WARNING! BROKERS CAN BE BAD FOR YOUR HEALTH!

Last Friday night I told a group of business owners, accountants and lawyers that brokerage firms are pushing mortgage back REIT's. I suggested that this is a negative indicator for interest rates as major institutions are "distributing" their shares. Rates do not have to go up much to cause mortgage backed REIT's to have substantially lower income and lower market values.

Sure enough it happened again yesterday. A reader asked me about Impac Mortgage Holdings, an REIT recommended by a full service broker. In past articles, I have made the point that the incentive to refinance has died. The holders of mortgages are about to see these "flexible bonds" extend their durations. The holders will be locked into relatively low yields for many years to come unless they want to sellout at capital losses. Since so many brokers are pushing these and since the risk is more than an interest rate risk, let me give you a Big Warning!

Mortgage backed REIT's carry significant risks; they are not bonds backed by the government. If a homeowner defaults, the mortgage company can foreclose but the process of foreclosing and re-marketing a home is an expensive process and can cause very high operating loses.

Impac deals in non-conforming loans. The company charges high fees and high interest rates but loans to folks that a national bank would not consider. In some cases they loan more than 100% of the value of the home! They will even loan more than 100% of the value on second mortgages! In other words they deal in very risky loans.

Brokers can brag about the high yields all they want but is there any guarantee you will continue to receive the high yield? NO!

The same broker recommended a Canadian Royalty Trust to the same client. He did not happen to mention concepts such as return of capital or even the fact that a Canadian Tax Return is required to get all the "dividends". He spoke to the client in terms of dividends and the client came away believing that the high dividend was the payment of a portion of the profits.

When many brokers are pushing the same or similar products, it is time to go the other way. Only the gambler who simply enjoys the excitement should play the "bigger fool game". Yes, the firms may push the stock or sector a long way but make sure you are not the one left holding the bag.

Stocks are so cheap relative to bonds (bond yields are so low) that the brokers have started selling "hybrid" bonds. The brokers should know better but don't put all the blame on them. He or she is simply trying to make a living and if the public will not buy stocks then maybe the broker can feed his family by selling "hybrid bonds". The fact remains that bonds are not cheap and ninety-nine times out of a hundred when investors start reaching-out for extra yield, they take far more risk than they know.

Investors should always remember that they are always playing a game of perception versus reality. If the majority of the investing public is afraid of an investment or in love with an investment, it automatically gradually becomes under or over priced.

Since September 11, 2001, the majority of folks have invested to avoid market risks. For the first time in 50 years the public actually reached the oft recommended level of having 6 months of income in cash. In the face of a strong economy and extraordinary profit growth, the public has stayed away in droves. Just in the last month of 2004 was it finally reported that the public is actively trading again. Of course the January swoon will cause many of them to leave again before the next big move begins.

The real problem is that risk is a swinging pendulum. There are times when bonds should be over-weighted and times when stocks should be. One simple way to dampen the swing is to split your investments, buy both sides and re-balance when one side gets too big. As I have stated for the past three years, I believe one should over-weight the stock side heavily in this market. It is fundamentally true that one must suffer below average returns if one takes below average risks. In the markets, you cannot avoid risk if you want to make money. You can preserve your capital by buying inflation protected securities (TIPS).

I have not looked at TIPS lately and I prefer not to look. I never want to take the "chicken way out". Without looking I know the current rate is between the rate of the ten year treasury and the one year note (TIPS are a hybrid of bonds and notes). The ten year is trading around 4.2% and the one year is around 2%. Stocks return an average of about 11%. The TIPS "hybrid" will consistently earn about the inflation rate (the ten year bond rate is the real rate of growth in the economy and the market forcasted inflation rate). The "hybrid" securities being pushed by the brokerage firms will over long periods of time yield more than the ten year treasury because of the risk premium. Ibbotson and Associates would probably be happy to sell you a report that shows the past performance but my guess is a long-term return of about 6%.

However, since the public is ready and willing to buy these "safe" (yuk-yuk) securities, the price is currently far too high. In my opinion, the return for the next couple of years will be much less than 6% and indeed could be negative. I believe this to be true even in regard to the royalty trust even in the face of oil priced at $48 per barrel today.

Bobby Wolff, one of the famous members of the world champion Aces bridge team, likes to say that a bird in the hand is worth two in the bush, but you must speculate to accumulate. A staff member today said she is simply not willing to speculate; I had to laugh. I asked if she had driven to work. I asked if she had rather fly to Atlanta or drive. Flying is one of those poorly perceived risks. Many folks who are afraid to fly because of the potential of a crash will drive miles and miles at a risk that is 250 times as great.

I plan to post my ten rules for successful investing one day. For now, let me share my three most important rules.

1. One should speculate with no more than 7% of your funds in any one security and no more than 10 to 12% in any one sector. No matter how good or how careful you are, you will make mistakes and it is important not to make huge mistakes. It is also a mistake to buy too many securities. You cannot reap maximum benefits by owning too many and you do not have the time to follow too many. Fifteen securities is about the right number for most folks. The selectivity risk becomes very small if you own 15 stocks.

2. One should keep ones costs or overhead extremely low. This means avoiding full service brokerage fees, management fees and high priced fund fees (management fees, 12b-1 fees and load fees). There are millions of people in the USA who are paying high fees for a "dressed up index fund". If you do not want to own individual stocks, a good alternative would be to own three to ten exchange traded funds. The hidden fees you will pay in these will be less than half and possible less than 10% of the fees others are paying.

3. Finally one should avoid buying what is already excessively popular. There are a number of facets to this last point. It is true that one should hop on board when a major move is underway and it is impossible to always be one of the first on board. In truth, one should not try to be the first on board. Let a stock or sector show relative strength before buying.

There are so many examples that it is hard to know which make the best points. Google is an internet stock and internet stocks EBAY and YAHO were up 300% or more in the years prior to the Google offering but the stock was not "hot". A lot of people offered their opinions as to why or why not one should buy and at what price. I talked to dozens of people and suggested they buy on the offering. Very few were interested and indeed the offering price and size of the offering kept dropping. I bought as much as I could at the time and have bought three more times since the offering. GOOG has gone up 229% and is still not a "hot" stock. If I did not already own so much I would buy more at today's price.

Yesterday, I wrote about energy. Energy has had a great run. However, the fundamentals are in place for several more years of high profits and yet the speculators are betting the other way! What are the TV pundits talking about? Apple and SIRI! CNBC reports that in November SIRI had more clicks for quotes than any other stock. There are billions of new dollars in energy stock earnings while 80% of the news coverage is about consumer electronics. How many months will it be before the i-pod must drop its price due to competition or come out with a whole new product to maintain leadership? A couple of months back, several readers asked about TASR and I said it was simply too hot to handle. In 8 days it dropped from 32 to 14!

I have been guilty of writing too much about SIRI. Partly because I am like the broker that is selling Mortgage REIT's. My readers have responded to me and asked me again and again about SIRI. I can't remember a single recent inquiry about an energy stock. And although I have written numerous times about GOOG, I am aware of only a few purchases other than the ones I made in several accounts.

GOOG and SIRI provide a stark contrast. It seems that every few days, Google announces another new service (today they offered a new network search tool). Some of these announcements have been incredible (such as the digitization of entire libraries). Never-the-less, SIRI gets the most coverage while almost every day a competitor announces a new business relationship or a new service (Verizon, Comcast, Sprint and many other companies have announced competing services). To be fair, Googles competitors also announce new services but they tend to be "me too services". Yahoo just announced a desk top search service similar to the one Google started months ago. In the case of SIRI, the services suggest that if you have a high data speed cell phone or wireless computer, you do not need to pay SIRI $12.95 per month. (One of the lawyers last Friday night reported that he is in love with his XMSR radio. He is a baseball fan and can hardly believe he will not miss a single game. The satellite stocks have long term merit but there seem to be more persons who want to own the stock than there are persons willing to buy the product. The Apple i-pod is the device that just set a new record for quick consumer addoption).

Now look at the fundamentals: Last quarter SIRI lost 169 million dollars on revenues of 19 million dollars! Last quarter GOOG made 52 million dollars on revenues of 805 million dollars. According to Larry Baker at Smith Barney, two thirds of the search revenue is now generated in the US and the revenues are growing at 20%. Google has about a 38% share! More incredible is that only one third of the search revenue is generated in all the other countries of the world, Google has better than a 50% share and revenues are growing by 30% per year!

My point comes down to the fact that the public is enamored with a company (SIRI) that is losing millions. The company may need to dilute the stock further; there are already more than a billion shares issued and indeed the company could fail completely. In contrast, the major new company of the decade (GOOG) has solid profits, hoards of cash and superior long-term growth potential and yet it trades in relative obscurity.

Did your broker recommend GOOG on the offering? Are you chasing profits by trading in and out of the high flyers? Is he pushing "hybrid bond" products at a time in history when long rates are extremely low? Is he simply following the crowd? Does his firm offer to pay him higher commissions on the products their institutional clients are trying to sell? Are you paying more than $7 to trade?

Don't get me wrong. There are some star brokers out there who earn the big bucks they receive (the average broker earns about $120,000 per year and star producers earn in the millions). Unfortunately the ratio of star brokers to mediocre brokers is probably one to seven and unless you have big bucks the star broker does not have time to talk to you. If just a third of the brokers were independent thinkers, the bubble and collapse of the late 90's would never have happened. Be careful, be wise, be smart because BROKERS CAN BE BAD FOR YOUR HEALTH!