Monday, March 10, 2008

Finding the Positive

This week a number of people have asked me to foretell the future. Instead of the question I am generally asked which is, "How's real estate?" now I am asked something like, "Has real estate bottomed out yet?" I usually blunder out avoidance-like comments such as "That depends where you live, or some areas have fallen more than others, or some areas have had greater appreciation than others." In any case, my answers were a well-calculated conversation stopper. The questioner leaves with nothing tangible and is unsure of my opinion, and yet with the impression that I sounded knowledgeable. I wormed my way through the rest of the week, hoping to avoid the subject altogther and felt intellectually inadequate and emotionally uneasy about our economic times.
Then I read Blanche Evans' March 7th article in Realty Times which listed the opinions of reputable housing crisis prognosticators. For the most part, the article described a grim picture and an ominous future with references to the Great Depression of 1929. Other than a few geographical exceptions, real estate was overvalued throughout America and due for a great correction, the most overvalued location, Bend Oregon, from where I am writing today. Likewise, new construction was due for a big hit as well, with sales according to NAHB to be off 22%. With such dire predictions, I went into survival mode and decided to reread passages from a favorite college text of mine, William Leuchtenberg's Perils of Prosperity hoping to find a better understanding of how to survive financially in the wake of crisis. Likewise I reviewed the events of the Panic and subsequent depression of 1893-1897. The same theme reoccured. Poor financial planning, deficit spending and amazing greed spelled the demise for millions of people who had little direct involvement or had shared in the blessings of the time.
Of course policymakers today understand the past. Fed chairman Bernanke has repeatedly confirmed his commitment to do whatever is necessary to prevent the downward spiral of housing, which could lead to massive unemployment and fortunes lost.
What seems to be the best hope for avoiding a catastrophe is creating the spin that the worst is over. We have hit bottom, and that this is really a great time to buy. In this way consumer confidence is bolstered and the trend is reversed. Banks make lending easier, FHA bails out subprime loans, and investors are given incentives to back real estate securities and, like the post depression song, happy days are here again.
Alexander Pope in Essays of Man wrote, "Hope springs eternal in the human breast, Man never is, but always to be blest." It seems like fabricating optimism in our world of great marketing is a preferable alternative to turn the economic tide than participating in some new war. Many argue that the Spanish-Ameican War was our saving grace in 1897 and that the beligerencies in Europe and WW2 did more to resolve the Great Depression than all of FDR's New Deal.
There is a lot to say for optimism. Scientists have even isolated a place in the brain where optimism resides. I have more confidence in it today than in political solutions. Give Pope, poetry and the spin doctors a go at it. What's there to lose?! Lee

1 comment:

Dennis said...

Panic, fear, and an emergency 75-basis-point cut in the Fed funds rate. Yes, dear readers, it's time to start nibbling at asset classes that have fallen on hard times.

But let's not go crazy. We're not in the business of calling market bottoms, or tops. Nobody knows how long the selling will last. It could be over tomorrow, unless a protracted bear market extends the pain for months or years.

This much, at least, looks clear: strategic-minded investors with long horizons should be taking advantage of the selling. Timing, of course, will be critical. Alas, there's no definitive bell-ringing ceremony at the bottom of bear markets. Clarity only arrives with hindsight. Nonetheless, waiting for clarity is sure to come with an opportunity cost. Once it's obvious that the trough is past, market's may have already bounced higher.

Overall, the risk of waiting too long to exploit a cyclical repricing of securities is balanced by the risk of pulling the trigger too early. In a perfect world, investors would buy at the bottom and sell at the top. In the universe we all inhabit, however, imprecision rules and so returns suffer relative to the ideal, albeit in varying degrees depending on the investor.

Despite the risk of buying too early or too late, few can afford to stand still and watch the world pass by. Lower prices equate with higher prospective returns. And so, after five straight years of bull markets in just about everything, the cycle has turned, risk has been reshuffled and a new deck of prospective returns has been dealt. We don't pretend to have the answer as to when it's time to buy. On the other hand, we're reasonably sure that the year ahead will offer compelling opportunities for rebalancing among the major asset classes. The source of this new opportunity: the churning of economic and financial risk.

That said, let's emphasize once more that the primary risk in the months ahead is one of balancing the risk of buying too early vs. buying too late. At the same time, level-headed investors shouldn't fret over the risk. They shouldn't ignore it, either. Most of us, perhaps all of us, will err on one side or the other. The good news is that the timing risk can be mitigated. Because we don't know when prices will stop falling, or start rising, prudence suggests a bit of time diversification is in order.

Let's say you've been rebalancing these last few years, selling into strength on the margins and raising weights in lower-risk betas and cash. Now what? You could throw caution to the wind and reinvest everything in risky assets on a single day. This approach will, of course, maximize future returns--if you're right. If you're wrong, you'll maximize losses. But that's just rank speculation. An alternative approach is rebalancing gradually over the coming months by purchasing asset classes periodically--otherwise known as investing.

Perhaps the waves of selling will be isolated in one or two asset classes, perhaps not. Perhaps the waves of selling will come in one concentrated burst, or perhaps it will come in stages, separated by weeks or months. However it comes, the essential point is psychologically preparing oneself for the future and monitoring the shifting sands of risk and reward. History teaches that the greatest buying opportunities often arrive at moments of extreme stress in the financial system. Positioning one's mind, and one's portfolio, to exploit such moments is vital for generating something other than mediocre performance for the long term. For those who keep a clear head, financial blood in the street represents opportunity.

This was written about the stock market. But can't this logic be applied to real estate.