Sunday, November 4, 2012

On Predictions and Housing

Back at the start of the new millennium, an now-infamous New York Times article asked 10 superinvestors for their one stock pick to hold for the next decade. Now ten years on, this basket of stocks in a equal wasted would have gained over about 35%, versus about -10% for the S&P 500 index. This is cumulative, not annualized. But the period from 2000-2009 was a terrible decade for stocks with two big crashes. On the surface it seemed like the 10 superinvestors did decently. As a group they did what we expect them to do, beat the market with their expert knowledge and skill. However, looking at the list closely. It outperformed the market only because one stock, Henry Schlein, carried the entire basket, rising 600% over the decade. Only one other stock, Waste Management, gained money. The remaining eight lost money. Overall, this basket did beat the market and in theory I would be ahead if I put my money with these experts. But the ten stocks individually tell me a much different story. I believe the experts picked ten easily justifiable stocks. An average reader can't fault them for their choice, they picked the high fliers of their day and they stated the known bull case. Yes the article was unfortunately written at the peak of the dotcom bubble. But the great investors must perform through both good times and bad. The New York Times, as with any other financial outlet, makes money by getting readers to their articles. The momentum view attracts the most readers because it agrees with the most readers. In essence, the media is biased towards the status quo. As are most mutual funds. But a follower of the status quo pays a heavy price. This article is one of my best case in point for contrarian investing. It illustrates the risk of following the consensus or the crowd. One of them, JDS Uniphase, even dropped 99%!

Another example of dubious predictions comes from Barron's yearly forecast. Barron's gathers a dozen or so of the well-known expert investors and ask them for their opinions of the market in the coming year. Each makes a prediction of the S&P 500 index value in one year. Invariably they predict the market will finish up around 8% of where it started. Why 8%? Because that is about the typical return of the stock market. If I was forced to predict the S&P 500 one year from now, I would postulate a probability distribution that centers around 8% also. I know that my prediction has a small chance of being right on. The outcome could be higher or lower that my prediction, but I just don't know which. I do know most likely my prediction is wrong! Benjamin Graham's philosophy is the future is unknowable, therefore do not try to bet on it, instead build a margin of safety for whatever happens.

I used to read the Barron's yearly predictions until I realized it is just a pointless exercise, it's a waste of newsprint.

The future is unknowable, I often remind myself when I invest.

In August I explained in my blog my WLP holding and why despite Obamacare I am bullish on WLP. Several posters called me ignorant, except they didn't use the word ignorant. WLP is depressed (it has a P/E of 8 after all) so the majority sentiment is negative. The prevailing sentiment today is to shun risk for safe havens. Safe havens are US government bonds, gold and high yield stocks. I recently wrote about another holding: Intel. Intel's earnings also yield 10%.

Both Intel and WLP are active buyers of their own stock by issuing debt. Their bonds mostly yield less than 4%, and their earnings yield 10%. So why not pay 4% to get back 10%? This is possible because investors, despite monetary easing by the Fed, are crowding out safe havens. I don't see how this won't end badly. Bond buys are eventually going to suffer zero or negative returns if inflation picks up to the 3-4% range.

I want to be on the other side of this trade. A lot of my investments, like Mircosoft, Wellpoint, Intel, AIG and Sears Holdings are issuing debt and buying back stock at the same time. I also like housing as a way for a small investor to easily do the same thing. Housing can be a dangerous investment, as the world has recently learned. But now, I like US owner occupied housing as a way for a small investor to easily be on the other side of the debt trade. In the US now, housing is roughly at the 2003 nominal price level. But considering real values by factoring inflation, housing is 19% cheaper than in 2003! US homeowner mortgage rates now are about 2.75% and 3.50% for 15 and 30 year terms, respectively. Typical property tax rates are 1% of home value. But US homes interest is tax deductible. So for a typical working person, the cost of borrowing a large amount of money to buy and live in a house is about 3% a year. That includes interest, taxes and insurance minus the effect of tax deductions. That is about the inflation rate. So a homeowner whose house rises with inflation essentially lives in his home for free! The only catch is the risk of a house price drop. Recently I heard Gary Shilling, one of the most bearish voices on housing, predicting houses could drop another 20%. So I take that 20% is a floor on price. In this scenario, I expect houses to then go up after this worse case drop. Many experts like Warren Buffett have said housing is a great investment, but it is impractical for someone with his capital base to take advantage. I can. I believe housing today for the small retail investor can play the role of gold. The major currencies are all in bad shape. That's why gold is at all time highs. But just as these fiat currencies can possibly have a bad fate, so can gold. Gold has no intrinsic value, it's value is so arbitrary, I can see a scenario where the US government gets its act together and holds down the debt. In that scenario I see that gold can drop by half its value. That kind of risk is speculation. Isn't housing a lot better bet?

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