It’s Time To Start Playing Offense . . .

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Vol. 23  No.8

April    2000

 

IT’S TIME TO START PLAYING OFFENSE . . .

 

In football, the defense keeps the other guy from scoring, but the offense  scores the points that win the game.  In prior issues, I’ve been concentrating our efforts on minimizing the effects of Y2K on our personal, professional, and financial lives.  Now, it’s time to see if we can’t put some points on our financial score board so we can wind up winners by the time the millennium bug has run its course.

 

Because the future holds infinite financial, social, and economic possibilities that cover the spectrum from the best to the worst, I can’t lay out a specific course of action for you, but I can attempt to point out strategies for both.  Of course, actual conditions will vary from region to region, and from period to period, so where you live, and where your local economy is in the business cycle will change the way in which you deal with year-2000.

 

I’m going to start with the assumption that the millennium bug’s effects would have fallen somewhere between a non-event and a world-wide calamity.  If, by some miracle, its effects have proven to be minimal, then the markets would still be held hostage by the business cycle in this election year.  On the other hand, even if the most dire Y2K predictions had been proven correct, three months into 2000, by April, a massive effort would have been mounted by government and businesses to mitigate and overcome them.

 

In short, the best and worst post-Y2K scenarios that might have been widely divergent Y2K in January would have started to converge as we learned how to accommodate the changes that might have been forced upon us.  We might not return to normalcy right away, but we can begin the process of transitioning our investments from a purely defensive posture to more aggressive positions.

 

By and large, investors don’t like uncertainty.  When in doubt, they tend to retreat to the high ground and do nothing.  They are followers, not leaders.  They wait for someone else to make the first move, avoiding taking action until they see how it all comes out.  In the stock market, they subscribe to investment advisories and chart price and volume movements in order to try to make the market more predictable.  In late 1990 many retreated to bonds, cash, T-Bills, GNMA certificates, natural resource stocks and precious metals, willingly accepting lower yields in an attempt to preserve capital rather than to increase profits.

 

About a year ago, speculators abandoned Real Estate Investment Trusts, which had enjoyed a spectacular run up in prices despite the fact that their yields compare favorably with bond yields.  In the absence of significant inflation, and in anticipation of a slow down in the market caused by Y2K, real estate investors also reduced leverage and consolidated holdings, paid down debt, sold off marginal properties, and concentrated upon cash flow rather than growth.  What they were doing was to bet against their local economy in the face of the uncertainty created by Y2K.  Their caution and concern with capital preservation versus capital growth is why investors usually are the first to leave volatile markets and the last to return.  And that’s what creates profits for speculators.

 

Speculators like volatility.  When markets move up and down, they can dart in and take positions that harness rapid market movements.  They buy “growth” stocks and real estate that they think will increase in value; usually with total disregard to earnings and cash flow.  They like to buy highly leveraged acreage in the “path of progress”, gambling on future growth.  Half of the fun for speculators is derived from the risks they run in order to reap higher profits.  Like most gamblers, they are optimistic to the extreme.  When they lose, they lose big, and when they win, they win big.  Until Y2K jitters began to impact markets, in the 1990s speculators have been right buying growth stocks and buying real estate for appreciation.

WHERE WILL MARKETS GO FROM HERE?

 

Ultimately, markets reflect a number of factors.  Most critical are the numbers of buyers compared to the numbers of sellers trying to buy the same thing.  For the past 10 years or so, the stock market experienced wave after wave of eager buyers willing to bet that stock prices would rise.  They were aided and abetted when Congress permitted corporations to hand over their pension plan liabilities to employees who formed K-401 plans.  Trillions of dollars of retirement funds were thus funneled into stocks via mutual funds and direct investment.  The numbers of mutual funds swiftly exceeded the numbers of stocks they could buy.  Demand caused stock prices to soar as Mutual Funds competed for relatively fewer and fewer shares.

 

Fund managers were given credit for sagacity when all that was really happening was that billions of dollars continued to pour into the market each month from an ever widening group of people who failed to perceive that what was happening was simply demand chasing supply.  As this money was cycled back into the banking system, interest rates and loan approval underwriting standards began to fall.

 

Easy mortgage credit enabled millions of people to buy and to sell houses, creating booming real estate markets virtually everywhere.  People sold real estate and bought stocks.  Other people refinanced their homes or borrowed via equity loans to get money to play the market.  As each person added his savings, prices rose to seemingly vindicate this strategy.  Markets demonstrated the classic symptoms of the tulip mania in which credit drove prices and prices drove credit without regard to the economic merits or the source of wherewithal to repay loans.  People felt rich, and many of them adapted their lifestyles to the wealth in their growing portfolios.  But they overlooked a fundamental fact:  Growing equities and growing incomes are two different things.

 

In order to convert growth stocks to income, they’d be forced to recognize high taxable gains.  Many of them chose instead to pledge or margin their portfolios and use credit to support purchases of luxury homes, automobiles, cruises, assorted toys, and vacation homes.  This credit binge left almost half the adult population of America dependent upon rising stock and real estate prices to cover the costs of interest.  Some of them didn’t make it.  As Y2K approached, despite the strength of the economy, lenders experienced the highest rate of credit card defaults and bankruptcies in history.

 

Consumers weren’t the only ones who were mesmerized by growth and price appreciation.  Lenders were too.  Home-equity loans reached as high as 125% of fair market value for existing home owners.  Otherwise marginal first-time buyers were able to borrow 100% of the purchase price of homes that were appraised at prices that jumped by as much as 2% per month in some markets, driven upward by buyer demand.  An epidemic of corporate  mergers and Initial Public Offerings (IPOs) were financed by banking consortiums that competed with easy terms and low rates.

 

The financial stage has thus been set for a massive transfer of wealth from speculators to investors; from growth stocks to value stocks; and from both borrowers and lenders to cash buyers.  It’s no longer a question of whether it will happen, but when.  In most cases, opportunities will be fleeting.  A lot of money is sitting on the sidelines waiting a chance to snap up bargains.  Not everyone will share equally. Just as happened in the Oklahoma land-rush, where “Sooners” staked out claims ahead of the mob, the first wave of profits will be captured by those willing to take the greatest risks by entering the market ahead of the pack.

 

Now is the time for you wheeler-dealers to take to the streets, or to the stock market, to try to capture assets that can be harvested in the next few years.  There will be a cornucopia of opportunity, but you’ll have to decide which you are best suited to take advantage of.  Play to your strengths, whether in stocks or real estate.  Managers should look for turn-around situations.  Speculators should focus on buy-low, sell-high propositions.  Investors should consider financing bargains with shared-appreciation loans.  The fire-sale of the century is about to begin.

OPTIONS: MAXIMUM LEVERAGE WITH MINIMUM RISK

 

When you are convinced that prices will rise, leverage is the key to the greatest profits.  Fortunately, both land and houses make excellent vehicles to propel equity upward and both are customarily bought with high leverage.  The basics of leverage are quite simple.  When the price of a $100,000 property bought with $10,000 down goes up 10% or $10,000, the speculator’s gain is 100%.  The gain on that same parcel bought with $100,000 cash would only be 10%.  Of course, the opposite is also true.  A 10% decrease in price would reduce the investment by 100%.  The key, then, is to use the highest leverage with the least risk.  Read on . . .

 

There’s an old saying that a rising tide floats all boats.  That has certainly been true of the past few years.  On the other hand, a falling tide sinks all boats too.  One of the most accepted scenarios concerning the aftermath of Y2K is sharp, short, world-wide recession followed by a world-wide boom that will dwarf that of the 1990s.  If this comes to pass, there will be money to be made as prices fall, and as they rise.

 

Think of price movements as forming a series of choppy “V”s.  Assuming that nobody is good enough to buy at the very bottom or to sell at the very top, a reasonable price objective would be to be able to buy within 15% of the bottom and to sell within 15% of the top of a price move.  You can make a lot of money.  As you look at the series as looking sort of like “VVV”, the most profitable side would be the portion on the right side of each individual “V”.  If you buy near the bottom, prices will already be on the rise.  If you sell on the left side, prices will continue to drop until they reach the bottom and must rise past the point at which you bought before you’ll make any profit.  If you sell near the top of the right side, prices will reverse and start dropping sooner, giving you an opportunity to buy back in in a shorter period of time.

 

The trick is to figure out where you are on the “V” price curve.  It changes between real estate, stocks, commodities, and bonds.  It varies with where you are in the business cycle, or credit market.  Real estate has a different cycle that varies with each type of property.  Houses, offices, retail space, warehouses, industrial space, resort and recreational properties all have different cycles that vary from region to region.  In stable economic times, a number of analysts can tell you about your own markets.  Legg Mason Wood Walker, Inc. puts out a quarterly report on real estate cycles in major markets across the USA that will help you pin point your position on the real estate cycle in your area as it pertains to the kind of property you’re looking at.

 

The most reliable indicator of where housing is can be gleaned from the local Multiple Listing Computers.  They usually reflect specific volumes of listings, sales pending, fall-throughs, and closed sales of 2,3,and 4 bedroom houses within MLS areas within any particular town each month.  Falling sales volumes and rising listings are a sure sign that the market has slowed.  Because housing sales are a leading economic indicator, where housing goes, so goes the economy.  Another reliable economic indicator is the expansion and contraction of the money supply.  The Federal Reserve Bank in Dallas, Texas has a free monthly publication called US Financial Data that you can request.  As the money supply expands, this is inflationary and will cause house prices to rise over time.  The problem with inflation is that interest rates rise along with house prices.  At the same time, stocks and bonds nose dive.  There’s a way to play both phenomena.

 

Even those with limited means can Option houses.  After all is said and done, whether buying or selling, an Option is nothing much more than a legal right to complete a transaction at a later date.  “Call Options” give the holder the right to buy at a preset price, while “Put Options” give him the right to sell at a set price.  With real estate, a “call” Option to buy is much more common than a “put” Option to sell, but both are used routinely in the securities market.  I could buy a “call” Option in anticipation that prices would go up after a time.  Put and Call Options would have enabled me to make money on both sides of the “V” price movement.

REAL ESTATE OPTIONS CAN TAKE A VARIETY OF FORMS

 

In its simplest form, a contingent contract acts like an Option to buy.  The buyer need not complete the transaction unless certain contingencies have been met.  These contingencies can include:

 

1 .  Being able to obtain desired or feasible financing

2 .  Being able to enter into a contract to re-sell the property prior to closing

3 .  Being able acquire additional properties or parcels

4 .  Being able to lease the property to a third party

5 .  Being able to obtain necessary re-zoning and building permits

6 .  Loans, contingent contracts, on remainders, on leases, on interest rates

7 .  Being able to establish value by means of a qualified appraiser

8 .  Being able to sell another property to raise necessary purchase funds

9 .  Being able to gain access, occupancy, and/or possession from a tenant

10.  Being able to get an easement, or to have an easement vacated

 

An Option can serve as an inducement to lend an owner money, as well as additional collateral for such a loan.  If a distressed owner needs extra money to overcome some financial difficulty caused by the economic downturn, selling an Option might make better sense than trying to borrow his way out of a financial hole.  The same thing holds true for someone with a highly appreciated asset who wants to defer paying high capital gains taxes on a sale.

 

Options can serve to delay a sale.  If a home owner with less than the required 2 years occupancy and ownership of a highly appreciated principal residence that would make any gain on sale tax free might choose to delay the sale.  In that case, he could raise tax-free cash by selling an Option rather than the property itself.  He could close the Option once he’d met the requirements of Section 121 of the Internal Revenue Code.

 

In a rising market, it’s better to negotiate for time and give the seller price concessions.  For instance, if I’m not certain where I am on the “V” curve, it’s safer for me to try to extend my Option out a year or so.  On a $200,000 house, I might agree to pay an additional $5,000 as Option consideration in return for a three year Option.  A few years ago California houses were losing value at about 7% per year.  It would have been easy to obtain such an Option.  In the resurgent housing market in which housing prices began rising at more than 10% per year, such an Option would have produced a 400% gain each year for several years.

 

In a falling market, Optioning a property is a lot safer than buying it.  If values continue to fall, all you’ve got at stake is the amount you paid for your Option.  In such a case, if you don’t know where you are on the “V” curve, you can structure some sort of indexing into your price.  For example, you could peg your Option strike price to a set amount in excess of the mortgage balance, but index that amount to the consumer price index.  As prices fell, so would your price.  When they turned around, you’d exercise the Option before the CPI reflected any increase.

 

Various employer retirement plans are fully invested in stocks, bonds, or mutual funds that don’t give the beneficiary much flexibility for strategic planning.  You can use Options to turn this to your own advantage.  Let’s say you were approaching age 59.5 and your pension plan contained a portfolio of stocks you fear might go down before you could liquidate your plan.  You could personally buy “Puts” on the same portfolio.  If portfolio prices went down, your personal fortune would increase.  If this happened, at the bottom of the “V” curve you could take a lump sum distribution from your retirement plan at greatly reduced values and pay a lot less taxes.  At that point, you could use the funds to buy “call” Options on either stocks or real estate, and ride the price escalator as it starts going back up as we recovered from the millennium bug.

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