Mr. Math

Thomas is the kind of guy you probably hated when you were eleven. He teaches math. He expects the world to be logical, orderly and transparent. Numbers don’t lie. They lack emotions. So if only everybody could be guided by the same data set, we’d all be cool.

“I think a key component of having the market work efficiently (on the upside and down),” he says, “is to ensure that homeowners and prospective buyers are aware of the most recent and undoctored statistics.”

His crusade now is to show his fellow Newmarket, ON citizens that they’re fools and pawns for having helped create the Hindenburg of all housing gasbags, then continuing to trade within in. He has tracked and catalogued, as only a mathematics nerd can, the last 1,136 real estate transactions in this northern GTA housing hotbed of 90,000 people.

Now, what does the official Toronto Real Estate Board data “prove” to us about the local market? Well, everything’s ducky, of course. Last month 128 properties changed hands for an average price of just under $879,000, which is $90,500 or 11.6% more than a year earlier. The sales-to-new-listings ratio was okay at 61% (Toronto was at 69%) and there was one month’s worth of inventory for sale (1.2 months in TO).

So, whazza problem, Tommy?

“I have been compiling up to date information on the market, until last Friday,” he says, “which appears to confirm all of the negative trends of late. I am appalled by the insanity.” The mathematician’s data clearly shows a market imploding, even as the real estate cartel suggests everything’s okay and people should keep buying. Given the fact Thomas is plotting actual transactions – recorded asking and selling prices, as well as the number of deals over time – it’s hard to argue this is not a stone-cold-sober snapshot of a community hemorrhaging equity. All those families who put all that wealth into a single asset? My, oh, my.

Average daily selling price down 300K in 3 months

Number of daily sales has plunged by 75%

Asking prices falling – $200K lower since March

From over-asking to below-list in 90 days

In case you question Mr. Math’s methodology or his completeness in capturing all of the relevant data, here’s the territory he’s been researching, and the 1,136 different property listings and completions included in the graphs above. This data is current to the beginning of this past weekend.

Sure, this is only one community of less than 100,000 people in an urban area of six million. But Newmarket and the surrounding hoods have typified the housing lust infecting the entire region. It’s now representative of what happens when the pendulum swings back. It never rests at neutral, but almost always shifts first to the extreme – suggesting there’s more pain and loss to come.

“My macro thesis,” adds T, “is based on a few key ideas:

1) Mortgage rates have likely bottomed – this creates an asymmetric bet on housing (rates stay flat, at best)
2) Demographics – we are currently trying to squeeze two generations into houses at once (millennials and boomers). This creates (temporary) extra demand.
3) Ownership rates are historically high (an indication of point #3) and will likely revert. If the US is a guide, ownership rates will revert, as prices start to come down.
4) Ontario affordability is peaking out (even with record low rates).”

Just as it was emotion – house lust, then greed, speculation and the irrational fear of missing out – that propelled us into a bubble, so it will be emotion that crushes it. This time buyers are afraid of catching a falling knife, walking into extreme leverage only to experience losses, or of doing something everyone else isn’t doing. The reasons they feel that way are irrelevant. We can yak all day about the mortgage stress test, foreign buyer’s tax, rent controls, Home Capital, an empty houses levy, CRA meanies, higher interest rates or an AirBnB crackdown – but in the end, real estate’s moved by emotion, not logic. That is what makes this asset class such a dangerous place to gamble the bulk of your net worth on.

So, this is not about Thomas. Or Newmarket. It’s a lesson in human nature. We buy high, we sell low. We never change.

The importance of balance

Investor/Client “What has been the best performing asset class over the long run?”

Me “Equities with the S&P 500 returning 9.5% annually versus bonds at 5%.”

Investor/Client “Great, I’ll go with 100% in equities since I have a long time horizon and they provide the highest rate of return.”

Me “Yes, but you’re only looking at the returns with little consideration to risk, and the commensurate pain that can come from an all equity portfolio.”

This week we go back to the basics, examining the benefits of a balanced portfolio. A balanced portfolio includes a mix of stocks (60%) and bonds (40%). We prefer this asset mix as it provides a solid long-term return but with far less volatility than an all equity portfolio.

In the table below we show every bear market for the S&P 500 since WW2. Bear markets are defined as 20%+ declines, but we find this 20% level to be arbitrary and therefore have included other major market sell offs over this period. On average, the S&P 500 declines 34% in bear markets and last 15 months. Bear markets during recessions tend to last longer at an average 19 months and with an average decline of 36%. The more recent bear markets, including the 2008/09 financial crisis and the 2000 tech bubble collapse, saw the S&P 500 decline 57% and 49%, respectively.

It is during these inevitable bear markets that investors’ resolve is tested with many throwing in the towel during these major corrections, often at the worst possible time. I’ve been in this business 20+ years and I have found this to be the most common and repeatable investor mistake. This is what we try to protect against by using a balanced portfolio.

Major US Bear Markets since WW2

Source: Bloomberg, Turner Investments

Now let’s look at some real life examples of how balanced portfolios performed during major equity bear markets.

During the last two bear markets of 2000 and 2007, balanced portfolios really showed their mettle. A 60/40 balanced portfolio of US Treasuries and the S&P 500 declined during both of these bear markets, but much less than the S&P 500. For example, during the 2000 technology meltdown a 60/40 balanced portfolio declined 15%, far outperforming the S&P 500, which fell 49%. During the 2007 financial crisis a balanced portfolio declined 27%, roughly half the decline in the S&P 500.

The key reasons why a balanced portfolio holds up better are: 1) you only have 60% of your assets invested in equities (hopefully your advisor or Portfolio Manager will be proactive and reduce this during bear markets helping to further limit the damage); and 2) bonds typically rally during bear markets as investors flood into safer assets like bonds and the Federal Reserve responds by slashing interest rates in an effort to stabilize the economy and stock market.

Balanced Portfolio During Previous Bear Markets

Source: Bloomberg, Turner Investment

To further hit home the point I’ve run some numbers to show empirically that a balanced portfolio gives you the best bang for your buck. Below I show the long-term rates of return of stocks and bonds. As mentioned the S&P 500 has returned 9.5% annually since 1926, with bonds at 4.9%. Therefore a 60/40 balanced portfolio would have returned 7.7% before fees. This is why we try to target 6-7% returns net of fees.

Now let’s bring volatility into the equation. Stocks have a standard deviation of 18.8%; meaning stocks should return 18.8% above or below the average of 9.5% in any given year. Looking at long-term US Treasuries as our proxy for bonds, they have a standard deviation of 7.8%. By combining these two assets we can significantly lower the volatility (versus the S&P 500) with a 60/40 balanced portfolio having a standard deviation of 12.3%. The key reason behind this is the low and at times negative correlation between stocks and bonds.

Finally we can take it one step further by calculating risk-adjusted returns, otherwise known as the Sharpe Ratio. This fancy financial term is actually quite simple to calculate and understand. It subtracts the return of a portfolio from the risk-free rate (US T-bills) and divides this by the standard deviation (volatility) of the portfolio. Essentially it measures portfolio return versus risk and the higher the number the better. Based on this statistical measure a 60/40 balanced portfolio has a higher risk adjusted return or Sharpe Ratio of 0.34 than the S&P 500 at 0.32 This is why we love this asset mix. We still get solid returns (6-7%) but with far less risk. It’s not too often that you can have your cake and eat it to, especially when it comes to investing. But we believe you can with a balanced portfolio.

Balanced Portfolios Provide Better Risk Adjusted Returns

Source: Aswath Damodaran, Turner Investments
Note: Stocks is the S&P 500, bonds are US Treasuries, and risk adjusted return is portfolio return less the risk-free rate divided by standard deviation

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Flag day in Belfountain!

Mike and Ian from the community citizens’ group let their coffees and bistros grow cold this morning as they helped me nail an important piece of cloth on the side of the old pile of bricks that is the Belfountain General Store. It was like Curly, Larry and Mo doing patriotism, but we got the sucker up. This flag flew atop the Peace Tower high above the Centre Block of Parliament while I sat in the House of Commons below. It lives again, in a simple hamlet within the dominion. Thanks Canada. — Garth. Belfountain Store blog.