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November 2015

“Whenever you find yourself on the side of the majority, it is time to pause and reflect."- Mark Twain

One early evening a few weeks ago, I stepped out of our modest offices in Hayes Valley, arguably ground zero for much of the most recent wave of gentrification sweeping through San Francisco, and my thoughts flashed back to the 80’s and early 90’s when the neighborhood was better known for crack addicts, hustlers, prostitutes, muggings and general homelessness. The homeless are still sprinkled about, as they are throughout much of the city, however things have changed along Hayes Street in a big way. Rents in the neighborhood are among the most expensive in San Francisco and the businesses located here are booming. Looking up and down the street, I could not help but see similarities between some of the more trendy blocks one would find in the West Village. The sidewalks are packed, Uber cars are clogging up the streets, and fashionable folks are socializing throughout the neighborhood. Longtime business residents including the Hayes Street Grill and Caffe Delle Stelle are joined by new restaurants such as Absinthe, Brass Tacks a cocktail lounge, and the NYC clothing boutique Steven Alan, to name a few.

Is gentrification a four-letter word? In many parts of the country it is looked upon as inevitable as neighborhoods and individual tastes change. Old businesses and buildings get torn down and new ones are built up. Generations of people evolve and so do cities. New York City has been particularly adept at this, which I believe contributes to it’s dynamism, putting the metropolis in a league of it’s own. In San Francisco, where my heart lies, gentrification as far back as I can remember has been looked upon with scorn. Rarely will one admit to supporting gentrification or cite the people and communities who have benefitted. In social gatherings, I have found people are instinctively quick to point out others whom they believe to be part of the problem without periodically taking a look in the mirror themselves. The idea that a group of residents be afforded special protections in the name of keeping the community balanced does not sit well with me philosophically. Change, in most forms is usually difficult on everyone.

Outside of wealthy international investors, a common question asked among San Francisco Bay Area residents is who can afford to buy into this explosive real estate market? Using Zillow’s mortgage calculator as a basis to calculate the hypothetical monthly payments on the median priced city home of $1.1mm, and assuming 20% down on a 30 year fixed loan at 4.0%, this comes to a monthly payment of approximately $5,400. If a household is bringing in $250k before taxes and they take home 65% after taxes and contributions or $162.5k, their housing payment would eat up approximately 40% of their disposable income. Not a lot of room for error.

So what is going on here? Stock options in the technology sector, that’s what. According to a 10/26/15 article in the Wall Street Journal, titled “Tech’s Effect on Home Prices.” “Protestors of rising home prices in the San Francisco area blame the technology sector saying the industry’s high salaries and lavish stock- option awards are fueling the increase... Home tracker Zillow, at the request of The Wall Street Journal, homed in on employees at Apple, the world’s largest tech firm, studying the neighborhoods where they live to tease out the extent to which tech workers in particular are pushing up home prices... The findings: Apple workers live in pricier homes than other residents in the region, and home values are rising much faster in neighborhoods where Apple workers live. The gap between homes that Apple employees live in and overall prices in those areas, according to Zillow, has widened since the release of the first iPhone in 2007.”

When will San Francisco home prices settle down? The answer most likely lies with the U.S. stock market and particularly within the technology heavy Nasdaq index (see Figures 1 & 2). So, when will the stock market settle down? Most market analysts would respond when the era of easy money begins to tighten. However, I believe we are unlikely to see any significant tightening much less a normalization in the term structure of interest rates as this would be politically difficult for two reasons. The first argument is well known and has to do with easy money igniting the stock market out of the 2007-09 credit bust. The second, and is less talked about, has to do with servicing the U.S. national debt (see Figures 3 & 4). According to a 2013 paper published out of Harvard University, “A World with Higher Interest Rates,” the authors Thomas Healy and Sandesh Dhungana simulated what effect a 5% increase in interest rates would have on the U.S.’s debt servicing ratio (debt service ratio = interest payments/tax receipts). They found that, “A five percent cent spike in interest (to the 7% average of the last 30 years) would force the U.S. government to commit as much as 25 percent of its revenues to debt service, prompting the need for draconian spending cuts.” This would be unthinkable in our current economic and political environment and therefore few people are even considering the possibility of this scenario much less the implications. With this in mind, I believe that the only way interest rates ever normalize to historical levels is if the Fed loses control of the yield curve and the market forces them there. Good luck bond bears.

Many academics believe that forecasting financial markets is a fool’s game that has more to do with chance than any real insight or skill. The best we can hope for as a group is average or market returns as any edge one possesses will quickly be arbitraged away. They might be correct “on average” but as the saying goes, “A statistician can have his head in the oven and his feet in the ice, and he will say that on the average he feels fine.” I believe financial market prices are a reflection of complex human emotions and behavior, which include greed, fear, belonging, jealously, and hope. The methods we use to model and forecast prices are imperfect to say the least. What individuals can bring to the table is a unique edge and arguably more important, a disciplined approach. With that said, my view last month that one should be cautious on the back of the late summer selloff appears highly conservative given the large rally stocks have exhibited during the month of October. I still believe in this environment that caution is the way to go, however I would look to revisit my market outlook should new equity index highs become breached. This equates to 2135 on the S&P 500 and 5232 on the Nasdaq composite.

Continuing onward with this in mind, I came across data showing that both retail and institutional money appears to be in wait and see mode. According to ICI (Investment Company Institute) total net assets in money market mutual funds has climbed 3.4% since 6/10/2015 and stands at $2.7 trillion. In addition, ultra wealthy families have also been on the sidelines. This is according to Bruce Stewart who is chief investment officer of the family office services group at BNY Mellon Wealth Management. He was quoted in the 10/25/15 edition of the Financial Times saying, “Another trend among some family office clients is to hold cash and wait for good opportunities to invest.” I believe this is a reflection of the high level of risk one assumes in today’s financial markets given the distortion that zero to negative bound interest rate policy is having on the developed economies financial markets. To put this into context, think about the typical 60/40 stocks/bonds portfolio. At historically low interest rates there is little cushion left in the bond portion of the portfolio should stocks go through a significant bear market. In years past when 10yr U.S. Treasury yields hovered north of 6%, a move to 3% would produce a price return of approximately 23% not including the positive effects of convexity, Now, with 10yrs around 2%, a move to 1% gives us approximately a 9% price gain, again without taking into account convexity. The example above illustrates how investors have lost a significant portion of the benefits from diversification due to the current low rate environment. In light of this, I believe investors will find that they could benefit from professional investment management and guidance now more than ever.

Lastly, I came across a recent interview with Sam Zell on CNBC. For those of you who are unfamiliar, Mr. Zell is chairman of Equity Group Investments a private investment firm, which he founded in the 1960’s. He has a reputation as a no nonsense outspoken personality in the investment world and is well known for being a giant in real estate having sold Equity Office Properties Trust, the largest office owner in the country to Blackstone Group at the top of the housing market in 2007. Listening in on his interview, I found it interesting that he was conveying to the hosts ideas along the same lines, which I had been discussing with clients and colleagues recently. Namely, that the stock market is out of sync with the real economy and that much of the Bay Area housing market is being fueled by stock options. Please click the link (here) to view this short video clip.


Justin Kobe, CFA Founder & Portfolio Manager


Securities and Advisory Services offered by Protected Investors of America, an SEC Registered Investment Advisor. Member FINRA/SIPC. The views expressed in this commentary are the personal views of Justin Kobe of Pacificus Capital Management and do not necessarily reflect the views of Protected Investors of America. There is no assurance that the investment process will consistently lead to successful investing. This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

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