Will the other shoe drop for real estate? - Published in the SB News Press in April of 2011

When I moved to California from Texas in 1993, the real estate market was just finding its bottom, after the excesses of the Savings & Loan debacle and the peak in prices around 1990/91.  Prices would stay at their lows until late in 1996, when they finally started to rebound.  I didn’t realize it at the time, but I had moved to California at the perfect time to buy real estate, with prices having just suffered such a tremendous collapse… or so I thought.  A more in-depth analysis of the conditions surrounding that 1993 price-point low, and a comparison to today’s real estate market, may shed some light on this issue, and may provide some insights into the attractiveness of real estate today.

The real estate boom of the late 1980s/early 1990s was driven, in part, by excess building, fueled by savings & loans, primarily in Texas and California, that were issuing high-yield (junk) bonds to raise the capital that they, in turn, lent to developers, speculators and buyers.  Like most bubbles that expand until they burst, this real estate cycle was driven by many factors all culminating in skyrocketing prices on the way up, and the inevitable crash we witnessed. 

Median home prices in California reached their peak in July of 1991, at around $206,000 (Santa Barbara peaked the month before at around $277,000).  By February of 1996, the California median home price had fallen to $170,000, or by about 17.5%.  In Santa Barbara, the media price declined to a low of about $170,000 in December of 1994, and was at $231,000 by February of 199, when the state hit its low, representing a 39% drop for Santa Barbara from the high to the low.

Prices in California did not surpass the $200,000 mark until May of 1998, almost two-and-a-half years after hitting bottom, and almost 7 years after the previous peak.  Santa Barbara prices surpassed the $277,000 high by June of 1996, only about one-and-a-half years after the bottom, but about 5 years after the previous peak.

What was so completely different about the current real estate bubble (that just burst) in comparison to the previous boom and bust cycle for real estate (1988 or so through 1996), is interest rates.  Even as real estate prices were rising dramatically back in 1988 and 1989, the 30-year fixed-rate mortgage rate was around 10 to 11 percent.  This contrasts sharply with rates during the 2006 and 2007 period, which were hovering around 6.5 to 7%.  In fact, even after prices began dropping, and while they continued to drop well into the 1993 through 1996 period, when real estate was hitting its lows, rates were still very high in comparison to where they are today.  Even in 1993 at the depths of the real estate declines, the 30-year fixed-rate mortgage was still running between 7 and 8 percent. 

I first moved to La Jolla from Texas in late 1993.  I was told that it was a good time to buy real estate, and that prices had just been hammered.  The first place I rented was owned by the builder, right at Wind-n-Sea Beach.  It was a 3-story duplex, which was only about one-year old.  It was about 2,000 square-feet and had a roof deck with tremendous views.  The owner was asking $385,000 at the time and no one would even look at it.  He begged me to buy it. I could not wrap my mind around paying almost $400,000 for a duplex (half of a duplex really), when in Texas, I could have bought a 5,000 square-foot house on 10 acres for that amount. 

I lived in the duplex for 2 years.  The owner lowered my rent while I was there so that I would allow him to show the unit.  No one cared.  He eventually sold it, years later, probably for substantially less than he was hoping to get in 1993. 

I am sure that place was worth $1.5 to $2 million during the latest boom.  I have always wondered if I made a huge mistake by not buying that place when I had the chance to get it cheap.  I often thought back about that place, and have felt like an idiot, knowing how much it’s worth today, even after the recent declines.

But did I really make a big mistake?  On closer examination, I am not so sure I did.  Starting in 1994, rates were climbing, and were already pushing 9 percent by the end of the year.  (Rates did come back down somewhat, to around 7.5% by the end of 1995, but went right back to around 8.5% by the middle of 1996.)     Using 8.5% as our assumed mortgage rate, and $400,000 as our loan amount, the monthly mortgage payment would have been about $3,850.  At the time (1994), I was paying $1,600 per month in rent, so the idea of assuming a $4,000 monthly mortgage payment was a bit scary to say the least (which is the key reason I didn’t buy anything).  Of course, there are some tax benefits to buying, especially in the early years of the loan, but even so, the next difference between renting and buying was still significant and therefore a huge deterrent. 

There would not have been an attractive opportunity to refinance at a lower rate until 1998 – 4 years later.  Which means that I would have been stuck making that $4,000 payment every month for at least 4 years – a pretty scary situation for a guy working on straight commission as a stockbroker at the time.  But, at least eventually I could have refinanced and brought my monthly payment down Rates dropped to about 7 percent in 1998 and 1999, and then down around 6 percent by 2002.  In 2004 and 2005, rates briefly approached 5.5 percent, ran back up, and then by 2009 had returned to the 5.5 percent area.  In 2010, the 30-year fixed got down around 4% and it is currently around the 4.4 percent area.

Looking back now at my cash flow requirements to support an 8.5 percent mortgage and the fluctuations in my income, I now feel my decision wasn’t such a bad on after all.  More importantly, I see some serious problems with the current real estate market that did not exist back in 1993 through 1996.  The most glaring is that rates are historically very low.  At first glance, this might seem like a positive, and it is as long as rates stay where they are.  But what happens if they begin to rise?  Unlike the previous situation, in which mortgage holders could eventually refinance, bringing their monthly payments down, there will be no opportunity to refinance at lower rates down the road.  What you see is what your get, for as long as you own the property, if you buy at the current rates. 

Also, if rates do start to move higher, which they certainly will once the Fed begins to raise interest rates (to fight inflation) and the entire rate structure moves up, real estate prices must adjust down further, meaning that anyone that buys now will be down on price and will not want to sell at a loss, only to buy a different house of lesser value (for the same mortgage payment) because rates are higher than they were when the first home was purchased.  With no refinancing opportunities, and the very real possibility of being forced to take a loss, should the homeowner want out, current home buyers will likely be making a very long-term purchase decision if they buy now. 

Prices ultimately are based on the affordability of the monthly payment, so the higher mortgage rates rise, the lower home prices have to move to make the payments affordable for buyers.  Rising mortgage rates could indeed be the other shoe to drop for real estate.

Don’t Miss the Free Tech Brew This Tuesday! - Published in the SB News Press in April of 2011

As we move into Spring, we have another fantastic opportunity to attend a free event for entrepreneurs—The Tech Brew, Multidimensional Mega Mixer!  These events, sponsored by FD3, Maverick Angels, and SBEC (Small Business Entrepreneur Center)/Green2Gold, feature expert speakers, high-quality seminars, and are attended by a wide variety of entrepreneurs, experts and investors.  They are a must for any serious entrepreneur on the South Coast, who wants to make connections with the people that make things happen for business owners.

I have been privileged to be able to consult with many of the top advisors and angel investors in our area.  I have made some tremendous contacts, both in the investor and advisory/consulting community.  Although there are many entrepreneur-centric events that take place within our market, the Tech Brews are exceptionally valuable, because they are so well-known, so frequent, and, most of all, they are free to attend!

One of the most dynamic members of our entrepreneur support community is Alan Tratner.   Alan is a former professor of environment and energy, and the founder of the international, 40 year-old non-profit institution EEG/Green2Gold(G2G), (which is now a project of FD3—a world helping international non-profit organization). 

FD3/Green2Gold facilitates the creation of sustainable economic development incubators, hosts workshops all around the world, and has thousands of members working on developments in technology, with a strong focus on green technologies.  FD3/G2G is unique in that it also assists some 30 non-profits working in social and environmental sectors. 

Alan also serves with me on the Board and Executive Committee of the Clean Business Investment Summit of the California Coast Venture Forum, and is an Affiliate Sponsor of the Maverick Angels network.  Alan has personally presented some 4,000 workshops, seminars, and conferences, around the globe, from Stanford University to Moscow Russia, and has appeared on/in many of the world's leading media, from CNN, CNBC, the Wall Street Journal, INC., Entrepreneur, Time, Business Week, Fortune Small Business, and USA Today, to Oprah, Good Morning America and NPR, and has been featured in hundreds of radio and magazine interviews. 

Alan is a dynamo, exuding enthusiasm for all things green, technology, and business development.  He is a huge resource for local entrepreneurs, and is just one of the many experts who make themselves available at each Tech Brew, so that entrepreneurs from all backgrounds can gather the information they need to help their businesses succeed.

The Tech Brew Mega Mixer will be held on Monday, April 18^th at the Fess Parker Double Tree Resort, from 4:30 until 9.  I always advise attendees to arrive early, because a lot of the mingling and connection-making happens as people are getting situated.  Those with booths, like me, will be setting up their materials, and will have time to meet people and answer questions.  A savvy entrepreneur can get a lot of valuable, free information, just by asking a few pointed questions.

Several colleges and universities from Central and Southern California will be featured at this Tech Brew as well.  This is a great event for college students and young entrepreneurs just starting out, perhaps working on their first venture.  It is also a superb event for even the most seasoned business owners, looking to expand, or looking for help with increasing efficiency, marketing effectiveness, Internet/SEO expertise, and the like.  There is truly something for everyone interested in what makes businesses work along the Central Coast.

Of course, this weekend will feature all of the Earth Day celebrations, and we will see plenty of demonstrations of new, environmentally friendly technologies, and can meet the innovators who have created these great ideas.  Many of these same entrepreneurs will also attend the Tech Brew with booths and presentations, which should be highly entertaining and interesting.

For entrepreneurs looking to raise money, either for a start-up, development, or expansion project, the audience of the Tech Brew will be ripe with potential candidates for investment.  As we know, it is difficult, if not impossible, to get a loan, especially for a start-up business these days.  Investors, and in particular Angel investors, are probably the single most active funding source available to entrepreneurs at-present.  The difficult thing with Angels is to get in front of them to make your pitch.  The Tech Brew serves that purpose, bringing entrepreneurs and investors together in a casual, comfortable environment, which allows for direct contact and interaction.

Internet marketing, including SEO (Search Engine Optimization—getting your business to show up when someone does a search through a web browser), banner ads, skins, pop-ups, cross-linking, blogs, Facebook and other social networking approaches, are complicated, and require specific expertise.  Most entrepreneurs (including me) don’t know the first thing about any of this stuff.  As a result, many of us put off, ignore, or outright shun doing anything relating to the Internet, in terms of promoting our businesses.  The Tech Brew brings together a strong contingent of Internet marketing experts that are ready to assist with all things Internet marketing-related. 

The Tech Brew is also a great place to gather additional information about upcoming events, such as the annual Clean Business Investment Summit, coming up August 12^th at the Corwin Pavilion at UCSB, where entrepreneurs will have an opportunity to qualify to present to a large group of investors.  There are also many great seminars sponsored by Green2Gold and other organizations, many of which are free of charge, that connect local experts in a wide variety of disciplines, each of which can be critical to business success. 

Perhaps one of the most beneficial aspects of the Tech Brew is connecting with other entrepreneurs within the same or complimentary business segments.  Business owners can share ideas, discuss common challenges, and refer colleagues to outside experts they have used with success in the past. 

One of the best things about living in Santa Barbara is that there are so many talented people here locally, who are willing to share their knowledge to help others succeed.  It is like no other community I have experienced, and it is a distinct privilege to live and work here. 

As always, I will have a booth at the Tech Brew, so stop by and say hello, should you decide to attend.  For more information, and to register (it is a free event), visit:  www.techbrewmegamixers.org.  I hope to see you there!

Santa Barbara Economy Still Lagging - Published in the SB News Press in April of 2011

The rally we have experienced in the stock market over the past two years has been impressive, and has underscored the rebound in not only the U.S. economy, but the entire global economy that has positively impacted nearly every major market worldwide.  While there are some signs that the economic recovery is taking root nationally, Santa Barbara appears to be lagging the nation as a whole.

Depending on which economic indicator we choose, several scenarios, in terms of our economic future here in Santa Barbara, are possible.  Some indicators look to be improving, while others are deteriorating, at least on a month-by-month basis.  This not only makes it extremely difficult to get a sense of what to expect, but also provides economists and market forecasters with plenty of ammunition to take either side of the recovery story – a robust, sustained recovery, or an anemic, painful stagnation.  Taken as a whole however, the indictors look to me to be showing that Santa Barbara is lagging the country overall, and lagging by a year or more. 

According to S&P/Case-Shiller, U.S. median home prices peaked at around $272,000 during the second quarter of 2006.  The current median home price is around $160,000.  With the exception of a few minor bounces, prices have been declining steadily from the 2006 peak and have not bottomed yet.  This decline represents a 41% decline from the peak (and counting).

Median prices in Santa Barbara County peaked much later—in July of 2007—according to the California Association of Realtors, (although the median price was as high as $859,000 in June of 2006).  The current median home price in Santa Barbara County is $366,000 (as of January 2011), which represents a 57% decline—yes you read that right!  For the city of Santa Barbara, we peaked in October of 2007 at $1,275,000.  The median price as of January 2011 was $820,000, which represents a 36% decline.  This discrepancy between the county and city declines would suggest that the north county has experienced some very dramatic price drops from the peak.

Prices for the city of Santa Barbara do appear to be starting to rebound a bit, at least on the median price level, although it seems that houses priced in the sub-$1 million range are selling much more briskly than those above $1 million.  It is too early to tell if prices are nearing a bottom yet, and as I wrote last week, if interest rates start to rise, (which they will), housing prices still have a good ways to fall before reaching bottom.

Unemployment peaked for the U.S. at 10.1% in October of 2009, according to the Bureau of Labor Statistics, and has now fallen to 8.8%--the lowest rate we have seen since March of 2009 (before the peak). 

As of March of 2011, we had 21,000 people officially unemployed in Santa Barbara County, which represents an unemployment rate of 9.6% (Employment Development Depart of the State of California).  We did not reach our peak unemployment rate of 10.4% until January of 2010, three months after unemployment peaked in the country as a whole.  We currently have an unemployment rate that is 0.8% higher than the country.  Since both rates appear to be declining, we can’t know if we will continue to lag behind the nation through the bottoming of unemployment, but we have a good ways to go to make-up the current difference, and an even longer road to a reasonable unemployment rate.

National GDP (Gross Domestic Product) was just reported this week for the first quarter of 2011, at an annualized rate of 1.8%.  This compares somewhat unfavorably to the 3.1% annualized GDP growth we achieved in the fourth quarter.  (The fourth quarter is typically strong, due to the holidays.)  Quarterly GDP growth peaked in the first quarter of 2006 at 5.4% annualized growth, although growth slowed to only 1.4% in the second quarter of 2006.  

The U.S. economy grew at around 1.9% through 2007, with the first signs of trouble coming in the first quarter of 2008 with our first quarter of negative growth -0.7%).  Not surprisingly, the worst quarter was the fourth quarter of 2008, just after the financial market implosion, with GDP growth of -6.8% (annualized).  Negative GDP growth continued through the first half of 2009, before turning positive in the third quarter.  In both 2009 and 2010 we have had strong fourth quarters (+5% in 2009, and +3.1% in 2010).  Although I believe we will only see about 2% to 2.5% GDP growth for 2011, we are definitely growing (although slowly), and have turned the corner from recession to recovery.  The U.S. economy was flat in 2008, contracted by 2.6% in 2009, and rebounded in 2010 to expand by 2.9%.    

The Santa Barbara-Goleta-Santa Maria Metropolitan Statistical Area grew by almost 4% (3.92%) in 2007, compared with less than 2% for the country as a whole that year.  Our area grew by about 1.5% in 2008, but lost ground in 2009, with negative growth (-0.66%).  The Bureau of Economic Analysis has not released the 2010 GDP numbers for Santa Barbara-Goleta-Santa Maria, so it is difficult to draw any conclusions on the comparison between U.S. GDP and local GDP trends.  Also, GDP bounces around so much that defining a trend is problematic at best.  Still, it does appear that the U.S. economy experienced a decline in GDP growth first, with our local economy following about one year behind. 

On balance, it seems that our local economy is lagging the country as a whole; at least it has been through the recession and recovery to this point.  This begs the question: Will our economy play a bit of catch-up, or are we destined to continue lagging?  A continuing lag would mean that it will be another year or longer before we see local unemployment come down significantly and local GDP growth improve. 

The bigger question is: Can the local economy stand another year or more of weak economic activity?  The answer to this may lie in the ability and willingness of local commercial property owners to negotiate more acceptable/reasonable/affordable rental rates with local business tenants.  As it stands, we are seeing far too many locally-owned businesses fail and close their doors for good, only to be replaced by national chains.  In some cases, businesses are leaving because they cannot afford their rent; leaving vacancies that are not being filled by any new businesses.  One need only drive down the streets of Santa Barbara and Goleta, in the business districts, including State Street, to see the large number of empty commercial/retail spaces. 

Some property managers in town have stated recently that many new businesses are coming into town and are willingly signing up at “good” rental rates.  I have heard about several national chains that were scheduled to open locations in town, but have not moved forward with these plans to-date.  Not only is having a lot of empty space along our major business thoroughfares depressing and bad for the remaining businesses, but it’s also a lose/lose for landlords as well—they have empty spaces, which are always tougher to rent than occupied spaces; and they are not receiving any rents as long as those spaces remain unoccupied.  Often only a relatively small discount in rent would be required to keep tenants in a space. 

It does appear that the national economy is improving, although not at a pace that would seem necessary to justify the strong performance of the stock and commodities markets over the past two years.  On a local basis, it does seem that we are still lagging pretty far behind the country in terms of economic activity.  With the threat of already very high commodity prices, including gasoline (which definitely affects the local economy due to our heavy focus on tourism), rising interest rates, rising inflation, the continuing global debt crisis and unrest in the Middle East, there is still a lot to worry about. 

Prudence demands that we plan for a long, drawn-out recovery with continuing slow growth well into 2012 for our local economy.  I tend to be overly optimistic, but given the current economic environment, local business owners should hope for the best, but be realistic about the time it will take to drive revenues back to good, or even acceptable, levels.  

Real Estate as an Asset Class - Published in the SB News Press in April of 2011

Most advisers use software programs to produce recommended asset allocations for investors.  These programs normally use long-term historical averages for risk factors and returns for each asset class, along with the Markowitz Efficient Frontier, to produce a recommended portfolio at a given level of assumed risk.  The “assumed risk” part of the analysis typically comes from a series of questions that the client/investor is asked, relating to their feeling about various scenarios, such as how they would feel if their portfolio fell in value by a certain percentage.  As these programs have evolved, they have begun to include more asset classes, such as gold and real estate, in addition to the traditional classes, such as stocks, bonds and cash.  For investors who own real estate in expensive areas like Santa Barbara, where real estate values are still comparatively high, these programs may recommend too much real estate for the investor’s portfolio.

I have written extensively about these programs and more specifically about how using historical averages for risk and return is a poor method for recommending allocations for investment portfolios.  (Historical averages would not have been very helpful for an investor putting money into the financial markets in early 2008, for example.)  Asset allocation programs also typically recommend a sizable allocation to foreign markets, which I do not agree with (as last week’s column highlighted).  In a nutshell, I disagree with using asset allocation programs at all.  They are far too general and rely, again, on long-term historical data that has very little to do with the current and future market conditions investors will face.

Depending upon how one answers the questions in an asset allocation program, the recommended allocation will include anywhere from 5 percent to as much as 30 percent be invested in real estate.  For some strange reason, many advisors will make this recommendation, knowing that the investors owns a home worth a significant portion of their total net worth—sometimes 50 percent or even more of that total.  Early in my career, which has spanned over 20 years, conventional “wisdom” was that only liquid assets should be considered when creating an asset allocation.  For this reason, the personal residence was typically excluded from the analysis (which was ridiculous). 

I am from Texas originally, and in Texas, this kind of thinking wasn’t as dangerous because the average single-family home was worth $100,000 or so.  For an investor with several million dollars to invest, excluding $100,000 in real estate wasn’t too damaging.  However, for a Santa Barbara resident with a home valued at $1 million, which isn’t too far above the median home price here in town, and who may have a $2 million investment portfolio, excluding the personal residence when formulating an asset allocation could be a serious mistake.

In the above-stated scenario, the personal residence represents fully one-third of the total net worth of the investor.  Adding even an additional 5 percent of the $2 million investment portfolio to real estate would exacerbate an already massive overweighting in real estate for this investor.  By definition, if the advisor (and the computer program he or she was using to generate the asset allocation) was recommending that 5 percent of the portfolio should be in real estate, this theoretical investor would therefore be overweight real estate by $850,000, or by about 28 percent (5 percent of $3 million is $150,000, so if the investor owns a $1 million home, they have $850,000 more in real estate than the program would recommend). 

If anything, the advisor should, at a minimum, not recommend that the investor place even more money into real estate.  More to the point, the advisor should be recommending ways to reduce exposure to real estate, or reduce risk associated with real estate.

An even more concerning aspect to the issue of real estate exposure for those living in expensive areas and owning real estate, is that most don’t own their houses outright, but instead hold mortgages (debt) on them.  In the investments business, this is referred to as leverage.  If the house were a stock trading on an exchange, we would call it margin.  A mortgage has the exact same impact on the risk associated with real estate as margin does for a stock transaction.  The only difference is that with margin, the investor could get a margin call, requiring more cash to be deposited, whereas with a mortgage, there would not be a call no matter how low the value of the house fell.

With regard to the investor’s asset allocation, there are two ways to look at a house with a mortgage:

1.) The investor could include the total value of the property in their asset allocation
2.)  The investor could include only their equity position in their home—home value less their mortgage

Both methods involve some challenges.  With option 1, the asset allocation is more accurate for analysis and planning, but does not address the associated risk of loss (due to the leverage involved).    As an example, if the investor owns a $1 million home, but has a $500,000 mortgage, this option would have the full $1 million represented in the asset allocation.  However, due to the mortgage (leverage), a given percentage decline in the value of the property will result in double the percentage decline in the investors equity position in the home.  (If the house fell in value from $1 million to $800,000, or by $200,000 (20%), the mortgage does not change—it’s still $500,000 in this example—so the entire $200,000 comes out of the investor’s equity, causing that equity to fall from $500,000 to $300,000, or by 40% (twice the decline in the home value).  Therefore this method captures the dollar risk more accurately than option 2, but does not reflect the potential for percentage losses.  (The investor in this example has fully twice the percentage risk one would normally associate with owning a $1 million outright.)

With option 2, the investor will have a more accurate representation of their dollar exposure to real estate, but their asset allocation will under-represent their total real estate risk in dollar terms.  Using our same example, if the investor only includes the $500,000 equity position they have in their home, the asset allocation will not reflect the other $500,000 in dollar exposure they have to real estate.  This could potentially cause an over-allocation to real estate, if the investor uses an asset allocation program and only inputs a $500,000 exposure to real estate, when the reality is that they have a $1 million exposure. 

I would use the first method, although again, it does not fully capture the true risk to the investor, if one uses an asset allocation program (which is why I do not use these programs). 

Even if one believes in using an asset allocation program, it is advisable to include the personal residence as a real estate investment, when generating an asset allocation recommendation.  For most investors, however, the program would recommend an allocation to real estate that is far less than their actual exposure.  What to do?

Contrary to what many advisors might recommend—adding even more real estate—theoretically, the investor in this case would want to find a way to reduce exposure to real estate.  One possible method of doing this would be to short real estate through selling short REITs or some other real estate stocks.  Another, more favorable method would be to use an ETF that provides short exposure to real estate.  But be careful!  Shorting REITs can be tricky for several reasons.  First, they don’t necessarily track real estate prices well.  Also, they typically pay high dividends, so if you are short, you are responsible for paying the dividends.  Also, many of the short ETFs use REITs, so you have the same issues if you buy an ETF that is short real estate. 

An indirect way to protect your downside would be to short financials, such as banks that make loans for real estate purchases.  As we saw, the banks get hammered when real estate bubbles burst, so shorting the banks would act as a hedge against price declines in real estate.

All of this is a bit academic and not very timely, to say the least, since real estate prices are down about 40 percent here in town from the peak, and we have already seen the negative impact on the banks, etc.  However, this discussion will hopefully inform investors of the dangers of depending too heavily on asset allocation programs, or the advice of advisors blindly using these programs and recommending large exposures to real estate.

International Diversification Simply Doesn’t Work - Published in the Santa Barbara News Press in April of 2011

When I was a portfolio manager with Wells Fargo, I also served as an analyst, covering certain stocks for the portfolio managers throughout the bank to use for managing client portfolios, etc.  Not long after I joined the bank, I performed an analysis of the model portfolio Wells used at the time as the basis for their stock allocations for most client portfolios. 

The Wells model portfolio included a sizable allocation to international companies, which I found to be of concern.  While most investment advisors these days will tell clients that it is important to own investments from outside the U.S. markets to diversify (reduce potential risks), I have always felt that this was a mistake. 

Through analyzing the Wells model portfolio, I reviewed the sources of revenues for all of the companies included in the portfolio.  What I found was that the U.S.-based companies in the portfolio as a whole had a significant amount of revenues generated from foreign markets.  My conclusion was that, even if you accepted the conventional thinking that every stock portfolio should contain foreign investments, this model portfolio was heavily overweighted internationally, due to the additional international revenues that the U.S. companies were generating.

Some may argue that what matters is not where the revenues come from, but rather where the company is headquartered.  I disagree completely.  The risk and the opportunity reside in the revenue generation potential of the company.  Even though McDonald’s, as an example, is headquartered in the U.S., it only generates about 40% of its revenues here; 60% come from outside the U.S.  One need only watch the fluctuations of McDonald’s stock to see that the performance and the risk in the stock are directly driven from their financial performance, which in turn is a direct result of their revenues and earnings.

Needless to say, the powers that were at the time, were none too happy with me for my research report, and refused to publish it to the other portfolio managers throughout the country.  (Just for the record, Wells is a great company, and I haven’t been there for years, so I don’t know how they manage money these days, and I am sure they do a great job for their clients.) 

My experience with Wells on the issue of international diversification to reduce portfolio risk underscores what I believe to be flawed thinking that is pervasive throughout the industry.  Just about any advisor out there will tell clients that in order to reduce their risk, they need to add international investments to their portfolios.  In fact, there are multiple studies that have been done over the years that appear to prove that owning foreign investments does actually reduce risk.  But what is risk?

Most of us in the investment management field define risk as portfolio volatility—the fluctuation of portfolio values over time around the mean return.  Investors think of risk in an entirely different way—they see risk as the potential for losing money.

If we use the investor’s definition of risk, the benefits (or lack thereof) associated with international diversification are easy to see and understand, from the investor’s point of view.  Diversification is the allocation of assets into various types of investments to reduce overall portfolio risk.  Again, using this definition, portfolio managers typically recommend purchasing international investments to improve diversification, thereby reducing overall portfolio risk.  The idea is that, at times when U.S. investments perform poorly, the international investments will go up, offsetting the losses from the U.S. investments, or will at least not go down as much as the U.S. investments, reducing the overall negative impact on the portfolio.

Investment professionals use what is called correlation to mathematically calculate the relationship between various asset classes, and to “prove” that international diversification works—reduces portfolio risk.  The problem with their “proof” is that they calculate their correlation coefficients, based on historical performance for the various asset classes. 

It is true that, if you use a very long time horizon, and back-test the relationships between U.S. and international assets, the correlation coefficients can show low correlations, meaning that U.S. and international assets do not move in the same direction at the same time, at least by the same amount.  In other words, these calculations appear to show that owning both U.S. and international investments in the same portfolio works—reduces risk.

However, what investors care about, or should care about, is losing money, as discussed above, and not simply reducing portfolio volatility.  Also, while looking at long-term averages might help investment professionals justify international investments, the reality is that it only takes one significant, negative event, such as we had in late 2008/early 2009, to crush an investor’s performance and completely disrupt and possibly delay their retirement plans.

To underscore my point (which is that international diversification doesn’t work), let’s look at some of the most popular international indexes and their returns through the market collapse of 2008 and 2009.  One popular international investment vehicle has been the BRIC countries—Brazil, Russia, India and China.  The Morgan Stanley index that tracks these markets dropped by about two-thirds around the time that Lehman Brothers failed.  During the same time-period the S&P 500 fell by about half (significantly less than the BRIC index).  The EAFE Index (Europe Australia and the Far East) tracks 21 indexes from these markets.  It also fell by about two-thirds during the same time-period; again, substantially more than the S&P 500.  In fact, if we look at just about any index representing almost any foreign equities market outside the U.S., we find the same result—the foreign market declined more than the U.S. equity markets during the same turbulent time-frame. 

This is not what is supposed to happen, if we believe the proponents of international diversification!  What should have happened is that the foreign markets should have gone up, or should have at least performed better than the U.S. markets.  Regardless of whether one defines risk as portfolio volatility, or losing money, diversification simply failed to protect investors from risk.

One could argue that the disruptions in the world financial markets were so extreme, so unexpected, so coordinated, that of course diversification failed to protect portfolios from losses.  If the proponents of international diversification could somehow guarantee us, or at least assure us, that nothing like this will happen again, maybe we could overlook the obvious.  Unfortunately, the world financial markets are forever linked (which is a key reason why back-testing correlation coefficients doesn’t yield usable data), making it much more likely that we will experience more significant market disruptions on a global scale in the future.

Returning to my original position, which was formulated many years ago, I firmly believe that investors gain plenty of international exposure by simply investing in top-quality, U.S. firms that generate significant revenues outside the U.S.  In other words, if an investor wants exposure to a foreign market, buy a U.S. company that does business there, plain and simple.  One need only review the financial filings of companies to see where they are doing business, so the process of evaluating and selecting viable candidates is not difficult or time-consuming.

If you agree with me up to this point, then there can be only one good reason to invest in a non-U.S. company—to make money.  If there is a company in a foreign market that is an outstanding prospect, that has a competitive advantage over its U.S. rivals, has dominant market-share, superior products, management, etc, etc, then, and only then, may it be a possible candidate for investment.  In other words, buying non-U.S. companies simply to diversify is a bad strategy and will not work.  So, unless the foreign company is a better prospect that it U.S. counterparts, there should be no reason to purchase it.

Investors should not take my word for this (or anything else).  Question your advisor.  Ask them why they are recommending foreign investments (if they are).  If they tell you its for diversification, don’t just accept it.  Make the advisor support his or her position and show you a valid reason for their recommendation.  It’s your money!  Unless they can convince you of the merits of each and every recommendation, just say no!

Dow off 170

Stocks are getting pummeled after weekly jobless claims came-in higher than expected at 429,000.  Obviously that isn't enough to cause 170 point drop in the Dow.  The real issue is that stocks are still seriously overvalued because economists and analysts have brainwashed investors into believing that the economy was going to recover at a much faster pace than we are experiencing.  The realization that economic growth will be more like 1.5% to 2% this year, and probably won't be much better in 2012 (I expect 2% to maybe 2.5% in 2012), is causing investors to reassess their expectations for stock valuations.

Each time stocks have a "bad" day like today (now down 180 points), some traders/speculators and some investors, falsely believing that stocks are "cheap" jump in with new cash and drive stocks back up.  We have seen this happen over and over again over the past several months.  Again, this reaction to any selling in stocks in based on the false belief that stocks are properly valued, which in turn is based on those overly optimistic analyst and economist predictions.  Once the investing public realizes the reality that growth will be much slower, stocks will have to adjust down to reflect slower growth.  I believe that stocks will over-correct, offering a good buying opportunity.  I will likely put more cash to work at around 1,250, but I could see stocks moving below that level, so I will still reserve some cash for lower levels.

Goldman missing the mark (again)

As is so typical these days with large investment firms, Goldman Sachs is still maintaining their 1,450 target for the S&P 500 for year-end 2011 even though they just reduced their growth forecast for U.S. GDP from 3% to 2%.  One explanation (excuse) from Goldman is that the group that has the 1,450 target is different from the group that just reduced the GDP growth estimate.  Abbey Joseph Cohen, the lead of the group that reduced the GDP growth estimate stated on CNBC this morning that they don't base targets for the S&P 500 on one quarter's growth and that the S&P 500 trades on expectations of future economic growth, among other factors, over many quarters.  Fair enough, and I completely agree.  But the fact remains that if the U.S. economy, which was expected to grow much faster than 2%, only grows at 1.5% to 2%, which is what I have been saying for more than a year, the S&P 500 and stock valuations in general, are, even at today's 1,295 level on the S&P 500, far too expensive.  How then can Goldman maintain their 1,450 target?  I will concede that a lot can happen in six months in the stock market, but to expect a 12% gain from current levels on the S&P 500 by the end of this year seems foolish.  I will bet money that Goldman will reduce that target in short order.  Or, they will be proven wrong (again).