Blessed by the Potato

Thank you all for the messages of congratulations. The long slog is over, the thesis is revised and accepted by the faculty, and in the morning I’ll be dropping off the printed copies to be bound into book form (I tried to get it done today but just barely made it up to campus graphic services just as they were locking up).

Some quick notes before I get back on track with the regular blogging:

Yes, it is a PhD (Doctor of Philosophy) degree, so I’m “not that kind of doctor”.

No, I didn’t end up meeting my weight goals (which were initially to lose a certain amount of weight, then to simply not gain weight during the final stretch), I ended up gaining about 8 lbs over the last few months. I’ve been really bad on both the exercise and diet fronts: though I started out the spring ok for exercise, when the oppressive heat hit in July I pretty much stopped biking and haven’t really gotten back in the saddle. There have been three times now that I went on road trips with my bike packed in the car, and didn’t even end up taking it out (though to be fair, on one of those the water pump at the cottage broke just as I was on my way out for my ride, and I didn’t much fancy the notion of going for a 20 km ride with no working shower at the end).

For student finances, it worked out almost according to plan. I’m pretty good at being frugal and sticking to a budget, and though it did end up taking longer than I thought (and after my MSc, I really thought I wouldn’t be overly optimistic for my PhD timeline… yeesh) I managed to cope. As you may recall, I had a scholarship for a number of years and was actively saving a portion of that since I expected I wouldn’t finish by the time the scholarship ran out. Most of that savings I invested, and most of that into dividend payers, so in this later phase I was using the dividend income to help make ends meet when departmental minimum funding wasn’t enough to pay the bills (well, it was enough to pay the rent and food bill, but not the internet, phone, insurance, or tuition bills). I did get surprised by a few mis-calculations, the most recent being figuring when my last stipend would be paid out: I knew June was the last month I was getting paid for, but I thought my pay was arriving the following month, so that I could count on money arriving in July — it turns out I had my pay cycle wrong and the money I got in June [which I thought was for May, etc.] was the last I got. So that lead to an even tighter belt than I thought, but I suppose that’s what emergency funds, lines of credit, and investments are for. I picked up a bit of contract work in July, and I didn’t realistically expect to be paid for it until August, but here we are at the end of August and I still have no idea when I’ll be paid. Wayfare’s in much the same situation, I think she just got her paycheque for work done in May.

So right now I’m into full-on defer everything mode. I know that I’ll eventually get paid again, but until then I’m trying to defer as many expenses as possible, and tapping my non-traditional emergency funds like reward points to pay for things like groceries and gas where possible. I normally keep a large stockpile of food on hand (I suppose I have my mom to thank for that), and aside from seeking some variety and fresh foods, I could probably go 3 weeks without having to go grocery shopping. So I’m going to eat through some of that cache. I wore a suit for my lecture and defence (yes, I own a suit now, crazy!), but I think it can wait a few more weeks to be dry-cleaned. My shoes have holes in them (not serious ones, I’ve just worn through the lining near the heel so the plastic heel cup is showing on the inside), but they still work and soon enough I can switch to my winter boots which are in good shape.

I’m really good at procrastination.

As to where I’ve been for the last week: well, I didn’t have that many revisions to make, but there were a few, and I only had a week or so to make them. Otherwise I’ve largely been catching up on half a lifetime of sleep deprivation and spending time away from the internet. I got a kobo reader as a graduation gift (which I’ll review shortly) and picked up the next few books in the George RR Martin Song of Ice and Fire series, and they are not short books. I’ve already finished the second one and have moved on to Storm of Swords. It’s still technically summer, so I can make some progress on that summer reading list!

Now that I’m done my PhD what comes next for Dr. Potato? The clever-boots answer I came up with was “Dieting. Definitely dieting.” Short-term, I’m going to be doing some more research work for the next few months. After that, I don’t know yet. I’m looking for jobs, but seem to have more of a geographic limitation than an occupational one: I’m open to private sector R&D, academia, or may even try a turn at finance or pure teaching/lecturing. I’ll just have to see what opportunities present themselves.

The appellation of “Doctor” (from Latin: teacher) indicated a life dedicated to learning, to knowledge, and to the spread of knowledge.

And now I am one.

I’m in full-on defer everything thesis mode. Whatever it is, it can wait until after my defence to get handled. Whether it’s cleaning, buying new shoes because my current ones have holes in them now, or restocking household supplies, it can wait. Except I may have cut it too close: I saw that I was down to my last 3 Q-tips, with two days yet to go before my defence. I asked Wayfare to bring a few with her, and “Please don’t tell my mom I nearly ran out of Q-tips. She’d probably let the zombies take me. ”

I thought that was a clever little bit, so I put it on Twitter, to which people asked “…What??” So, for those who don’t know the story of Q-tips:

My mom is a bit of a hoarder. Not in the reality-TV crazy way, but in the she grew up in rural PEI and has at several points experienced what it’s like to be snowed in and isolated from the rest of civilization for a week or two at a stretch way. So she stockpiles things like food and toilet paper and what-not.

We say that our house is one of the most zombie-apocalypse ready ones since we’ve got lots of food and bandaids stockpiled, enough to last months without having to venture out to resupply. Indeed, that’s what we do when we open a cupboard and find 48 cans of soup, or a giant 44-lbs bag of flour in the storage room: we shake our heads and go “well, mom’s ready for when the zombies come”. And as an aside, a 44 lbs bag of flour is seriously impressive to see outside of a bakery. I remember the first time I saw that Wayfare only bought the little one pound bags of flour, and I was like “oh, that’s so cute, it’s like a travel-size thing of flour for when you’re baking on vacation.”

But what really strikes me as bizarre is that more than food, toilet paper, ammo or medicine: my mom stockpiles Q-tips. Q-tips come in boxes of 400, and you probably use about one a day (maybe a few more if you use them for other purposes). So there’s my mom and dad, and sometimes my brother and sister, and she also occasionally uses them to clean out the pets’ ears or face wrinkles. Whatever. A box of 400 Q-tips is still a several month supply. One or two boxes of Q-tips should, realistically, satisfy any normal person’s need to stockpile Q-tips.

But my mom has two or three boxes in the bathroom. Three more in the ensuite. One in the closet. One in the guest bathroom. Two in the kitchen, one in the laundry room, and two more in the basement storage. At any given time, my mom has something like a 3-4 year supply of Q-tips on hand.

So the only explanation we can come to is that more than food or bandages or cricket bats, more than clean water or bottle caps, Q-tips will be needed in the zombie apocalypse. I don’t know if it’s because keeping your ears clean will help prevent infection with the mind-destroying parasite, or if throwing handfuls of them at the undead will lead them to kill themselves by putting one into the brain through the ears, but whatever the reason, they will be needed. And my mom is ready.

Yet there I was, raised in a household that respects the power of the Q-tip, and I nearly let myself run out. So please don’t tell my mom that I nearly ran out of Q-tips.

“He’s been predicting that for years and it hasn’t happened yet.” It’s a common refrain heard as a housing bear, or indeed, a brush-off argument used against someone making predictions in a wide variety of other areas (e.g.: global warming). There’s a certain comforting logic to “it hasn’t happened yet.” After all, at some point you have to consider the possibility that your prediction was wrong and isn’t going to happen.

But the thing is, “it hasn’t happened yet” was true at the time the prediction was made, too. So one needs to try to estimate how much time is needed before you need to start worrying about events not unfolding as planned. It’s not a stand-alone argument.

When I first started getting bearish on real estate around 2007, I told Wayfare the time to buy wouldn’t come until 2010-2012. Here we are in 2011 and it’s still going to be years yet. The recent market troubles leading to a prolonged ZIRP in the states is not going to help matters on that front. While rising rates are not a necessary condition for the market to start to correct, they sure would help.

While I sometimes make some (small) speculative investment moves when going long, the extra risk factors of shorting have kept me away, even when I had some good reasons to be short. But if I could, I would be short Toronto RE now — no matter how I try and look at it, it looks over-valued unless I assume crazy things like ZIRP forever (a few more years, sure — but 25 more?). One issue with that though is timing: RE cycles are long, and can take years to play out. It’s very tough to have any manner of certainty when it comes to crowd psychology. I do have to stop every now and then and look back at the data and my analysis to wonder if I’m wrong, since it does keep defying gravity, and I keep coming back to the same conclusions. Assuming people do any math at all before making their purchase decision (and everything I’ve seen suggests they don’t), the current prices are factoring in continued price growth of at least 3-4%/year, with rates at basically nothing going out forever. Yet even many of the bull-inclined analysts and real estate associations are calling for a plateau as a kind of best-case scenario.

I went and re-read the story of Mike Burry, one of the few genius hedge fund managers that caught on to the brewing US real estate bubble in the early years. The problem was that by being early by several years, he strained the relationship with his investors as they constantly doubted him and his unpopular bets; he ended up closing his hedge fund as soon as he could (though not before making hundreds of millions of dollars by betting against subprime loans). It looks like being right but early seems to be every bit as bad as being wrong, at least as far as interpersonal relationships are concerned.

It’s tough because my cohort is of the home buying age. I feel like I have a responsibility to warn them of the dangers, that the “pride of ownership” is currently a several hundred dollar per month expense. I worry not only for my friends’ sake that they might in the not-too-distant future find themselves trapped and house poor, but also for my own guilty conscience over my inability to prevent a predictable loss. I’m haunted by visions of when the dinner party conversations inevitably switch from “we could add forty thou in value by putting in a second washroom” to “can you believe interest rates these days? We had to cancel our vacation this year to keep the house. I don’t know what we’ll do next year if they keep going up.”

But, what’s a socially acceptable warning? I’ve blogged about the matter enough that if they follow my writings, they probably already know my arguments and don’t care: I sometimes worry that maybe they don’t read my blog (though everyone, of course, should). Even if they’re not BbtP readers, surely they’ve at some point heard about the crash in the US (and around the world), which should have delivered the message that real estate doesn’t always go up. It is their money to lose; maybe they do have a few thousand a year to spend and value pride-of-ownership that highly — just because my pride is cheap doesn’t mean everyone’s is. Maybe the other assumptions don’t apply (like that they would actually save and invest the difference). Plus that timing issue keeps rearing its head: not many people think on 5 or 10 year timescales, so it’s hard to counsel patience on that level when people are making decisions for next month.

Plus, if I’m wrong (though this is one of my “highest conviction” long-term predictions), they’ll fucking hate my guts because real estate is so very emotional.

David Fleming at Toronto Realty Blog recently tried to get that across with a little anecdote, but got the moral of the story backwards. He describes, in a very round-about post designed to stir the pot (I know I shouldn’t give in), a place he liked to visit called Park City, Utah. This place like many others got caught up in the buying frenzy in the states, despite the fact that it was this little artificial town surrounded by empty land. There was no land scarcity, and no one should have bid up the prices of existing RE since you could just go a half mile down the road and build a new place on an empty lot. Yet they did anyway. It wasn’t a logical investment based on the fundamentals, it was emotion-driven. A frenzy. David then tries to spin that as being evidence that Toronto doesn’t have a bubble brewing: Park City had no land scarcity and prices crashed; Toronto does have land scarcity, so prices won’t crash.

But the true take-home message is that land scarcity has very little to do with short-term valuations. Was land any more or less scarce in 1989 in Toronto than it was in 1992? Yet prices dropped 30% in those 3 years. Is it any more scarce today than it was in 2001? Yet prices have roughly doubled. And of course in the US, the cities with equal land scarcity to Toronto also experienced run-ups in price and subsequent crashes.

Even in places like Park City, Utah — with abundant land for development all around — prices got over-heated and later corrected, even though it should have been obvious that a bubble was brewing and those rapid price increases didn’t make sense. How much easier then is it to then inflate prices beyond fundamentals in a place like Toronto, where the fundamentals aren’t quite staring you in the face so dramatically as the cornfield next-door?

Yet we come full circle: it hasn’t happened yet. Prices may be too high, having leap-frogged ahead of the fundamentals. Indeed, I’ve been arguing that it is highly likely that that’s the case. I figured that the most likely way such a large imbalance could be corrected was through a decline in prices, i.e.: a crash. It’s a very unstable position to be in for the speculators at the margin: losing money or at best breaking even on rental properties purchased recently with maximum leverage. It was always possible that the corrective action could instead be a long period of stagnation while inflation helps the fundamentals catch up to the price. The banks and the housing pundits pushed that theory, but I always thought that was very unlikely: we’re dealing with the madness of crowds, so exact timing is difficult, and long periods of stability are rare. But without the pressure of rising rates, that unlikely solution to the problem is looking well, a fair bit less unlikely.

Oh, and just before I hit publish I saw the news that the TREB stats for the first two weeks of August were released, and detached homes in the 416 were down something like 15% in price. While I would love to call that as the beginning of the end, I don’t think it means much at all. Prices were down about 15% last summer too, only to rebound in the fall. Plus there are very few transactions in the detached home segment, particularly in the summer doldrums, so it’s possible that the price decline is just a shift in the sales mix and not a legitimate decrease in prices. I wouldn’t get too excited just yet: see what the Teranet numbers have to say, or better yet, see if October brings a rebound. If it’s still weak by October I’ll start letting my hopes get high, and hold my breath through the spring that ZIRP be damned, buyer exhaustion has finally hit. But for now, I’m still a patient, sad bear.

There have been a few questions in the fora recently about market-linked GICs. From the description, they sound like the best of both worlds: sharing in the returns of the stock markets with full, government-backed downside protection. I’m sure that’s where a lot of the attention is coming from. Unfortunately the reality is far different: these are usually sneaky products (only including partial performance, caps, etc) so it usually ends up being the case that if you need downside protection you’re probably better off to just get a regular GIC (where you’re guaranteed some return too) and a regular low-cost market index fund for the bit of exposure you can tolerate.

I just saw a new version of this trick in a product from Meridian credit union that promised “No cap on returns, no fees, participate in 100% of return.” The sneak on this one comes in the way they calculate the return:

The interest earned will be based on the average return of the index for the five years of the investment period. The average is calculated by adding the month-end closing values of the index and dividing the sum by the total number of months.

So if the index is at say 100 now and closes at 134 after 5 years (a total 34% return or 6% compounded annually), you’d only get ~20% return (or about 3.7% compounded). That hardly sounds like participating in 100% of the return to me, and that’s not even getting into the matter of how these products conveniently forget the dividend yield, or that the return you get is counted as interest income rather than capital gains (like it would be if you had invested in the markets).

It also makes the return path-dependent: if the market goes down for the next 4 years, then rallies hard in the last year to finish up, you’ll get far less out of a product like this than if you had just invested in the market. For example, if the market goes down 10% and stays down that much for 4 years, then rallies in the final year to finish at 134 (the same ending value as the previous example), you’d get nothing.

Though to be fair, this method would still give you some return if the market tanked just before redemption. But a regular GIC would likely give you just as much or more in that scenario, and you’d at least have a predictable return, too.

So how do you go about making your own version of these types of products? Well, one way is like I said above, buy a GIC and an index fund. If you figure that the worst 5-year return you need to protect yourself from is -25% (and even then you’d have to be really unlucky — but you can get more pessimistic if you wish), then just figure out how much you can risk for a given regular GIC rate so that even in that “worst-case” scenario your principal is still protected. Right now a regular 5-year GIC can be had for 2.75%, which would give a total return of ~14.5% after 5 years. If the amount to put in a GIC is g and the amount to put in the markets m and your total principal p, then you have two equations with two unknowns: the amount to invest at first g + m = p and the amount you have left at the end in your worst-case scenario: (remaining stock value)*m + (GIC total return)*g = p. Using my example numbers (predicting that even in a bad stock market outcome 75% of the value would remain after 5 years, and that the GIC would return 14.5%) that second equation becomes: 0.75m + 1.145g = p. Pull out some grade school arithmetic, and you find that you if you have $1000, you can risk investing $367 in the market while putting $633 in a GIC, and still be very likely to have at least $1000 at the end of your 5 years.

If the market performs well, at say that 6%/year I used above when examining the Meridian GIC, you’d walk away with $125 in profit from the equity investment, and $92 from the GIC, for a total return of 21.7% over the 5 years. Plus, you’d collect any dividends paid out by the companies in the index giving you a fairly significant boost to returns, get a slightly more tax-efficient mix of income, and you wouldn’t care how you got to the end point at the end of the 5 years. If the market doesn’t perform well, things can get a touch complicated: if the market ends up returning 3%/year, you’d get less than that from the market-linked GIC scheme, but nearly 3% from this plan (since the vanilla GIC-portion is also yielding about 3%). If the market goes down, the tax situation can be a little more complicated because instead of ending up with nothing, you end up with taxable interest income from the GIC plus a capital loss from the mutual fund.

The big issue is that though in all likelihood this scheme would give you every bit as much principal protection as a market-linked GIC, based on historical 5-year returns, it’s not actually a guarantee. If a new stock market crash hits that’s off the charts (like the 30’s — an investor in 1929 had a 5-year return of -75%), then this approach will fail. I don’t think it’s really worth worrying about events that are even worse than the 2008/2009 credit-crisis crash (which is where I got my worst-case 5-year -25% from — and even then, your timing had to be unlucky to the month to be down that much).

To get an actual guarantee with a scheme like this you can instead invest more in a GIC and use options to get that bit of market exposure. Preet and Michael James described that some time ago. The issue there is that you may notice they say things like “for a $100,000 investment…” because the options route just isn’t feasible for someone with a smaller amount of money to invest (like ~$1000 for a market-linked GIC).

In the end, removing risk or providing a guarantee ends up being costly almost no matter how you construct it (though the DIY-option allows you to collect more of the upside from the market). With a lot of ways to get less than the interest from a regular 5-year GIC, these market-linked products are usually a bad deal if you do need absolute protection.