Special Holiday Letter: December 2010

Put It There and the Gift of Real Estate

In October we talked about how the end of the baby boomer spending wave has led the United States into a prolonged downturn in the economy.  Today, we will talk about an equity strategy we use extensively and the generational opportunity to accumulate valuable real estate assets during this prolonged economic downturn.

New Drivers in the Economy

My son turns sixteen this week and he is in driver's ed, so beware Muskego in about two or three months.  Although he is not the son of a boomer (I am an "X"er), he falls into the young end of the  "millennials" or echo boomers.  That group, kids in their teens and young adults in their twenties, make up the next large group to enter the economy.  Today, that group has virtually no money, so their ability to push the economy anytime soon is minimal, except for some retail and consumer technology.  When the echo boom is ready to spend however, that spending will look similar to what the baby boomers did in the 1970s through 1990s.

There is a second major driver to helping the economy recover.  However, it is a group of people who is not in the United States.  Throughout the world there are literally billions of people who want the standard of living we enjoy.  They are in places like China, India, Russia, Brazil, southeast Asia, eastern Europe, northern Africa, the middle east, central and south America.  Their demand for higher end products should be a huge driver to the United States economy.  Foreign demand will likely mitigate the baby boomer spending collapse which is dragging the American economy.  Somewhere near the end of the decade, it appears that foreign demand for goods produced in the United States should offset the drop in demand from within the United States.

From the two groups above, the echo boom and developing international demand, we can find almost all of our long term investment opportunities.

The Boom Ahead

While the financial industry is virtually always bullish (optimistic) about the economy and markets, clearly I have not been since about 1999.  That is beginning to change.  I am very bullish on the markets of the 2020s.  Shorter term, it looks like we will see uneven gains across markets, with many markets, including the U.S. struggling to make real gains (inflation adjusted).  Foreign markets likely to do well are positioned for growth with the ability to export, in many cases, exporting natural resources.  In the U.S. and other markets we may see nominal gains (rising numbers like 2003-2006) in the short run, but that would likely be a result of a response to a developing creeping inflation and massive government intervention.  I an increase in anticipate volatility and a sideways trend for some time in many markets the next several years.

That volatility and sideways trending is a huge opportunity for astute investors as there is a significant floor under the markets.  It is rare that we see such a floor, which in this case is a result of massive government intervention.  While politicians can argue over the size of that intervention, it is happening and will continue to happen.  Need proof it will continue?  Today we saw the extension of tax cuts that will add about a trillion dollars to the deficit over the next couple years.  Fed Chairman Ben Bernanke said on "60 Minutes " this weekend that the Fed may buy more bonds than the $600 billion it already has committed to (which lowers interest rates), again, adding money to the economy.  While this added money might not stimulate growth, and I really do not expect it to for the demographic reasons we have discussed before, it does add explicit support to the markets as the government seeks to introduce inflationary pressure in a deflationary environment.

In the short term, government support should at least offset the risks of the markets.  While I do not expect we can do this forever, and I was in the camp for raising taxes on incomes over a million dollars a year, it is hard to fight the government.  They helped create (with the primary culprits in the financial world) the last bubble that burst, and now they may very well be helping to create another one.  The trick for investors is to find short term strategies to make money in a choppy market without reaching out too far for risk.  When the next pullback comes, I would expect it to be as violent as the last one.  For now, we will be very patient and careful in case we fall through the floor one or two more times before real growth takes hold later in the decade.  Let me repeat, chasing short term gains is a recipe for disaster.  A cautious approach and managed expectations short term are imperative to avoiding portfolio damage.

Putting a Positive Spin on Things

If you are a baby boomer coming up on retirement or already retired there are a handful of growth and income generating strategies to follow for the assertive side of your portfolio.  One strategy we use extensively is selling put options.  This strategy allows us to take less risk than buying stocks outright and generate income to boot.  While this strategy is new for many people, it rarely takes longer than a few quarters for people to see results and understand their statements completely.

The basic premise here is that instead of buying a stock, we instead agree to buy somebody else's stock if the stock price drops to a pre-agreed upon price during a certain time frame.  In essence we are insuring somebody from losing beyond a certain price on a particular stock.  For that insurance, they pay us a premium.  In about 3 out of 4 cases, in sideways or up markets, the options expire without us having to buy the stock.  We simply keep the premium they paid us and move on to the next investment.  In some cases, we do have to buy the stock because it has dropped in price. In those cases, we have added stock in a company we like at a price lower than what it was when we decided we liked it.

The trick to this strategy is to do these put options only with companies that we would like to own if the price dropped a bit.  Every company we do this with is actually a company I would be willing to own at the current price, but am trying to buy with the premium discount coupon.

Here is one example:

If I like the long term prospects for natural gas producers and one of my favorite producers is Chesapeake Energy (CHK), then I might be willing to sell a put option on the stock of Chesapeake.  I could sell the Chesapeake Put Option for January 2011 with a strike price (the price I have to buy the Chesapeake stock) of $21 a share.  Currently the stock is about $22 a share.  In this case, I will receive $1 per share for this deal, which I get to keep no matter what.

If the price of Chesapeake drops to $21 or lower by the third Friday in January (when the option expires) I will have to buy it for $21.  Remember, I keep the $1 premium no matter what, just like an insurance company does when it collects premium.  My "downside" therefore is that I have to buy the stock at $21 a share, which is cheaper than the $22 price today.  My actual cost would actually be $20 a share when you remember the $1 in premium I have received.

If the stock stays above $21, I simply add the $1 to my balance sheet and likely make another similar trade in the future.

In a sideways to slightly positive moving market, this strategy has obvious appeal as it can systematically be used to lock in small gains repeatedly without taking all of the risk of the markets.  Only in a rallying markets would we fall slightly behind in performance.  Giving up some upside in return for small steady returns and more safety is a trade-off I am willing to make right now.  If we would see a sharp drop in the markets, I would put this strategy on hold and move to outright long positions with the cash we have on hand.

Here is a link to a Forbes article you might find useful in understanding what I consider to be a valuable strategy in a range bound market. which includes a short interview with a successful small investor who uses a put selling strategy.

The Gift of Real Estate

As we have discussed in our annual investor meetings real estate is not done declining in value.  However, given the support given to the economy and real estate in particular by the government, it has likely fallen near to its bottom at this point.  Real estate could drop another 10 to 30% from these levels, but that pales in comparison to the 50% or more drops some markets have seen from higher levels.  The chart below shows that we are approaching the post World War II trend level for home prices.  Although not impossible, I find it unlikely we will break below the 110-120% level versus the benchmark price level.

At some point later this decade, the economy will rebound with increasing strength.  When that happens, home and commercial property prices will both begin to rebound.  Over the next several years those who have the willingness and ability to buy property ought to look into buying.  I have gone so far as to tell younger people to only invest in their 401k plans up to the match point, not max out their contributions, so that they can accumulate cash for real estate down payments quicker.

People will have to realize that this time around, there will be three things necessary to buying real estate:

  1. At least a 10% downpayment.  20% will be common and is a good idea to avoid private mortgage insurance on home purchases.
  2. Good credit with at least a score in the 700s, the closer to 800 the better.
  3. Verifiable income, no more liar loans

One strategy that some families may want to use is that where one generation is retiring and another is in their earlier working years, it might be advisable to consider joint family ventures for buying real estate.  For the retiring generation, this can be a strategy to generate income with a significant margin of safety.  For the younger generation, this can be a strategy for getting an appreciating asset on the cheap.  Make sure to use appropriate legal documents to secure rights for all involved in the future and make sure the numbers work from day one.

For those who do not want to directly own real estate they must manage, Real Estate Investment Trusts (REITs) for their investment portfolios can make a lot of sense.  This is a strategy that younger investors can also utilize if they do not want to manage property directly.

Right now I am looking into selling puts on several REITs.

Happy Holidays

I'm a Merry Christmas guy, so I wish everybody the peace and happiness of the Christmas season.  To all my friends celebrating another holiday this December, I wish you all the happiness and joy of your season. Here is to hoping that people all over the world come together and celebrate our lives together in ever more tolerant and peaceful ways.

Until next time, your cautiously grinding along through a range bound market, looking to a brighter future and preparing for the next booms advisor.


Kirk Spano