March 2005 Newsletter
Issue Three, Volume Six

REAL ESTATE IS OVER

By Mike Gasior

This month's edition may actually take on characteristics more common to a newspaper than a newsletter. My feeling is that we have reached a very substantial crossroad in several markets and that a long-term cycle is currently ending and a new one will soon be underway. I have to honestly admit that I cannot remember a time anywhere in the recent past where I felt so compelled to address so many different topics. The financial markets and economy have spent several years in a fairly boring trough with no substantive or major changes in trend, but I now feel that huge changes have begun on many fronts. Very big things are already underway.

APRIL VIDEO CLIP IS UP

This month my video commentary is dedicated to my final two equity-based topics of rights and warrants. I try to explain simply what the two securities are, and why corporations issue them, even getting into a discussion about how warrants can be used as an "equity kicker" on a debt issuance. At the end of the conversation I also share with you a lesson taught to me by an old-timer when I first got into the business about spotting major trends without being distracted by the daily noise. This lesson is particularly valuable in better understanding the reasoning behind my change of viewpoint on several fronts this month.

You can view both high-speed and low-speed versions of the clip by visiting the homepage at the following link:

http://www.afs-seminars.com

GRAND CAYMAN HEDGE FUND SESSION

The Grand Cayman "Providing Services to the Hedge Fund Industry" is definitely being held at the Hyatt Regency Grand Cayman Resort at the beachfront portion of their property on May 18th, 19th and 20th. Attendance is already extremely heavy but there might be some limited availability if you would like to attend. Please call our offices at (860)347-6568 to inquire, or you can reach by email.

Information on the session can be viewed at:

http://www.afs-seminars.com/cayman.html

Without wasting anymore time prefacing the subjects, let me begin to address each one in a direct and to-the-point type of manner.

REAL ESTATE IS OVER

While I am almost always loath to make anything other than macro predictions about most aspects of the economy at large, or particular asset classes, all I can tell you is I feel amazingly comfortable in telling you that the boom in residential real estate values is over. With a fair degree of confidence I predict that we have seen the top of U.S. housing values and that prices will begin a long a cyclical decline. I have not felt similar confidence since 1999 when I wrote in this letter that I believed that the NASDAQ had peaked on the day it crossed through 5,000.

What makes me so extremely confident is the message that is being sent by the Federal Reserve, in what I find to be surprisingly blunt language, is that among the reasons for steady rate increases by the Fed they cite the "pricing power" being exhibited by home builders. The Federal Reserve is keenly aware of the price bubble they created in real estate due to the reductions in rates that was absolutely necessary back in 2001 and 2002 to avoid a quite serious recession at that time. Now I believe they have decided to end it and you can be sure the Fed will win this battle because they ALWAYS do. Should the housing market somehow show any resiliency through the rate increases we've already seen and the promised ones coming in the future (and I don't believe that it will be resilient at all) the Fed will most certainly continue on course until the real estate market's back is broken. This I can guarantee you.

How much the overall value of residential real estate will decline is dependent upon the region the property is located in as well as changes in the economy that are difficult to precisely predict at this point. Based on some cursory research and modeling I have performed in the past few days I will share my viewpoint on the real estate market at various mortgage interest rate levels:

30-YEAR FIXED RATE REACHES 6.00% - At this rate level, inventories of housing will begin to expand rapidly. There will be a rush of sellers trying hard to get out of their current homes and the recent rash of speculators in many markets will exasperate the situation. With so many people rushing the doors at once, a sudden glut of "For Sale" signs immediately emboldens buyers who have been waiting for things to turn their way. Based on my statistics, for every 100 homebuyers that could have qualified for a mortgage at 5.25%, that buying pool is immediately shrunk to 85 buyers with the 30-year rate at 6.00%. Real estate values will need to decline by 5% to get the pool back to 100.

30-YEAR FIXED RATE REACHES 6.50% - Based on my statistics, the pool of buyers that can now qualify for a mortgage at 6.50% has shrunk again to 68 buyers. Real estate prices will need to decline almost 12% from current levels for the pool to return to 100 potential buyers who could have afforded the home with a 5.25% mortgage.

30-YEAR FIXED RATE REACHES 7.00% - Now the pool of buyers has slid below fifty to 46 potential buyers with the mortgage rate at 7.00%. Suddenly housing values need to decline almost 22% from current levels to get the pool of potential buyers back to 100.

30 YEAR FIXED RATE REACHES 7.50% - This is the level where a "doomsday" scenario for real estate begins in many regions of the country that have experienced the largest increases in the previous 5 years. Our fictitious pool of 100 buyers who could have afforded housing with a 5.25% mortgage has now been reduced to 28 people. At this point, values would have to decline by almost 35% from current levels to get our buying pool back to 100.

30-YEAR FIXED RATE RISES ABOVE 8.00% - At this point the market will need to give back nearly all the gains enjoyed between 1999 and 2005 in order to stabilize the marketplace. The decline that would result would be more severe that the one experienced in the Northeast and Southern California between 1989 and 1994 when homes depreciated between 20% to 25% in those markets and condo prices dropped between 40% and 60%. No region of the U.S. would be immune although each area could look to 1999 market values for an idea where their respective bottom might be.

If you are curious what may make interest rates rise simply read on to the next line.

THE BOND MARKET IS OVER TOO

I was one of the few people in the world who maintained a low interest viewpoint for the economy all the way through 2004 and so far into 2005, but the time is now over for me to keep that stance. The very long-term trend of low interest rates is over and we will now enter an extended cycle of slowly and steadily increasing rates.

For the purposes of full disclosure (not that I feel that this is necessarily anybody's business than mine) I have completely liquidated all bond holdings in my taxable accounts. I continue to be heavily invested in bonds in my retirement accounts and I cannot foresee that situation changing. I also want to remind my readers that none of what I am saying in this newsletter should be construed as investment advice, and should you find yourself making decisions based on my opinions, please do me a favor and lose my email address and phone number. I don't want to hear about it.

Some of my rationales for my change of viewpoint are as follows:

THE FISCAL SITUATION IN THE INDUSTRIALIZED COUNTRIES

Just over a week ago, the rating agency Standard & Poors confirmed what I have been telling my readers for a very long time, which is that the massive and looming liability of an aging population will be devastating to all the major industrialized nations. Many people would never be able to conceive that the debt issued by the U.S., U.K., Japan, Germany or France could ever be considered "Junk Bonds", but consider these facts released by S&P:

JAPAN - Their debt is already "junk" rated and it is estimated that their debt will reach 700% of their GDP by the year 2050. That is the equivalent of a person earning $50,000 a year being $350,000 in debt. Maybe that person will be able to repay that debt. Maybe they won't.

FRANCE - Their debt should reach "junk" status by the year 2023 and their debt reaches 235% of their GDP in 2050.

UNITED STATES - Uncle Sam's rating will reach "junk" level by 2026 and debt levels will surpass 239% of GDP by 2050. For some perspective, the debt of the United States Government is currently only 65% of their GDP.

GERMANY - The Germans will pull into the "junk bond" garage right before New Years Eve 2030 while their debt grows to 221% of GDP in 2005 compared to the 68% level it is at today.

UNITED KINGDOM - Perhaps feeling somewhat left out of this pity party, England will join everyone else in the "losers lounge" right before 2035 when their bonds drop below "investment grade" and their debt level rises to 160% of GDP in 2050 versus only 42% today.

ITALY - Our Italian friends have already suffered some ugly financial problems during the past 10 years and their debt is already 104% of their GDP. I felt compelled to mention them since they deserve a gold star for being the only major country who should actually see their debt level SHRINK by 2050 to 91% of GDP.

The other factors that are unavoidable that will also cause a rather long and cyclical increase in interest rates are:

--Credit related spreads on many corporate, municipal and asset related products have already started to swell from the nearly historic lows recently reached. This simply means that in the recent past lenders (bond investors) have been accepting very little "extra" return for lending to entities that present more credit risk than U.S. Treasury offerings. With the potential credit downgrading of many corporate and municipal offerings, along with the extending duration of lots of mortgage and asset backed securities, investors will quickly demand higher returns to compensate them for the increased risk. This will drive the prices of these products down and interest rates upward.

--Oil prices will not go down in any significant way for what is likely to be a very long time. As much as I have been trying to warn readers that it was inevitable that oil would spike in the near future, even my jaw dropped last week when Goldman Sachs raised their upper limit on oil to $105 per barrel. The prospect of oil prices being quoted in triple digits was and will be an enormously sobering thing for many investors and industries. This, along with other commodity inflation will contribute to driving rates higher and higher. As the cost of manufacturing, travel and nearly everything else begins to price in these increased costs, bond investors will demand to be compensated to keep them ahead of this inflation.

--The possibility of an unexpected financial disaster that is impossible to predict with any pinpoint accuracy increases on a daily basis as interest rates rise. It has always been the historic case that environments like we are currently experiencing tend to hatch economic explosions in one segment of the marketplace or another without fail, and this is true going back to well before the 1929 stock market crash. If forced to make any particular prediction, I suspect we will witness the failure of a fairly major financial institution due to a position in mortgage related products or an un-hedged, or inadequately hedged position in credit default derivatives. Remember who warned you about this and watch the dampening effect it will have on a wide variety of markets.

STOCKS WILL LANGUISH

The headline says enough, but the facts remain that overall U.S. stock values remain too high by historic standards. While I feel that valuations are by no means horrifying, my belief is that the stock market will become a surprisingly volatile whipping boy whenever negative news filters into people's consciousness. You can always argue that "stock pickers" can make money in any sort of market, this will become increasingly difficult in a market that seems to punish the good companies almost as much as the bad. Overall, the stock market will prove to be worth avoiding for the most part.

CASH AND COMMODITIES WILL BE KING

More than anything, try very hard not to lose money in the coming few years.

--Don't lose money in this real estate market.

--Don't lose money in mid to long-term bonds.

--Don't lose money in this miserable stock market.

There will be very little wrong with sitting on a pile of cash while the upcoming storm rolls through, and there may be money to be made in commodities and the stocks of companies in commodity businesses. I don't have any particular choices to offer, but you get the idea. When you look back five years from now, the prospect of having made 3% to 5% on your money by staying liquid in cash might make you feel like you were quite the genius. In the meantime many people will be well served to head back to harbor and securely fasten your boat to the dock until things blow over.

IMAGINE THIS

Everyone knows that the world's largest carmaker is General Motors and you likely are already aware of the pressures that GM has come under in the past few months. What you may NOT know is that GM stock was around $90 as recently as 2000 and has most recently been trading at about $29.50. This decline has brought the stock market value of General Motors Corporation to about 16.6 billion dollars.

This next piece of information is the part that is difficult to imagine, but just weeks ago Harley Davidson watched their stock market value soar to a level that actually exceeded GM's value by in excess of a billion dollars. Harley's stock has since declined by about $6.00 bringing their market capitalization to 16.4 billion dollars.

I just wanted to share this with you because I don't think I could have ever imagined the day that would find General Motors so out of favor that investors would find Harley Davidson a more valuable company. More evidence to keep in the back of your mind is that there are plenty of things that you might never imagine happening, which managed to happen anyway. Always keep that thought in the back of your head before being dismissive toward any future scenario occurring that might effect an investment you are considering. John Lennon said it best; "Life is what happens while you're busy making plans."

A SORRY DISPLAY

I hate that fact that I actually stooped to using my wonderful readers as unwitting participants in a social experiment, but alas, I did precisely that last month.

I titled last month's newsletter "Mother's Little Helper" and then deeper into the edition I made mention how I had lifted the title from a Beatles tune. I was curious to find out how many of my 250,000+ subscribers and Lord knows how many thousands of others that get my newsletter forwarded to them would point out this GREVIOUS misappropriation of one of my favorite Rock and Roll lyrics of all time.

Well, the results are in and they were miserable. A grand total of 14 people out of hundreds of thousands spotted the mistake and wrote me to point it out. With the list so horribly small, I have even decided to credit them by name. Here are the notes I got:

Annie - I *know* you know this but..."Mother's Little Helper" is Stones, not Beatles - am I like the 9000th person to tell you this?! And I got the brainteaser too..I think, haven't checked my answer yet.

Dennis - Wasn't "mother's little helper" a stones tune, not Beatles?

Kathleen - Just read your February Newsletter and I enjoyed it immensely, as I always do. Your candor and insight make for some marvelous reading. However, I must call to your attention the fact that I believe "mother's little helper" is a line from a Rolling Stones tune (19th Nervous Breakdown), not The Beatles.

Michael - Great newsletter as always! Add my correction to the hundreds you have or will receive correcting you that "Mother's Little Helper" is a Rolling Stones tune.

Phil - I'd never knock your opinions, but the Stones (not Beatles) are responsible for 'Mother's Little Helper'.

Charles - You of all people!! Rolling Stones not Beatles!

Michael - Mother's little helper is the Rolling Stones not the Beatles. I am shocked!!

Bill - Mother's Little Helper was a Stone's song.

Hey Mike. I really enjoy your newsletters. Please keep e-mailing them to me. Your reasoning is quite accurate, as far as I'm concerned, about most of the subjects you cover (especially the Stupid Politician Tricks).

Joe - However, I ran across your statement in the latest newsletter that linked the phrase "Mother's Little Helper" to a Beatles song. I'm unfamiliar with any Beatles song that uses that line (although I could certainly be wrong), but would suggest that the song you actually meant to quote was by the Rolling Stones and actually called "Mother's Little Helper." "What a drag it is getting old..." Just thought I'd point that out. Please feel free to correct me if I'm wrong. I won't be insulted, I promise.

Brian - Re: the following quote from your newsletter: "First and foremost, let me cop to lifting the "mother's little helper" line from a Beatles tune." FYI, the line is from a Rolling Stones song (of the same name), not Beatles. Thought you'd want to know. Keep the good stuff coming!

David - That was "The Stones", man!

Tom - First and foremost, let me cop to lifting the "mother's little helper" line from a Beatles tune. Don't you mean a Rolling Stones tune?

Paul - Isn't the "mother's little helper" lyric from the Rolling Stones?

So I promise there are no hidden tests in this edition, but I can't rule out something in the future so pay attention. And definitely feel free to point out horrible errors like that to me in the future.

BRAINTEASER

For a change of pace I thought I might toss a business/finance related trivia question for you. The question actually popped into my head this past week when I spent a decent amount of time talking about the person who is part of the answer on several occasions during my seminars. There will likely be only two kinds of reactions to the question. "That was way too easy" or "How the heck am I supposed to know that?" Now let's see which group you fall into.

"Who holds the world record as the highest paid EMPLOYEE in history, how much did they earn, and for extra credit, who paid it to them and when?"

When you can't stand it anymore, just click the following link for the answer:

http://www.afs-seminars.com/brainteaser_Mar2005.html

And the answer to LAST month's brainteaser is:

The ball in the buckets of 45 degree F water hits the bottom of the bucket last. Did you think that the water in the 30 degree bucket is frozen? Think again...the question said nothing about the bucket having anything in it. Therefore, there is no water (or ice) to slow the ball down.

http://www.afs-seminars.com

Copyright 2005, Michael Gasior. All Rights Reserved.

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