Newsletter November 29, 2009

InvestorsFriend Inc. Newsletter November 29, 2009

Stock Market Direction

The question that investors always want answered is: “Will the market be higher or will it be lower in 3 months, 6 months, one year or two years?”.

The honest but unsatisfactory answer to this question is: “Nobody knows”.

That is a frustrating answer, investors often argue that their advisors are “paid to know where the market is headed”. It’s frustrating when stock market experts claim they can’t predict where the market is headed.

In fact, many experts will claim to be able to predict where the stock market is headed, even in the short term. And many investors are attracted to such claims of being able to predict the future.

But here are some reasons why the real answer is “nobody knows” where the stock market is headed in the short term.

The level of the stock market today and at any given point in time represents the consensus view of market participants as to the fair value of the stock market. If experts could see that the market is likely to fall in six months they would tend to sell stocks now and push the market down now. The actions of buyers and sellers in the market is always pushing the market level to a neutral level where approximately half the participants may believe it is under-valued and half believe it is over-valued.

Random economic news affects the stock market. When news that was truly unexpected arrives it will drive the market in one direction or the other. Many events in the economy are unpredictable and the actual results will tend to move markets in one direction or the other. For example economists might on average predict unemployment to be 10% next month. If the actual figure is 11%, that will tend to push stock markets down. If the actual is “only” 9% then stock markets will tend to rise.

Surprise political events like terrorist attacks and saber rattling between countries, can occur unexpectedly and cause unexpected movements in the stock market.

Warren Buffett, probably the world’s most successful investor, has always said that he can’t predict the short-term direction of stocks markets.

An Intelligent Approach to Investing

I indicated above that stock markets can’t be predicted in the short-term.

Buffett has argued (For example in Fortune magazine in 1999 and updated in 2001) that there are times when stock markets can be observed to be over-valued or under-valued based on reasonable and rational analysis.

Buffett recognizes that just because the stock market is over-valued that does not necessarily mean that it will drop any time soon. And similarly when it is under-valued that does not mean that it will soon rise. But he does believe that markets that are over-valued will tend to give lower long-term returns than markets that are under-valued.

I have applied an analysis, based on my understanding of Buffett’s approach to attempt to determine if markets have recently been under-valued or over-valued.

See: Valuation of S&P 500 and Valuation of the Dow Jones Industrial Average.

Canadian Mortgage Delinquencies

The latest Statistics on Canadian mortgage delinquencies have just been released. They show that as of September 0.43% or 1 out of every 233 Canadian residential mortgages were in arrears by three months or more. This is a noticeable increase from the approximate 0.30% level or 1 in 333 that prevailed from early 2004 all the way to the end of 2008. (For much of that time period the delinquencies were at 0.25% or just 1 in 400 mortgages).

This report provides figures back to January 1990. At the start of 1990 the delinquencies were about 0.20% or, incredibly, just 1 in 500! During the recession of the early 90’s the delinquencies got as high as 0.65% or 1 in 154. It again reached a similar level in 1997.

My expectation is that such delinquencies will reach at least 0.65% and quite possibly  1.0% or 1 in 100 before this recession is over.

The Burden of High House Prices and jumbo mortgages

The average price of a Canadian home has approximately doubled in the past 12 years. (See Teranet National Bank home price index which shows a 92% gain since February 1999)

Medium family incomes have not come close to doubling in that period. Statistics Canada shows that the median after-tax income for families of two or more individuals rose from $52,000 in 1998 to $61,800 in 2007. If I am generous and assume a 5% gain in the past two years, the result is that incomes have risen 25% in the past 12 years.

Families were able to afford the doubling in house prices because of the dramatic decline in interest rates, increased use of lower floating rate interest, longer amortization periods (up to 40 years from the previous 25 year maximum) and lower down payments (as low as zero, from the former minimum 10%).

Recent buyers of these double-the-price homes obviously face the risk that interest rates will rise at the renewal of their mortgages and that the new payments will be unaffordable.

But there is a related problem that is quite insidious and little talked about.

It’s the fact that the large mortgages associated with buying a home today are almost impossible to pay down early. Families may be able to afford the monthly payments, but they cannot find the extra money to make any meaningful extra dent in the principle and pay these mortgages down early.

Consider that in 1998 a family making $52,000 (after-tax) and having a mortgage of $100,000 could scrimp and save 10% of their income. They could then pay down their mortgage principal by 5.2%. If that were repeated for five or ten years the mortgage would be paid off years early.  And if interest rates rose, the payments would likely still be affordable due to the much lower principle.

But consider the median family in 2009, earning $64,900 but starting out with a $200,000 mortgage (made affordable due to lower interest rates and a 35 year amortization. Now when this family scrimps and manages to save 10% they have $6,490 to pay down on their principal. But instead of representing 5.2% of their principle, it is only 3.2%.

The point is that today, it is much harder for families with a new and large mortgage to come up with the cash to make any significant dent in the principle.

These families face the risk of higher interest rates at renewal time. If they could make extra payments and whittle their principle down to size, that would take care of this risk. But as discussed above, when the principle is double the amount that was typical a dozen years ago, it becomes extremely difficult to whittle these large mortgages down to size.

The result is that new home buyers today are often truly signing on for up to 35 years of indentured debt slavery. And if interest rates climb significantly at their first renewal, these mortgages are going to become unaffordable for many of the recent buyers.

Getting Stated Buying Individual Stocks

Many people invest strictly through mutual fund advisors. For those who are interested in getting started in investing in individual stocks, we have a short article that explains how.

Our Stock Picking Performance in 2009

The average stock which we had rated as a Buy or higher, is up 32% in 2009.

Individual winners include Home Capital Group, up 105%, Melcor Developments up 126% and Starbucks up 127%.

Until now we had only revealed our full list of 2009 stock picks to our paid subscribers. However, as the year is nearly over and our current stocks picks have changed somewhat since the start of the year, all visitors to this Site can now see what our 2009 stock picks and ratings were and the detailed performance this year.

Stocks to Buy Now

We only reveal our current specific stock picks and Buy/Sell ratings to our paid subscribers. If you are interested in subscribing we can offer you a discounted price at this time. Click to see details.


Shawn Allen, President
InvestorsFriend Inc.

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