“As we work our way through the Great Recession, the discussion often sways between whether to expect inflation or deflation.  Deflationists mention the huge credit bubble that we are digesting, and often like to point out Japan’s experience over the last 20 years.  Inflationists point out all of the government spending and quantitative easing (essentially money printing) that may lead us to hyperinflation, mentioning episodes like the 1970’s Great Inflation, or even worse, Germany’s Weimar Republic. Who is right, and is the answer actionable for an investor?  In order to keep the brief discussion more interesting, I’ve decided to add a few quotes from John Maynard Keynes, the economist our leaders claim to emulate.

“It is better to be roughly right than precisely wrong” – John Maynard Keynes

Getting the inflation/deflation call seems very important. Inflation typically crushes fixed income, as higher rates can choke business, and pushes down the value of investor’s bonds.  Further, high interest rates make stock investments less appealing relative to bonds, and therefore stocks tend to fall in price until their dividend yields become more interesting to investors.  Hard assets can often make large gains during these periods, as falling currency values lose purchasing power, pushing up the nominal value of real assets.

On the other hand, deflation can cause investors to flock to bonds, which makes their values rise, and yields fall.  Business suffers as prices drop.  Wages also drop, as business slows.  People often save more and spend less, further deepening the deflationary spiral.  As business suffers, stocks typically drop.  A poor business climate usually leads to less use of commodities (hard assets), and their prices often fall.

It is easy to conclude that making a bold bet on inflation will be disastrous if deflation continues, and vice versa.

“Markets can remain irrational far longer than you or I can remain solvent.” – John Maynard Keynes

Even if an investor ultimately makes the right call on inflation/deflation, when does her/his thesis play out?  Remember, one of the best investors  of our generation called the debt bubble well before it happened.  George Soros (among others) mentioned the dangers of our enormous leverage in the mid 80’s, through the 90’s, and into the 2000’s.  He was spot on in his analysis, but acting on his forecast would have made one miss the greatest bull market in American history.  Imagine being short stocks as they rose 16+ percent a year from 1982-2000?

“Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally” - John Maynard Keynes

In order to avoid being out of sync, or even worse, loosing their investors, many “professional” money managers choose to follow the crowd.  They “manage” risk by hugging investment indexes, and feel it is ok to lose 49% of an investors portfolio, as long as the markets went down 50%.  Clearly, this may work for the stockbroker/financial advisor profession, but it doesn’t work for people who want to grow their assets and retire in comfort and safety.  We believe this mentality is destructive to most people’s savings.  The need to follow the herd is deep seeded in the human psyche.  To overcome this bias, one must first understand it.  Then, one must study history to see what people did well, and where they failed.  Most importantly, a rational investor must be willing to do things differently than the herd.  It is difficult to watch the neighbors make millions on tech stocks, or reap huge profits flipping houses and condos.  However, fundamentals eventually apply.  A rational investor will be called stupid, old fashioned, and jealous while bubbles expand.  She/he will be resented when the bubble pops.  In order to survive and thrive in an investment career, it would be wise to avoid “worldy wisdom”.

“A study of the history of opinion is a necessary preliminary to the emancipation of the mind.” - John Maynard Keynes

In the inflation/deflation debate, most people with an opinion attach their ideas to a specific guru or school of economics.  One theory is memorized, and doggedly followed, even when experiences dictate that things aren’t working as forecasted.  There is very little thinking and learning involved, only determined rooting for whichever “team” one has chosen to follow.  History is ignored, and few people open their minds to the idea that they might be wrong.  Instead of learning all sides of an issue, most observers start with a premise and assume that everyone else is wrong.  In our opinion, these debates are interesting, but only semi-relevant.   Often times, each school of economic thought offers a few nuggets of wisdom attached to much hubris.

“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” John Maynard Keynes

While we understand the different schools of economic thought, and pay attention to their lessons, we choose to be open minded as to what may happen in the future.  History leaves a thick paper trail, and what actually happened to markets and asset valuations over time is more valuable to us than defending individual theories.  We want our clients to survive and thrive over their investing careers regardless of the direction that inflation goes.

Those of you that visit our office frequently know that while we religiously track current events, we also spend an enormous amount of time studying the history of the markets.  Often times, the parallels are chilling.

What we find is that most often, the bulk of the mainstream economists are wrong.  Most of our leaders appeared to be caught off guard by the collapse of the debt bubble, despite nearly twenty years of warnings by high profile investors, competent journalists, and the lessons of history.  Politicians typically follow Keynesian policies (stimulus spending to create jobs until the economy gets back on its feet), as this is often the school of economic thought most readily pushed on students at American Universities.  Further, Keynes’ prescription for recessions requires massive amounts of deficit spending and appeal to the populist mentality of “doing something to help”.  Our leaders forget that Keynes recommended government surpluses in good times, and government spending in tough times.  It seems that we either suffer from selective memory, or that we have chosen our theory because it allows our leaders to avoid fiscal responsibility, while feigning to follow a well known economist.  Historically, stimulus hasn’t worked well in solving recessions or credit bubbles.  Tough love (bankruptcies, assets price collapses, high unemployment) has worked faster, but has understandably wrought political unrest.  Our politicians don’t have the will to say “no” to their voting base, therefore stimulus will most likely continue until it creates massive inflation, high interest rates, and potential social unrest.  (Hey, no one said running a democracy is easy!)

We also find is that quality businesses purchased at low prices tend to thrive over all time and space.  The price of their stocks may swing with the ebb and flow of boom and bust cycles, but this really has little to do with the cash that these businesses earn and distribute to their shareholders.  Large, multinational corporations have the added advantage of doing business in different countries.  Some countries boom while others bust, creating some protection in the event of regional issues.  Regardless of the economic outlook, people still eat, drink, and wear clothes, and the companies that supply these products really don’t care if we are of the Keynesian or Austrian persuasion!

Further, when we buy a bond, we actually become a creditor.  Our thought process, when loaning money, is no different when buying a corporate bond than if we were loaning money to a distant cousin.  When do we get paid back?  Is there adequate cash flow to pay us timely interest and principle?  Is the interest rate we are charging enough in context of both the risk of the loan, as well as in regard to competing investments?  Only if these questions can be adequately answered will we invest.

By the way, these things also work for real estate investments, with an additional look at regional supply/demand characteristics as well as incomes and cap rates.

History shows that rational analysis of business and loans, as well as the proper pricing of these investments is more important to financial success than just looking at the economic backdrop prevailing at the time of investment.  To reiterate, the safety of an investment (whether it be a loan or an ownership position) is of paramount concern for an investor, but the price paid is nearly as important.  Money managers and individuals that got these two concepts right made money during the 30’s and 70’s, two difficult periods for investors.

“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”  John Maynard Keynes

As pointed out above, it is not only difficult to pinpoint the direction of inflation/deflation, but also the timing.  Credit bubbles tend to cause significant damage to an economy (see Reinhart and Rogoff’s This Time is Different) that takes years to play out.  Contrast this with the United States high debt, inflationary policies, and a fed Chairman that has stated he will “drop money from helicopters” before he allows deflation to take hold.

Instead of making a bold wager on one or the other directions, we think it is prudent to remain open minded and hedge our bets.  Housing and other big-ticket items that require financing to purchase are likely to continue falling in price.  Until incomes begin to stabilize, and even rise, expect other discretionary purchases to remain weak.

Keep in mind (thanks Dave Rosenberg of Gluskin Scheff) that some Americans are walking from their homes and freeing up their cash, which leaves more room for consumption, while further hurting banks, investors, and the fed which hold the mortgages on these properties.  If enough people strategically default, without retribution, consumption can recover quicker, although the losses will most likely be born by investors and by taxpayers in the form of more bailouts, with  higher government debt and rising taxes.

As the government continues to add debt, and the Federal Reserve continues to monetize assets (print money), we put our currency at risk.  A floating currency means that the value of said currency is left up to the financial markets in theory at least. In practice, many countries manage the value of their currencies through market intervention.  If investors believe in the stability of the U.S. dollar, it’s value can remain high despite skyrocketing debt and quantitative easing.  If, on the other hand, investors panic, the results could be severe, and could happen almost instantly. The British Pound’s recent sharp drop should be a warning to developed countries.  We are a nation that imports more than we export.  If the value of our currency plummets, the cost of much of what we import will rise.

Tying it together, we think it is entirely possible to see, for example, houses continue to fall, while the cost of food and oil rise.

We could spend hours discussing other potential sources of inflation/deflation, but I think our readers get the big picture.  There are legitimate threats for both inflation and deflation.  Over time, our spiraling deficits will most likely lead to a weaker dollar.  Whether these trends play out over 2 years or 10 years, nobody knows. In the meantime, the collapse of a credit bubble tends to push prices down for years, slowly unfolding despite our impatient desire for “things to get better”.  In conclusion, we think it is entirely possible to see, for example, house prices continue to fall, while the cost of food and oil rise. There is no reason to believe that all prices must rise or fall at the same time.  If history is any guide, quality assets bought at cheap prices will provide protection from inflation and deflation.  By owning assets of this type, we believe an investor can both protect capital, and grow purchasing power.”  Courtesy of Ancorawest, Robert Barone

Bob says a lot in his writing but I feel that this is worth reading, and thought provoking as well.

David Morris

CRS, CRB,CLHMS, CDPE, SFR, ABR

Here is a quick note from Vince Lotito with PrimeLending, INFO THAT HITS US WHERE WE LIVE:

“There wasn’t a ton of housing news last week, but one can always find a few significant items. For example, foreclosure filings in February were down 2% from January and up just 6% from a year ago — their smallest increase in four years. Most significantly, in the six states that made up 61% of the national total for February, foreclosure filings were down 15% from a year ago. We’re definitely heading in the right direction. �

Here’s a chart showing that housing is a great long-term investment, not withstanding the last 3 years.”

Inventory is getting tight, I know that many of you will find this odd with prices still showing declines and, in some neighborhoods, a For Sale sign on every corner, but inventory is getting slim in select parts of Reno, Sparks and Carson City.

For the first time ever, we are seeing multiple offers on short sales, and the offers are no longer at the bottom of the barrel.  Encouraging signs and with 16 days left in March, this month may well prove to be a bellwether month.

In 2009, Washoe County had 5,231 sales of existing single family homes; an increase of 45 percent from 2008. The median sales price for existing single family homes in Washoe County in 2009 was $185,000; a decrease of 26 percent from the previous year. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Washoe County in 2009 was $78,950; down 47 percent from 2008.

During the fourth quarter of 2009, Washoe County experienced 1,436 sales of existing single family homes; an increase of 57 percent from the fourth quarter of 2008 and a 5 percent decrease from the third quarter of 2009. The median sales price of existing single family homes in Washoe County in the fourth quarter of 2009 was $180,000; a decrease of 19 percent from the fourth quarter of the previous year and a slight 2 percent decrease from the third quarter of 2009. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Washoe County during the fourth quarter of 2009 was $65,000; down 38 percent from the previous year.

During December 2009, the report showed Washoe County had 416 sales of existing single-family homes; an increase of 41 percent from December 2008 and an 8 percent decrease from November 2009. The report listed the median sales price for an existing single family residence in Washoe County in December 2009 at $179,500; an 18 percent decrease from last year and a 3 percent increase from the previous month. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Washoe County in December 2009 was $50,950; down 50 percent from December 2008.

The report showed Reno (including North Valleys) had 3,515 sales of existing single family homes in 2009; an increase of 42 percent from the previous year. The median sales price for existing single family homes in Reno during 2009 was 189,900; a decrease of 27 percent from 2008. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Reno in 2009 was $72,250; down 51 percent from the previous year.

In Reno (including North Valleys), there were 979 sales of existing single family homes during the fourth quarter of 2009; an increase of 61 percent from the fourth quarter of 2008 and a 6 percent decrease from the previous quarter. The median sales price of existing single family homes in Reno during the fourth quarter of 2009 was 185,000; a decrease of 21 percent from the fourth quarter of 2008 and a slight 3 percent decrease from the third quarter of 2009. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Reno during the fourth quarter of 2009 was $61,000; down 37 percent from the fourth quarter of 2008.

The report indicated that Reno (including North Valleys) had 265 sales of existing single family homes during December 2009; an increase of 43 percent from last year and a 12 percent decrease from November 2009. The median sales price in Reno for an existing single family residence in December 2009 was $180,000; a decrease of 22 percent from December 2008 and a slight 2 percent decrease from the previous month. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The existing condominium/townhome median sales price for December 2009 in Reno was $43,400; down 51 percent from last year.

Sparks (including Spanish Springs) experienced 1,638 sales of existing single family homes in 2009; an increase of 53 percent from 2008. The median sales price for existing single family homes in Sparks during 2009 was 175,000; a decrease of 26 percent from 2008. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Sparks in 2009 was $75,000; down 45 percent from 2008.

During the fourth quarter of 2009, Sparks (including Spanish Springs) experienced 441 sales of existing single family homes; an increase of 48 percent from the fourth quarter of 2008 and a slight 2 percent decrease from the third quarter of 2009. The median sales price of existing single family homes in Sparks in the fourth quarter of 2009 was 170,000; a decrease of 21 percent from the fourth quarter of the previous year and no change from the third quarter of 2009. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The median sales price of existing condominium/townhomes in Sparks during the fourth quarter of 2009 was $70,000; down 33 percent from the previous year.

Sparks (including Spanish Springs) experienced 144 sales of existing single family homes in December 2009; an increase of 41 percent from December 2008 and less than a 1 percent decrease from the previous month. The Sparks’ median sales price for an existing single family residence in December 2009 was $175,000; a 17 percent drop from last year and an increase of 3 percent from November 2009. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales. The existing condominium/townhome median sales price for December 2009 in Sparks was $65,000; down 45 percent from last year.

In Fernley, there was 579 sales of existing single family homes in 2009; an increase of 69 percent from the previous year. The median sales price for existing single family homes in Fernley during 2009 was 109,900; a decrease of 34 percent from 2008. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales.

Fernley experienced 167 sales of existing single family homes during the fourth quarter of 2009; an increase of 78 percent from the fourth quarter of 2008 and a 10 percent increase from the previous quarter. The median sales price of existing single family homes in Fernley during the fourth quarter of 2009 was 104,000; a decrease of 29 percent from the fourth quarter of 2008 and less than a 1 percent decrease from the third quarter of 2009. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales.

The December 2009 report showed Fernley had 54 sales of existing single family homes; an increase of 69 percent from last year and a 10 percent increase from November 2009. The median sales price in Fernley for an existing single family residence in December 2009 was $100,500; a decrease of 28 percent from December 2008 and a 12 percent increase from last month. All sales numbers are for existing “stick built single family dwellings” only and do not include condominium, townhome, manufactured, modular or new home sales.

“Turning the corner on the new year calls for a cautious celebration,” said Ken Amundson, 2010 president of Reno/Sparks Association of REALTORS and managing broker of Coldwell Banker Select Real Estate’s Sparks office. “There were many positive signs that we can point to including the fact that more people purchased homes in 2009 in every quarter than the previous year and median home prices have remained stable for the past seven months. As we move into 2010, we can optimistically look at the fact that the supply of homes is at a five year low, government incentives for first time buyers and move up buyers are available through April, and low interest rates remain in effect.”

The Reno/Sparks Association of REALTORS® is an organization providing services to its members to ensure their success as real estate professionals, as well as protecting and promoting the consumer’s dream of homeownership. For more information visit www.rsar.net.