Archive for September, 2008

3Q-2008 Report Card

September 30, 2008

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With 70% of the portfolio allocated to equities, the Sleepy Portfolio could not be expected to escape the carnage in the stock market. The portfolio was down 10% over the course of the third quarter. Canadian stocks were down 18%, US stocks down 7.5%, EAFE stocks down 15.5% and emerging markets (all in Canadian dollar terms) down 22%.

Cash and short-term bonds provided the only refuge. Surprisingly, real-return bonds are down 7.5% in value and real returns are now in excess of 2.0%. Is the market now starting to worry about deflation?

[Sleepy Portfolio Performance for 3Q 2008]

As the majority of our portfolios are passively managed, our performance was in line with that of the Sleepy Portfolio (i.e. not pretty). On the bright side, I bought some Vanguard Emerging Market ETF (VWO), Vanguard Europe Pacific ETF (VEA) and Royal Bank (RY) in addition to regular contributions to my group RRSP account. Once I complete the process of moving our accounts to RBC Direct Investing, I’ll be rebalancing the portfolio by selling some bonds and buying equities with the proceeds.

Keeping the faith in stocks

September 30, 2008

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Dow: down 777.7 points (7.0%)
S&P 500: down 106.9 points (8.8%)
TSX Composite: down 840.9 points (7.0%)

It started off as a bad day as Wachovia Bank and two large European financial institutions joined a long list of casualties. When the markets closed the trading day, it was time to trot out the superlatives: the biggest percentage drop in the S&P 500 since 1987, the biggest percentage drop on the Dow since 2001, the biggest drop in the TSX Composite in eight years etc. and newspapers are already calling it another Black Monday. There was simply no place to hide in equities — among the stocks that make up the S&P 500, only Campbell Soup Company (CPB, up 0.32%) finished in the positive column. Bonds, cash and gold were the only holdouts in an otherwise ugly day.

When stock prices are collapsing, it is not easy to keep the faith in equities but times like these require wisdom and sound judgement such as that displayed in this memo sent by Dean Witter to clients on May 6, 1932, just months before the market bottomed (Source: Stocks for the Long Run):

There are only two premises which are tenable as to the future. Either we are going to have chaos or else recovery. The former theory is foolish. If chaos ensues nothing will maintain value; neither bonds nor stocks nor bank deposits nor gold will remain valuable. Real estate will be a worthless asset because titles will be insecure. No policy can be based upon this impossible contingency. Policy must therefore be predicated upon the theory of recovery. The present is not the first depression, it may be the worst, but just as surely as conditions have righted themselves in the past and have gradually readjusted to normal, so this will again occur. The only uncertainty is when it will occur….

Is Canadian Real Estate Overvalued?

September 28, 2008

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A recent UBC report that found real estate in many Canadian cities to be overvalued got much play in the media. It found that home prices are over-priced by as much as 25% in some cities. The surprising part is the cities mentioned wouldn’t be the first ones that come to mind as overvalued: Montreal, Ottawa, Regina, Winnipeg and Halifax. Calgary and Vancouver were found to have “balanced” conditions with predicted price declines ranging from 7% to 11%, Edmonton undervalued by 8% and Toronto priced just right.

If you dig deeper, you’ll find that the report is riddled with questionable assumptions. The study arrives at its findings by comparing difference between the cost of ownership (calculated by adding the mortgage rate, taxes, insurance and maintenance) and the rental yield of a home with the expected rate of appreciation. If the cost differential equals the expected price appreciation, home prices are said to be in equilibrium; if it’s less, homes are undervalued, overvalued otherwise.

The problem isn’t with the methodology (in fact, we’ve used the same method in many earlier discussions on housing) though there is a lot to quibble about in the data. For instance, does a 7.37% mortgage rate sound reasonable when a discount of almost 2% off the posted rate can easily be obtained? The key question is the expected rate of home price appreciation and the authors recognize the challenge:

The greatest challenge in measuring the cost of capital is determining the expected price appreciation. All other variables in the equality are directly measurable, even if they are measured with some error, but individuals’ subjective expectations are not. The “correct” rate cannot be solved for from the relationship without assuming that prices and rents are already in equilibrium because the owner cost of capital relationship is an equality. There is always some expectation of future house price growth that will ensure that the relationship between rents, prices, and the cost of capital holds. In this study we assume that the best predictor going forward of expected long run equilibrium house price appreciation is the historic rate.

The authors then assume that future returns will be the same as “the average of trough-to-trough and peak-to-peak rates of appreciation of past cycles”. In addition, conclusions are drawn about certain markets (Halifax and Ottawa) using data that spans just 17 years. As Canadian Financial DIY pointed out, these assumptions are, at best, tenuous and hardly justify the bold assertions made in the report.

Merrill Lynch joined the negative parade recently warning that Canada faces a “meltdown” but their report is not available online (Update: Thanks to Retire @ 31 for the link to the report). Scotia Bank economists, on the other hand, think that a “modest erosion of house prices” is more likely.