Gnostic Capital Portfolio Return for the Fiscal Quarter Ended 09/29/23.

The fiscal quarter was all red ink for the major indices.

The S&P 500 declined by 3.6%, the DJIA fell by 2.6% and the NASDAQ Composite Index declined by 4.1% for the third quarter of 2023.

The Gnostic Portfolio was not immune to the broadly based decline.

The global portfolio declined from last quarter’s closing price of $768.29 to a share value of $751.91, a percentage decline of 2.1%.

Despite the relative outperformance in Q3, the Gnostic account return still trails two of the three major indexes on a year-to-date basis.

In the first 9 months of 2023, the Gnostic portfolio has advanced by 11%. This compares favorably to the return of the DJIA, which is up 1.1% on the year, but still lags the S&P 500 return of 11.7% and continues to seriously underperform NASDAQ Composite Index YTD return of 26.3%.

A large divide exists in the equity market outlook, based upon various data sets that assess the likelihood of interest rate declines.

Investors banking upon a potential peaking in interest rates point to August reports indicating that the median household disposable income, adjusted for inflation, has fallen to pre-pandemic levels. That shouldn’t come as any surprise, because the nature of wage and price inflation is that prices for goods and services advance first, with wages ultimately catching-up over time. There is a lag effect on wage inflation and that lag tends to be overlooked. Armed with August data, those who look at an income survey in isolation are making an argument, quite vehemently, that the lowest 80% of US income earners are so strapped that interest rates must have largely peaked and are destined to decline soon, possibly starting within the next six months and certainly within the next nine months.

This bullish outlook for an interest rate top and nearer term fall comes into direct conflict with US Federal Reserve Board’s telegraphing of intent. The most hawkish on the board are of the view, given the preponderance of evidence, that interest rates have not only further to climb, but will then remain elevated for years to come. Were one to accept the commentary of the US federal Reserve at face value, this suggests a structural shift in the capital plans for corporations, institutional portfolios and individual investors alike. Every aspect of the business economy will need to adapt, to adjust and if unwilling to change, to suffer as a consequence. There is an aspect of moral suasion to the tone put forth by the board, because fear is a tool that has real results in equity and capital markets, but the central bank finds itself unable to do the work needed to combat inflation, while at the same time minimizing the potential for a harder landing, so long as fiscal and monetary policy remain at odds.

What is missing by the assessments of both camps is greed-driven imprudence.

I recently returned from a series of fact-finding tours inspecting residential and development properties in several of the priciest real estate markets in North America. I toured more than 30 individual homes as well as multiple tracts of development acreages, both publicly and privately offered, for sale. What I determined doesn’t get noted by the real estate investment media, who promotes a view that the market is well balanced, despite high interest rates. Now, if it were true that the majority of residential real estate holders possessed just a single property, it could certainly be argued, with credibility, that the real estate markets are, more or less, fine, that the built-in equity, due to appreciation in real estate, will back-stop households until rates break on the downside. What I observed, in my sample, was less than balanced.

Roughly 50% of the properties I toured were not owned by individuals seeking to move, but were in fact owned by the real estate agents themselves or by their proxy relations. It seems that many realtors had succumbed to temptation during the pandemic and persuaded family and/or friends to purchase real estate to flip. The tide has gone out and now many are overextended.

Another 20% of the properties that I toured were being marketed for sale by persons who were either building a new home, were renovating another home or had just purchased another home. They are betting that real estate prices will not fall and that liquidity remains adequate in the residential markets for them to carry two properties for a time, their actual intention is to hold just one. These persons are trying to leg a real estate trade, but with such a trade, there is a leg risk. During the period of interest rates being close to zero, buying a house while waiting for one’s house sale to be completed worked out well, but those trying to do so in the highest interest rate market since 2006 carry meaningful execution risk; there seems to be no thought to the notion of how they will carry two mortgages for a duration longer than the time required to vacate one house and move to another. The purpose of the leg trade was to build or buy a better/newer house for the same money as was hoped to be received for the sale of the lesser house; now the leg trade has broken down and some are now on the hook to try to either sell the newly purchased/built house or accept less money for the existing home.

25% of the homes I toured were renovation DIY or small contractor flips. These were properties purchased prior to, or early in, the pandemic. Such homes have superficial modifications, such as paint, flooring and countertop changes designed to add visual appeal to a dated home, in an effort to boost the selling price beyond the cost of the renovations. During an extremely hot market, flips made money because the more expensive structural modifications not done, such as ripping out all of a home’s KITEC/IPEX water piping, the removal of the gypsum wallboard covering that KITEC, prohibitively expensive, those needed “behind the wall” changes, not done, were previously overlooked by desperate buyers. With fewer qualified buyers in the market, flippers must now face more thorough property inspections prior to closing, and such scrutiny brings up issues, structural issues, that could either prevent a close or materially change the asking price. All of the flipper homes I toured look likely to be hung out to dry in this market.

Only 5% of the homes I toured were being offered by legitimate sellers looking to relocate or completely vacate, without an overarching, speculative, profit motive.

I am aware that such an overweighting of residential real estate listings by professional realtors is not remotely representative to the North American market as a whole. That’s not the point. Rather, my sample indicates a clear skewing in listings towards several groups who have the ability to better utilize financial leverage than do the general public at large, that have the ability to scoop up supply during certain periods, ultimately to release that supply when they choose or when forced by external factors. These groups are not long term home owners, they are housing market speculators. One of these groups in questions serves as an informal price-setter, guiding others towards a starting point for listing a home, or potentially purchasing a home, through the act of producing “comps”.

If my anecdotal sample has any bearing on the overall state of the housing market, it would appear that there actually isn’t a shortage of homes at all; rather, we have a combination of house “hoarding” coupled with rampant speculation that could be on the verge of an unwind. This harkens back to the issues that faced housing markets back in 2006-2007, too many people owning multiple houses and that, when interest rate hikes took hold, proved unable to handle the leverage.

Those who will parry to the notion that this could be a localized problem should be aware that I didn’t tour just one market, I inspected properties in a total of 11 cities in North America. Should the number of homes on the market be disproportionately held by realtors and their proxies, list pricing could be highly suspect, because a statistically relevant percentage of realtors may be conflicted to the point that they are encouraging legitimate sellers to overprice their homes; the goal would be to make professional realtor owned properties appear to be in-line with the market, when in fact the prolific number of proxy properties are distorting the market. This is, in equity terms, analogous to putting out favorable research reports in the goal of trying to prop up a stock. An alternative analogy would be that of an investment firm participating in an equity underwriting “bought deal”, producing a favorable research report on the deal in order to maintain the price and exit their position.

Greed driven stupidity, likely, isn’t being factored into mainstream investment media outlooks.

The interest rate bulls, those who are banking upon a rapid decline in interest rates and a soft landing, a “goldilocks” scenario, are viewing the overall financial leverage in markets and considering it to be manageable should debt costs decline quickly, but might well be missing the distribution of such leverage. Unlike the 2007 housing implosion, that started first with low income earners, the leverage could well be in the middle and upper income households at this time. Lower income households scraped together enough money to buy one house, but few have the ability to obtain bridge financing for leg-trades. That is the domain of the upper middle income earners and beyond.

Interest rate hawks, those who are forecasting interest rates that are “higher for longer” don’t tend to talk about how high rates impact demand in most of the economy, because the media doesn’t ask and the public really doesn’t want to know. 8% 30 year mortgages in US markets lead to unsustainable housing markets, regardless of pay raises.

If one is at all concerned about financial leverage and how it may impact equity markets, in a 22 year high for interest rates, the answer is simple, as it has always been.

Do not own leveraged companies and do not be personally leveraged.

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