October 29, 2007

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Market Summary

What a difference a few weeks can make. In just four weeks, from mid-July to mid-August, the S&P 500 dropped 9% and foreign stocks declined 12%. Despite the wild swings, the S&P 500 Index is up 7.3% and the EAFE Index (foreign stocks) has gained 11.1% this year through October 22nd.

There was a huge change in the five-year return from last quarter to this quarter. As of June 30, 2007 the five-year annualized return of the S&P 500 Index was 10.7%. One quarter later, on September 30, 2007, the five-year annualized return jumped to 15.5%. What caused such a profound effect on five years worth of returns? Looking back to the second quarter of 2002, the S&P 500 Index lost 17.3%. Having that one quarter "roll off" the end of the last five years increases the quarterly returns by nearly one percent, increasing the annualized return from 10.7% to 15.5%.

This is a good time to point out that equity investment returns in Q2 2002 were terrible: besides the S&P 500 loss of 17%, foreign stocks dropped 20% and small caps lost over 21%.

Notice a trend here? When returns are exceptionally high, we're going to remind you that markets behave badly at times. When markets drop, we're going to remind you of earlier, happier times. The message is to stay invested and try to ignore the short-term fluctuations.

Your Home as an Investment

Home prices are making headlines lately and we get a lot of questions about home ownership as an investment opportunity.

It is the mantra for some that a home is a good investment. However, looking back to 1890, appreciation of personal residences has trailed appreciation of publicly traded stocks through most periods. And when the costs of home ownership such as property taxes, maintenance and insurance are included, home ownership is decidedly not a good investment.

We have always advised our clients to consider home purchases as partly a consumption decision, i.e., some of the purchase price and operating costs are a pure cost of enjoyment. Even if home appreciation rivaled stock market returns, it is difficult to apply the same discipline to home buying that we use in purchasing and managing pure investments.

I have not yet met a person who sold their home to rebalance their real estate investment. Nor have I met a person who moved regularly to capture the $250K capital gain exemption for personal residences that is available per person every two years. And while few of us are willing to buy stocks using a margin loan, most of us are comfortable leveraging our investment in our home, typically borrowing 400% more than the dollars we invest (e.g., borrowing $400,000 against a $100,000 down payment).

To fully evaluate home ownership, we would consider operating costs, capital improvements, taxes and risk before purchasing a property. Operating expenses of a personal residence are high, with little or no tax benefit (property taxes are subject to AMT, and rarely provide a usable deduction).

From a tax perspective, the $250,000 per person capital gain exemption is a benefit, but less desirable than the tax benefits of investment real estate, which include tax-free exchanges and full deductibility of operating expenses.

From an investment perspective, the best that can be said about homes is that the payment of the mortgage represents forced savings. The growth of the investment is a testament to the power of compounding, and not to higher appreciation than other traditional investments.

From a risk perspective, it is better to own a small share of many properties than one large property, especially where we experience earthquakes, fires, and mudslides regularly.

Are we suggesting that people do not buy homes? Absolutely not! People get a lot of enjoyment from their homes and it is reasonable to pay for that enjoyment. Financially, the payment of the mortgage is a type of savings; houses are a good inflation hedge; and values fluctuate far less than stock values. Best of all, a home provides a cushion in old age, offering the potential to downsize or obtain a reverse mortgage.

In contrast to a home, investment real estate offers better potential returns. Investors with knowledge of local markets, time for research, and access to capital are able to make opportunistic purchases of commercial properties and obtain returns that compare favorably with the stock market.

Investors who wish to diversify their real estate investments or who do not have the resources to buy individual properties can invest in real estate through REITs (Real Estate Investment Trusts). REITs offer many advantages and can be incorporated into most investor portfolios. Grubman Financial has included REITs in portfolios in the past; however prices have become very inflated in recent years and we have avoided most REIT investments lately.

Sales of existing homes in the Bay Area declined 46% from September 2006 to September 2007. The median sale price declined 5% in one year and 18% from the peak reached last May. The national numbers reflect the same trend, although the declines are not as extreme.

We expect median prices to decline further as a result of increased inventory (8.5 months in September 2007 vs. 1.9 months one year ago). The price declines thus far are reasonable and not unexpected, given the tremendous increases seen in the last five years. We expect the rate of price decline to slow markedly as buyers step back in to the market and prices regain equilibrium.

Regards,

Audrey Grubman, CFP^®