Thursday, November 29, 2012

Fiscal Cliff Doesn't Matter

So the markets now are driven by the fiscal cliff.  What will happen?  If they don't do something, the markets will plunge.  If they come to some sort of agreement, the Dow would be up 1,000 points. 

Nobody wants to be long on a failure to come up with a solution, and nobody wants to miss the boat on a 1,000 point Dow rally.   OK, 1,000 points is not much.  Maybe I should say 2,000 points.

In any case, this reminds me of a recent Howard Marks interview where he talked about the European situation.  He says there are three things he can say for certain about the situation:

  1. He doesn't know what will happen in Europe
  2. Nobody knows what is going to happen in Europe
  3. If you ask an expert what they think will happen and take their advice, it would be a mistake.

So to apply this to the current situation:
  1. I have no idea what will happen in Washington with the fiscal cliff
  2. Nobody knows what will happen in Washington with the fiscal cliff
  3. If you ask an expert what they think will happen and take their advice, you are making a mistake.
Of course, ths fiscal cliff matters in many ways.  But what I am talking about is within the context of investing for the long term.

If you believe that the U.S. and the world is drowning in debt and the Fed is out of silver bullets and the economy is peaking out and won't recover for years to come, then you shouldn't be invested in the stock market fiscal cliff or not.

If you believe that the U.S. and the world will eventually recover and be fine (maybe not as 'hot' as back in 2007, but some growth and stability), then you should be invested in businesses you like at reasonable prices fiscal cliff or not.

Here are some things you might want to think about:
  • Selling stocks now because you are worried about the fiscal cliff is a mistake.  This is not a rational decision; it is driven by emotion (fear).  And emotions should never drive investment decisions.
  • Buying stocks now because you think the fiscal cliff will be resolved is a mistake.  This is not investing; that's speculating.  Nobody knows what will happen with the fiscal cliff.  Betting on single event outcomes is speculating, not investing.  (One should invest in businesses or situations because they are priced right etc...)  Betting on single outcomes if the odds are reasonably calculable and the stock is priced or mispriced accordingly, that's different.
  • Shorting stocks or hedging against the fiscal cliff is also a mistake as it is not too different from selling your stocks out of fear (although hedging may be tax efficient as you don't have to realize capital gains like you do when you sell out longs).  This may seem 'prudent' and responsible, but it's still speculating.  Nobody ever knows when the markets go up or down.  Hedging or buying puts in anticipation of a sell-off, to me, seems more like speculating than rational investment behavior.  
...which leads me to the something that I thought about that is related to Buffett's frequent comments about not selling a good business you own just because of what is in the headlines.

Why People Make Money in Real Estate
OK, so this title seems odd given that we are trying to recover from the biggest real estate bubble/collapse in history.  Real estate has a history of big booms and busts, and there have been big real estate bankruptcies (Reichmann, Trump etc...) not to mention the disaster that is Japan and the most recent U.S. real estate bust.

But on the other hand, why is it that so often the biggest gain that many people have ever made in their lives have been in real estate?   (I know tons have been lost in real estate too)

Just thinking about family, relatives and friends (very small sample size, but...), it seems that the biggest winner has been their house or some other property, and not a stock.  I don't live in Omaha so I don't know anyone in person that has owned Berkshire Hathaway since the 1970s.

I have always noticed this and thought about it but never really expressed it out loud. 

There are a lot of reasons for this, of course.  Your primary residence is a big asset; if there is inflation, of course it's going to be your biggest winner.  Tax-incentivized leverage also helps.  Nobody is going to take out a 20% down loan and spend a good portion of their disposable income paying interest/principle on a stock investment.

But for me, what I often thought about was the illiquidity of the house.  This is why individuals were able to do so well in real estate over time while they get clobbered in stocks. 

Check this out. Compared to stocks, in real estate:
  • You can't get a quote on your house every day.  You can't look up the price of your house on Yahoo Finance.  OK, you can Zillow it, but it's not the same as seeing a firm bid and offer that is hittable instantly.
  • The evening news doesn't start by telling you that your house price was marked down by 2% that day due to some event that happened in Europe, or because of what some politician in Washington said.
  • You can't push some buttons on your iPhone and liquidate your house in less than five seconds.
  • Pundits are not on TV, the internet or in magazines telling you every minute of the day to sell your house and buy the one across the street because it will go up more, or tell you to sell your house because it will go down because of some fiscal cliff, canyon, valley or whatever...
  • People don't talk about how much their house went up at cocktail parties (well, this did happen during the housing bubble) and tell you to buy a house next to theirs (unless you are so wealthy that you buy and sell homes like people buy and sell stocks).
  • Financial Advisors don't tell you to sell some of your house and put more in bonds as the economic outlook isn't as good as it was a few months ago.
  • People don't pound the table and tell you to sell your house because it has been raining in your neighborhood for the last five out of seven days.
  • People don't tell you to sell your house because it is worth 10% less than it was last week and it may go down more.  Or because your house value, as of yesterday, is now below the 200-day moving average.
  • You don't have some crazy guy on CNBC every day waving his arms around spitting into the camera telling you to sell your house and buy the one across the street one day and then doing the exact opposite the very next day.  But I already said this in bullet point three, but I thought it's important enough to say it again.
  • Most people can only afford to own one or two houses at a time, so each purchase is done very, very carefully (like the Buffett 20-hole punchcard*; only most people have a 2-hole punchcard).  They spend days, weeks, months and even years looking and researching their house before they buy as it is a huge commitment (unlike people buying 100 shares "for fun" just in case someone's 'tip' proves correct.  Many people can afford to do this very often; so often as to build up a really crappy portfolio of stocks they know nothing about).
Anyway, we can go on and on with this list.  Surely, there are some negatives too.

But my point is that many people have done really well in real estate over a long period of time, but it's not so common to hear the same about stocks.  And that's because of the curse of liquidity.  I think liquidity is actually a good thing, of course.  But it can have it's drawbacks.  When it's right there at your fingertips, it's hard not to want to do something. And everyone around you including the professionals are constantly telling you to do something!

I was stunned when a "professional" investor on CNBC was telling people with a straight face that you can't ignore this stuff (fiscal cliff); this stuff is very important and it will move markets.   Well, if you are a professional fund manager being evaluated on a daily, weekly and monthly basis, I guess he is right; you can't ignore this stuff.  But if he thinks people can trade in and out based on what is going on in Washington, I think he's nuts.

Anyway, with the fiscal cliff approaching, everybody talks about what to do with the stock portfolios, but nobody ever talks about what to do with their houses (OK, I admit some people must be thinking about it and I'm sure personal finance magazines, websites and blogs probably do consider that too as they would make good 'filler' content).

But no real rational person is going to buy or sell their house on this issue.  And that's what Buffett keeps saying about stocks.  You have to look at it like a business (or a house).

What businesses are thinking about selling out because of fears of the fiscal cliff?  If you own and run a profitable restaurant at a great location, why would you sell just because of this near term issue?   If you love your house, why would you sell just because of this?

So What's Going to Happen?
Well, I said I have no idea and nobody really knows.  Anyone who claims to know has something to sell you.

Having said that, this is a blog and we are allowed to say anything we want.  So if I had to guess, my guess is that they go to the very end of the line, the market plunges, people freak out and they come to some sort of kick-the-can-down-the-road agreement.

You know at the end of the day they will come to some agreement.  The only question is when it will happen and how far the market has to go down to convince Washington that something has to happen.

It's just like what happened with TARP.  First, they said "no", the market plunged 700+ points (or whatever it was) and they all suddenly rushed in, "where do I sign?!".

This doesn't mean that's the way it's going to go this time around.  It's just my guess.

To do anything based on that scenario (buy puts, sell out with the intent of getting back in cheaper later etc...) is pure speculation so don't do it. 

Ignore all this noise.

*Buffett's 20-hole Punchcard
Value investors know what this is, but I realize this blog is read by a wide range of people.  For those who don't know what the 20-hole punchcard idea is, it's Buffett's way of telling students to choose investments carefully.  In a lifetime, people will find only very few really good ideas. And having just a few very good ideas is going to be enough to get very rich.

So instead of just buying stocks left and right promiscuously (as many novices tend to do), do solid research, look hard and look for only the best ideas.  When that is found, then invest big in the idea and try to go on to the next one.   And invest as if you only have 20 times you are allowed to invest.  Once you invest in one thing, one hole in the punchcard will be punched out. 

This will make you think very carefully about what you buy as you can't afford to make too many mistakes.

This also reminds me of Peter Lynch's comment that he is baffled that people spend more time researching and shopping for a refridgerator or car than they do a stock even when their stock investment is much larger than their fridge or car.

Going back to my house argument, if people did as much work on stocks they buy as they did shopping for a house, more people would do better.

Even if they did, though, since this is not Lake Wobegan, we can't all become better than average investors.


  1. The ability to access very low cost covenant-free debt (i.e. mortgages) with no ability for lender to call it in other than for non-payment provides a hugh edge for real estate over the long-term. Growth in the housing market is structurally built-in to US housing policy.

    1. Yes, that's right. It's a huge part of why people just sit on their house for decades, unlike stocks.

      I did think about the debt factor too. I used to joke with a real estate investor and tell him that he is allowed to get levered up and make tons of money in a bull market because his portfolio is not marked to market. As long as he is current in his payments, he is going to be fine.

      Not so with my margin account or with a hedge fund's prime brokerage account. Stocks are marked to market and you will get margin called when stock prices go down.

      I never heard of a margin call on a mortgage.

      But anyway, I bet that if there was a large, liquid, futures market where people could hedge their house price cheaply, there would be way less people sitting on big gains on their house even with the mortgage advantage.

      If you let them, most people will screw things up. That's human nature.

    2. Newbie here, but enjoyed this post a lot, especially your point about the curse of liquidity encouraging speculation and discouraging delayed gratification.

      Do\did home equity lines of credit and refinancings function as a hedge on house prices? I guess it depends on what one means by the word 'hedge,' but we have a couple neighbors in our condominium complex who were constantly re-financing and staying leveraged to the hilt in the expectation that prices would continue to rise in perpetuity. In a way, these neighbors were hedging against a decline in home prices by pulling equity out ahead of declines in the market. That they eventually felt they had to walk away from their units via 'strategic defaults' may only suggest that they were walking away from non-recourse loans once the collateral backing those loans had declined to $0 equity.

    3. Hi,

      I suppose refinancing and then walking away at the end was just a messy way to liquidate the house.

  2. Lovely insight! I find it easier to allow my emotions a bit of control than to try and shut them off completely, so, yes, I'm not buying or selling anything because of the financial cliff/slope/dirt rode/wave surfing/whatchewmatcallit but I do sit on some cash, just in case, rubbing my hands in greed :) It's fun...

  3. Excellent post!I have been telling my friends this very same thing for years now. Liquidity is very often a curse. The few other points I would add are:
    • In real estate/homeownership, they have control over the asset and can work hard to improve upon it,( Fix it up, grow rents, add a unit, convert it to condos, etc). That is not so in passive ownership of stocks and bonds.
    • In most cases the homeowner or small real estate investor has a fairly deep understanding of what it is they own and why they own it and will know when things change. For instance, things may be going bad or improving with the neighborhood, city, or a how the addition or subtraction of a large employer that could affect prices, etc. This is generally not the case in publicly held securities. At best, they probably have a grasp on the basic facts and surface information on the financials (Low P/E, not much debt, etc.)
    • Learning all about a new industry and the practice evolutions that may give a business a durable competitive advantage is hard work and most people are not cut out for it. I would go so far as to say that most money managers don’t bother with this level of detail either. However, if you really did approach each investment as though you were working with all the money you were ever going to have in the world and if you get it wrong you will be returning to the start over line…. well you would be much better off. It takes significant discipline to ignore all of the news in the WSJ, FT, CNBC, etc and believe you have it right and the world is crazy to be worried about these things. As Buffett says, the investor is very often doing battle with himself.
    • It’s much more practical for most people to invest in what they know and see every day because it’s much easier to gather the knowledge necessary to make a reasonably good decision by just prudently going about their day to day lives and observing/experiencing life with an eye toward opportunistic investing when they see something come up for sale that they think they should own.

    1. Thanks for the comment.

      It's so simple and yet so hard to get people to understand.

      As Buffett, Klarman and others always say, the industry is geared to make you do something. Telling people to sell, lighten up or buy puts because of the fiscal cliff is great for business. Wall Street would be a tiny lane if everyone was a long term investor...

      Continuing with this discussion, I also used to point to the Forbes 400 or some such wealthy list. I asked them to skim through the list and see if there is anyone in there who made their wealth getting in and out of the markets according to the headlines.

      Of course, there are a few billionaire hedge fund managers in there that clouds the thesis (but I would argue even then that these guys are doing something quite different than getting out of markets when afraid and getting in when greedy).

      Most of the wealthy have gotten that way by finding or creating an asset and then holding it over many decades. Of course many of these are founders (like Buffett, Gates, Ellison) and most can't simulate that sort of thing because most of us can't control businesses like that unless we found them.

      But still, the big wealth is created and increased by holding great assets over a long, long time and not doing stupid things. Also, the holdings tend to be concentrated. Of course since there are things like Lehman, FNM, BSC etc... it may not be wise to be 100% in any given asset. But concentration also seems to be common in the Forbes 400.

  4. Great post! The blog is one of the best investing blogs I've come across. Thank you for you work. I agree with all of your points related to the role liquidity and leverage play in the role of real estate investing. Specifically for homeowners, I wonder how well most have done if you correct for for inflation? Shiller has pointed out how much of a role money illusion plays in the psychology of the homeowner. I'm not sure the average homeowner considers this when evaluating the outcome of their investment in their home.

    1. Hi,

      Yes, inflation is the main driver of gains in house prices but it's also a big factor in stock price returns too.

      You can correct for inflation and say people didn't do as well as it looks like, but then if they held cash or some other asset, they may not have kept up with inflation.

      Anyway, the point of the post is that people can sit on a house for many, many years without worrying about the value on a daily basis and that let's people ride their houses (not always) up.

      We can argue all sorts of things; I always marvel at how little many people paid for houses back in the 1970s, but the real return can be tricky not just because of inflation but because of real estate taxes and other maintenance expense.

      But still, a lot of people are sitting on pretty substantial assets thanks to their sitting on the house.

      One thing I forgot to mention above which really helps drive the emotion in investing is that monthly envelope that comes into the mailbox to remind you what your financial assets are worth, how you did for the month and year-to-date. This so-called "sticker shock" may contribute to irrational behavior too.

    2. I suspect the author may have read this, however there is a good article on why there might be stocks that don't benefit from inflation like we would expect:

      It basically boils down to amount of capital that is employed, like debt, because their coupon is renegotiated, and it's possible that as interest rates rise, they will capture any real benefit.

  5. Enjoyed the blog a lot, but I'm still gonna hedge my bets irrespective of the cliff as anyone should. I understand that dividend tax rates are a big concern and one reason utilities are down so much. That being said, it is still a solid buy long term in my book, cliff or no cliff

    1. Should tax rates impact the intrinsic value though?

      If investors are focused on their return on capital measures when creating/liquidating a company, then the costs of a tax increase will be passed onto the consumer. If I own a business, like an insurance company, and I find myself earning too low of a return on capital, then I'm going to sell the assets and put it into a business with higher returns. Because of this kind of a movement, if tax rates suddenly go up, my expenses of doing business have gone up, and in order to have the same return on capital, I'm going to increase my prices.

      Think about WalMart. Let's ignore taxes. If their cost of purchasing a toothbrush goes up 5% in 1 year, then they will be passing that increase onto the consumer. Their profit ultimately stays at about the same level.

      To some extent, a firm's profitability level will be relative to others. Some people have spoken about the increased cost of reinsurance markets going up 10-15% this year and while that is a big move, the insurers who utilize reinsurance are going to be just fine - their increased cost will be passed onto the consumer.

      Because capital can move around, and demands are placed by investors on what they purchase, I think the long term returns on capital will be independent of the tax rate, so long as the tax rate changes apply uniformly. Now, if you make a special tax for only 1 company, then that could be an issue, however barring that, the intrinsic value of the companies should stay the same.

  6. Something I wanted to add to your benefits of real estate is that demand is easy to predict. It's easy to say that in 50 years, people will still live in homes and need shelter. One of the biggest issues I find on a daily basis is the expiration date that looms for some companies. As an investor, you don't want to be stuck in a place where entire business models are destroyed and your company's preciously developed assets are no longer usable. (Some assets can converted as Marty Whitman would describe, however some may not be usable)

    Homes are generally better at this than tech-focused companies, because that outlook is easier to see. They don't have to be entirely reinvented, and I think that's why Buffett says that change is bad for the investor.

    1. That's a good point about real estate. What you say is exactly what Buffett looks for in a stock; easy to predict future.

      This is why he stays away from fast changing industries (like tech).

      You don't need to predict the next quarter's earnings to the penny; it's more important to see that they will still be in business and as dominant 10 years from now etc...

    2. Real estate demand is NOT easy to predict. In most places, real estate prices are driven by increasing salaries and jobs (not just increasing population if salaries and jobs are not growing).

      Jobs in turn are a product of industries. For example, real estate boom and bust in Detroit was due to the auto industry. Who could have foreseen 30 years ago (typical length of a mortgage) that two of the big three would become so uncompetitive globally, as to end up in bankruptcy? Although change occurs slowly in real estate, it can be just as devastating when it accounts for a majority of an individual's net worth.

  7. One thing about houses, that you somewhat alluded to regarding leverage, is that their returns are actually a lot less when you subtract out interest paid on the house.

    Just something to keep in mind.

    Oh, and the fact that the gains are unrealized. Realizing gains and reinvesting (like most stocks, even with a 305 year holding period) will diminish your returns due to taxes.

  8. KK, great job again. I've been coming to your blog for a while now and I greatly appreciate your insight and thoughts. I may be biased because I've owned a lot of what you talk about but it's great to hear some thoughts and receive some confirmation from another thoughtful source.

  9. KK, any thoughts on MBIA as it related to BAC? I know you've written on that in the past regarding valuing BAC and I was wondering your thoughts on MBIA. Seems to be another confusing and potentially appealing situation. Thanks.

    1. Hi, I haven't looked at MBIA recently but it certainly is an interesting situation.

  10. Can you provide a list of your top holding? Great website. We have similar thoughts on investing.

    1. Thanks. I do own a lot of the things I talk about here, but I'd rather not make a list of it.

  11. Speaking as a Brit, the situation in Europe is much more frightening to me then the fiscal cliff!

  12. The blogger has a bug where some comments don't get posted on the blog but I do get the email message. Someone posted that real estate is NOT easy to predict; just look at Detroit.

    In answer to that, I would say that my point is simply that in real estate it's harder to do irrational things. I'm sure there are people who bought homes and held it for thirty years but still lost money, or people who buy and sell houses a lot and lost money over time.

    But generally, people tend not to buy and sell houses that often and that does seem to contribute to their doing well.

    Buffett always points out that the Dow went from 40 to over 14,000 in the past century but very few people have done as well. That's because they buy at the wrong time and sell at the wrong time.

    My best example is someone I actually know. I was stunned when someone told me that they have never, ever made money in the stock market and that's why they won't invest in stocks. Well, that's a good thing; if they keep losing money, they should stop doing it.

    What shocked me, though, was that this person has been involved in the stock market since at least the early 1990s, and this conversation happened in 2007/2008.

    So you had the stock market go from 3000 to 14000, and there was someone that "never made money in the stock market".

    Nobody will ever find a better example than this one how right Buffett is.

  13. Good day! Does the rate of your posting depend on some thing or you write articles when you have an inspiration or you create when you have time? Can't wait to hear from you.

    1. Hi, I don't have any set targets, but I do try to post once or twice a week. But I will only post when I think I have something to say and some work behind it. There is a lot of stuff on the net which is just opinion/rants of the moment, and I try to prevent that. I can post every day if I do that. But we don't need more of that stuff.

      If I haven't posted anything in a while and feel like I should, I won't just post something for the sake of it.

      Thanks for reading.

  14. Somewhat late to the party here, but I just came across a link to this post. You've got some great points about real estate. I also think it's a less efficient market because of the inherent illiquidity and the fact that many units are owner-occupied rather than bought by investors (who are often local), meaning transactions are infrequent and emotional and the market can take years to adjust rather than minutes.

    But the biggest reason people make more money in real estate instead of stocks, is that it's easy for peer/family pressure to push people into buying a home in their 20s and staying out of financial markets until their 50s. The stories we pass around, societal norms, and the simple fact that you can tell if someone lives in a house or not all push people towards homeownership and instill a fear or prudent investing. At least that's the case today, I didn't live through the 70s so it might have been different then.

    Although buying a house is better than shopping or gambling, inflation often masks the pitifully small returns from owning a home over a long period of time. And that doesn't account for the maintenance costs that make those returns negative. I like to say that I can make $1m any time I want; I just need to buy something for $2m and resell it at half that price the next day. Long-term homeownership as an investment seems to follow that pattern.

    If someone bought stocks on a large scale in their 20s (avoiding dumb mistakes like selling during a crash) and rented for 30 years, they would tell you that securities they have never touched are far more profitable than physical assets. Of course if everyone did this it wouldn't be as profitable. Let's keep the secret :)

  15. Hi kk,
    I loved reading this piece! Well written! :)

    RMP Property


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