By Professor Ricardo Ulivi, Ph.D.

November 2013

The stock market continues to roar, setting new records nearly every day. Isn’t it wonderful? After all, we invest to make money—that is, to buy low and sell high. So, if you haven’t sold, should you? Or, if you hang in there, will you make a few more bucks?

What if you have been waiting on the sidelines, thinking that the appreciation we have seen in the last few years, and especially this year, was too fragile to really be sustainable? After all, the economic recovery has been weak and still the market keeps rising. Perhaps you stayed out or reduced your exposure to stocks. Now, you wonder, should you get back in?

What Can We Learn from Real Estate?

What to do? In answering this question, I believe it is useful to review the recent history of home price appreciation in California. In the eighties we experienced a great boom. Prices appreciated by more than 70% in that decade. Then came the period between 1992 and 1996, and prices fell a cumulative 13%. Some people got burned, so many became cautions. You didn’t necessarily want to invest in real estate. After all, you heard stories of people losing their homes, being upside down, etc. Real estate, as an investment, lost its luster.

Then, suddenly, in the twelve months that ended in the third quarter of 1997, prices shot up by 35%. That got some attention, and people began investing again, but cautiously. That’s because the wounds and frightening tales of the early 90’s were still fresh in people’s minds. But 1998 ended, and prices were higher by 9.12%. Hmmmm. In 1999 prices were up further by 7.85%.  More hmmm. Remember too, that most people buy homes with a small down payment, say 20%. That means, because of the leverage involved, a 7.85% appreciation in house value translates into a 40% gain in one’s down payment. Wow, this story is getting very sweet all of a sudden!!!

Let’s say that your brother bought a bigger house, and boasted about how much money he was making. Your neighbor sold his at great price, bought a new one and later you found out how much money HE had made. All of a sudden you started wondering whether you were the idiot who missed the train!

But, you are a cautious individual, and you still remembered the stories of the 90s. So, you sat this out thinking it was just a false appreciation. But, the next year, 2000, prices went up another 15%, followed by 11% in 2001, and 13.5% in 2002. If you remember the impact of leverage, to calculate a home purchaser’s actual profits, multiply those appreciation rates by 5 or by 10. The result is that home buyers were making enormous profits. Maybe even three or four times their annual salaries. Life was good for those who chose to dive into the real estate market in 2000.

But for people like you, who decided to stay out of the market, or never traded up, the picture wasn’t so bright. You watched everyone make loads of money, and with that money, buy all sorts of things. For example, more houses (there were suddenly lots of real estate tycoons), boats, cars, fancy remodels, etc. And you? Finally you began wondering whether you really are an idiot, not a cautious person. But you decided to wait again. You didn’t really believe in this rally.

Will the Real Estate Party Continue?

2003 ended with prices up another 15%, plus the huge profits from leverage. OK, now you were not the only one thinking you were an idiot–all your friends, family, neighbors and co-workers swore you were as well. Your spouse was giving you hell, your kids thought you were clueless, and even your dog was having doubts about you. So, what did you do? You gave in, of course. You sold your house, bought an enormous one with one of those no-doc loans, and then 2004 ended. You were a bit nervous about your decision, but prices shot up a whopping 25% that year, which meant, because of leverage, you had increased the equity in your house by 5 or 10 times your original investment. This proved you were not an idiot, but a savvy investor. You felt like you were king of the hill!

Another year went by, and you found your house had appreciated another 21%, plus the leverage factor. This totally confirmed that you are a smart son of a gun! Like Tarzan, you beat your chest for all to see. You were one hell of a good investor. Even your dog was nicer to you once again! What did you do then? After all, you experienced some incredible profits, just like everybody out there. What you did was the smart thing: You refinanced your loans, took a big cash-out, remodeled your house and bought an investment property, too.

2006 ended and prices were up a notch–just 3%. But because you were highly leveraged, that measly 3% translates to a 30% gain on your equity. Life was still good. Your investment acumen only confirmed how clever you really are!!!!

The Hangover

In 2007, home prices in California dropped 10%. Because of leverage, that drop could easily have wiped out all of your equity. What did you do? Life is full of bumps; you couldn’t quit when the first one hit. So, shrewd as you are, you stayed put.

2008 saw prices drop 22%. Taking leverage into account, not only had you lost it all, you now owed tons of money to the bank and the IRS. Your house was foreclosed, and so was your investment property. You were lucky if your marriage survived. Your dog left you, of course!

Opportunists jumped into the market. After all, prices were incredibly low, but then they dropped again. Another 7% that year and the hemorrhage continued in 2009, 2010 and 2011.

For real estate investors and homeowners, those five years were a disaster. The hangover was terrible, terrible, terrible.

Where Are We in the Stock Price Race?

In 2008, stock prices dropped a bone chilling 37%. This meant that if you had a $500,000 portfolio at the beginning of 2008, it was worth $315,000 at year’s end. You would have been crazy to invest more, and even crazier if you just didn’t sell all and lick your deep wounds. You might have sworn off stocks forever, and nobody would have found fault with your thinking.

Rightfully so, you, and many others, stayed on the sidelines that year. But then something interesting happened in 2009. Stock prices were actually UP 26%. Yet, after the debacle of 2008, only certified lunatics were willing to invest in stocks again. In 2010, prices shot up another 15%, which meant that by then investors had nearly recovered all their losses of 2008. Naturally, you started wondering whether you should begin investing, AGAIN, in stocks. But the 2008 wounds were still deep, so you waited.

Between 2011 and 2012, stock prices rose another 19%, which meant that if you had not sold in 2008, you were now actually ahead. Should you invest now? No, you are a cautious guy after the debacle of 2008.

In the first quarter of 2013 prices were up another 5% and by Sept. 30th they were up by an astounding 20%. In November, new records are being set nearly daily. Should you invest now? Have you missed the train, once again?

What Should You Do Now?

If you are being tempted to join the stock market’s rally, please go back and reread the hangover section of this article. Stay away from temptation. And if you have large gains, go back and reread the hangover section as well.

This stock market rally is being fueled by super low interest rates generated, not by the success of American capitalism, but by the Federal Reserve’s misguided easy money policy. Don’t be sucked into this rally. At least, that’s my opinion.

Most individual investors are not like government employees, who enjoy a defined benefit plan. That is, if huge losses occur, the government just contributes more into the nest egg. If you rely on yourself, and you have losses, who replenishes your nest egg?  Preservation of capital should be the number one financial goal, followed by prudent risk taking to try to earn higher rates of return.

If you need a financial check-up, call me at 714-771-6000, or reply to this email. My goal is to help you achieve your ideal vision for retirement.