Understanding How “This Time Is Different” to Make Great Investment Decisions – Week 7

What is Different This Time – A Second Wild Card: The second wild card is the ripple effects of the stronger US Dollar created by The Fed as it raises interest rates. Raising our interest rates results in a stronger US Dollar. When the US Dollar strengthens, other currencies lose value relative to the US Dollar. As a result, emerging markets have all sorts of negative economic impacts. The short-term result is a slowing global economy. A slowing global economy sends ripple effects globally. Exactly how those ripples will impact the USA economy is unpredictable with any precision. That is the point where this “Normalization” transition could become bumpy. Add a Black Swan Event to the mix and serious problems could occur. The difficulty is accurately estimating the time required for all of these moving parts to move into harmony. Until that point is reached, our economy is subject to volatility and problems. It is critical to remember that land is the source of all wealth. Every product that we humans consume originates with land. Not all tracts of land are equal in quality and portfolio management requires every investor to hold some cash for liquidity. But historically, long term the best investment is...

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Understanding How “This Time Is Different” to Make Great Investment Decisions – Week 6

What is Different This Time – The First of Two Wild Cards: It is absolutely critical that The Fed return interest rates to whatever is “Normal”. But that transition is the event where in every previous attempt in history to “Normalize” resulted in total economic collapse. If The Fed had asked my advice, I would have recommended that they pause for one year whenever they increased interest rates by 1% per annum, four 0.25% increases per year. The one-year pause would allow the markets for financial and real estate assets to adjust. One wild card in The Fed’s current plan of action is that without a pause in the interest rate increases, the portion of the real estate market that does not have Section 179 assets is negatively impacted by interest rate increases UNTIL household income (HHI) increases enough to offset the higher mortgage rates. Therefore, how rapidly the HHI increases becomes a limiting factor to economic stability and recovery. HHI will increase and we will get to the point that because of higher HHI the higher interest rates will not be a drag on the economy. I believe that the same group that designed the 2017 Tax Law to underwrite support for the financial markets and commercial real estate, also relied on faster economic growth to spur low unemployment and creating a shortage of workers forcing employers to increase wages or HHI. As we said earlier, higher HHI will stabilize the non-commercial real estate market. Once...

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Understanding How “This Time is Different” to Make Great Investment Decisions – Week 5

What is Different This Time – The Real Estate Market: In our previous blogs, we have illustrated the fact that rising mortgage rates typically mean a reduction in the value of real estate. There are a number of facts in addition to interest rates that determine the severity of the impact of the increasing interest rates, such as household income growth, rate of inflation, etc. Just focusing on increasing interest rates and therefore, higher mortgage rates, one would expect the real estate market to suffer severe problems. Once again, the 2017 Tax Law gives reasonable hope that a transition will be bumpy but achieved without too severe a disaster. The key in the real estate arena are the Section 179 assets, typically equipment. From a seminar I attended, it appears the 2017 Tax Law broadened what qualifies as Section 179 assets. If this is correct, it could create an incentive to invest in commercial real estate because of the increase of the after-tax return on commercial real estate investments. The effect is similar to the decrease in corporate tax rates working to increase corporate profits to offset the effects of stock values of increased interest rates. Once again, the change in the Section 179 assets may offset some of the effects on real estate values of increasing interest rates. The group that designed the 2017 Tax Law were Absolutely Brilliant. I am not saying it is perfect, but the 2017 Tax Law provides our economy with a reasonable chance to transition back to normal without a financial catastrophe. Pray it works, because the alternative is total collapse. It is critical to remember that land is the source of all wealth. Every product that we humans consume originates with land. Not all tracts of land are equal in quality and portfolio management requires every investor to hold some cash for liquidity. But historically, long term the best investment is land....

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Understanding How “This Time is Different” to Make Great Investment Decisions – Week 4

What is Different This Time – Financial Markets: The 2017 Tax Law has numerous positive benefits. In this case, we are going to focus just on the values of stocks and other financial instruments. In our last blog, we talked about how higher interest rates should lead to lower asset values and quantified that impact on the real estate arena. You will recall that higher interest rates could mean a reduction in values of approximately 25%. If the financial markets, including publicly traded stocks, suffered a 25% decline, that would be called a financial panic. The stock market volatility over the last few weeks reflects the stock market attempting to calculate the impact of higher interest rates on stock values. If the 2017 Tax Law did not exist, the higher interest rates appeared to be permanent, and nothing else changed, then the impact would be a financial crisis similar to the Great Recession or perhaps even the Great Depression. Fortunately, the 2017 Tax Law was passed. We are experiencing the potential problems of transitioning away from QE, Quantitative Easing. Raising interest rates as part of normalization simply exacerbates the effect. Therefore it is critical to understand one of several IMMENSE BENEFITS of the 2017 Tax Law is the reduction in corporate taxes. That single event dramatically increases corporate profits. The increase in profits could easily offset the increased cost of money, called interest rates. The result…the stabilization of stock values. That is not the same as removing volatility from the stock market. Whereas normally rising interest rates would mean lower stock prices, because of the 2017 Tax Law we have enjoyed both rising interest rates (Normalization) and a rising stock market. The result is a VERY STRONG possibility that the financial markets may remain stable contrary to every other transition out of Quantitative Easing that has occurred in the economic history of the world. The group that designed the 2017 Tax Law were Absolutely Brilliant. I am not saying it...

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Understanding How “This Time is Different” to Make Great Investment Decisions – Week 3

The Cost of Normalization: The formula that is used to value the stock of publicly traded companies has two leverage points, anticipated rate of inflation and interest rates. For this discussion, the easiest way to understand the formula is that if interest rates go up, stock prices go down. Bonds are similarly inversely affected by interest rates. In the exact same manner real estate values are influenced by interest rates, in particular the mortgage rates. The higher an interest rate a borrower has to pay on a loan for a real estate investment, the higher the rate of return the investor wants to obtain on that real estate investment. If the interest rate paid for the loan is higher than the rate of return on the real estate investment, that is called “negative leverage”. Obviously, it is a very dangerous position and it means someone made a very bad investment because they are losing money. Perhaps the simplest way to illustrate the impact of interest rates on real estate values is to look at housing: If a potential home buyer can afford a $1,000 per month principle and interest payment and interest rates are 3.5% per annum for a 30-year fixed rate mortgage, then that borrower can borrow approximately $223,000. However, if the interest rate on the 30-year fixed rate loan becomes 6%, then that same borrower can only borrow about $160,000, about 25% less. The lower amount that the buyer can borrow means that their purchasing power relative to a home has been reduced by about 25%. This ignores a lot of factors, but it gives a very simple illustration of the impact of higher interest rates. If a home buyer’s purchasing power is reduced, that takes some buyers out of the market thus slowing the market/economy and puts downward pressure on home prices. Does this sound familiar? This impact of higher interest rates will be felt across the economy. The 2017 Tax Law is brilliantly designed to...

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Understanding How “This Time is Different” to Make Great Investment Decisions – Week 2

Normalization: For this portion of our discussion we have to define the term “normalization”. In economics normalization refers to the central bank moving interest rates back to a “normal” relationship. Our central bank, The Federal Reserve Bank (The Fed), is continuing to unwind the Quantitative Easing (QE) it did during the Great Recession. The Fed influences the American economy via its control over interest rates. The Fed lowers interest rates when they want to encourage economic growth by increasing both liquidity and asset values. The reverse is also true. Having held interest rates at abnormally low levels since December 2008 as The Fed aggressively encouraged economic growth in our country during the Great Recession, The Fed is now raising interest rates in an attempt to get the financial markets back to “normal”. From a long-term perspective on the economy, it is critical that our USA financial markets get back to a more normal state both from a stability and future economic growth perspective. An important question is “What is normal today?”. A review of 150 years of economic history shows that there are many definitions of “normal” financial markets. During my almost 48 year career, I would define a “normal” financial market as a Federal Funds rate around 4%, 10 year Treasuries around 5%, and mortgage rates around 6%. To me that is Historical Normal. During the Great Recession the Federal Funds rate was 0% to 0.25%, ten-year Treasuries were around 2%, a 30-year fixed rate mortgage was 3.5%, and interest rates paid on savings accounts were as low as 0.19%. Clearly those are abnormal rates compared to my Historical Normal. But they existed for so long that they began to feel like they were a New Normal. The inherent risk of normalization is that adjusting back to higher interest rates because they are “normal” will mean adjustments in asset values. That is a nice way of saying there is a high risk of a total collapse in stock,...

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