have made a lot more. But, like musical chairs, you want to be sitting down when the music stops. If I had waited a year beyond that, I would have made far less. Since I only paid $95,000 for the property, I took my profit and moved on. There is such a thing as "too greedy."

In another case, I waited a year too long - after the market had cooled off, and I had to lower my price somewhat. Fortunately I sold before the "hard" crash occurred. I still made out (having owned the property for a decade) but since I was no longer a Florida resident, I had to pay a huge capital gains tax in Georgia. Cashing out of Real Estate is never easy, as if you've been depreciating property over the years, you'll discover that that you may owe more in taxes than you realize from the sale.

But even if you cash out, where do you put the money? I realize that doing another Starker-type deferred exchange was out of the question. Selling one piece of property only to buy an overpriced piece of property elsewhere would not protect me from the crash in prices. So I took the cash, paid the taxes and bought a personal residence elsewhere. I lucked out, as I found two places where the Real Estate market continues to grow (Central New York, and Jekyll Island). But if I had to stay in Virginia, I think I would have used that money to simply pay off my mortgage and/or invest in bonds. Not sexy investments, but in an economic recession, sound ones with an effective positive rate of return.

With stocks, I did not "get out" in time. While I could see the bubble in Real Estate pricing, based on firsthand experience, the decrease in the stock market came as something of a surprise to me. Like most folks, I did not realize how much the mortgage-backed securities underpinning this whole bubble were a large part of the stock market - and how a credit crunch would take down a huge sector of the economy as well.

However, I believe that once credit becomes available again, many of these stocks will go back up in value - over time. The worst thing to do at this point would be to sell stocks in a panic to try to get out "before they go any lower". Many folks do just that - often the same folks who got into those same stocks too late - after they were nearly at the peak. Trying to "time" the market inevitably results in buying high and selling low.

One way ANY investor can better survive a downturn without having to try timing the market is to DIVERSIFY their portfolio. The folks who lost out big-time in the 'dot com' bubble were the folks who invested it all in "dot com" stocks. They "doubled down" their investment on the premise that if they won, they'd win big. They failed to realize that if they lost, they'd lose it all.

A balanced portfolio of Real Estate, Stocks, bonds, life insurance, and other investments means that if one segment of the market goes down, then not all the portfolio tanks out. In the current recession, this may not seem like helpful advice, as it seems that EVERY segment of the market has collapsed. But stocks, while down as much as 50%, are doing much better than some Real Estate, which is worth even less than that. And not all stocks are down that much - if you have an expanded portfolio, you'll note that some might even be up. And Bonds in this market are doing quite well, provided they are not shaky corporate bonds.

(Note that how your porfolio should look depends on how old you are. Many oldsters here on the island were heavily into stock and lost a great deal in the current recession. Shame on them! Every financial book, tome, article, and guide out there preaches the same thing: By the time you retire, the majority of your portfolio should be in safe, government-backed securities, such as bonds and FDIC insured accounts. While a 30-year old can recover from the current market, a 70-year old might not live long enough to see the turnaround!)

At this stage in this present recession, we are seeing an inverse bubble - sort of the same thing that happened after 1929. Instead of "irrational exuberance" of a the bubble economy, we are seeing "irrational depression" - the idea that everything is on the skids and it will never get better. Bad economic news fuels more bad economic news - and depresses spending, investing, and savings. It will take some time before we realize that we have "nothing to fear, but fear itself."

What causes these brief incidents of mass-insanity?So what DOES cause these mass-hysteria swings in the market? Again, it is Psychology, not economics which drives these things. People believe things that make no sense. And in many instances, it is government intervention (the ultimate irrational thinking) that fuels such market swings. When the government intervenes in a market in an irrational manner, the market reacts irrationally. This is not to say that all government intervention is irrational, of course. Most of it is, unfortunately. Rational intervention is often shouted down by special interests that want irrational intervention that favors their own interests. And of course irrational lack of government intervention, in the form of irrational deregulation, can also be at fault.

Many have pointed to the Community Reinvestment Act of the 1990's as fueling the current mortgage meltdown. It is not clear that this alone caused the problem - or even lead to it at all. However, changes in the standards for lending over the last decades have created a number of problems that are present today. Fannie Mae and Freddie Mac, both government controlled entities, are largely to blame for the flood of "easy money" in the form of questionable mortgage instruments.

One problem that goes back decades is the Home Mortgage Interest Deduction. At one time, interest on any loan was considered deductable. So your credit card interest and car loan interest could be itemized on your 1040 long form and deducted from your income. Congress decided to eliminate those deductions, and Home Mortgage Interest remained the only deductable interest on your taxes.

This skewing of the tax code (irrational intervention) was designed to encourage home ownership. However, as many rational economists have noted, it served only to increase prices of homes and lending, as the deduction effectively lowered monthly ownership costs, which meant that prices were free to rise to make up the difference. If this deduction was eliminated, home prices would fall further. Of course, at this point, you cannot eliminate this deduction without greatly disturbing the market and throwing millions out of their homes. So it stays on the books. If it ever were to be eliminated, it would have to be phased out over a period of 30 years or more -the term of most home mortgage loans.

But the home mortgage interest deduction, along with the fantastic run-up in home prices, did create a secondary monster - the re-fi mania of the last decade. When mortgage refinancing became popular, particularly with lower rates, it became "rational" for many folks to refinance their homes to pay off non-detectable interest loans. Folding your car loan and credit card debt into a "re-fi" made "sense" as the interest rate was much lower and the interest was deductable as well. Why pay 10% on a car loan or 18% on a credit card, when you could refinance at 6% and deduct the interest? Monthly cash flow would increase, allowing the homeowner to pay off the debt faster - if they chose to do so.

In reality, these waves of "re-fi's" served only to increase consumption. Some folks would get a home equity line of credit, and use it to buy a Mercedes, instead of buying a Chevy and financing it the old-fashioned way. Paid-off credit cards were quickly ratcheted-up again, until the consumer was even further in debt. Consumer spending took off like a rocket in the 1990's and early 2000's. Ecomonists warned of the danger in article after article - that this type of "growth" was not sustainable. But no one listened.

Once home prices plummeted, the whole game ground to a halt. The giddy overspending of the last decade is now history. It will be a long time before people have that kind of money to throw around.

Questionable mortgages were issued because the folks issuing them took no risks - but reaped huge bonuses every year for making the mortgages. The mortgages were "bundled" together and foisted off on investors or Fannie Mae. The disconnect between risk and reward in the financial sector was one compelling reason behind the meltdown.

Long-term recovery from this recession will be difficult, and actions by the government to "prop up" failing institutions such as banks and car companies may simply exacerbate the problem. Of course, realistically, given the politcal climate, we cannot expect the government to take any rational economic steps, as they will be shouted down by the irrationals. Instead, we can expect more "faith-based" investment thinking, such as propping up the car companies.