Category Archives: Finance

Ritholtz Says Home Prices are Still Too High

“The data suggests home prices will continue to drift lower for a couple of years – maybe just go sideways for a decade.”

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The federal government is looking to rent foreclosed homes that are owned by Fannie Mae and Freddie Mac. This is completely absurd. The government, being poor allocators of capital and poor investors, thinks it would be better off renting homes rather than selling them. Are you kidding?

Investors are buying most of the foreclosed homes anyway, especially in the most distressed markets. Investors, being much more savvy financially then the federal government, will buy and rent them anyway. If the government engaged in the’ buy, rent, sell business’, my guess is that it would be so inefficient that it would create another money pit for taxpayers.

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Why the Government was Responsible for the Housing Problems

Efficient Market Hypotheses (EMH) – the notion in which asset prices always resemble an sense of balance was demonstrated to be inaccurate in real estate markets during the bubble period. Property costs traditionally had been a reflection of the region’s economic climate. When the economy was doing well, prices would certainly climb until additional residences were built. Afterward, prices would reach a plateau as supply would match the demand. Declining prices, people used to think, were very rare because whenever inventory went up too fast, then developing would simply stop and developers could possibly go out of business. One other popular delusion had been that if anyone paid out too much for a home, it could not get past the appraisal procedure; thereby resulting in not being able to qualify for a loan. The offer would basically fall through or even be renegotiated.

Long periods of rising price trends are emotionally self-reinforcing. “Real estate prices always goes up” became the prevailing bias and resulted in the real estate bubble arriving at an extreme. The more prevalent the bias, the more the speculative funds that the bias draws in.

Crowd psychology is often incredibly crucial with regards to what ultimately transpires in a real estate market. George Soros believes that markets are always biased in one direction or another and markets may effect the incidents they anticipate. This generally leads to a temporary illusion that investing arenas are generally accurate. The truth is, the market merely becomes more unstable.

Precisely what does this have to do with government regulations? A lot. Initially, governments will do practically anything to defend the present model during the boom portion of the economic cycle. Low lending standards are a typical symptom of an over-heating financial sector. Furthermore, financial institutions were allowable by law to be greatly leveraged. Leveraging can result in greater financial gain, but the reverse is definitely true on the downside. When leveraged at a ratio of 40 to 1, a relatively minimal drop in actual value is, actually, all it takes for a portfolio to become worthless.

At the peak of the bubble, politicians had been quick to publicize the prosperity of record levels of ownership. In reality, the situation was such that lots of individuals bought houses which they could not manage to pay for. The housing mania also brought about a great wealth deception, causing a negative personal savings rate. Folks felt financially safe due to the large amount of equity they were building in their properties. The fundamentals didn’t affect the bias, but the bias affected the fundamentals. A false sense of security was the main trigger that eroded the foundation in the real estate market.

The aftermath of the economic downturn in 2001 caused the Fed to bring about artificially low interest rates with the purpose of strengthening the economy. Lending money under the inflation rate results negative real interest rates. Assets that have relaxed financing requirements and low interest rates doesn’t make them less expensive. In reality, cheap financing results in prices to increase. Cheap money impacts selling prices. That is why it’s really a big misconception that low interest rates are always a good thing.

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Financial Calculations that Every Business Owner and Investor Should Know

It’s obvious that not everyone is cut out for math. However, if you go into business, there are some important metrics that you should learn and understand well. Simple items that you should know include: your cost of goods, profit margin, sales per square foot, payroll percentage, advertising percentage, inventory turnover, return on equity, and liquidity ratios. These are very basic and fundamental, especially for product-based businesses. All formulas in this post work best for an annualized period.

Every industry is different. Some industries have a high volume of sales with low profit margins while, in other industries, the opposite may be true. As a business owner, you should seek to compare your business and strive to be the best in your industry. Obviously, a mini-mart will have a lower profit margin than an upscale restaurant.

First, you must know how much your goods cost and make sure you are making a healthy profit margin. You costs of goods are calculated by:

Cost of Goods = Beginning Inventory + Purchases – Ending Inventory

Relying on intuition alone here doesn’t cut it. Many small product businesses do this. Intuition can be misleading because a lot of money can be spent on materials that remains tied up in inventory at the end of the period. This may lead you to think you’re overspending when you’re actually very profitable.

Next, business owners need to know their gross profit margins. The profit margin on your products accounts for all operating expenses including labor, rent, utilities, materials, etc. It is calculated as follows:

Profit Margin = 1 – (Cost of Goods / Sales of Goods)

Keep in mind that a small percentage can make a world of difference for many businesses.

Next, how well are you utilizing the space in which you rent? Sales per Square Foot is a good metric to analyzing this. Are there competitors that are able to carry as much product and make as many sales with less space? Here is the calculation:

Sales per Square Foot = Total Sales / Square Feet

How much of your total sales is paid for labor? How do you compare to other businesses in your industry?

Payroll Percentage = Total Payroll / Total Revenues

Advertising is an expense in which you can easily overspend in comparison with how much business the advertising generates. General advertising through traditional media is generally expensive and it’s usually impossible to pinpoint how much you are getting in return. Direct advertising, such as direct mail and pay per click online, is easier to quantify and understand its effectiveness. Similar to the payroll calculation, advertising cost is viewed as a percentage of your total sales:

Advertising percentage = Total Advertising Costs / Total Sales

How fast is your inventory turning into sales? Inventory turnover is a key metric in determining how fast your inventory cycle is. The faster you turn your inventory, the less time your cash is tied up. The calculation is as follows:

Inventory Turnover = (Beginning Inventory + Purchases – Ending Inventory) / (Ending Inventory * Number of Periods)

Many business calculate this based on 4 periods per year. That is, each period is one quarter. In general, the higher the inventory turnover, the better your cash flow is. You can usually improve inventory turnover through redesigning business processes and software.

Return on Equity tells you what your return is on the net worth of your company. This is a function of your profits and the difference between your assets and what you owe on them.

Return on Equity = Net Income / (Total Assets – Total Liabilities)

For return on equity, you should aim for a percentage that is at least in the high teens, higher if you’re in a fast growing industry. Be careful with this metric, however. A high number could be an indication that you are too far in debt. On the other hand, I feel that this is one of the most important metrics of a business.

Liquidity ratios are important in determining how well you are managing your short term cash. I tend to lean towards the conservitive side here. There are two ratios I want to introduce. The first is the Current Ratio. This is simply:

Current Ratio = Current Assets / Current Liabilities

I typically prefer to maintain a 2 to 1 ratio here. Some businesses, such as Wal-Mart, have consistent enough cash flows in which they can operate on a lower ratio. This is because the income they have coming in is very steady and is turned into cash quickly. There is nothing tied up in accounts receivable for long periods of time.

There are many business that build up inventory and accounts receivable too fast and the ratio between accounts receivable to sales increases. As a side note, before investing in a company (or buying a stock), always look at how fast inventories and accounts receivable is increasing in relation to sales. If inventory and accounts receivable are rising faster than sales, it should be a red flag.

The amount that you have in accounts receivable is important in two ways: 1) the actual balance and 2) how fast you typically collect on these. High balances with long collection periods may lead to disaster because the business still has yet to collect the money from the sale and it must buy new inventory and operate in the mean time. It can also be misleading because accrual accounting allows a business to book the sales as income prior to collecting the money. The important concept here is that a company’s management can decieve investors buy showing rapidly increasing sales when they are recklessly financing their customers.

The Acid-test Ratio is similar to the Current Ratio but it strips out inventory. This ratio should, for most businesses, be greater than 1 to 1.

Acid-Test Ratio = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities

When you use these ratios, you should compare them to other businesses within your industry. Some industries are more capital intensive than others and some have steadier cash flows than others. The more capital intensive and the more erratic your cash flows are, the more conservative you should be when financing your company.

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Hernando de Soto on the Lack of Knowledge in Finance

Hernando de Soto argues that in the past, things were much simpler. If you owned property, the information regarding your property was safeguarded locally and it was clear who the owner was and who made the loan  (if the property was fiananced).  Today, things are much more complicated. It is harder to track who owns what. Those who bought paper assets cannot figure out who the actual owner is. Shadow inventory consists of a total asset value of $600 to $700 trillion dollars which is 10 times the size of the world economy!

De Soto believes that the problems with today’s financial industry and banking have not been solved. He outlined the following sectors as trouble areas:

Mortgage Bundling

“Banks that have tried to foreclose on nonperforming mortgages have discovered that in many cases they can’t collect the debts. Why? Because some companies that pooled, packaged, and converted those mortgages into liquid securities had dispensed with the usual procedures to record mortgage owners and passed the property to a shell company called MERS, which pretended to own the mortgages.”

According to Christopher L. Peterson, professor of the University of Utah, “For the first time in the nation’s history, there is no longer an authoritative, public record of who owns land in each county.” Various courts have deemed foreclosures as being improper. Another problem that persists is with areas in which home prices are still declining.  This will increase the already massive pipline of foreclosures.

Default Swaps

Credit default swaps still exist and pose a threat to the financial system. They have been a key part in making securitization possible. Getting rid of these would have reduced leverage in the fiancial system and getting rid of these should have been a no-brainer.


Mark-to-market accounting has been suspended which banks can now overvalue the net worth of their assets. This, however, is a bit of a double edged sword. Mr. Market has often valued assets at prices that were far above or below fair value. This policy added too much volatility to banks’ financial statements and was a poor idea to implement in the first place. When assets prices are rising, the banks are happy because they can report results that are in their favor. The same is true on the downside in which if the market results in a panic sell-off (whether it is truly justified or not), the banks would be forced into taking writedowns.

The other method, which consists of the value being based on a model, also has its problems. When market conditions change, banks can hide the symptoms by not having to take the writedowns until much later or if the borrower defaults. This results in a lack of transparency for investors.

Off-Balance Sheet Accounting

This method “makes companies appear more profitable, despite their debts. By the time Enron closed its doors in 2002, it had created some 3,500 SPEs (special purpose entities).” Another accounting trick being used is to place information in footnotes that are carefully worded.

Rating Agencies

Do we need to explain here? Rating agencies are simply fire alarms that go off after the house burns down.

In the end, record keeping had been an advanced part of Western capitalism. The financial innovations over the last 20 years has put this system in jeopardy.


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Inflation and the End of QE2

QE2 will end June 30.  The economy is barely growing despite low interest rates, stimulus spending, and quantitative easing.  The side effect of the Fed’s policies has been the excess money going into commodities.  The price of silver has skyrocketed.  Other commodities have also rallied because of the speculation in which investors expect continued weakness in the dollar and future inflation.  The end of QE2 may result in a pull back in commodity prices.

Real estate is still slumping and will continue.  Automobiles cost about the same as they did some years ago, we’re paying about the very same for airline travel that we did 10 years ago, and computers are becoming more affordable.  (Keith Springer) For many items not tied directly to commodities, the list goes on.  Nonetheless, it does not really feel like that because food and energy are much higher. The Fed eliminates food and energy from the inflation index, but the problem is, we all eat and drive. 

There seems to be no problems associated with the supply of oil and the Saudis have claimed to reduce production.  This implies that much of the rising prices has been due to speculation.  According to Yahoo! Daily Ticker, only about 1% of oil futures trades involve actual delivery.  The rest is form speculators attempting to profit from price volatility.  Prices may continue to rise in the very short term, however, there will be downward pressure in the intermediate term.

There may eventually be a QE3.  However, it will likely come later because of rising inflation.  If we were to go into a new recession or renewed slump in the economy, QE3 may be the only tool the Fed has because interest rates are already at zero.  A worsening economy always results in a government feeling the need to do something.  With our budget problems and the limitations of the Fed, there are fewer options.

QE2 did not lower interest rates which was the Fed’s intent.  Instead, it pushed up asset prices in equities, commodities, and emerging markets.

Bill Gross, the world’s most prolific bond investor, believes that government spending is out of control.  He has sold his positions in treasuries and is now short treasuries.  That being said, the smart money betting against treasuries should be a warning.

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FROM vs. TO in Financial Freedom

The Financial Philosopher blog had an interesting post in reference to the two different types of freedom.

“Freedom from” is described as a “negative freedom and it is based in fear because it is sought as relief from uncertainty or from restrictions placed on the individual by society (other people) and/or institutions (e.g. government, financial creditors). The pursuit of freedom from can paradoxically reduce or remove one’s freedom.”

“Freedom to” is “the healthy form of freedom because it is the form where the individual obtains the capacity to be creative, to act as the authentic self. When one obtains the means to be authentic, they are enabled to reach the highest form of productivity because their actions are purposeful and meaningful; thus the actions are self-feeding and self-radiating; therefore, the individual is happy by virtue of doing — they are free because they are acting as the authentic self, not because of a certain or pre-defined amount of financial capacity.”

The author believes that you can’t accomplish “freedom to” until you have accomplished “freedom from.”  You can read the full post here:

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John Mauldin: We will get through the Next Financial Crisis One Way or Another

“We generally only accept change in the face of necessity and we only see necessity in the face of a crisis,” says Mauldin. “The odds are we’ll have to have a crisis” that might lead to a long-lasting recession.” ( We do have choices to fix our debt problems. However, the longer we wait, the fewer (and more painful) choices we will have. Structural problems with income taxes and Medicare will need to be dealt with. In the long run, trends that can’t continue won’t. The videos below show Mauldin’s view that taking action now will eliminate or reduce the severity of the next crisis.

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Stocks Rise Despite Negativity

Last week featured plenty of negative news but the financial markets still went higher.  Rising oil prices, problems in the Middle East, Japan, falling home prices, and sovereign debt problems couldn’t stop the financial markets from going up.  Walmart’s CEO has said that consumers should expect higher prices because of the surge in commodity prices.

The Federal Government faces a shutdown if no new budget is passed.  The entire debate is over a drop in the bucket; about $30 Billion when our budget deficit is over a trillion dollars.  David Walker referred to as “arguing about the bar tab on the Titanic.”

According to the Case-Shiller Home Price Index, home prices have returned to their 2003 levels.  Home prices fell 3.06 % (year over year) in January.  With high unemployment, high inventories, and the coming foreclosures, prices will remain depressed for some time and likely to drop even further.

In other finance news this week, real wages continue to fall and have not improved in over a decade.  Wages have generally been falling since the recession began in 2007 and remains the current trend.  This, combined with commodity inflation, is a big problem and will negatively impact consumer spending. 

Josh Brown of the Reformed Broker believes there will be no QE3 and that the economy should be able to pick up the slack when QE2 ends.  In an interview on CNBC, it was noted that banks are still not lending to the most important part of our economy – small business.  Brown sees commodities prices going lower which should help consumers.       

Stimulus vs. Austerity

The never-ending debate over stimulus vs. austerity wages on.  This week, Paul Krugman fired back at those who often refer to the depression in 1921 as validation that austerity and a “hands off” approach by the government is always best.  Although I generally disagree with Krugman’s magnitude of stimulus (he continues to claim that government stimulus and spending is too small), he brings up a great point that the depression in 1921 is far different from the Great Depression and the situation we are in right now.  The depression in 1921 did not take place because of a credit bubble and was rather ordinary.  Like a typical recession, this one was a function of the normal business cycle and had a v-shaped recovery.  A recession/depression brought on by a credit crisis is different because the deleveraging phase usually takes years to get through.  Instead of spending money, people will save and pay down debt instead.  This is why historians are wrong in assuming that governments doing nothing will lead to a fast and painless recovery similar to 1921.

In the current environment, consumers are paying down debt while the government is adding debt.  This trend cannot continue without serious consequences, but that is a discussion for a different day.  We will eventually have to get our fiscal house in order, preferably before the bond market forces it.

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Skyscrapers as Bubble Indicators

When we think of financial bubbles, we usually think of insane valuations and amateurs entering the market.  Here is a video of how the emergence of skyscrapers as being an indicator.

On Skyscrapers, Vikram Mansharamani states, “Skyscrapers are a spectacular indicator. They are the manifestation of easy money, overconfidence, and hubris inaction.” The taller the skyscraper, the greater the indicator. The most recent instance of this was Dubai in 2007.

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The Casino Economy

The 21st century has given us one bubble after another: stocks, real estate, and commodities.

Bubbles are driven by excessive speculation. In a recent article by John Hussman, he states, “we can think of a bubble as an advance in an asset’s price to levels that are “detached from fundamentals” – essentially, the primary motive for investing ceases to be the expectation of future cash flows or consumption, and instead centers on the expectation of further increases in price.”

When an asset has reached bubble status, the investment makes no sense because its high price cannot justify the return on investment from future cash flows.  For example, during the real estate bubble, investors had to “feed” their properties.  That is, they had to take money out of their own pockets to pay the expenses since their cash flows were negative.

Valuation is the Most Important Metric

Valuation when you enter an investment is the biggest determinant of your success. Buying an asset for less than its intrinsic value, as Warren Buffet describes it, is the basic formula for success.  In the S&P 500 (or any other index), long-term bull markets begin at low valuations (usually with an average P/E less than 12) and long-term bear markets start with high valuations (usually with an average P/E of over 20).

The last bull market in the US started in 1982 and ended in 2000. Over that period, people started assuming that the stock market was an easy and guaranteed way to make a return of 10-15% per year.  Currently, we are in a secular bear market that began in 2000. Valuations were at all-time highs and the trend was unsustainable.


Where do we stand now?

Currently, valuations are still high with the Case-Shiller adjusted P/E at over 24.  They were reasonable at the bottom of the market crash in 2009 but the rebound has risen to the point in which the next 5-10 year outlook looks to be below average.  The rally that started in April 2009, John Hussman, believes is basically a mild speculative bubble.  A lot of what may be driving the speculation is the anchoring of the stock price peaks we saw in 2000 and 2007. This anchoring gives the illusion that prices are not all that high.

The Case-Shiller adjusted P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. The chart below from shows the Case-Shiller index since 1880.  As you can see, the adjusted P/E was around 7 in 1982 and rose to nearly 45 in 2000.  In 2011, we still stand above the long-term trend.  The chart also illustrates how P/E ratios are mean reverting over long periods of time.


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