'Hedging' Your Home & The Precious Metals Boom
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Housing Futures & Options

Later this month, reportedly on April 26, the Chicago Mercantile Exchange (CME) will introduce new housing futures and options markets. While other industries, such as agriculture, metals and the financial markets, have had access to a wide range of financial risk management tools (ie - futures and options markets) for many years, such tools have not been available to the housing industry - until now. The CME is continuing its tradition of innovation with the creation of the first comprehensive products to hedge risk in real estate.

The CME housing futures and options will provide opportunities for protection in down markets, and extend to the housing industry the same financial tools that have been available in many other commodities for years. By providing a means of hedging exposure to home prices, participants will have the potential to diffuse the impact of sustained declines in housing prices. According to the CME, the new housing futures and options markets will:

1. Create a new means of risk transfer to a broad range of participants;
2. Have the potential for fostering stability in the housing industry; and
3. Provide an innovative way to participate in the real estate market without having to buy and sell actual properties.

The US housing market today is estimated to be in the range of $20 trillion. That compares to the total market cap of the New York Stock Exchange of $13.9 trillion as of the end of January of this year. So the housing market is a HUGE asset class.

The new futures markets will be based on the S&P/Case-Shiller Home Price Indexes (see below). The housing futures and options will be cash-settled to a weighted composite index of US real estate prices, as well as to specific markets in 10 major U.S. cities:

Boston, Miami, New York, San Diego, San Francisco, Washington, D.C., Chicago, Denver, Las Vegas and Los Angeles. There will also be a composite index made up of all 10 cities. Other cities are expected to be added in the future as the housing markets gain popularity.

 

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The Case-Shiller Indexes

Karl Case and Robert Shiller are two widely-known economists at Yale. Some 20 years ago, they began developing various indexes to measure home values. Their so-called Case-Shiller Indexes are reportedly the most accurate indicators of residential real estate values around the country.

Case and Shiller began their collaborative research endeavors in the 1980s with a view towards developing an accurate method of quantifying residential property price changes. Their initial research was motivated by the following observations:

1. The magnitude of aggregate home equity and its potential influence on savings behavior. According to one estimate, at the end of 1999, aggregate US home equity totaled $6.5 trillion ($11.6 trillion in housing value less $5.1 trillion in mortgage debt).
2. Despite the size and importance of home equity as a driver of economic trends throughout the country, the nation lacked accurate measures of home price appreciation/depreciation.

The Case-Shiller Indexes (CSI) are based on observed changes in the value of actual housing units. Case-Shiller collects transaction information on all properties that sell in a given month or quarter. For each home sale transaction, Case-Shiller searches its database for previous sales of the same property. These "repeat sales" are examined and any non-arm's length transactions are removed. The sale pairs from each geographic area are then statistically combined to calculate each of the various regional indexes. Case-Shiller calculates the CSIs utilizing both published and unpublished index calculation techniques developed throughout the years.

The Case-Shiller Home Price Indexes are widely followed, and this is the reason the CME selected them as the basis for the new housing futures and options markets.

Who Will Be The Players In This New Market?

The Chicago Mercantile Exchange believes the new housing futures will be widely accepted by a broad host of participants. The CME hopes that the major players will include homebuilders, mortgage companies, property and casualty insurers and perhaps even producers of home building materials. And, of course, speculators of all sorts.

While the new CME housing futures and options are targeted mainly at institutions and large homebuilders, they may prove attractive to individual homeowners and rental property owners and investors in general. Home and rental property owners will be able to hedge their property values by "shorting" housing futures to protect from a downward move in prices. Investors who believe that housing prices will continue to increase will be able to go "long" in housing futures and benefit if prices do in fact go up. Of course, they can also lose if prices go down.

A spokesman for the CME told me in late March that the new housing futures and options will begin trading "sometime in the second quarter," but as noted above, the launch is expected later this month. He also indicated that each futures contract would represent apprx. $70,000 in value. If that is the case, someone with a home valued at $350,000 could short five contracts and effectively "hedge" his home from a decline in value. Or he could purchase put options rather than the actual futures contracts (although I am not a big fan of options).

While it is easy to see who the likely sellers of housing futures would be - homebuilders, mortgage companies, etc. - it is not so easy to determine who the buyers will be. Certainly, there will be speculators who will want to bet that home prices continue to rise. But it remains to be seen if there are many institutional players that have a legitimate reason to be long in this market.

It will be very interesting to see how these new markets are accepted, especially with home prices starting to soften in many parts of the country. It will also be interesting to see if the new housing futures and options markets make home prices more stable or more volatile.

As a warning, I would NOT recommend that most investors get in this market, especially early-on. Remember, futures and options trading is very risky, and risks can be even higher in a new market such as this. I do not recommend that individual investors trade futures and options on their own.

Now let's shift gears and take a look at the latest activity in the precious metals markets.

A New Way To Own Silver

As this is written, a new exchange traded fund (ETF) that will track the spot price of silver is awaiting final approval. The SEC has already approved a rule change that will allow the American Stock Exchange to list the iShares Silver Trust, so the final go-ahead for trading the silver ETF could come at any time now.

This new silver ETF was developed by Barclays Global Investors, and will operate similar to the already-popular gold ETF developed by State Street Global Advisors, which I will discuss in more detail later on. The silver ETF will seek to duplicate the spot price of silver by buying large quantities of physical silver, which will be kept in a vault. The purchase of a share of the silver ETF will be backed by 10 ounces of actual silver. That means each share will trade for over $120, based on silver's current spot price.

The advantages of owning silver through an ETF structure are obvious, in that it is no longer necessary to worry about physical storage of coins or silver bars, or having to go through a metals dealer to buy or sell. Since ETFs trade like stocks, an investor can buy or sell them at any time during regular business hours on the AMEX. In addition, since the ETF is an exchange-traded security, it can be "shorted" in your regular brokerage account without having to resort to futures or options. Try that with the silver coins in your safety deposit box.

An additional advantage of the new silver ETF is that it may be less volatile than holding individual mining stocks or mutual funds. Analysts point out that mining any precious metal requires high capital expenditures, so a lot of a mining companies' profits may already be spent on new exploration. As you may know, exploration for new sources of precious metals has been at a snail's pace for the last decade or longer due to the depressed prices for silver, gold and other precious metals. Restarting exploration is expensive, and this comes straight out of mining company profits.

For all these reasons, inflationary concerns and others, the prices of silver and other precious metals have risen sharply in the last year. This increased investor interest in the metals will no doubt add to the popularity of the new silver ETF.

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The Silver ETF Will Be Popular, But. . .

While there will no doubt be a lot of interest in the new silver ETF, there are also disadvantages to this brand of precious metals investment. Barclays has applied to list 13 million shares of the new silver ETF backed by 130 million ounces of silver. It is no secret that the precious metals markets are relatively small as compared to other financial markets, and investment bank Salman Partners has estimated that this 130 million ounces of silver equates to about 16% of the world's annual silver production and 21% of the known above-ground inventories. That's huge!

There is a feeling among some market analysts that investors will rush to purchase shares of the new silver ETF when it begins trading. Therefore, it doesn't take a rocket scientist to figure out that this ETF could influence the small silver market that is already under pressure from increased foreign demand and a declining dollar, and then fall hard later on.

The price of silver has recently skyrocketed to near $13 per ounce, the highest level in more than 20 years, at least partly the result of the anticipated increase in demand for the metal from the silver ETF. A recent Wall Street Journal article documented that the price of silver has jumped roughly 28% since the SEC sought public comment on the proposed silver ETF in January of this year. Needless to say, silver prices have already spiked dramatically, even before the new ETF starts trading.

Another potential disadvantage of the silver ETF is that it could cause a shortage in the metal for its many industrial uses. Aside from being a popular inflation hedge, silver is used in numerous industrial applications including jewelry, photography, electrical components and is even used as an antibacterial agent. By providing an easy way for small investors to jump on the precious metals bandwagon, the iShares Silver Trust could not only increase prices, but might actually lead to shortages for needed industrial applications.

Taking this potential shortage scenario another step, the shorter the supply of silver available for industrial uses, the higher the price of silver is likely to rise. The more it rises, the more investors are likely to want to get in on silver's price inflation through the silver ETF, potentially pushing up the price of silver even more. Any increase in the price of silver will likely lead to higher prices to the end users of some industrial, electronic and medical products. In other words, silver's price inflation could lead to inflation in other areas of the economy.

There are also potential disadvantages at the investor level. Since the silver ETF will represent actual physical silver, tax laws dictate that gains upon the sale of the ETF will be taxed as a "collectible," rather than as a stock or other security. Thus, no matter how long the ETF is held, the maximum tax rate will be 28% rather than the 15% applied to other capital assets. That is, unless the tax laws are changed, which I doubt.

In addition, neither physical silver nor the silver ETF pays dividends of any kind, while mining stocks may do so. This lack of any kind of annual income element is why many countries sold some of their gold reserves in favor of financial assets that would provide some level of income. Even low-yield Treasury securities looked attractive when compared to a lump of metal that not only pays no interest, but also requires additional expenses for storage and safekeeping.

Not everyone is welcoming the new iShares Silver Trust with open arms. Due to the potential price and supply disruptions, the new silver ETF is being criticized by the Silver Users Association, a trade group made up of silver producers and distributors. The Association has contested the proposed silver ETF, saying it could lead to illiquidity in the silver market and even lead to job losses in those industries dependent upon the metal.

I do not think it is likely that the Silver Users Association will be successful in their attempt to keep the iShares Silver Trust off the market. As a result, it is possible that the price of silver could continue to rise sharply in anticipation of the availability of the silver ETF, and even for a while afterward. However, the party might not last for long.

There's an old theory in the financial markets that says when small investors flock to a particular asset, it might be time to get out. That could be exactly what happens in this instance. Speculation in silver has run rampant since the SEC's January announcement, and the price of silver could be artificially high when the silver ETF finally does hit the market. Once investors start flocking into the silver ETF, these speculators might decide to lock in profits, and this selling activity could lead to a sharp retreat in silver prices.

Despite the potentially huge volatility that could be coming with the advent of the ETF, many analysts see the iShares Silver Trust as having the potential for a long-term positive impact on the silver market. As the ETF continues to grow, it will divert more physical silver away from industrial uses. This, coupled with increased global demand and a falling dollar, could help move the price of silver higher over time.

There is no question, in my opinion, that the new silver ETF will be an easier and more cost effective way to own silver, as compared to owning silver coins or bars. As discussed above, there are some compelling reasons to believe that the new ETF will increase demand for, and decrease supply of, silver at least in the near-term.

But then we have to consider how much silver has already risen. Remember that silver prices were at or below $7 per ounce this time a year ago. Today, silver prices are near $13; that's more than a 75% increase in less than a year; and the spike could be exaggerated even more as we move toward the launch of the new ETF. As a result, I would not want to be the first one in line to buy the silver ETF once it is available.

A Golden Predecessor

Part of the reason for the euphoria surrounding the upcoming silver ETF is the success of the StreetTracks Gold Trust (NYSE: GLD) that began trading on November 18, 2004. On its very first day of trading, investors poured over $550 million into this fund, which now boasts assets of over $6.5 billion. According to the World Gold Council, only 16 nations now hold more physical gold reserves than the StreetTracks Gold Trust. Perhaps most importantly, the gold ETF's share price has been successful in its goal to accurately track the spot price of gold.

Each share of the StreetTracks Gold Trust represents one-tenth of an ounce of gold. Thus, the current share price is in the $59 - $60 dollar rage, which makes it an excellent way for small investors to have an exposure to the yellow metal. As noted above, ETFs are traded just like a stock, so they have no storage problems and are always liquid, though not necessarily at the same price at which they were bought.

One initial reaction to the gold ETF was fear that it would make the price of gold, which is already very volatile, even more so. The theory went that forced buying and selling of gold bullion based on the demand for the ETF could make both peaks and valleys in gold prices more pronounced. However, recent analysis of data from the ETF's custodians showed that stores of gold were not sold off during periods of decline in the price of gold, but actually grew at a gradual pace.

Could this mean that the ETF might actually provide stability to the very volatile price of gold? So far, the gold ETF has yet to experience a mass exodus of investors that could lead to it having to sell part of its gold inventory on the open market. Gold prices have risen steadily from below $400 when the ETF started to near $600 today. So ETF investors have had no reason to sell. Thus, I think it's still far too early to tell what the long-term effects on gold price volatility will be, but the prospect of lower price volatility is inviting.

There is another factor in the gold ETF's experience that might be useful to those of you who may be wanting to jump on the silver ETF bandwagon as soon as it is available. According to a study conducted by Anindya Mohinta, a London-based J.P. Morgan analyst, the introduction of the silver ETF could actually lead to a correction in the price of silver.

The study looked at all of the seven ETF-type products that currently track the price of gold available on a number of global exchanges, and noticed an interesting trend. Mohinta discovered that gold prices rose up to 12% in the 90-day periods leading up to the launch of the various gold ETFs, only to fall between 7% and 10% in the corresponding period after the date the securities were listed. As noted above, silver has risen 28% since January when the SEC opened the comment period, so any price correction could be more intense than those seen for gold.

Again, the J.P. Morgan study provides a good reason to not rush out and purchase the silver ETF as soon as it is available. It is probably best to wait for at least 90 days or so, and see what the ETF's share price is doing.

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Conclusions

financial services industry never seems to run out of new and different ways to invest your hard-earned nest egg. In recent years we have seen the birth of index mutual funds, including mutual funds that can short certain indices, mutual funds that use hedging strategies once only found in sophisticated hedge funds, futures and options on all sorts of financial instruments, exchange traded funds based on stock indices, and now ETFs that allow you to have an exposure to precious metals just as if you had physical possession.

The problem comes in trying to determine which, if any, among these new and different securities offer the potential for gain and/or diversification for your portfolio. Some investors like to be among the first to buy into these new products, if for no other reason than to have bragging rights in the break room or on the golf course. I hope none of my readers are among that crowd.

In the investment industry, there is a term known as "suitability." It is the standard by which Advisors are judged, and is the basis upon which we provide investment advice. Unfortunately, individual investors do not always consider whether an investment is suitable for them, especially in the excitement of learning of a new and different investment program.

If I can impart any wisdom to you at the end of this discussion about a way to hedge home prices and new ways to invest in precious metals, it is to make sure any investments you consider are suitable for your situation. I would go out on a limb and predict that very few of my readers would be appropriate investors in a housing futures program of any kind. While some of you may be very familiar with how real estate works, you also need to be aware of the landmines that exist in the futures markets.

If you happen to have a large amount of investment real estate that you want to hedge, then this may be just what you need, but I do not think it is appropriate for someone who just has a hunch that the housing market is headed down and wants to go along for the ride. Housing markets have defied premature predictions of their demise for several years, and could easily continue to do so.

By the same token, I'm sure that many of my readers are interested in the new gold and silver ETFs, and I can't say that I would argue with them. Precious metals can be a good long-term investment, especially now that the issues of storage and safekeeping have been solved. However, it is also important to note that neither physical precious metals nor the new ETFs provide any return other than the potential for capital gains (and losses). There is no income element, so if you need income, these ETFs are not the place to invest.

If the availability of all of these new investment alternatives leads you to more questions than answers, we stand ready to help. If you would like to talk to a qualified professional about what might be best for your own portfolio, please feel free to contact one of the Investor Representatives that work for my company. You can discuss your investment situation with no cost or obligation, and no pressure. Just call 800-348-3601, send us an e-mail at [email protected], or visit our website at www.profutures.com.

Very best regards,

Gary D. Halbert

Gary Halbert is the president and CEO of the ProFutures companies, a diversified investment advisory firm located in Austin, Texas. ProFutures offers professional financial planning services to a nationwide base of clients. Mr. Halbert's firm specializes in tactical investing, and its recommended investment programs include mutual funds, managed accounts with professional Investment Advisors and alternative investments. For more information about the programs offered, call 800-348-3601 or visit the website at www.profutures.com.

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Disclaimer

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"Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend any product or service advertised herein, unless otherwise specifically noted."

Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.




Posted 04-11-2006 5:38 PM by Gary D. Halbert
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