Preview

In this first issue, I discuss the creation of the newsletter and its primary goals moving forward. I then provide a brief preview of upcoming issues, some comments and thoughts on the 2008 credit crunch, and a broad overview of my investment strategy for the next 3-7 years. Most of the issues following this one will be dedicated to defending the positions listed below and discussing current events as the market unfolds.

Here is a brief summary of my investment outlook for the next several years:

Most Unfavorable
• U.S. Residential Real Estate
• U.S. Stocks: Financial, Lending, Credit, Construction, Retail, and Real Estate
Unfavorable
• U.S. Stock Market Indexes
• U.S. Commercial Real Estate
Neutral
• Technology Stocks
Favorable
• International Stocks
• U.S. Stocks: Consumer Staples
• Oil and Commodities Stocks
Most Favorable
• Gold and Gold Stocks

The Creation of Market Comments

The idea for this newsletter began in the summer of 2006, when I moved to New York City for an internship with JPMorgan. At the time, I knew almost nothing about stocks and investing. My only guiding principle was to "diversify and hold for the long-term". I was working on a credit derivatives trading desk, but I wanted to learn not only about Wall Street finance but also about personal investing strategy. To my surprise, many of my co-workers had little, if any, interest in investing. Most of them knew a lot about making money but knew very little about investing money. So I began reading as many financial columnists as I could throughout my workweek.

By chance, one of my JPMorgan assignments was to read and learn about commercial and residential real estate default rates (because, hey, we were selling CDOs). Outside of work, I was interested in investment property in New York or New Jersey so that I wouldn't be 'throwing away' money on rent each month. Through my readings and research I realized that we were at the top of a long-term residential real estate cycle. I made a spreadsheet to compare buying and renting and confirmed my suspicions that prices were too high to be buying an apartment.

This realization kicked off an intense desire to read as much financial news and analysis as I could. If I was not going to put my money into real estate, what was I to do with it? I soon concluded that U.S. stocks were not a good investment right now. Oil, commodities, and international stocks had all done very well in recent years, though I didn't know much about these markets. After reading for many months and creating a historical spreadsheet of stock prices, earnings, and commodities prices, I sold all of my U.S. stock investments and bought gold bullion. I have since diversified somewhat, but the important moment was when I discovered an understanding of the financial markets that now makes sense to me. I finally "get it" when I read financial columns, and I have well-formulated investment opinions.

I no longer believe that buying and holding broad U.S. stock market indexes is an acceptable strategy for individuals who want to take active management of their investments. It has been a particularly bad investment strategy since 2000, and I expect it to continue to be such for the next 5-10 years. I began writing a blog in the Fall of 2006 to organize and record some of my investment ideas. A list of these writings can be found here, though readers should recognize that my views were much less developed than they are now. I will be revisiting and reworking many of these ideas in the first few issues of this newsletter.

This newsletter is designed for individuals who want to be more active than diversifying and holding for the long-term. Broad diversification is perhaps acceptable for people who do not enjoy active investing, but I think that there can be substantial gains from financial analysis and taking calculated risks. My purpose in writing this newsletter is to identify good opportunities and suggest risks worth taking.

On a personal note, another reason for writing this newsletter is to force me to synthesize and consolidate financial information, and I hope that readers will help me in this process by providing thoughts and feedback in response to my articles.

I will be publishing 12 issues each year, ideally within the first few days of every month. Because I spend so much time thinking and reading about housing (as a research economist), real estate will be the focus in roughly every third issue.

While I will resist the temptation to lay out all of my big picture views in the first issue, below is a preview of likely topics for the rest of 2008, though they of course may change as the market plays out:

• Feb 08   Why home prices will not bottom anytime soon
• Mar 08   A brief history of the US stock market
• Apr 08   The case for buying gold
• May 08   Price to rent ratios
• Jun 08   Historical price to earnings ratios
• Jul 08   The US dollar and international investing
• Aug 08   Buying versus renting
• Sep 08   Fed Watch 2008
• Oct 08   Why tech will eventually go bust (again)
• Nov 08   Housing outlook for 2009 and beyond
• Dec 08   2009 Predictions

In addition to writing a monthly market comment, I also plan to provide readers with comments and links to the best online articles that I have read in the previous month. Some of the writers that I read frequently include John Hussman, Peter Schiff, John Rubino, Eric Janszen, Robert Kiyosaki, Jeremy Siegel, and several others. I do this to provide multiple voices and to remind readers that my ideas are not held in isolation. Indeed, many of my views are a direct consequence of these analysts' articles.

I also intend to add value by providing readers with spreadsheets and calculations that may be useful in making sound investment decisions. The Renting Versus Owning Calculator is a good example of how a detailed spreadsheet analysis can uncover what beliefs about market fundamentals (in this case price and rent growth) are required in order to justify one investment decision over another (in this case homeownership versus renting).

For now, this is all I will say regarding the creation and format of the monthly newsletter. This newsletter is not made to provide direct financial advice. Readers should come to their own conclusions regarding how much weight to put on my analysis when making investment decisions. Over time, I hope that this newsletter becomes a forum for collaboration and sharing ideas in order to make the best possible investment choices.

The 2008 Credit Crunch

I believe that one of the main themes for 2008 will be the continuation of the 2007 credit crunch. Subprime mortgages were only the first domino to fall in an otherwise much larger credit problem. In the last year, home prices declined at their fastest rate since 1941, according to Yale professor Robert Shiller (NYTimes: "Home Prices Fell Faster in October"). Do you really think the only mortgage defaults will occur among individuals with the lowest credit scores? If prices continue to fall, some individuals may intentionally default on their mortgages if the value of their homes is perhaps tens of thousand dollars less than they borrowed. The amount of leveraged used on many home purchases in the past few years will leave many homeowners completely underwater.

Even though delinquencies and defaults have just begun, many of the major Wall Street investment banks have lost tens of billions of dollars from mortgage backed securities. The KBW Bank Index (BKX) has fallen over 25% from its peak in February 2007, mostly due to mortgage-related losses:

Just today I read that Merrill Lynch plans to cut 1,600 jobs and that 4th quarter write-downs are as high as $10 billion. The stock is down over 40% for 2007. The only bank that seems to have escaped the crisis was Goldman Sachs, though I believe it is only a matter of time before their earnings collapse as well. And even Goldman isn't immune to the counterparty risk that could arise in a credit contagion. I can't say for sure whether the financial sector will pull down the rest of the economy, but it sure looks that way so far.

More importantly, however, is that the credit problems go deeper than just mortgage backed securities. Consumer credit is at all time highs by almost any measure, and I wouldn't be surprised if we soon see increasing defaults in credit cards and auto loans (though it is already starting to happen, see Unpaid credit cards bedevil Americans and Alarm at rising US car loan defaults), both of which have massive asset backed securities markets. An even larger danger exists in the credit default swap markets, which had a reported $28.8 trillion notional value in 2006, up from $14.9 trillion in 2005. Financial losses could be enormous if this largely unregulated market begins to implode.

The systemic risk at work here arises from tremendous leverage and counterparty risk. Suppose, for example, that a major hedge fund goes bankrupt from a highly leveraged investment. The investor on the other side of the trade, an investment bank perhaps, may not get paid. What was once a hedged position can become completely open if an investor's counterparty defaults. I don't know the true likelihood of a major credit meltdown, but the system has never really been tested yet. The potential for large stock market losses in 2008 certainly remains a possibility.

Building Wealth in the Today's Market Environment

The key to building wealth in the years to come is going to be to select asset classes that will appreciate relative to U.S. real estate and stocks. I think that both are favorable asset classes in the long run but that current prices make them overvalued to the extent that they will be lousy investments in the next 3-7 years.

The main focus of this newsletter in the coming months is to defend this viewpoint and suggest alternative investments that will likely outperform these two asset classes. Ultimately, I would like to build wealth by investing in U.S. real estate, but I am currently very cautious and would advise making only the most prudent housing investments.

My overall investment strategy right now is to hold international investments in commercial real estate, oil, and gold stocks. I also have some cash and limited exposure to domestic real estate. Regardless of whether home prices fall in dollar terms or in real value via inflation, my investments will be able to buy substantially more U.S. real estate in 3-7 years. Finally, I am avoiding any investments in financials, housing, and lending, and I am in fact short some stocks in these areas. On the whole, I would advise against any U.S. index that includes these industries.

Conclusion

It is unclear to me just how much risk there is in the current financial system, but my investment strategy right now is to avoid exposure to U.S. stocks and real estate until valuations become more favorable. Until that happens, I think there is a strong possibility of substantial losses in these two asset classes, especially in specific real estate markets. I am currently trying to build wealth relative to stocks and housing by investing in real assets, both domestic and foreign.

Although I try to remain unbiased and focus on market fundamentals, I recognize that my current outlook for the U.S. economy is quite bearish. I don't anticipate a depression type of scenario, but a recession may certainly be in the cards in the near future. Either way, I expect U.S. stocks and real estate to underperform in the next few years. Unlike your stockbroker, at least you'll know that when I finally become bullish on U.S. stocks that my outlook is genuine.

Thanks for reading. I look forward to producing this newsletter for many months to come.