Be Careful About What You Invest In
Thursday, May 23, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

The Role of REITs
REITs are an easy and low-cost method of investing in real estate.

Pitfalls of Life Settlements
Buying the benefits of someone else’s life insurance is risky.

AAII Discussion Boards
Do you invest directly in real estate?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 49.0%, up 10.5 points
  Neutral: 29.5%, down 2.7 points
  Bearish: 21.6%, down 7.8 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

I want to start with a short comment about Japan before moving onto the main subject of this week’s newsletter. As you probably heard, the Topix index plunged almost 7% today, the biggest drop since 2011’s earthquake and resulting tsunami. According to both Bespoke Investment Group and James Mackintosh of The Financial Times, this was also just the ninth time in the past 50 years that the Nikkei has fallen by more than 7% on a single day. (The Nikkei encompasses 225 stocks; the Topix tracks about 1,700.)

The drop was blamed, in part, on disappointing economic news from China and rising interest rates. Another contributing factor was the magnitude of this year’s rally in Japanese stocks. Even after today’s drop, the Topix is still up 2% this month and up 38% year-to-date, according to Bloomberg News. Volatility goes in both directions, and today was an example of downside volatility occurring after a large degree of upside volatility.

Prior to today’s Japanese market action, I had intended to start today’s commentary with the words, “Just because you can, doesn’t mean you should.” It is a phrase I find myself occasionally tweeting after hearing about a new investment product or strategy, such as a new specialty fund. There is a never-ending list of new products and revived investment ideas whose risks are capable of derailing your long-term plans.

Two of the most recent ones involve real estate and pension and settlement income streams.

CNNMoney published an article on Monday discussing how some investors are using their retirement savings to make investments in real estate. Not in real estate investment trusts (REITs), but directly in individual properties. My presumption is that the practice is not widespread, but there are enough people doing it to prompt an article on a popular website.

For a small portion of the population, direct investments in real estate can make sense. I have two friends who fit into this category. One spent years working for a major homebuilder before starting his own homebuilding business. The other not only had parents who owned rental properties, but also managed rental properties on his own before using his retirement savings to finance the purchase of an apartment complex.

Those of you without these types of backgrounds should tread carefully when investing in real estate. Buildings and land are comparatively illiquid relative to stocks, REITs and funds. Transaction costs are high. Buildings require upkeep. Mortgage payments, insurance, property taxes and any association fees require a constant outflow of cash, regardless if the property is rented or not. Add in the other potential headaches, such as bad tenants and late repair calls, and it becomes clear that considerations other than price appreciation must be factored into the decision process.

There is also a risk if retirement savings are used to fund the down payment on one’s home. If the house falls in value or fails to appreciate faster than the stock market over the long term, a sizeable opportunity cost occurs. If a 401(k) loan is taken, tax liabilities are created if the loan is not repaid by the time the person leaves their job.

The second is pension and settlement income streams, which the Securities and Exchange Commission (SEC) and FINRA recently published an alert about. Often pitched as pension loans, pension income programs, mirrored pensions, factored structured settlements or secondary-market annuities, these are investments intended to provide a stream of income based on someone else’s pension or lawsuit settlement.

The appeal of these investments is the 5.75% to 7.75% yield. The downsides are the high transaction costs, the difficulty of selling them, the risk you may not be paid and the risk that the agreements may not even be legal. In other words, these can be investments that are too good to be true. More information about them will be included in next month’s AAII Journal.

Like real estate, buying and selling receivables and cash flow streams (a practice referred to as “factoring”) can be profitable if you know what you are doing, have the contacts and have enough capital to build a diversified portfolio. Factoring can be a challenging business for those who have experience doing it; it is very risky for an investor looking to buy a stream of income from a middleman.

There will always be investments that sound appealing. However, some investments are often pitched to benefit the seller or the company facilitating the transaction, not the investor. This is why just because you can buy an investment, does not mean you should.

More on

The Week Ahead

The U.S. financial markets will be closed Monday in observance of Memorial Day.

Just four S&P 500 member companies will report earnings next week: Tiffany (TIF) on Tuesday, Joy Global (JOY) on Thursday, and Costco Wholesale (COST) and Pall Corp. (PLL) on Friday.

The week’s first economic reports will be the March S&P Case-Shiller Housing Price Index and the Conference Board’s May consumer confidence survey. Both will be released on Tuesday. Thursday will feature the April pending home sales index and revised first-quarter GDP. The final May University of Michigan consumer sentiment survey, April personal income and spending and the May Chicago PMI will be published on Friday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Optimism jumped to its second-highest reading of 2013 in the latest AAII Sentiment Survey. Accompanying the increase was a drop in pessimism to its lowest level in more than a year.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 10.5 percentage points to 49.0%. This is the highest level of optimism since January 24, 2013 (52.3%). This is also just the second time in the past 10 weeks that bullish sentiment is above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, fell 2.7 percentage points to 29.5%. This is the first time in five weeks that neutral sentiment is below its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 7.8 percentage points to 21.6%. This is the lowest level of pessimism recorded by our survey since February 9, 2012 (20.2%). The historical average is 30.5%.

Both bullish and bearish sentiment are near the outer edges of what we consider to be normal readings. Though optimism is high and bearish sentiment is low, neither are at unusual levels. One standard deviation above average for bullish sentiment is 49.3%. One standard deviation below average for bearish sentiment is 20.5%.

Since bearish sentiment peaked at 54.5% on April 11, 2013 (nearly a three-year high), it has fallen by a cumulative 32.9 percentage points. Over the same period of time, bullish sentiment has rebounded by a cumulative 29.7 percentage points (from a low of 19.3%).

The market’s resilience and the ongoing record highs being set by the Dow Jones industrial average and the S&P 500 index are keeping AAII members optimistic about the short-term outlook for stock prices. Also helping sentiment were the first quarter’s better-than-expected earnings, signs of continued economic growth and a lack of new bad news. Some investors remain cautious, however, because of current valuations, the actual pace of economic growth and a lack of progress on key issues by the White House and Congress.

This week’s special question asked AAII members for their opinion of the current dividend yields. Nearly one in four respondents (23%) described current yields as being low or too low. Another 16% described dividend yields as being higher than bond yields. A similar percentage thought dividends could be or should be raised. Many in this third group expressed a desire for companies to divert money from share buybacks to dividend increases. More than one in five respondents described dividends as either being good or satisfactory.

Here is a sampling of the responses:

  • “I would rather see companies pay shareholders with increased dividends than share buybacks.”
  • “Getting leaner as we speak. Searching for value is more difficult every day.”
  • “Share price increases have pushed dividend yields too low.”
  • “Yields could be higher. More cash rich companies should declare dividends than hoarding cash beyond reasonably foreseeable requirements.”
  • “Definitely beats the current yield on bonds.”
  • “Reasonable considering the other options for income.”

» Take the sentiment survey